United States: Final Definition Of "Swap" And Final End-User Exception

Originally published in V&E Finance Update E-communication, July 16, 2012

On July 10, 2012, the Commodity Futures Trading Commission ("CFTC") approved the final definition for the term "swap" and the final rule that exempts end users from the clearing requirement for swaps in the Dodd–Frank Wall Street Reform and Consumer Protection Act (Pub. L. No. 111-203, 124 Stat. 1376 (2010)) (the "Dodd-Frank Act"). These are significant developments, since any derivative product that constitutes a "swap" will be subject to regulation unless an exemption applies, and entities that fall within the "end user" definition will not be subject to the clearing requirement.

What Constitutes a "Swap"?

The definition of "swap" includes a broad range of derivatives including, but not limited to: interest rate swaps; commodity swaps; currency swaps; equity swaps; credit default swaps; foreign exchange (FX) swaps and forwards; foreign currency options; commodity options; cross-currency swaps; forward rate agreements; options to enter into swaps (swaptions) and forward swaps.         

The definition provides that FX swaps and FX forwards will be treated as "swaps" unless the Secretary of the Treasury makes a determination that FX swaps and FX forwards (i) should not be regulated as swaps under the Dodd-Frank Act and (ii) are not structured to evade the Dodd-Frank Act.

Other FX derivatives, like FX options, currency swaps, and non-deliverable forwards are not subject to such  a determination by the Treasury Department and will be treated as "swaps" (i.e., among other things, these other FX derivatives will be subject to the clearing and exchange requirements).

What Does Not Constitute a "Swap"?

In addition to certain insurance, consumer, and commercial contracts, the final definition explicitly excludes forward contracts in non-financial commodities from the term "swap." This exclusion of nonfinancial commodity forwards is of particular importance to entities in the energy industry as it has the potential to exempt many commodity transactions from regulation. The definition excludes "any sale of a non-financial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled." 

Book-out transactions in nonfinancial commodities will qualify for the forward exclusion from the "swap" definition, provided that such transactions satisfy the principles underlying the Brent Interpretation. The Brent Interpretation principles provide that "market participants that regularly make or take delivery of the referenced commodity in the ordinary course of their business, where the book-out transaction is effectuated through a subsequent, separately negotiated agreement, should qualify for the forward exclusion to the swap definition."

End-User Exception

The Dodd-Frank Act requires every swap to be cleared through a clearing house, unless such swap is exempt. However, this clearing requirement will not apply to a swap if one of the parties to the swap:

1. is not a financial entity;
2. is using swaps to hedge or mitigate commercial risk; and
3. notifies the CFTC, in a manner set forth by the CFTC, how it generally meets its financial obligations with respect to non-cleared swaps.

Financial Entity

A "financial entity" is a swap dealer,¹ a major swap participant,² a commodity pool,³ a private fund,⁴ an employee benefit plan, or a person predominantly engaged in the business of banking or in activities that are financial in nature.

Hedging or Mitigating Commercial Risk

The CFTC's end-user exception fact sheet states that the criteria for determining whether a swap is hedging or mitigating commercial risk is similar to the criteria used in the definition of "major swap participant."  According to the final "major swap participant" definition, a swap hedges or mitigates commercial risk if it:

• qualifies as bona fide hedging under the Commodity Exchange Act rules;
• qualifies for hedging treatment under Financial Accounting Standards Board Statement No. 133 or Governmental Accounting Standards Board Statement 53, Accounting and Financial Reporting for Derivative Instruments; or
• is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from:
  • a potential change in the value of (i) assets that a person owns, produces, manufactures, processes, or merchandises, (ii) liabilities that a person incurs, or (iii) services that a person provides or purchases;
  • a potential change in value related to any of the foregoing arising from foreign exchange rate movements; or
  • a fluctuation in interest, currency, or foreign exchange rate exposures arising from a person's assets or liabilities.

Notification

The final prong of the end-user exception rule requires that a counterparty to a swap report  the following information to a swap data repository (SDR) or to the CFTC (if no SDR is available), for each swap for which the end-user exception is elected: (i) notice of  election of the end-user exception and (ii) the identity of the counterparty electing the exception. The following information is also required to be reported either in an annual filing by the electing counterparty or on a swap-by-swap basis by the reporting counterparty:

(1) whether the electing counterparty is a financial entity electing the exception on behalf of an affiliate or as a small financial institution;

(2) whether the swap for which the exception is being elected is used to hedge or mitigate commercial risk;

(3) information regarding how the electing counterparty generally meets its financial obligations with respect to non-cleared swaps; and

(4) if the electing counterparty is an "SEC Filer," whether its board of directors has approved generally the decision to enter into swaps that are exempt from the clearing requirement.

Effective Date

The swap definition and the end-user exception rule will become effective 60 days after publication in the Federal Register. The publication of the swap definition in the Federal Register will also trigger the implementation for other Dodd-Frank rules, including the following:

The text of the final swap definition and the final end-user exception rule has yet to be released, but the CFTC has made Fact Sheets and Q&A sheets with respect to the definition and rule available on their website.

Footnotes

1 A "swap dealer" is a person who (1) holds oneself out as a dealer in swaps, (2) makes a market in swaps, (3) regularly enters into swaps with counterparties as an ordinary course of business for one's own account, or (4) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. 

2 A "major swap participant" means a person who is not a swap dealer, and (1) maintains a substantial position in swaps for any of the major swap categories as determined by the CFTC or SEC, as applicable, excluding: (a) positions held for hedging or mitigating commercial risk; and (b) positions maintained by any employee benefit plan under ERISA for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan, (2) whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets, or (3) is a financial entity that is (a) highly leveraged, (b) maintains a substantial position in swaps, and (c) is not subject to capital requirements established by a federal banking agency.

3 A "commodity pool" is an organization that raises capital through the sale of interests in it, such as shares or limited partnerships, and uses that capital to invest either entirely or partially in commodity contracts or swaps.

4 A "private fund" is a fund that is exempt from the definition of investment company under Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. Generally, this would include hedge funds, private equity funds and venture capital funds.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.