Written by Michael Wu
On December 7, 2010, the Securities and Exchange Commission (the “SEC”) proposed joint rules with the Commodity Futures Trading Commission (the “CFTC”) to define the types of swap traders that would be subject to the new derivatives regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The proposed rules attempt to implement the provisions of the Dodd-Frank Act, which established a comprehensive framework for regulating the over-the-counter swaps market.
The Dodd-Frank Act creates new categories of market participants that are subject to registration, capital and margin, record keeping, reporting and other regulatory requirements. The proposed rules define the categories of market participants that would be deemed “Security-Based Swap Dealers” and “Major Security-Based Swap Participants.”
- Security-Based Swap Dealers. Under the Dodd-Frank Act, a Security-Based Swap Dealer is any person that holds itself out as a dealer in security-based swaps, makes a market in security-based swaps, enters into security-based swaps with counterparties in the ordinary course of its business, or is commonly known in the trade as a dealer or market maker in security-based swaps. The CFTC proposal would exempt a firm from registration as a Security-Based Swap Dealer if (i) its notional aggregate amount of security-based swaps in the prior 12 months did not exceed $100 million (of which only $25 million can be with “special entities” as defined in the Commodity Exchange Act), (ii) it did not enter into security-based swaps as a dealer with more than 15 counterparties (other than security-based swap dealers) in the prior 12 months, and (iii) it did not enter into more than 20 security-based swaps as a dealer in the prior 12 months.
- Major Security-Based Swap Participants. Under the Dodd-Frank Act, a Major Security-Based Swap Participant is any person that is not a Security-Based Swap Dealer and has (i) a “substantial position” in any major security-based swap categories (held other than for hedging or mitigating risk), (ii) whose security-based swaps create “substantial counterparty exposure,” which could have a serious adverse effect on the financial stability of the United States banking systems or financial markets, or (iii) is a “financial entity” that is “highly leveraged” and that has a substantial position in any of the major security-based swap categories.
- The CFTC proposed that a firm has a “substantial position” in swaps if it (i) has a daily average or current uncollateralized exposure of at least $1 billion on a net basis for credit, equity or commodity swaps or $3 billion for rate swaps, or (ii) has a daily average of current uncollaterized exposure and future exposure of at least $2 billion for credit, equity or commodity swaps or $6 billion for rate swaps.
- The CFTC proposed that a firm has “substantial counterparty exposure” if it has uncollateralized exposure of more than $5 billion or current and future exposure exceeding $8 billion.
- The CFTC proposed that a “financial entity” be defined under Section 3C(g)(3) of the Securities Exchange Act of 1934, as amended.
- The CFTC proposed two definitions of “highly leveraged”; the first is an 8 to 1 ratio of total liabilities to equity determined in accordance with US GAAP and the second is a 15 to 1 ratio of total liabilities to equity determined in accordance with US GAAP.
In addition, the proposed rules permit clearinghouses to provide portfolio margining of futures and securities in futures accounts. The proposed rules also require Security-Based Swap Dealers and Major Security-Based Swap Participants to keep daily trading records regarding the security-based swaps and all related records, which would be open to inspection by the CFTC. The CFTC and the SEC are expected to vote on the final rule in July of 2011.