CFTC Clears Up Swap Definitions, but Questions Linger

The Commodity Futures Trading Commission approved new rules this month that will make it one of the most influential and powerful regulatory agencies around, stretching its oversight further into the $650 trillion derivatives marketplace.

It did so by settling a matter that sounds deceptively simple— defining the transactions it oversees. The CFTC, by a 4-to-1 vote, approved final rules that further define the terms “swap,” “security-based swap,” and “security-based swap agreement,” as well as participants in the market. The vote, later accompanied with a 600-page document, started the clock on compliance deadlines for numerous regulations mandated by the Dodd-Frank Act that are intended to better police the derivatives market, which played a large role in the mortgage lending crisis.

The challenge is now focused on how, and when, it will exercise its evolving powers.

Title VII of the Dodd-Frank Act gives the CFTC regulatory authority over swaps (the Securities and Exchange Commission has authority over securities-based swaps) and both commissions are jointly responsible for regulations regarding mixed swaps.

Eleven rules will go into effect 60 days after the final rule and interpretation is published in the Federal Register—expected in the final days of July or early August—including those that require the registration of swap dealers and major swap participants. Other rules set to take effect include those on swap dealer reporting and recordkeeping obligations, position limits, mandatory clearing, the operation of security-based swap and swap execution facilities and data repositories, capital and margin requirements, business conduct standards, and regulatory access to more information on swap transactions.

The CFTC defined “swaps” as: foreign exchange forwards, currency swaps, cross-currency swaps, foreign currency options, commodity options, total-return swaps, interest rate swaps, and forward rate agreements.

Not “swaps”: most insurance products; consumer transactions to purchase products at a fixed, capped, or collared price (such as arrangements to lock in the price of heating fuel ); transactions that provide for an interest rate cap or lock on a consumer loan or mortgage; various mortgage products; service agreements, product warranties, extended service plans, and buyer protection plans; employment contracts and retirement benefit arrangements; sales, servicing, or distribution arrangements; and the purchase, sale, lease, or transfer of real or intellectual property.

Exemptions will apply to commercial entities that use derivatives to hedge against risks, such as volatile commodity prices or spiking interest rates.

“Now the clock really starts ticking on a lot of things for swap dealers and market participants,” says Evan Koster, a partner with the law firm Hogan Lovells. “[But] there are still some things that are up in the air.”

 For example, he says, there is a question of whether foreign exchange forwards and foreign swaps will be exempted by the Department of the Treasury for most of the compliance obligations. “There is rough guidance, at least, to finalize compliance programs around what is a swap and what isn't a swap,” Koster says. “Nobody expected to answer all questions and there are going to be plenty that come up given that it's impossible to define every particular circumstance. The industry and lawyers are always very good at presenting new tweaks to different products, so there are still going to be plenty of interpretive questions.”

“Now the clock really starts ticking on a lot of things for swap dealers and market participants, [But] there are still some things that are up in the air.”

— Evan Koster,

Partner,

Hogan Lovells

Peter Malyshev, a counsel in the Washington D.C. office of Latham & Watkins, commended the CFTC's dedicated work under tremendous time constraints, but also cautioned that there are “a lot of inadvertent gaps still left that have not been addressed.”

Extraterritoriality is one pressing issue, with questions remaining about requirements for a trading facility with operations on both sides of the Atlantic. “There are so many technical things that, in practice don't quite work yet without further guidance,” Malyshev says.

Lingering Questions

Despite scoring a victory with the CFTC on swap definitions that would have impacted utilities, there are still lingering questions on how the new rules will affect power companies and other utilities.

The Edison Electric Institute, an association of U.S. shareholder-owned electric companies, was among the industry groups making the case that utilities engage in over-the-counter, bilateral transactions with other utilities and within the financial markets in order to lock in a guaranteed price for commodities such as electricity, natural gas, and coal for future delivery. It is necessary, they said, to hedge against and protect their customers from price volatility.

SWAP TRANSACTIONS AND SECURITY-BASED SWAPS

The following is a selection from a Commodity Futures Trading Commission fact sheet on final rules and interpretations explaining what transactions are considered swaps and security-based swaps:

Foreign Exchange (“FX”) Forwards and FX Swaps:

These products are defined as swaps, subject to a determination by the Secretary of the Treasury, as permitted under Title VII, to exempt them.

If exempted by Treasury, the final rules reflect the provision of the statute that certain requirements will continue to apply, including reporting and business conduct standards.

FX Products that are outside Treasury's determination and are swaps (unless otherwise excluded by the statute):

Foreign Currency Options

Non-Deliverable Forwards in Foreign Exchange

Currency Swaps and Cross-Currency Swaps

Forward Rate Agreements, notwithstanding their “forward” label, are swaps (unless otherwise excluded in the statute)

Interest Rates, Other Monetary Rates and Yields

Title VII Instruments on interest rates and other monetary rates (including interbank offered rates, money market rates, government target rates, general lending rates, rates from indexes, and other monetary rates) are swaps.

Title VII Instruments on “yields,” where “yield” is a proxy for the price or value of a debt security, loan or narrow-based security index, are security-based swaps, except in the case of certain government debt obligations.

Government Debt Obligations

Title VII Instruments on rates or yields of U.S. Treasuries and other exempted securities (other than municipal securities) are swaps and are not security-based swaps.

Total Return Swaps (“TRS”)

A TRS on a single security, loan, or narrow-based security index generally would be a security-based swap.

Where counterparties embed interest-rate optionality or a non-securities component into the TRS (e.g., the price of oil, a currency hedge), it would be a mixed swap.

TRS based on broad-based security indexes or on two or more loans are swaps subject to CFTC regulation.

Security Indexes/Portfolios

Where parties to a Title VII Instrument directly/indirectly have discretion to change the composition/weighting of securities in a portfolio, the Title VII Instrument is a security-based swap.

Settlement of Broad-Based Index CDS

If a broad-based index CDS requires mandatory physical settlement, it will be a mixed swap.

If a broad-based index CDS requires cash settlement or auction settlement, it will be a swap, and will not be considered a security-based swap or a mixed swap solely because the determination of the cash price to be paid is established through a securities or loan auction.

Source: CFTC.

The final swap definition, which recognizes that many utility transactions should not be considered swaps, is “essential to consumers who depend on an affordable supply of electricity,” EEI President Tom Kuhn said.

Still up in the air, he said, is clarification on the scope of the “forward contract exclusion,” which states that sales of physical commodities like electricity for deferred shipment or delivery are not swaps. Also awaiting clarification, how the CFTC will consider grid-traded products such as Financial Transmission Rights which are already regulated by the U.S. Federal Energy Regulatory Commission.

Another open question is how the rules will apply to commodity pools. “Overnight, thousands and thousands of investment vehicles that were just quietly hedging their exposures with swaps became commodity pools and they are going to have to register or seek an exemption,” Malyshev says. “It is going to be a big issue.”

Recently, the CFTC extended, until the end of this year, the time during which operators of (and advisers to) commodity pools can continue to rely upon a rescinded exemption and the prior exclusion from registration under the Commodity Exchange Act.  The no-action relief applies to operators of both registered investment companies and private funds.

Enforcement Timetable

The timetable for compliance is also a major concern to participants in the swaps market. The technical and logistical challenges of building the required real-time reporting system will be an ongoing compliance hurdle, Malyshev says. It could take months to achieve full and required functionality, he adds.

“In one of the CFTC meetings, a commissioner said that everyone was preparing for a marathon run, but this is actually turning out to be a 50-yard sprint,” Malyshev says. “That somewhat changes the dynamic if it means that a whole bunch of very complicated and technical things will have to be done, and effective, immediately [when the products rule becomes effective].”

The CFTC and SEC, however, could exercise any number of options as October deadlines approach. There could be no-action relief, or delays on enforcement of the new rules.  “They could start issuing ‘speeding tickets,' [saying that] you need to have substantial compliance and then, later, really cracking down,” Malyshev says, adding that the CFTC's history has shown it "is not a gotcha" organization and he fully expects it to work with the industry to ensure a smooth implementation.

On July 18, the CFTC announced the availability, upon request, of temporary no-action relief for reporting by non-clearing member swap dealers under the CFTC's large trader reporting requirements for physical commodity swaps. The relief gives extra time for swaps dealers to transition to full compliance after registering with the Commission.

In testimony before the a Senate sub-committee meeting, Robert Cook, director, of the SEC's Division of Trading & Markets, shed some light on the continuing rulemaking process for Dodd-Frank Act swaps provisions. The SEC, he said, is focused on a timeline for enacting rules that “seeks to avoid the disruption and cost that would result if compliance with all the rules was required simultaneously or haphazardly.”

“All of those subject to the new regulatory requirements will be given adequate but not excessive time to come into compliance with them,” he said.

As for remaining efforts, he said the plan is to propose “single, holistic rulemaking, rules, and interpretive guidance” to address international implications of its cross-border approach to derivatives regulation.