On 18th April 2012 regulators finalised rules further defining “Swap Dealer”, “Major Swap Participant” and “Eligible Contract Participant” – giving long awaited guidance on which swap market entities will be subject to the provisions of Title VII of the Dodd-Frank Act.
The salient point of the finalised guidance is the increased threshold of up to $8 billion in swap transactions that firms must trade in a 12 month-period to be designated a “Swap Dealer”. This figure is a significant increase from the original proposed rules of December 2010 when the threshold was $100 million.
The regulators have also added a more explicit exemption for swaps pertaining to the hedging of market risks, such as reducing exposure to interest-rate fluctuations. These trades will not count towards the threshold invoking “Swap Dealer” designation.
What it means for firms
Firms defined as swap dealers will ultimately be subject to the highest level of capital and collateral requirements in the market.
The $8 billion threshold will fall to $3 billion within 5 years unless initial reported data persuades regulators otherwise. This will further designate more firms as “swap dealer” though it is much higher than the initial proposed level of $100 million.
Despite this, Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler said that he was “confident the rule would impose new requirements on the dominant players in the swap market”. The CFTC did not provide details on how many firms would be subject to the heightened oversight.
The rule will take effect 60 days after it is published in the Federal Register.
With a clearer picture on their market participant designation and the requirements beholden on them as a result, firms must prepare now for the implementation of the provisions of Title VII of the Dodd-Frank Act.
Definition of “Swap Dealer”
A swap dealer has been defined 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 activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.
Interpretive guidance on the definition of swap dealer
The Adopting Release provides interpretive guidance on the “holding out” and “commonly known” criteria, market making, the not part of “a regular business” exception, and the overall interpretive approach to the definition. The guidance clarifies the following:
- The determination of whether a person is a swap dealer should consider all relevant facts and circumstances, and focus on the activities of a person that are usual and normal in the person’s course of business and identifiable as a swap dealing business; making a market in swaps is appropriately described as routinely standing ready to enter into swaps at the request or demand of a counterparty
- A person making a one-way market in swaps may be a market maker, and exchange executed swaps are relevant in the determination
- Examples of activities that are part of “a regular business,” and therefore indicative of swap dealing, are entering into swaps to satisfy the business or risk management needs of the counterparty, maintaining a separate profit and loss statement for swap activity, or allocating staff and resources to dealer-type activities; and
- The SEC’s dealer-trader distinction may be applied.
De Minimis exemption from the definition of swap dealer
The Dodd-Frank Act provides an exemption for a person who “engages in a de minimis quantity of swap dealing in connection with transactions with or on behalf of its customers.”
The rule requires that, in order for a person to be exempt from the definition on the basis of de minimis activity:
- The aggregate gross notional amount of the swaps that the person enters into over the prior 12 months in connection with dealing activities must not exceed $3 billion.
- Also, the aggregate gross notional amount of such swaps with “special entities” (as defined under CEA Section 4s(h)(2)(C) to include certain governmental and other entities) over the prior 12 months must not exceed $25 million.
The rule also provides for a phase-in of the de minimis threshold to facilitate orderly implementation of swap dealer requirements. During the phase-in period, the de minimis threshold would effectively be $8 billion (while the $25 million threshold for swaps with special entities would apply unchanged). Two and one-half years after data starts to be reported to swap data repositories, the Commission’s staff will prepare a study of the swap markets, including data and information that becomes available about the de minimis threshold. Nine months after this study, the Commission may end the phase-in period, or propose new rules to change the de minimis threshold (either up or down). If the Commission does not take action to end the phase-in period, it will terminate automatically five years after data starts to be reported to swap data repositories.
The regulators also defined the term “Major Swap Participant” (see below) which will affect firms holding large positions in certain categories of asset classes. One of the guidelines on what constitutes a “substantial position” would be daily uncollateralised exposure of $1 billion in any major asset class excluding rate swaps where the de minimis level is $3 billion.
Definition of “Major Swap Participant” (MSP)
There are three parts to the Dodd-Frank Act definition and a person that satisfies any one of them is classified as a Major Swap Participant:
- A person that maintains a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan.
- A person whose outstanding swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.”
- Any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency” and that maintains a “substantial position” in any of the major swap categories.
The statutory definition excludes swap dealers and certain financing affiliates.
Definition of “Substantial Position”
The final rules define “substantial position” using objective numerical criteria, which promote the predictable application and enforcement of the requirements governing MSPs. The tests adopted by the Commission account for both current uncollateralized exposure and potential future exposure. A position that satisfies either test would be a “substantial position.” The definition of substantial position excludes positions hedging commercial risk and employee benefit plan positions.
The tests apply to a person’s swap positions in each of four major swap categories: rate swaps (any swap based on reference rates such as interest rates or currency exchange rates), credit swaps (any swap based on instruments of indebtedness or related indices), equity swaps (any swap based on equities or equity indices) and other commodity swaps (any swap not included in the first three categories, including any swap based on physical commodities).
First test of substantial position
The first substantial position test:
- Measures a person’s current uncollateralized exposure by marking the swap positions to market using industry standard practices
- Allows the deduction of the value of collateral that is posted with respect to the swap positions; and
- Calculates exposure on a net basis, according to the terms of any master netting agreement that applies.
The thresholds adopted for the first test are the daily average current uncollateralized exposure of $1 billion in the applicable major category of swaps, except that the threshold for the rate swap category would be $3 billion.
Second test of substantial position
The second test adopted by the Commission for substantial position accounts for both current uncollateralized exposure (as discussed above) and the potential future exposure associated with a person’s swap positions. The second substantial position test determines potential future exposure by:
- Multiplying the total notional principal amount of the person’s swap positions by specified risk factor percentages (ranging from .% to 15%) based on the type of swap and the duration of the position
- Discounting the amount of positions subject to master netting agreements by a factor ranging between zero and 60%, depending on the effects of the agreement, and
- If the swaps are cleared or subject to daily mark-to-market margining, further discounting the amount of the positions by 80%.
The thresholds adopted for the second test are $2 billion in daily average current uncollateralized exposure plus potential future exposure in the applicable major swap category, except that the threshold for the rate swap category would be $6 billion.
Specific asset classes are impacted: Credit, Rates, Equities, FX and Commodities, with compliance dates ranging from 16th July – October 2012. It is anticipated that ALL asset classes will be covered by 12th January 2013.
From 16th July 2012 firms executing Swaps in the above asset classes, that meet any of the below three criteria, must submit details of the Swap, ‘real-time’, to a Swap Data Repository (SDR) and, for the duration of the Swap, notify the SDR of any amendments to it in order to meet the Dodd-Frank Act Swap data reporting regulations which are:
The regulations in Title VII impact firms executing Swaps where:
- The counterparty is a US person OR
- The Swap was executed in the US, even if it was not executed with a US person OR
- The Swap was cleared through a registered clearing agency with a principal place of business in the US. Again, even if neither party was a US person.
Both regimes require Swap data to be reported throughout the lifecycle of the trade providing reporting for:
- Real-time public dissemination – for price and volume transparency and
- Confidential regulatory use – to help conduct market oversight, enforce position limits and track systemic risk
This includes: on-trade creation; daily, throughout the lifetime of the trade; when any significant trade event occurs (e.g. amendments, fixing, option exercise, termination, etc.); the natural end-of-life of the trade (e.g. trade maturity or option expiry without exercise).
All information is required to be reported ’as soon as technologically practicable‘ and requires sending Swap data to SDRs.
The information to be reported is not restricted to the primary economic data of the trade, but also includes MtM valuation and other data derived from SSIs and CASs.
How Lombard Risk can help
The Lombard Risk Dodd-Frank Act Title VII reporting solution has the following features – to:
- Listen for new trades in specified asset classes as they are booked – interacting with the firm’s front/middle office system(s), of which there may be many
- Generate and report the required information to the SDR
- Receive Unique Swap Identifiers (USI) back from the SDR
- Listen for CHANGE EVENTS impacting the applicable Swap deals as they occur – interacting with the firm’s back office and other appropriate system(s)
- Generate and send the appropriate information for changes to the SDR, cross-referenced with the USI
- Handle the large volumes of Swaps that are impacted by these regulations
- Generate full audit trails on all activities
- Provide the firm with its own SDR – which will enable enhanced management and business information
- Meet the regulators’ demands as defined in the Title VII of the Dodd-Frank Act: WALL STREET TRANSPARENCY AND ACCOUNTABILITY – Regulation of Over-the-Counter Swaps Markets
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For more information on any of these topics email info@LombardRisk.com
Source: Commodity Futures Trading Commission website, Final Rules Regarding Further Defining “Swap Dealer”, “Major Swap Participant” and “Eligible Contract Participant”