Introduction. May 8, Key Takeaways: Contents

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1 May 8, 2012 CFTC and SEC Finalize a Key Piece of the Dodd-Frank Act Registration Requirements Puzzle with the Final Entity Definitions Rules, but Many Pieces of the Puzzle Remain Missing Key Takeaways: > Swap Dealer and Security-based Swap Dealer determinations parallel statutory text, but in both cases the scope of the de minimis exemption has been dramatically expanded, and other useful exclusions, limitations and interpretative guidance have been provided. > Major Swap Participant and Major Security-based Swap Participant determinations also mirror the analysis set forth in Title VII, and the final rules set out the thresholds that must be met in order to fall within that statutory definition. > Eligible Contract Participant definition has been amended and clarified, particularly with respect to the look through and retail FX provisions. Introduction On April 18, 2012, in one of the most anticipated final rulemakings under the Dodd-Frank Act ( Dodd-Frank Act ) 1 to date, the Commodity Futures Trading Commission ( CFTC ) and the Securities Exchange Commission ( SEC ) approved for publication in the Federal Register a joint final rule (the Final Rule ) with respect to the Further definition of swap dealer, security-based swap dealer, major swap participant, major security-based swap participant and eligible contract participant. 2 The CFTC and SEC also adopted a joint interim final rule (the Interim Final Rule ) excluding certain hedging swaps from swap dealing activity such that they would not be included in determining whether a person is a swap dealer. Since the Dodd-Frank Act was enacted nearly two years ago, one of our most commonly received questions has been: will we have to register as a swap dealer ( SD ), security-based swap dealer ( SBSD ), major Contents Introduction... 1 Who is required to register as a swap dealer?... 3 Who is required to register as a security-based swap dealer? Who is required to register as a major swap participant? Who is required to register a major security-based swap participant? Modifications of and interpretative guidance in respect of the Eligible Contract Participant definition Extraterritoriality Effective Dates H.R th Congress (2010). The Final Rule has not yet been published in the Federal Register and all page references herein are to the pre-publication PDF version available at DC4CD4EA3E5/FinalDownload/DownloadId E5FC71CCAD0B9B0A2D732FD254A/3E72032F-B8FA-46FD DC4CD4EA3E5/ucm/groups/public/@newsroom/documents/file/federalregister041812b.pdf (the Final Rule Release ). Entity Definitions Rule May 8,

2 swap participant ( MSP ) or major security-based swap participant ( MSBSP ) and, if so, will we have to register in respect of our entire business or only the relevant portions of our business? These questions are vitally important because the answers can trigger what many consider to be onerous burdens under the Dodd-Frank Act. 3 When the original CFTC and SEC proposed rulemaking on this subject matter was published (the Proposed Rule ), 4 the reactions of market participants varied from stupefaction to outrage and everything in between, as the Proposed Rule was incredibly broad. 5 Much commenting, lobbying and related efforts commenced and the Final Rule and the Interim Final Rule reflect a significant narrowing of the market participants that will be caught within the ambit of the registration requirements, particularly in the case of SDs and MSBSPs. 6 The Final Rule also provides greater guidance on a number of topics than did the Proposed Rule, including the meaning of various elements of the statutory language. For example, interpretive guidance has been provided in respect of the various elements of the SD and SBSD determinations, as well as the overall characterization of those determinations as being in the nature of a facts and circumstances test rather than a rigorous application of disjunctive statutory elements in a vacuum. Notwithstanding the joint nature of the rulemaking in respect of the Final Rule, there are some differences in approach between the SEC and the CFTC. For example, the de minimis exemption is set at different levels for the SD and SBSD determinations. The Final Rule also makes changes to and provides guidance in respect of the definition of eligible contract participant ( ECP ), which is important because under the Dodd-Frank Act, only an ECP may enter a swap that is not executed on a designated contract market or a security-based swap ( SBS ) that is not executed on a national securities exchange and registered with the SEC and also because the Dodd-Frank Act effected a number of changes to the definition of ECP under the Commodity Exchange Act ( CEA ). The definition of ECP has been expanded to include MSPs, SDs, MSBSPs and SBSDs, but tailored to For example, in addition to registration requirements, compliance with margin, capital and internal and external business conduct rules. Final Rule Release at 11; see also Melnick, Forbes-Cockell & Renas, CFTC Adopts Final External Business Conduct Rules Transforming Swap Disclosure and Fundamentally Altering the Interaction Between Most Swap Counterparties, Futures & Derivatives L. Rep., Vol. 32 No. 3, March 1, See CFTC and SEC, Notice of Proposed Joint Rulemaking: Further Definition of Swap Dealer, Security-Based Swap Dealer, Major Swap Participant, Major Security-Based Swap Participant and Eligible Contract Participant, 75 FR (Dec. 21, 2010) available at See, e.g., Letter of Russell Goldsmith, Midsize Bank Coalition of America, dated February 22, 2011, stating in reference to the de minimis exception in the Proposed Rule that [w]e believe that these criteria are too narrow; most, if not all, small dealers will fail to meet these criteria effectively eliminating the usefulness of the de minimis exemption and disregarding the legislative intent for including such an exemption. See Open Meeting of the 26th Series of Rulemakings Under Dodd-Frank Act (April 18, 2012), p.61, comments of Commissioner Bart Chilton regarding the de minimis threshold. The transcript of the Open Meeting is available at trans.pdf. Entity Definitions Rule May 8,

3 exclude certain types of commodity pools and to provide further clarity on the look through and related retail FX provisions. To make this note as useful a tool as possible we begin by walking through in a simple narrative way the process for determining whether a person is required to register as an SD, SBSD, MSP or MSBSP, including a consideration of the relevant interpretative guidance and the various exemptions and exclusions that apply. We have also included graphical and tabular representations for ease of understanding where appropriate. We explore in a bit more detail what each element of the definitions means, as well as the parameters of the limitations, exclusions and exemptions based upon the guidance the regulators have provided, including, where applicable, how they differ. 7 We then discuss the Final Rule as it relates to ECPs. Finally, we conclude with a brief discussion on timing and effectiveness. Who is required to register as a swap dealer? Flow Chart of Swap Dealer Determination Do you hold yourself out as a dealer in swaps? Do you make a market in swaps? Do you regularly enter into swaps with counterparties as an ordinary course of business for your own account? Do you engage in any activity that causes you to be commonly known in the trade as a dealer or market maker in swaps? Did you exclude the excluded items? If not, reassess. If so, and you still answered yes to any of them, see if you satsify the de minimis exemption. Excluded items: (i) swaps activities not part of a regular business; (ii) swaps entered into by an insured depository institution with a customer in connection with originating a loan to that customer; (iii) swaps between majority-owned affiliates; (iv) swaps entered into by a cooperative with its members; (v) swaps entered into for hedging physical positions; and (vi) certain swaps entered into by registered floor traders. If you answered "yes" to any of the questions in the first four boxes above, are your swap dealing activities (i.e. such activities) de minimis? If "yes," i.e. total included swaps notional < $8B during initial phase or < $3B during subsequent phase and always less than $25mm with special entities, DO NOT REGISTER as an SD. n.b. in each case measure across affiliated entities, but exclude interaffiliate swaps. If "no," YOU MUST REGISTER as an SD. Overview The Final Rule Release provides a walkthrough of the analytical process that should be undertaken in the course of determining whether a person falls within the SD definition. Excluding swaps not required to be included in the SD determination, a person must determine, on a facts and circumstances basis applying the interpretive guidance in the Final Rule Release, whether its activities 7 For example, the definition of hedging under the SD test versus the definition of hedging under the MSP test. Compare Final Rule Release at 600 with Final Rule Release at 587. Entity Definitions Rule May 8,

4 fit into any of the four enumerated categories of SD activities. 8 If any of its activities are within those categories of SD activities, it must then determine whether the de minimis exemption applies so as to take that person outside the definition of swap dealer (i.e., if after the activities analysis a person appears to fall within the SD definition, the question becomes whether the relevant activity is within the de minimis exception). 9 Above is a high level flow chart of the swap dealer determination. We discuss the details in greater depth below. Statutory Definition of Swap Dealer Section 721 of the Dodd-Frank Act defines a swap dealer as any person: > holding itself out as a dealer in swaps; > making a market in swaps; > entering into swaps with counterparties in the ordinary course of business for its own account; or > engaging in any activity causing the person to become commonly known in the trade as a dealer or market maker in swaps. Subject to various exclusions and limitations, a person engaged in any one of these categories of activities may be required to register as an SD even if it is not engaged in any of the other categories of activities. 10 The Dodd-Frank Act includes three further qualifications: > an insured depository institution ( IDI ) shall not be considered to be a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer; > a person that enters into swaps for such person s own account, either individually or in a fiduciary capacity, but not as a part of a regular business, will not be a swap dealer; and > the CFTC shall exempt from designation as a swap dealer an entity that engages in a de minimis quantity of swap dealing in connection with transactions with or on behalf of its customers. The statute also provides that a person may be designated by the CFTC as a swap dealer for a single type or single class or category of swap or activities and considered not to be a swap dealer for other types, classes, or categories of swaps or activities. What seems like a relatively simple statutory provision leaves much subject to debate and disagreement, including with respect to the nature of its application and the meaning of its elements and scope. Indeed, Section 712(d)(1) of the Dodd-Frank Act provides that the CFTC and the SEC in consultation with the Federal Reserve Board shall jointly further define, among 8 9 Final Rule Release at 49. Final Rule Release at Final Rule Release at 12 and at 49; see also Final Rule Release at 58, n190. Entity Definitions Rule May 8,

5 others, the terms SD, SBSD, MSP, MSBSP and ECP, which is the genesis of the Final Rule. 11 Further Definition of Swap Dealer and Interpretive Guidance Pursuant to the Final Rule Release, Section 1.3 of the CFTC s rules under the CEA has been modified to include a new subsection (ggg), which, largely tracking the text of the Dodd-Frank Act, defines in clause (1) an SD as any person who: > Holds itself out as a dealer in swaps; > Makes a market in swaps; > Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or > Engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps. 12 Consistent with the text of the Dodd-Frank Act, the Final Rule Release provides interpretive guidance with respect to the meaning of the four main elements of the SD definition; addresses the exceptions and exemptions called for by the statutory text; and also addresses various other exemptions and exclusions promulgated by rule although not required by the text of the Dodd-Frank Act. We will discuss these in more detail below, but in particular, they include: > the IDI exemption; > the own account/not part of a regular business exemption; > the interaffiliate exemption; > the floor trader exemption; > the cooperative exemption; > the hedging exemption; and > the de minimis exemption. The exemptions listed in the first, second and last arrows were not required by the text of the Dodd-Frank Act. The hedging exemption was adopted as an interim final rule rather than as part of the Final Rule and thus remains subject to public comment. The Final Rule Release also provides guidance around the limited SD designation contemplated in the statute and allows for a registrant to apply for such limited designation at the time it seeks to register or subsequent to 11 Dodd-Frank Act Section 712(d)(1); See also Further Definition of Swap Dealer, Security-Based Swap Dealer, Major Swap Participant, Major Security-Based Swap Participant, and Eligible Contract Participant, available at Various other provisions of the Dodd-Frank Act also require further definitional rulemaking. 12 Final Rule Release at 565. Entity Definitions Rule May 8,

6 registration, but the default position is that if you have to register, you must register the entire enterprise absent such application being granted. As discussed below, in many cases there may be significant hurdles to such limited designation registration being permitted. Interpretative Guidance The Dealer-Trader Distinction In the Final Rule Release, the Commissions take the view that the dealer-trader distinction that exists in the federal securities laws and related interpretive guidance in general provides an appropriate framework for interpreting the statutory term swap dealer... [and] forms the basis for a framework that appropriately distinguishes between persons who should be regulated as swap dealers and those who should not. 13 The Commissions further noted that the dealer-trader distinction would need to be adapted to swaps activities in light of the special characteristics of swaps and the differences between the dealer definition and the swap dealer definition. 14 The Commissions identify several activities indicative of dealing activity in connection with the dealer-trader distinction that would also be indicative that a person is acting as a swap dealer: 15 Activities indicative of swap dealing activity > providing liquidity by accommodating demand for or facilitating interest in swaps; holding oneself out as willing to enter swaps (independent of whether another party has already expressed interest), or being known in the industry as being available to accommodate demand for swaps; > advising a counterparty how to use swaps to meet hedging goals, or structuring swaps on behalf of a counterparty; > having a regular clientele and actively advertising or soliciting clients in connection with swaps; > acting in a market maker capacity on an organized exchange or trading system for swaps (although it is noted that the presence of an organized exchange is not a prerequisite to market making nor is market making a 13 Final Rule Release at 51. Note, as the Q&A on the Final Rule Release points out, although the CFTC is not formally adopting the SEC s dealer-trader precedents, those precedents may be applied to determine if a person is an SD Final Rule Release at For example, some of the important differences between the swaps and securities markets identified in the Final Rule Release include level of activity; no separate issuer; predominance of OTC and non-standardized instruments; mutuality of obligations and significance to customer relationship. Id. The Commissions go on to say, As a whole, the relevant statutory provisions suggest that we should interpret the swap dealer definition to identify those persons for which regulation is warranted either: (i) due to the nature of their interactions with counterparties; or (ii) to promote market stability and transparency, in light of the role those persons occupy within the swap and security-based swap markets. Id. at Final Rule Release at Although these activities are indicative of acting as a swap dealer, engaging in one or more of them is not a prerequisite to a person being a swap dealer. Id. at 54, n.182. Entity Definitions Rule May 8,

7 Activities indicative of swap dealing activity prerequisite to being an SD); and > helping to set prices offered in the market, e.g. by acting as a market maker, rather than taking those prices (although regularly taking market prices does not preclude being an SD). The Commissions note several other activities consistent with the dealer-trader distinction that are not prerequisites to being an SD: Additional Dealer-Trader Distinction Interpretative Guidance > willingness to enter swaps on either side of the market is not a prerequisite to SD status; 16 > SD analysis does not turn on whether a person s swap dealing activity constitutes the person s sole or predominant business; > a customer relationship is not a prerequisite to SD status; > in general, entering into a swap for hedging purposes, absent other activity, is unlikely to be indicative of dealing; and > whether a person is acting as a dealer will turn upon the relevant facts and circumstances, as informed by the interpretative guidance set forth in the Final Rule Release. Despite the similarities between the dealer-trading distinction and the interpretative approach to swap dealing activity, market participants are warned not to apply the dealer-trader distinction rigidly to the swaps context or to expect that the analogous CFTC framework will evolve in a manner identical to the way the dealer-trader distinction has evolved. Indeed, the Commissions expect the dealer-trader distinction to evolve over time with respect to swaps independently of its evolution over time with respect to securities or security-based swaps. 17 This discussion and the parallel discussion in respect of SBSDs forms the backdrop for the other interpretive discussion in the Final Rule Release with respect to the SD and SBSD determinations. 16 Indeed, it is possible for a person making a one-way market in swaps to be a market maker. Final Rule Release at ( This may be true, for example, where a person routinely stands ready to enter into swaps on a particular side of the market say, routinely bidding for floating exposures on a swap trading platform while entering into transactions on the other side of the market in other instruments (such as futures contracts). ). 17 Final Rule Release at 55. Entity Definitions Rule May 8,

8 The First and Second Main Categories of Swap Dealer Activity: Holding Itself Out as a Dealer in Swaps or Engaging in Activity Causing Itself to be Commonly Known in the Trade as a Dealer or Market Maker in Swaps The prongs of the SD definition that capture a person that holds itself out as a dealer in swaps or engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps provide color to the CFTC s view that the SD definition should be applied to the facts and circumstances of a particular person s activities. The factors to be considered under both prongs were originally outlined in the Proposed Rule and are set forth below. 18 Holding itself out as a swap dealer or engaging in activity causing it to be commonly known in the trade as a dealer or market maker in swaps > contacting potential counterparties to solicit interest; > developing new types of swaps and informing potential counterparties of their availability and of the person s willingness to enter into the swap; > membership in a swap association in a category reserved for dealers; > providing marketing materials describing the type of swaps the party is willing to enter into; and > generally expressing a willingness to offer or provide a range of products or services that include swaps. These indicia should not be considered in a vacuum, but instead should be considered in the context of all the activities of the swap participant. 19 Satisfying any one of them does not conclusively establish SD status and could be countered by other factors indicating the person is not an SD. 20 The Third Main Category of Swap Dealer Activity: Market Making The essential element of market making is routinely standing ready to enter into swaps at the request or demand of a counterparty. 21 Routinely means more frequently than occasionally, but does not require that the person do so continuously. 22 Activities indicative of standing ready to enter into swaps at the request or demand of a counterparty, and thus market making, include routinely: 23 Market Making > quoting bid or offer prices, rates or other financial terms for swaps on an 18 Final Rule Release at 56, note Final Rule Release at Id. 21 Final Rule Release at Final Rule Release at Final Rule Release at 59. Entity Definitions Rule May 8,

9 Market Making exchange; > responding to requests made directly, or indirectly through an interdealer broker, by potential counterparties for bid or offer prices, rates or other similar terms for bilaterally negotiated swaps; > placing limit orders for swaps; or > receiving compensation for acting in a market maker capacity on an organized exchange or trading system for swaps. This is a non-exhaustive list and other activities may constitute market making if the person engaging in them routinely stands ready to enter into swaps as principal at the request or demand of a counterparty. The dealer-trader distinction can also be usefully applied to these four factors because under the dealer-trader distinction, seeking to profit by providing liquidity to the market is an indication of dealer activity. 24 Thus, in applying these four factors, if the person is seeking, through its presence in the market, compensation for providing liquidity, compensation through spreads or fees, or other compensation not attributable to changes in the value of the swaps it enters into it is likely to be an SD, and if not, then likely it is not. The Fourth Main Category of Swap Dealer Activity: Entering Into Swaps with Counterparties for its Own Account as Part of a Regular Business and the Exclusion for Swaps Entered Into Other Than as Part of a Regular Business One of the statutory and rule elements of the SD definition is entering into swaps with counterparties for its own account as part of a regular business. Correspondingly, both the statute and the rule expressly preclude from consideration in the SD determination swaps not entered into as part of a regular business. Subsection (ggg)(2) of the Final Rule exempts from the SD definition a person that enters into swaps for such person s own account, either individually or in a fiduciary capacity, but not as part of a regular business. 25 The Commissions take the view that the terms regular business and ordinary course of business are synonymous for these purposes. 26 The analysis of whether swaps activity constitutes a regular business or is in the ordinary course of business focuses on whether the activity is both usual and normal in a person s course of business and identifiable as a swap dealing 24 Final Rule Release at Final Rule Release at Final Rule Release at 63. They also note that the regular business exclusion is not limited solely to the ordinary course of business prong of the SD definition and that the interpretative guidance on the other three prongs should be read consistently so as to exclude swaps that are not part of a regular business. Id. at n.203. Entity Definitions Rule May 8,

10 business. 27 It is not necessarily relevant whether those activities are a person s primary or ancillary business so long as they are identifiable as a swap dealing business. 28 Any of the following activities would constitute having a regular business of entering into swaps: 29 Entering into swaps as part of a regular business > entering into swaps with the purpose of satisfying the business or risk management needs of the counterparty (as opposed to entering into swaps to accommodate one s own demand or desire to participate in a particular market); > maintaining a separate profit and loss statement reflecting the results of swap activity or treating swap activity as a separate profit center; or > having staff and resources allocated to dealer-type activities with counterparties, including activities relating to credit analysis, customer onboarding, document negotiation, confirmation generation, requests for novations and amendments, exposure monitoring and collateral calls, covenant monitoring, and reconciliation. The Commissions suggest that the staff and resources prong of their guidance on what constitutes a regular business is not designed to capture end-users that may have staff allocated to the activities enumerated under that prong, but rather is to be applied in a reasonable manner, to all appropriate circumstances, and is targeted at firms that allocate staff and resources to those activities to a significant extent. 30 Hedging Swaps and Interaffiliate Swaps Excluded Pursuant to the Interim Final Rule, in determining whether a person is an SD certain hedging swaps and interaffiliate swaps are not to be taken into account. Hedging Swaps Swaps entered into for the purpose of hedging physical positions can be ignored in determining whether a person is an SD provided that they satisfy a conjunctive multi-part test that essentially asks whether: > the person is entering into the swap for the purpose of offsetting price risks associated with assets, liabilities or services to which the person has or will have real exposure, > the swap is a substitute for transactions made or to be made or positions taken or to be taken by the person in a physical marketing channel, 27 Final Rule Release at Id. 29 Final Rule Release at Final Rule Release at 65. Entity Definitions Rule May 8,

11 > the swap is economically appropriate to the reduction of the person s risk in the conduct and management of a commercial enterprise, > the swap is entered into in accordance with sound commercial practices, and > the person does not enter into the swap in connection with activity structured to evade designation as an SD. 31 Interaffiliate Swaps In making an SD determination market participants may also disregard swaps with majority-owned affiliates. Counterparties are affiliates under the Final Rule if one counterparty directly or indirectly owns a majority interest in the other or if a third party directly or indirectly owns a majority interest in both. 32 Majority interest means the right to vote or direct the vote of a majority of a class of voting securities of an entity, the power to sell or direct the sale of a majority of a class of voting securities of an entity, or the right to receive upon dissolution or the contribution of a majority of the capital of a partnership. 33 Although not required by the text of the Dodd-Frank Act the treatment of interaffiliate swaps was of concern to many market participants and commentators who argued that they were fundamentally different in nature than outward facing swaps with the market. Floor Trader Exception In order to avoid the duplicative regulation of persons registered with the CFTC as Floor Traders that would result were they required to register as SDs, under the Final Rule parties may ignore swaps entered into by a person in their capacity as Floor Traders when making an SD determination. 34 Cooperative Exception Swaps entered into by a cooperative with a member of the cooperative can be disregarded when determining whether the cooperative is an SD, subject to risk monitoring and management, and reporting requirements, and if the cooperative is a cooperative association of producers, the swap is primarily based on a commodity that is not an excluded commodity. 35 Insured Depository Institution Swaps in Connection with Originating Loans to Customers Swaps entered into by an insured depository institution ( IDI ) with a customer in connection with originating a loan with that customer shall not be considered in determining whether the IDI is an SD. To ensure that the Final Rule complies with the statutory mandate that the swap in question be in connection with the 31 Final Rule Release at Final Rule Release at Final Rule Release at Final Rule Release at Final Rule Release at 571. Entity Definitions Rule May 8,

12 origination of a loan to a customer by an IDI, the CFTC requires the following elements to be satisfied for the IDI exemption to be utilized: > the person is an IDI; > the IDI enters into a swap with a borrower that does not extend beyond the termination of the loan; > the swap is connected to the financial terms of the loan or is required by loan underwriting criteria to be in place as a condition of the loan in order to hedge the borrower s commodity price risks (other than excluded commodities) incidental to the borrower s business; > the relevant swap is entered into no more than 90 days before or 180 days after the date of the execution of the loan agreement, or no more than 90 days before or 180 days after the date of any transfer of principal to the borrower; > the loan is within the common law meaning of loan (i.e., not synthetic or a sham loan); > the IDI is directly or indirectly (where IDI is the source of at least 10% of the entire loan amount) the source of money to the borrower in connection with the loan; > the aggregate notional amount of all swaps entered into by the borrower with all persons in connection with the financial terms of the loan at any time is not more than the aggregate amount of borrowings under the loan; and > the IDI agrees to report the swap to a swap data repository. 36 De Minimis Exception Subsection (ggg)(4) addresses the de minimis exception which is initially $8B in aggregate gross notional amount over the prior 12 month period, but drops to $3B in aggregate gross notional amount over the prior 12 month period five years from the date that a swap data repository first receives swap data in accordance with the relevant CFTC rules, unless the CFTC changes it. 37 From inception, however, there is a much smaller ceiling on swaps with special entities under the de minimis exception and that is $25mm in aggregate gross notional amount over the prior 12 month period. In each case, measuring across all affiliated entities, but exclude interaffiliate swaps. 38 Additionally, with respect to the initial measurement period, the Final Rule Release provides that the relevant period will be the period following the effective date of the final products rules if that period 36 Final Rule Release at Final Rule Release at Final Rule Release at 566. Entity Definitions Rule May 8,

13 is less than 12 months, but it is not entirely clear what period is being referred to. 39 Even at the fallback level of $3B the Final Rule reflects a significantly more generous de minimis exemption than the $100mm contemplated in the Proposed Rule. 40 It is also important to note, as the Final Rule Release makes express, that these references to notional amounts are intended to refer to effective notional amount[(s)] such that if the stated notional is a dollar amount and there is a multiplier increasing the effective amount of the notional, the effective amount rather than the stated amount would be used. 41 If a person not registered as an SD by virtue of the de minimis exception can no longer rely on it, such person shall not be an SD until the earlier of the date it submits an SD application or two months after the end of the month it can no longer use the exception. 42 The Final Rule requires a report to be produced by the CFTC staff no later than 30 months after the date that a swap data repository first receives data in accordance with the rules on swap data recordkeeping and reporting requirements. 43 The study is essentially intended to assist the CFTC in evaluating whether the de minimis threshold should be altered and the implications of doing so. The rationale for this approach is that the SD definition starts out being narrow by virtue of the higher de minimis threshold and if no action is taken the definition grows more expansive as a result of the lowering of the threshold. 44 However, the study should provide the CFTC with sufficient information to determine whether an adjustment is required. 45 Limited Designation 46 The Commissions construe the language in the Dodd-Frank Act providing that a person may be designated as a dealer for one type, class or category of swap or security-based swap, or specified swap or security-based swap activities, without the person being considered a dealer for other types, classes, categories or activities as permissive grants of authority that do not require the Commissions to provide limited designations. 47 Consistent with the Proposed Rule, the Final Rule also provides for such limited designation, but only upon such person seeking and receiving a designation as a dealer for only specified categories of 39 Final Rule Release at See comments of Gary Gensler, CFTC Chairman, Open Meeting Transcript at 8 ( For those who question the level of di minimis, we considered the de minimis threshold in the context of an overall $300 trillion notional swaps market ). 41 Final Rule Release at Final Rule Release at 568. The corresponding provisions for SBSDs and the de minimis exception to that definition are identical. 43 Final Rule Release at See comments of Mark Fajfar, CFTC Assistant General Counsel, at the Open Meeting on the 26 th Series of Rulemakings under Dodd-Frank Act, at 61, a transcript of which is available at trans.pdf ( Open Meeting Transcript ). 45 See comments of Gary Gensler, CFTC Chairman, Open Meeting Transcript at 85, regarding the use of swap data collected by swap data repositories in the preparation of the CFTC staff report. 46 This discussion is identical for SDs and SBSDs so rather than include it twice we have simply referred to both. 47 Final Rule Release at 185 (quoting Proposed Rule). Entity Definitions Rule May 8,

14 swap or security-based swap activities. 48 The Final Rule clarifies that such an application may be made at the time a party registers or subsequent to registration. 49 Absent such a limited designation, the presumption remains that a person who meets one of the dealer definitions will be deemed to be a dealer with regard to all of its swaps or security-based swaps activities. Perhaps, most interestingly, the Commissions do not fully deal with the fact that the statute and the rules are not really set up, in many cases, to deal with an entity that is an SD or MSBSP for some of its activities, but not others although they do note that certain requirements were intended to apply at the entity level (e.g., registration, capital, risk management, supervision and appointment of chief compliance officers) while others apply at the transactional level (e.g., requirements relating to trading records, documentation and confirmations). 50 The Commissions skirt around this issue by indicating that anyone applying for such limited designation will be required to demonstrate that it will be able to comply with all applicable requirements, Regardless of the type of limited designation being requested, the Commissions will not designate a person as a limited purpose dealer unless it can demonstrate that it can fully comply with the requirements applicable to all dealers. 51 The Commissions emphasize the same point several pages later, A key challenge that any applicant to a limited dealer designation will face is the need to demonstrate full compliance with the requirements that apply to the type, class or category of swap or security-based swap, or the activities involving swaps or security-based swaps, that fall within the swap dealer designation. 52 It is not entirely clear, as a practical matter, how this may be achieved. It is likewise unclear how rigorous the Commissions will be in applying this requirement to such limited designation dealers. 48 Final Rule Release at Final Rule Release at Final Rule Release at Final Rule Release at Final Rule Release at 194. Entity Definitions Rule May 8,

15 Who is required to register as a security-based swap dealer? Flow Chart of SBSD Determination Do you hold yourself out as a dealer in SBS? Do you make a market in SBS? Do you regularly enter into SBS with counterparties as an ordinary course of business for your own account? Do you engage in any activity that causes you to be commonly known in the trade as a dealer or market maker in SBS? Did you exclude the excluded items? If not, reassess. If so, and you still answered yes to any of them, see if you satsify the de minimis exemption. Excluded items: (i) SBS activities not part of a regular business; and (ii) SBS between majority-owned affiliates. Are your SBS dealing activities de minimis? If yes, i.e. total included CDS that are SBS aggregate notional < $8B during initial phase or < $3B during subsequent phase; non-cds SBS aggregate notional < $400mm during the initial phase or < $150mm during subsequent phase; and SBS notional with special entities is less than $25mm DO NOT REGISTER as an SD. n.b. in each case, measure across affiliated entities, but exclude interaffiliates SBS. If no, YOU MUST REGISTER as an SBSD. Overview The four-part SBSD definition is substantially the same as the SD definition, with a similar exception carved out for persons that enter into SBS for their own account, either individually or in a fiduciary capacity, but not as part of a regular business. 53 Not surprisingly, the dealer-trader distinction is also relevant to the interpretation of the SBSD definition. 54 A key distinction between the SD and SBSD regimes is the de minimis exception. For SBS dealing activity involving credit default swaps that are SBSs, there is an aggregate gross notional phase-in threshold of $8B, which may be lowered to $3B automatically upon termination of the phase-in period or varied pursuant further rulemaking. With regard to SBSs that are not credit default swap that are SBSs, there is a phase-in threshold of $400mm in aggregate gross notional value, which fades to $150mm upon termination of the phase-in period or which may be varied by further rulemakings. 53 Final Rule Release at Final Rule Release at 84. Entity Definitions Rule May 8,

16 Who is required to register as a major swap participant? Flow Chart of Major Swap Participant Determination Do you have a substantial position in a major swap category, excluding hedging positions? Do you have substantial counterparty exposure as a result of your swap positions? Are you a highly leveraged financial entity with a substantial position in swaps? Overview Section 721 of the Dodd-Frank Act defines an MSP as an entity that is not a swap dealer and: > maintains a substantial position in any of the major swap categories, excluding positions used for hedging or mitigating commercial risk, > has outstanding swaps that create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets, or > is a highly leveraged financial entity that maintains a substantial position in any major swap category. These three tests seek to capture swap market participants whose activities create the potential for systemic risk. The CFTC is authorized to flesh out and set thresholds for a number of the terms used in the statutory definition, including substantial position, hedging or mitigating commercial risk, substantial counterparty exposure, financial entity and highly leveraged. Thresholds for the first and third tests are established with reference to major swap categories, which the CFTC has defined to include rates, credit, equity and other commodities. Substantial Position The Final Rule sets forth two separate tests to define a substantial position. Current Exposure Test The first substantial position test calls for a market participant to mark to market its swap positions to determine their current exposure and then deduct from that amount the value of any collateral posted with respect to its swap positions 55 and any netting offsets available under the terms of any master netting agreements with its counterparties. If the entity has an average uncollateralized exposure of $3B or more in rates or $1B or more in any of the other swap categories over the course of a fiscal quarter, it is an MSP. 55 As noted by the CFTC in its release, cleared swaps will largely be excluded from any analysis under the MSP definition that assesses uncollateralized exposure. Entity Definitions Rule May 8,

17 Current Exposure Calculation Current Exposure = Mark-to-market value of swap positions minus (value of collateral posted + netting offsets + swap positions used to hedge commercial risk) If Current Exposure > $1B in any category of swaps (or $3B in rates), you are an MSP. Current Exposure and Potential Future Exposure Test The second substantial position test is more complicated and considers both current uncollateralized exposure and potential future exposure. Future exposure is calculated by > multiplying the total notional amount of an entity s swap positions by a risk factor discount percentage ranging from 0% to 15%; 56 > discounting positions subject to master netting agreements by between 0% and 60%,efficiency; 57 and > reducing the amount by another 80% if it is subject to daily mark-to-market margining or 90% if it was cleared. The thresholds established for the second test provide that a market participant is an MSP if the sum of its average current uncollateralized swap exposure (as calculated under the first test) and its potential future exposure is $6B or more in the rates category or $2B or more in any other category. 58 Potential Future Exposure Calculation Potential Future Exposure = (Gross notional amount of swap contracts minus notional amount of swap contracts used to hedge commercial risk) x Risk factor discount percentage x discount for netting agreements (if applicable) x [80% (if subject to daily mark-to-market) or 90% (if subject to clearing)]. If Current Exposure (as calculated above) + Potential Future Exposure > $2B in any category of swaps (or $6B in rates), you are an MSP. Hedging or Mitigating Commercial Risk The first prong of the MSP definition seeks to capture market participants that use swaps to speculate, not those that rely on swaps to hedge risk. Under that 56 The risk factor discounts are listed in a table contained in the rule. Final Rule 1.xx(jjj)(3)(ii)(A)(1) tbl. 1. Generally, swaps with shorter maturities are considered less likely to result in future exposure, and thus have lower risk factor discounts. The table also lists different categories of swaps by asset class with progressively higher risk factor discounts generally applying to swaps in the following order: rates, foreign exchange and gold, other precious metals, equity, credit and other commodities. 57 The Final Rule sets forth a formula that market participants must use in order to calculate the discount for netting agreements. Final Rule 1.xx(jjj)(3)(ii)(B). Under this provision, the notional amount multiplied by the risk factor discount is further reduced by the ratio of net currency exposure to gross current exposure, consistent with the [provided] equation on a counterparty-bycounterparty basis. 58 The calculation of potential future exposure may result in the double counting, to at least some extent, of an entity s potential liability. If, for instance, an entity has $5 of exposure under a swap with a notional amount of $100, it makes little sense to use that notional amount as the basis for calculating the potential future exposure inasmuch as the calculation of current exposure has already caused that $5 of risk to be realized in the substantial position analysis. Entity Definitions Rule May 8,

18 prong only, in calculating both current and future exposures, market participants are allowed to exclude any swap positions that hedg[e] or mitigat[e] commercial risk. The Final Rule defines that term to include swap positions that are not held for trading or speculative purposes and that > reduce commercial risk arising from the change in value of an entity s assets or liabilities, the change in value of services provided by an entity, the change in value of inputs that the entity has acquired or reasonably anticipates acquiring in the ordinary course of business, or the change in interest, currency or foreign exchange rates associated with any of the above, > would qualify as a bona fide hedge under the position limits rule adopted by the CFTC, or > qualify as a hedging position under certain Financial Accounting Standards Board and Government Accounting Standards Board rules. The Final Rule also forbids a market participant from excluding from an exposure calculation a swap position designed to hedge a separate speculative swap or security-based swap position. Employee plans under the Employee Retirement Income Security Act of 1974 ( ERISA ) are granted more flexibility in that they may exclude swaps from their first prong analysis where the primary purpose of the swap is to hedge, even if the plan is using the swap for speculative purposes as well. Substantial Counterparty Exposure The second prong of the MSP definition captures market participants that have a substantial counterparty exposure in swaps that could threaten U.S. financial stability. Under this prong, a market participant must calculate its aggregate current exposure and potential future exposure across major swap categories. In conducting these calculations, the entity must include swap positions designed to hedge, though it may continue to take into account the offsetting benefits of collateral and netting agreements as discussed above. An entity will be considered to have a substantial counterparty exposure and be an MSP if it has a current uncollateralized current exposure of $5B across all major swap categories or a sum of current uncollateralized current exposure and potential future exposure of $8B across all major swap categories. Entity Definitions Rule May 8,

19 Substantial Counterparty Exposure Calculation Current Counterparty Exposure = Mark-to-market value of swap positions minus (value of collateral posted + netting offsets) Potential Future Counterparty Exposure = Gross notional amount of swap contracts x Risk factor discount percentage x discount for netting agreements (if applicable) x 80% (if subject to daily mark-to-market) or 90% (if subject to clearing). Both are calculated in the aggregate across all swap categories. If Current Counterparty Exposure > $5B across all swap categories or (Current Counterparty Exposure + Potential Future Counterparty Exposure) > $8B across all swap categories, you are an MSP. Highly Leveraged Financial Entities with a Substantial Position in Swaps The final category of entities that fall within the definition of MSP are financial entities that (1) are highly leveraged relative to the amount of capital they hold, (2) are not subject to U.S. bank capital rules, and (3) maintain a substantial position in a major swap category (without the exclusion of hedging transactions). The final rules borrow from the definition of financial entity used in the end user exemption from Title VII s clearing mandate, and dictate that financial entities that may be considered an MSP under this prong include: > SBSDs and MSBSPs; 59 > commodity pools; > private funds (as defined under the Investment Advisers Act of 1940); > ERISA employee benefit plans; and > entities primarily engaged in activities that are financial in nature under Section 4(k) of the Bank Holding Company Act. In its Proposed Rule, the CFTC sought comment on three possible liabilities-toequity ratios to define highly leveraged, ultimately rejecting the highest and lowest proposal and settling on a ratio of 12-to-1 in the Final Rule. 60 The Final Rule directs market participants to calculate their balance sheet liabilities and equity under U.S. generally accepted accounting principles ( GAAP ) to determine whether they will be considered highly leveraged. 61 Such a highly leveraged financial entity must also maintain a substantial position in a major swap category to qualify as an MSP. The calculation of 59 As discussed in more detail below, the MSBSP definition is largely the same as the MSP definition. One obvious difference is that under the MSBSP definition, financial entity is defined to include SDs and MSPs rather than their security-based swap equivalents. 60 Final Rule at The commandment to calculate liabilities and equity under U.S. GAAP could prove problematic for some foreign market participants. There are some notable differences between U.S. GAAP and the International Financial Reporting Standards applicable in many other countries, particularly with respect to the netting treatment of derivative positions. While the CFTC may address the issue when it issues its much-anticipated rulemaking on extraterritoriality, it is possible that foreign market participants with a foothold in the U.S. market will find themselves assessing their balance sheet under both local accounting rules and under GAAP, which could be costly. Entity Definitions Rule May 8,