2012-10562

Federal Register, Volume 77 Issue 100 (Wednesday, May 23, 2012)[Federal Register Volume 77, Number 100 (Wednesday, May 23, 2012)]

[Rules and Regulations]

[Pages 30596-30764]

From the Federal Register Online via the Government Printing Office [www.gpo.gov]

[FR Doc No: 2012-10562]

[[Page 30595]]

Vol. 77

Wednesday,

No. 100

May 23, 2012

Part II

Commodity Futures Trading Commission

-----------------------------------------------------------------------

17 CFR Part 1

Securities and Exchange Commission

-----------------------------------------------------------------------

17 CFR Part 240

Further Definition of ``Swap Dealer,'' ``Security-Based Swap Dealer,''

``Major Swap Participant,'' ``Major Security-Based Swap Participant''

and ``Eligible Contract Participant;'' Final Rules

Federal Register / Vol. 77, No. 100 / Wednesday, May 23, 2012 / Rules

and Regulations

[[Page 30596]]

-----------------------------------------------------------------------

COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AD06

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-66868; File No. S7-39-10]

RIN 3235-AK65

Further Definition of ``Swap Dealer,'' ``Security-Based Swap

Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap

Participant'' and ``Eligible Contract Participant''

AGENCY: Commodity Futures Trading Commission; Securities and Exchange

Commission.

ACTION: Joint final rule; joint interim final rule; interpretations.

-----------------------------------------------------------------------

SUMMARY: In accordance with the Dodd-Frank Wall Street Reform and

Consumer Protection Act of 2010 (``Dodd-Frank Act''), the Commodity

Futures Trading Commission (``CFTC'') and the Securities and Exchange

Commission (``SEC'') (collectively, the ``Commissions''), in

consultation with the Board of Governors of the Federal Reserve System

(``Board''), are adopting new rules and interpretive guidance under the

Commodity Exchange Act (``CEA''), and the Securities Exchange Act of

1934 (``Exchange Act''), to further define the terms ``swap dealer,''

``security-based swap dealer,'' ``major swap participant,'' ``major

security-based swap participant,'' and ``eligible contract

participant.''

DATES: Effective date. The effective date for this joint final rule and

joint interim final rule: July 23, 2012, except for CFTC regulations at

17 CFR 1.3(m)(5) and (6), which are effective December 31, 2012.

Comment date. The comment period for the interim final rule (CFTC

regulation at 17 CFR 1.3(ggg)(6)(iii)) will close July 23, 2012.

Compliance date. Compliance with the element of the CFTC regulation

at 17 CFR 1.3(m)(8)(iii) requiring that a commodity pool be formed by a

registered CPO shall be required with respect to a commodity pool

formed on or after December 31, 2012 for any person seeking to rely on

such regulation; compliance with such element shall not be required

with respect to a commodity pool formed prior to December 31, 2012.

FOR FURTHER INFORMATION CONTACT:

CFTC: Jeffrey P. Burns, Assistant General Counsel, at 202- 418-

5101, [email protected], Mark Fajfar, Assistant General Counsel, at 202-

418-6636, [email protected], Julian E. Hammar, Assistant General

Counsel, at 202-418-5118, [email protected], or David E. Aron, Counsel,

at 202-418-6621, [email protected], Office of General Counsel; Gary

Barnett, Director, at 202-418-5977, [email protected], or Frank

Fisanich, Deputy Director, at 202-418-5949, [email protected],

Division of Swap Dealer and Intermediary Oversight,Commodity Futures

Trading Commission, Three Lafayette Centre, 1155 21st Street NW.,

Washington, DC 20581;

SEC: Joshua Kans, Senior Special Counsel, Richard Grant, Special

Counsel, or Richard Gabbert, Attorney Advisor, at 202-551-5550,

Division of Trading and Markets, Securities and Exchange Commission,

100 F Street NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

I. Background

On July 21, 2010, President Obama signed the Dodd-Frank Act into

law.\1\ Title VII of the Dodd-Frank Act established a statutory

framework to reduce risk, increase transparency, and promote market

integrity within the financial system by, among other things: (i)

providing for the registration and regulation of swap dealers and major

swap participants; (ii) imposing clearing and trade execution

requirements on standardized derivative products; (iii) creating

recordkeeping and real-time reporting regimes; and (iv) enhancing the

Commissions' rulemaking and enforcement authorities with respect to all

registered entities and intermediaries subject to the Commissions'

oversight.

---------------------------------------------------------------------------

\1\ See Dodd-Frank Wall Street Reform and Consumer Protection

Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the

Dodd-Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.

---------------------------------------------------------------------------

The Dodd-Frank Act particularly provides that the CFTC will

regulate ``swaps,'' and that the SEC will regulate ``security-based

swaps.'' The Dodd-Frank Act also adds definitions of the terms ``swap

dealer,'' ``security-based swap dealer,'' ``major swap participant,''

``major security-based swap participant'' and ``eligible contract

participant'' to the CEA and Exchange Act.\2\ Section 712(d)(1) of the

Dodd-Frank Act further directs the CFTC and the SEC, in consultation

with the Board, jointly to further define those terms, among others.\3\

---------------------------------------------------------------------------

\2\ See Dodd-Frank Act sections 721 and 761. Sections 721(b)(2)

and 761(b)(2) also provide that the CFTC and SEC may by rule further

define any other term included in an amendment made by Title VII to

the CEA or the Exchange Act, respectively.

\3\ In addition, section 712(d)(1) directs the CFTC and SEC, in

consultation with the Board, jointly to further define the terms

``swap,'' ``security-based swap,'' and ``security-based swap

agreement.'' These further definitions are the subject of a separate

rulemaking by the Commissions. See CFTC and SEC, Notice of Proposed

Joint Rulemaking, Further Definition of ``Swap,'' ``Security-Based

Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps;

Security-Based Swap Agreement Recordkeeping, 76 FR 29818 (May 23,

2011) (``Product Definitions Proposal''). Section 712(d)(2)(A), in

turn, provides that the Commissions shall jointly adopt such other

rules regarding the definitions set forth in section 712(d)(1) as

they ``determine are necessary and appropriate, in the public

interest, and for the protection of investors.''

In addition, section 721(c) of the Dodd-Frank Act requires the

CFTC to adopt a rule to further define the terms ``swap dealer,''

``major swap participant,'' and ``eligible contract participant''

for the purpose of including transactions and entities that have

been structured to evade Title VII. Also, section 761(b) of the

Dodd-Frank Act permits the SEC to adopt a rule to further define the

terms ``security-based swap dealer,'' ``major security-based swap

participant,'' and ``eligible contract participant,'' with regard to

security-based swaps, for the purpose of including transactions and

entities that have been structured to evade Title VII.

---------------------------------------------------------------------------

In December 2010, the Commissions proposed rules and

interpretations to further define the meaning of the terms ``swap

dealer,'' ``security-based swap dealer,'' ``major swap participant,''

``major security-based swap participant,'' and ``eligible contract

participant.'' \4\ The Commissions received approximately 968 written

comments in response to the Proposing Release.\5\ In addition, the

Staffs of the Commissions participated in approximately 114 meetings

with market participants and other members of the public about the

Proposing Release,\6\ and the Commissions held a

[[Page 30597]]

Joint Public Roundtable on the proposed dealer and major participant

definitions.\7\ After considering the comments received, the

Commissions are adopting final rules and interpretations to further

define these terms.

---------------------------------------------------------------------------

\4\ 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,'' Securities

Exchange Act Release No. 63452, 75 FR 80174 (Dec. 21, 2010)

(``Proposing Release'').

Prior to issuing the Proposing Release, the Commissions issued a

joint Advance Notice of Proposed Rulemaking (``ANPRM'') requesting

public comment regarding the definitions of the terms ``swap,''

``security-based swap,'' ``security-based swap agreement,'' ``swap

dealer,'' ``security-based swap dealer,'' ``major swap

participant,'' ``major security-based swap participant,'' and

``eligible contract participant.'' See CFTC and SEC, Advance Notice

of Proposed Joint Rulemaking: Definitions Contained in Title VII of

Dodd-Frank Wall Street Reform and Consumer Protection Act,

Securities Exchange Act Release No. 62717, 75 FR 51429 (Aug. 20,

2010). The Proposing Release and these final rules both reflect

comments received in response to the ANPRM.

\5\ Comment letters received in response to the Proposing

Release may be found on the Commissions' Web sites at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=933 and at

http://www.sec.gov/comments/s7-39-10/s73910.shtml.

\6\ Summaries of these staff meetings may be found on the

Commissions' Web sites at http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_2_Definitions/index.htm and http://www.sec.gov/comments/s7-39-10/s73910.shtml#meetings.

\7\ A transcript of the roundtable discussion and public

comments received with respect to the roundtable may be found on the

CFTC's Web site at http://www.cftc.gov/PressRoom/Events/opaevent_cftcsecstaff061611.

---------------------------------------------------------------------------

II. Definitions of ``Swap Dealer'' and ``Security-Based Swap Dealer''

The Dodd-Frank Act definitions of the terms ``swap dealer'' and

``security-based swap dealer'' focus on whether a person engages in

particular types of activities involving swaps or security-based

swaps.\8\ Persons that meet either of those definitions are subject to

statutory requirements related to, among other things, registration,

margin, capital and business conduct.\9\

---------------------------------------------------------------------------

\8\ See section 721 of the Dodd-Frank Act (adding Section 1a(49)

of the CEA, 7 U.S.C. 1a(49), to define ``swap dealer'') and section

761 of the Dodd-Frank Act (adding Section 3(a)(71) of the Exchange

Act, 15 U.S.C. 78c(a)(71), to define ``security-based swap

dealer'').

\9\ The Dodd-Frank Act excludes from the Exchange Act definition

of ``dealer'' persons who engage in security-based swaps with

eligible contract participants. See section 3(a)(5) of the Exchange

Act, 15 U.S.C. 78c(a)(5), as amended by section 761(a)(1) of the

Dodd-Frank Act.

The Dodd-Frank Act does not include comparable amendments for

persons who act as brokers in swaps and security-based swaps.

Because security-based swaps, as defined in section 3(a)(68) of the

Exchange Act, are included in the Exchange Act section 3(a)(10)

definition of ``security,'' persons who act as brokers in connection

with security-based swaps must, absent an exception or exemption,

register with the SEC as a broker pursuant to Exchange Act section

15(a), and comply with the Exchange Act's requirements applicable to

brokers.

In mid-2011, the SEC issued temporary exemptions under the

Exchange Act in connection with the revision of the ``security''

definition to encompass security-based swaps. Among other aspects,

these temporary exemptions extended to certain broker activities

involving security-based swaps. See ``Order Granting Temporary

Exemptions under the Securities Exchange Act of 1934 in Connection

with the Pending Revision of the Definition of ``Security'' to

Encompass Security-Based Swaps, and Request for Comment,''

Securities Exchange Act Release No. 64795 (Jul. 1, 2011), 76 FR

39927, 39939 (Jul. 7, 2011) (addressing availability of exemption to

registration requirement for securities brokers).

---------------------------------------------------------------------------

The CEA and Exchange Act definitions in general encompass persons

that engage in any of the following types of activity:

(i) Holding oneself out as a dealer in swaps or security-based

swaps,

(ii) making a market in swaps or security-based swaps,

(iii) regularly entering into swaps or security-based swaps with

counterparties as an ordinary course of business for one's own account,

or

(iv) engaging in any activity causing oneself to be commonly known

in the trade as a dealer or market maker in swaps or security-based

swaps.\10\

\10\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A); Exchange Act

section 3(a)(71)(A), 15 U.S.C. 78c(a)(71)(A).

---------------------------------------------------------------------------

These dealer activities are enumerated in the CEA and Exchange Act in

the disjunctive, in that a person that engages in any one of these

activities is a swap dealer under the CEA or security-based swap dealer

under the Exchange Act, even if such person does not engage in one or

more of the other identified activities.

At the same time, the statutory dealer definitions provide

exceptions for a person that enters into swaps or security-based swaps

for the person's own account, either individually or in a fiduciary

capacity, but not as a part of a ``regular business.'' \11\ The Dodd-

Frank Act also instructs the Commissions to exempt from designation as

a dealer a person that ``engages in a de minimis quantity of [swap or

security-based swap] dealing in connection with transactions with or on

behalf of its customers.'' \12\ Moreover, the definition of ``swap

dealer'' (but not the definition of ``security-based swap dealer'')

provides that an insured depository institution is not to be considered

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.''

\13\ The statutory definitions further provide that a person may be

designated as a dealer for one or more types, classes or categories of

swaps or security-based swaps, or activities without being designated a

dealer for other types, classes or categories or activities.\14\

---------------------------------------------------------------------------

\11\ See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C); Exchange Act

section 3(a)(71)(C), 15 U.S.C. 78c(a)(71)(C).

\12\ See CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange Act

section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).

\13\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).

\14\ See CEA section 1a(49)(B), 7 U.S.C. 1a(49)(B); Exchange Act

section 3(a)(71)(B), 15 U.S.C. 78c(a)(71)(B).

---------------------------------------------------------------------------

In the Proposing Release, the Commissions proposed rules to

identify the activity that would cause a person to be a dealer,\15\ to

implement the exception for de minimis dealing activity,\16\ to

implement the exception from the swap dealer definition in connection

with the origination of loans by insured depository institutions,\17\

and to provide for the limited purpose designation of dealers.\18\ The

release also set forth proposed interpretive guidance related to the

definitions.

---------------------------------------------------------------------------

\15\ See proposed CFTC Regulation Sec. 1.3(ggg)(1); proposed

Exchange Act rule 3a71-1(a), (b).

\16\ See proposed CFTC Regulation Sec. 1.3(ggg)(4); proposed

Exchange Act rule 3a71-2.

\17\ See proposed CFTC Regulation Sec. 1.3(ggg)(5).

\18\ See proposed CFTC Regulation Sec. 1.3(ggg)(3); proposed

Exchange Act rule 3a71-1(c).

---------------------------------------------------------------------------

After considering the comments received, the Commissions are

adopting final rules and interpretations to further define the terms

``swap dealer'' and ``security-based swap dealer.'' In this Adopting

Release, we particularly address: (i) The general analysis for

identifying dealing activity involving swaps and security-based swaps;

(ii) the exclusion from the ``swap dealer'' definition in connection

with the origination of loans by insured depository institutions; (iii)

the application of the dealer analysis to inter-affiliate swaps and

security-based swaps; (iv) the application of the de minimis exception

from the dealer definitions; and (v) the limited designation of swap

dealers and security-based swap dealers.

A. General Considerations for the Dealer Analysis

1. Proposed Approach

The proposed rules to define the activities that would lead a

person to be a ``swap dealer'' and ``security-based swap dealer'' were

based closely on the corresponding language of the statutory

definitions.\19\ The Proposing Release further noted that the Dodd-

Frank Act defined the terms ``swap dealer'' and ``security-based swap

dealer'' in a functional manner, and stated that those statutory

definitions should not be interpreted in a constrained, overly

technical or rigid manner, particularly given the diversity of the swap

and security-based swap markets. The Proposing Release also identified

potential distinguishing characteristics of swap dealers and security-

based swap dealers based on the functional role that dealers fulfill in

the swap and security-based swap markets, such as: dealers tend to

accommodate demand from other parties; dealers generally are available

to enter into swaps or security-based swaps to facilitate other

parties' interest; dealers tend not to request that other parties

propose the terms of swaps or security-based swaps, but instead tend to

enter into those instruments on their own standard terms or on terms

they arrange in response to other parties' interest; and dealers tend

to be able to arrange customized terms for

[[Page 30598]]

swaps or security-based swaps upon request, or to create new types of

swaps or security-based swaps at the dealer's own initiative.\20\

---------------------------------------------------------------------------

\19\ See CFTC Regulation Sec. 1.3(ggg); Exchange Act rule 3a71-

1(a), (b).

\20\ Proposing Release, 75 FR at 80176.

---------------------------------------------------------------------------

The proposal recognized that the principles for identifying dealing

activity involving swaps can differ from principles for identifying

dealing activity involving security-based swaps, in part due to

differences in how those instruments are used.\21\

---------------------------------------------------------------------------

\21\ Id.

---------------------------------------------------------------------------

a. ``Swap Dealer'' Activity

Consistent with the statutory definition, the proposed rule stated

that the term ``swap dealer'' includes a person that ``regularly enters

into swaps with counterparties as an ordinary course of business for

its own account,'' but also that ``the term swap dealer does not

include 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.'' The Proposing Release stated that these two

provisions should be read in combination with each other, and explained

that the difference between the two provisions is whether or not the

person enters into swaps as a part of, or as an ordinary course of, a

``regular business.'' Thus, the Proposing Release equated the phrases

``ordinary course of business'' and ``regular business.'' The Proposing

Release also stated that persons who enter into swaps as a part of a

``regular business'' are those persons whose function is to accommodate

demand for swaps from other parties and enter into swaps in response to

interest expressed by other parties. Such persons would be swap

dealers.\22\ Conversely, the Proposing Release said that persons who do

not fulfill this function in connection with swaps should not be deemed

to enter into swaps as part of a ``regular business,'' and thus would

not likely be swap dealers.\23\

---------------------------------------------------------------------------

\22\ In addition, the Proposing Release explained that (in

general, and not specifically limited to the provisions relating to

entering into swaps as part of a ``regular business'') the proposed

swap dealer definition does not depend on whether a person's

activity as a swap dealer is the person's sole or predominant

business (other than through the de minimis exception discussed

below).

\23\ See Proposing Release, 75 FR at 80177.

---------------------------------------------------------------------------

In addition, the Proposing Release noted that the nature of swaps

precludes importing concepts used to identify dealers in other areas.

The Proposing Release explained that because swaps are typically not

bought and sold, concepts such as whether a person buys and sells

swaps, makes a two-sided market in swaps, or trades within a bid/offer

spread cannot necessarily be used to determine if the person is a swap

dealer, even if such concepts are useful in determining whether a

person is a dealer in other financial instruments.\24\

---------------------------------------------------------------------------

\24\ See id. at 80176-77.

---------------------------------------------------------------------------

The Proposing Release further stated that swap dealers can be

identified through their relationships with counterparties, explaining

that swap dealers tend to enter into swaps with more counterparties

than do non-dealers, and in some markets, non-dealers tend to

constitute a large portion of swap dealers' counterparties. In

contrast, the Proposing Release said, non-dealers tend to enter into

swaps with swap dealers more often than with other non-dealers. The

Proposing Release noted that it is likely that swap dealers are

involved in most or all significant parts of the swap markets.\25\

---------------------------------------------------------------------------

\25\ See id. at 80177.

---------------------------------------------------------------------------

The Proposing Release concluded that this functional approach would

identify as swap dealers those persons whose function is to serve as

the points of connection in the swap markets. Thus, requiring

registration and compliance with the requirements of the Dodd-Frank Act

by such persons would thereby reduce risk and enhance operational

standards and fair dealing in those markets.\26\

---------------------------------------------------------------------------

\26\ See id.

---------------------------------------------------------------------------

The Proposing Release also noted that the swap markets are diverse

and encompass a wide variety of situations in which parties enter into

swaps with each other, and invited comment as to what aspects of the

parties' activities in particular situations should, or should not, be

considered swap dealing activities. Specifically, the Proposing Release

invited comment regarding persons who enter into swaps: (i) As

aggregators; (ii) as part of their participation in physical markets;

or (iii) in connection with the generation and transmission of

electricity.\27\

---------------------------------------------------------------------------

\27\ See id. at 80183-84.

---------------------------------------------------------------------------

First, regarding aggregators, the Proposing Release noted that some

persons, including certain cooperatives, enter into swaps with other

parties in order to aggregate the swap positions of the other parties

into a size that would be more amenable to entering into swaps in the

larger swap market. The Proposing Release explained that, for example,

certain cooperatives enter into swaps with smaller businesses because

the smaller business cannot establish a commodity position large enough

to be traded on a swap or futures market, or large enough to be of

interest to larger financial institutions. The Proposing Release said

that while such persons engage in activities that are similar in many

respects to those of a swap dealer, it may be that the swap dealing

activities of these aggregators would not exceed the de minimis

threshold, and therefore they would not be swap dealers. The CFTC

requested comment as to how the de minimis threshold would apply to

such persons, and in general on the application of the swap dealer

definition to this activity. The Proposing Release also noted that the

CFTC was engaged in a separate rulemaking pursuant to section

723(c)(3)(B) of the Dodd-Frank Act regarding swaps in agricultural

commodities, and requested comment on the application of the swap

dealer definition to dealers, including potentially agricultural

cooperatives, that limit their dealing activity primarily to swaps in

agricultural commodities.\28\

---------------------------------------------------------------------------

\28\ After publication of the Proposing Release, the CFTC

adopted a final rule on agricultural swaps under which swaps in

agricultural commodities will be permitted to transact subject to

the same rules as all other swaps. See Agricultural Swaps; Final

Rule, 76 FR 49291 (Aug. 10, 2011).

---------------------------------------------------------------------------

Second, the Proposing Release noted that the markets in physical

commodities such as oil, natural gas, chemicals and metals have

developed highly customized transactions, some of which would be

encompassed by the statutory definition of the term ``swap,'' and that

some participants in these markets engage in swap dealing activities

that are above the proposed de minimis threshold. The CFTC invited

comment as to any different or additional factors that should be

considered in applying the swap dealer definition to participants in

these markets.

Third, the Proposing Release noted a number of complexities that

arise when applying the swap dealer definition in connection with the

generation and transmission of electricity. In particular, the

Proposing Release noted that additional complexity results because

electricity is generated, transmitted and used on a continuous, real-

time basis, and because the number and variety of participants in the

electricity market is very large, and some electricity services are

provided as a public good rather than for profit. The CFTC invited

comment as to any different or additional factors that should be

considered in applying the swap dealer definition to participants in

the generation and transmission of electricity. Specifically, the CFTC

invited comment on whether there are special considerations, including

without limitation special considerations arising from section

[[Page 30599]]

201(f) of the Federal Power Act,\29\ related to not-for-profit power

systems such as rural electric cooperatives and entities operating as

political subdivisions of a state and on the applicability of the

exemptive authority in section 722(f) of the Dodd-Frank Act to address

those considerations.

---------------------------------------------------------------------------

\29\ 16 U.S.C. 824(f).

---------------------------------------------------------------------------

b. ``Security-Based Swap Dealer'' Activity

The Proposing Release noted the parallels between the definition of

``security-based swap dealer'' and the definition of ``dealer'' under

the Exchange Act,\30\ as well as the fact that security-based swaps may

be used to hedge risks associated with owning certain types of

securities or to gain economic exposure akin to ownership of certain

types of securities. As a result, the Proposing Release took the view

that the same factors that are relevant to determining whether a person

is a ``dealer'' under the Exchange Act also are generally relevant to

the analysis of whether a person is a security-based swap dealer. The

Proposing Release also addressed the relevance of the ``dealer-trader''

distinction for identifying dealing activity involving security-based

swaps,\31\ while recognizing that certain concepts associated with the

dealer-trader distinction--particularly concepts involving ``turnover

of inventory'' and ``regular place of business''--appeared potentially

less applicable to the security-based swap dealer definition. In

addition, the Proposing Release noted that under the dealer-trader

distinction, we would expect that entities that use security-based

swaps to hedge business risks, absent other activities, likely would

not be dealers.\32\

---------------------------------------------------------------------------

\30\ See Exchange Act sections 3(a)(5)(A), (B), 15 U.S.C.

78c(a)(5)(A), (B), as amended by Section 761(a)(1) of the Dodd-Frank

Act.

\31\ The Proposing Release referred to the fact that the SEC

previously has noted that the dealer-trader distinction:

``recognizes that dealers normally have a regular clientele, hold

themselves out as buying or selling securities at a regular place of

business, have a regular turnover of inventory (or participate in

the sale or distribution of new issues, such as by acting as an

underwriter), and generally provide liquidity services in

transactions with investors (or, in the case of dealers who are

market makers, for other professionals).'' Proposing Release, 75 FR

at 80177 (citing Securities Exchange Act Release No. 47364 (Feb. 13,

2003) (footnotes omitted)). The Proposing Release further noted that

other non-exclusive factors that are relevant for distinguishing

between dealers and non-dealers can include receipt of customer

property and the furnishing of incidental advice in connection with

transactions. See id.

\32\ See Proposing Release, 75 FR at 80177-78.

---------------------------------------------------------------------------

c. Additional Principles Common to Both Definitions

i. ``Hold Themselves Out'' and ``Commonly Known in the Trade'' Tests

The Proposing Release identified the following non-exclusive list

of factors as potentially indicating that a person meets the ``hold

themselves out'' and ``commonly known in the trade'' tests of the

statutory dealer definitions:

Contacting potential counterparties to solicit interest in

swaps or security-based swaps;

Developing new types of swaps or security-based swaps

(which may include financial products that contain swaps or security-

based swaps) and informing potential counterparties of the availability

of such swaps or security-based swaps and a willingness to enter into

such swaps or security-based swaps with the potential counterparties;

Membership in a swap association in a category reserved

for dealers;

Providing marketing materials (such as a Web site) that

describe the types of swaps or security-based swaps that one is willing

to enter into with other parties; or

Generally expressing a willingness to offer or provide a

range of financial products that would include swaps or security-based

swaps.\33\

---------------------------------------------------------------------------

\33\ See id. at 80178.

---------------------------------------------------------------------------

The Proposing Release further stated that the test for being

``commonly known in the trade'' as a swap dealer or security-based swap

dealer may appropriately reflect, among other factors, the perspective

of persons with substantial experience with and knowledge of the swap

and security-based swap markets (regardless of whether a particular

entity is known as a dealer by persons without that experience or

knowledge). The Proposing Release also stated that holding oneself out

as a security-based swap dealer likely would encompass a person who is

a dealer in another type of security entering into a security-based

swap with a customer, as well as a person expressing its availability

to enter into security-based swaps, regardless of the direction of the

transaction or across a broad spectrum of risks.\34\

---------------------------------------------------------------------------

\34\ See id.

---------------------------------------------------------------------------

ii. Market Making

In addressing the statutory definitions' ``making a market'' test,

the Proposing Release noted that while continuous two-sided quotations

and a willingness to buy and sell a security are important indicators

of market making in the equities market, these indicia may not be

appropriate in the swap and security-based swap markets. The proposal

also noted that nothing in the statutory text or legislative history

suggested the intent to impute a ``continuous'' activity requirement to

the dealer definitions.\35\

---------------------------------------------------------------------------

\35\ See id.

---------------------------------------------------------------------------

iii. No Predominance Test

The Proposing Release further addressed whether a person should be

a dealer only if that activity is the person's sole or predominant

business, and took the view that such an approach was not consistent

with the statutory definition. The Proposing Release rejected this as

an unworkable test of dealer status because many parties that commonly

are acknowledged as dealers also engage in other businesses that

outweigh their swap or security-based swap dealing business in terms of

transaction volume or other measures.\36\

---------------------------------------------------------------------------

\36\ See id. at 80178-79.

---------------------------------------------------------------------------

iv. Application to New Types of Wwaps and New Activities

The Proposing Release noted that the Commissions intended to apply

the dealer definitions flexibly when the development of innovative

business models is accompanied by new types of dealer activity,

following a facts-and-circumstances approach.\37\

---------------------------------------------------------------------------

\37\ See id. at 80179.

---------------------------------------------------------------------------

2. Commenters' Views

Numerous commenters addressed the proposed rules and

interpretations in connection with the ``swap dealer'' and ``security-

based swap dealer'' definitions. Several commenters addressed

principles that are common to the two dealer definitions, while a

number of commenters also addressed interpretations in the Proposing

Release that were specific to the ``swap dealer'' definition.

a. ``Hold Themselves Out'' and ``Commonly Known in the Trade'' Tests

Some commenters expressed the view that the persons that hold

themselves out as or are commonly known as dealers are easy to

identify.\38\ In addressing the ``hold themselves out'' and ``commonly

known'' criteria of the dealer definitions, commenters placed

particular focus on whether only dealers engage in the activities cited

by the

[[Page 30600]]

Proposing Release, or whether those activities are common both to

dealers and to other users of swaps and security-based swaps.

Commenters particularly stated that end users contact potential

counterparties,\39\ develop new types of swaps or security-based

swaps,\40\ and propose terms or language for swap or security-based

swap agreements.\41\ One commenter further stated that identifying

dealing activity based on whether a person develops new types of swaps

or proposes swap terms would discourage innovation and the free

negotiation of swaps.\42\ Some commenters stated that merely responding

to a request for proposals or quotations should not, in itself,

constitute dealing.\43\ Commenters also criticized the Proposing

Release's suggestion that criteria for identifying dealing activity

include membership in a dealer category of a trade association,\44\ as

well as providing marketing materials and offering a range of financial

products.\45\ Commenters also argued for more objective criteria for

identifying persons ``commonly known'' as dealers.\46\

---------------------------------------------------------------------------

\38\ See transcript of Joint CFTC-SEC Staff Roundtable

Discussion on Proposed Dealer and Major Participant Definitions

Under Dodd-Frank Act, June 16, 2011 (``Roundtable Transcript'') at

22-23 (remarks of Ron Filler, New York Law School), 50-51 (remarks

of Ron Oppenheimer, Working Group of Commercial Energy Firms), 215

(remarks of Bella Sanevich, NISA Investment Advisors LLC).

\39\ See letters from the Financial Services Roundtable

(``FSR'') dated February 22, 2011 (``FSR I''), the International

Swap Dealers Association (``ISDA'') dated February 22, 2011 (``ISDA

I'') and the Midsize Bank Coalition of America (``Midsize Banks'').

\40\ See letters from the Committee on Capital Markets

Regulation (``CCMR'') dated February 22, 2011 (``CCMR I''), FSR I,

ISDA I and Midsize Banks.

\41\ See letters from the BG Americas & Global LNG (``BG LNG'')

dated February 22, 2011 (``BG LNG I''), CCMR I, EDF Trading North

America, LLC (``EDF Trading'') and The Gavilon Group, LLC

(``Gavilon'') dated February 21, 2011 (``Gavilon II'').

\42\ See letter from EDF Trading.

\43\ See meeting with American Electric Power, Calpine

Corporation (``Calpine''), Constellation, DC Energy LLC (``DC

Energy''), Edison International (``Edison Int'l''), Exelon Corp.,

GenOn, Southern Company, Edison Electric Institute (``EEI'') and

Electric Power Supply Association (``ESPA'') (collectively

``Electric Companies'') on April 13, 2011.

\44\ See letter from ISDA I and joint letter from National Corn

Growers Association (``NCGA'') and Natural Gas Supply Association

(``NGSA'') (``NCGA/NGSA'') dated February 22, 2011 (``NCGA/NGSA

I'').

\45\ See letter from ISDA I.

\46\ See letters from ISDA I and Peabody Energy Corporation

(``Peabody'').

---------------------------------------------------------------------------

Conversely, one commenter said that three particular activities

cited in the Proposing Release--membership in a swap association

category reserved for dealers, providing marketing materials and

expressing a willingness to offer a range of financial products--are

indicative of holding oneself out as a dealer or being commonly known

in the trade as a dealer, and should be codified in the final rule.\47\

Another commenter suggested other factors, such as having a derivatives

sales team, that should be treated as indicators of dealer

activity.\48\ Commenters also expressed the view that this aspect of

the dealer definition should focus on whether a person solicits

expressions of interest in swaps from a range of market

participants,\49\ and that end users of swaps can actively seek out and

negotiate swaps without necessarily being swap dealers.\50\

---------------------------------------------------------------------------

\47\ See letter from FSR I.

\48\ See meeting with Vitol, Inc. (``Vitol'') on February 16,

2011.

\49\ See letter from Midsize Banks.

\50\ See letter from EDF Trading.

---------------------------------------------------------------------------

b. Market Making

Several commenters generally requested that the Commissions provide

more guidance as to which activities constitute making a market in

swaps or security-based swaps.\51\ Commenters also described various

activities as indicating, or not indicating, market making activity.

For example, two commenters expressed the view that market making is

characterized by entering into swaps on one side of the market and then

establishing offsetting positions on the other side of the market.\52\

Other commenters equated market making to providing liquidity by

regularly quoting bid and offer prices for swaps, and standing ready to

enter into swaps.\53\ One commenter stated that market making activity

is indicated by a person consistently presenting itself as willing to

take either side of a trade.\54\ Two commenters said that market makers

receive tangible benefits (such as reduced trading fees) in return for

the obligation to transact when liquidity is required.\55\

---------------------------------------------------------------------------

\51\ See joint letter from American Benefits Council and the

Committee on Investment of Employee Benefits Assets (``ABC/CIEBA'')

and letters from FSR I.

\52\ See letters from DC Energy and FSR I.

\53\ See letters from Edison Int'l, NextEra Energy Resources,

LLC (``NextEra'') dated February 22, 2011 (``NextEra I'') and Vitol,

and joint letter from American Electric Power, Edison Int'l, Exelon

Corp., and Southern Company (``Utility Group'').

\54\ See letter from ISDA I.

\55\ See joint letter from EEI and EPSA (``EEI/EPSA'') and

letter from Vitol.

---------------------------------------------------------------------------

In contrast, one commenter said the proposal correctly did not

limit market making to consistently quoting a two-sided market, because

to do so would insert a loophole into the definition.\56\ Some

commenters expressed the view that mere active participation in a

market or entering into swaps on both sides of a market does not

necessarily constitute market making.\57\ Others said that occasionally

quoting prices on both sides of the market is not market making when

done to obtain information about the market or to mask one's view of

the market.\58\ One commenter stated that futures commission merchants

(``FCMs'') and broker-dealers that facilitate customers' entering into

swaps are not necessarily market makers.\59\ Other commenters urged the

Commissions to reject the view that market making requires continuous

activity.\60\

---------------------------------------------------------------------------

\56\ See letter from Americans for Financial Reform (``AFR'').

\57\ See letters from ABC/CIEBA, Managed Funds Association

(``MFA'') dated February 22, 2011 (``MFA I''), and Vitol.

\58\ See letters from NextEra Iand Vitol.

\59\ See letter from Newedge USA LLC (``Newedge''); see also

Roundtable Transcript at 39 (remarks of Eric Chern, Chicago Trading

Company).

\60\ See letters from American Federation of State, County and

Municipal Employees (``AFSCME''), and FSR I.

---------------------------------------------------------------------------

A number of commenters addressed the issue of how the dealer

definitions should treat swaps or security-based swaps entered into on

a trading platform such as a designated contract market (``DCM''),

national securities exchange, swap execution facility (``SEF''), or

security-based SEF (collectively referred to herein as

``exchanges'').\61\ Several stated that entering into swaps or

security-based swaps on exchanges should not be considered in

determining if a person is a dealer.\62\ Some of these commenters

emphasized the fact that parties would not know the identity of the

counterparty to the swap executed on an exchange (i.e., such swaps are

``anonymous''),\63\ while other commenters said that such swaps do not

constitute ``accommodating demand'' for swaps or ``facilitating

interest'' in swaps.\64\ Another commenter said that future means of

executing swaps on exchanges are likely to be diverse, and it is

premature to draw conclusions

[[Page 30601]]

about how they should be treated in the dealer definitions.\65\

---------------------------------------------------------------------------

\61\ While some of these commenters specially addressed this

issue in the context of whether a person is a market maker in swaps,

others more generally addressed the issue in terms of whether a

person is a dealer. For clarity, all of those comments are being

addressed in the market maker context.

\62\ See letters from EEI/EPSA, International Energy Credit

Association (``IECA-Credit'') dated February 22, 2011 (``IECA-Credit

I''), and NextEra I, joint letter from Shell Trading (US) Company

and Shell Energy North America (US), L.P. (``Shell Trading'') dated

February 22, 2011 (``Shell Trading I''), and joint letter from

Allston Trading, LLC, Atlantic Trading USA LLC, Bluefin Trading LLC,

Chopper Trading LLC, DRW Holdings, LLC, Eagle Seven, LLC, Endeavor

Trading, LLC, Geneva Trading USA, LLC, GETCO, Hard Eight Futures,

LLC, HTG Capital Partners, IMC Financial Markets, Infinium Capital

Management LLC, Kottke Associates, LLC, Liger Investments Limited,

Marquette Partners, LP, Nico Holdings LLC, Optiver US, Quantlab

Financial, LLC, RGM Advisors, LLC, Tibra Trading America LLC,

Traditum Group LLC, WH Trading and XR Trading LLC (``Traders

Coalition'').

\63\ See letters from Shell Trading I and Traders Coalition.

\64\ See letters from EEI/EPSA, IECA-Credit I, and NextEra I.

For further discussion of this issue, see parts II.A.4 and II.A.5

below.

\65\ See letter from Metropolitan Life Insurance Company

(``MetLife'').

---------------------------------------------------------------------------

Two commenters asserted that firms that provide liquidity in

cleared and exchange-executed swaps by actively participating in the

market provide heterogeneity among liquidity providers and thereby

disperse risk, and further stated that to regulate such persons as swap

dealers subject to increased capital requirements would discourage

their participation in the market and increase risk.\66\

---------------------------------------------------------------------------

\66\ See letters from Newedge and Traders Coalition; Roundtable

Transcript at 39 (remarks of Eric Chern, Chicago Trading Company).

---------------------------------------------------------------------------

One commenter expressed the view that the statutory definition uses

dealing and market making interchangeably, and suggested that the

analysis of whether a person acts as a dealer should be subsumed within

the analysis of whether it acts as a market maker.\67\

---------------------------------------------------------------------------

\67\ See letter from ISDA I.

---------------------------------------------------------------------------

c. Exception for Activities Not Part of a ``Regular Business''

Several commenters addressed the exception from the dealer

definitions for swap or security-based swap activities that are not

part of a ``regular business.'' Some commenters supported the

Commissions' proposed interpretation in the context of the ``swap

dealer'' definition and stated that this interpretation should be

codified in the text of the final rule.\68\

---------------------------------------------------------------------------

\68\ See letters from FSR I, MFA I and Midsize Banks.

---------------------------------------------------------------------------

Many commenters said that the activity of entering into swaps or

security-based swaps should not be deemed to be a ``regular business,''

and thus not indicative of dealing activity, when the person's use of

swaps or security-based swaps are ancillary to, or in connection with,

a separate non-swap business that is the person's primary business.\69\

Some commenters making this point said that when the person's primary

business relates to physical commodities, the person's use of swaps

relating to those commodities does not constitute a ``regular

business.'' \70\ Other commenters stated that where a person enters

into swaps to serve its own business needs, as opposed to serving the

business needs of the counterparty, the person's use of swaps does not

constitute a ``regular business.'' \71\ Other commenters said that the

use of swaps to hedge the commercial risks of a business does not

constitute a ``regular business'' of entering into swaps.\72\ Some

commenters also suggested that the ``regular business'' exclusion

should be interpreted to mean ``regular swap dealing business'' or

``regular security-based swap dealing business'' to prevent the dealer

definitions from capturing hedgers.\73\

---------------------------------------------------------------------------

\69\ See Roundtable Transcript at 88 (remarks of Steve Walton,

Bank of Oklahoma).

\70\ See letters from Atmos Energy Corporation (``Atmos

Energy''), Dominion Resources, Inc. (``Dominion Resources''), EDF

Trading, Edison Int'l, EEI/EPSA, Gavilon II, Hess Corporation and

its affiliates (``Hess''), Mississippi Public Utility Staff, NextEra

I, National Milk Producers Federation (``NMPF''), Shell Trading I,

Utility Group and Working Group of Commercial Energy Firms

(``WGCEF'') on the swap dealer definition dated February 22, 2011

(``WGCEF I''), and meeting with Bunge on February 23, 2011.

\71\ See letters from BT Pension Scheme Management Limited

(``BTPS''), EDF Trading, EEI/EPSA and Vitol.

\72\ See letters from American Petroleum Institute (``API'')

dated February 22, 2011 (``API I''), Calpine, Coalition of Physical

Energy Companies (``COPE'') dated February 22, 2011 (``COPE I''),

Dominion Resources, EDF Trading, Edison Int'l and Peabody; see also

Roundtable Transcript at 45 (remarks of Ed Prosser, Gavilon) and

letter from Church Alliance. In addition, three commenters said that

the interpretation of the provisions relating to a ``regular

business'' in the Proposing Release is correct, because it will

exclude from the definition of swap dealer those persons using swaps

to hedge commercial risk. See letters from Air Transport Association

of America, Inc. (``ATAA''), IECA-Credit I and joint letter from

Petroleum Marketers Association of America and New England Fuel

Institute.

\73\ See letters from Church Alliance and Peabody.

---------------------------------------------------------------------------

On the other hand, two commenters said that the proposed

interpretation was correct in the view that the test of whether a

person has a ``regular business'' of entering into swaps does not

necessarily depend on whether a person's swap activities are a

predominant activity, because such an approach would allow a person to

engage in a significant level of swap dealing activity without

registering as a swap dealer simply because the person also has

substantial activities in a non-swap business or businesses.\74\

---------------------------------------------------------------------------

\74\ See letters from AFR and Better Markets, Inc. (``Better

Markets'') dated February 22, 2011 (``Better Markets I'').

---------------------------------------------------------------------------

Other commenters suggested that the types of swap activities that a

person engages in are relevant to determining whether the person has a

``regular business'' of entering into swaps. One commenter stated that

a person has a ``regular business'' of entering into swaps when the

person has a primary business of accommodating demand or facilitating

interest in swaps,\75\ while others similarly emphasized that a

``regular business'' of entering into swaps is characterized by

financial intermediation activities.\76\ One commenter took the view

that a person that enters into swaps primarily with financial

intermediaries does not have a ``regular business'' of entering into

swaps.\77\

---------------------------------------------------------------------------

\75\ See letter from IECA-Credit I.

\76\ See letter from NextEra I and Shell Trading I. Another

commenter disagreed with this approach, however, saying that a

person who enters into swaps as an intermediary between smaller

customers and larger financial institutions is not entering into

swaps for its ``own account'' and therefore is not a swap dealer,

but rather would be an FCM or introducing broker. See letter from

MFX Solutions, Inc. (``MFX'') dated February 22, 2011 (``MFX I'').

\77\ See letter from Traders Coalition.

---------------------------------------------------------------------------

Some commenters said that the final rule should clarify the point

at which a person's episodic or occasional swap activities become a

``regular business'' of entering into swaps.\78\ Others stated that the

fact that a person enters into swaps frequently or with a large number

of counterparties does not necessarily mean that the person has a

``regular business'' of entering into swaps.\79\

---------------------------------------------------------------------------

\78\ See letters from BG LNG I and WGCEF I.

\79\ See letters from NCGA/NGSA I and Vitol. One of these

commenters asked that the final rule clarify that simply because a

person engages in swap activity exceeding the thresholds for the de

minimis exception from the swap dealer definition does not

necessarily mean that the person is engaged in a ``regular

business'' of swap dealing. See letter from Vitol.

---------------------------------------------------------------------------

Commenters proposed specific tests for determining if a person has

a ``regular business'' of entering into swaps. One commenter said the

determination should look to whether a person enters into swaps to

accommodate demand from other parties and to profit from a bid/ask

spread on swaps (as opposed to swaps that are substitutes for physical

transactions or positions and used by at least one party to hedge

commercial risk), and consider specifically the volume, revenues and

profits of such activities, the person's value at risk (VaR) and

exposure from such activities, and its resources devoted to such

activities.\80\ Another commenter said that the determination should be

based on the nature of the person's business, the person's business

purpose for using swaps, and the person's method of executing swap

transactions (e.g., a person whose business primarily relates to

physical commodities, who uses swaps to hedge commercial risk, and who

executes swaps on an exchange would be less likely to have a ``regular

business'' of entering into swaps).\81\

---------------------------------------------------------------------------

\80\ See letter from NextEra I; see also letter from Hess

(proposing similar criteria).

\81\ See letter from Shell Trading I.

---------------------------------------------------------------------------

One commenter argued that the ``regular business'' exception should

apply to all four of the dealer tests--not only the test for persons

that regularly enters into swaps or security-based swaps as an

``ordinary course of business''--and further argued that the ``regular

business'' exception should be linked to a ``two-way market'' base

[[Page 30602]]

requirement to avoid commercial hedgers being encompassed by the dealer

definitions.\82\

---------------------------------------------------------------------------

\82\ See letter from ISDA dated I.

---------------------------------------------------------------------------

d. Other Dealer Issues

Commenters also addressed other issues in the Proposing Release,

including: (i) Whether Congress intended that there be implicit

preconditions to dealer status; (ii) whether the concepts of

``accommodating demand'' for swaps or security-based swaps or

``facilitating interest'' in swaps are useful in identifying dealers;

and (iii) whether the interpretation of the dealer definitions should

depend on pre-defined, objective criteria.

i. Preconditions

Several commenters said that the proposal is overbroad and would

encompass persons that Congress did not intend to regulate as

dealers.\83\ Comments in this vein said that the statutory definition

should be interpreted to require that persons meet certain criteria or

engage in certain activity, not explicitly stated in the statute, to be

covered by the swap dealer definition. For instance, some commenters

said that a dealer is a person who enters into swaps or security-based

swaps on either side of the market and who profits from fees for doing

so, or from the spread between the terms of swaps on either side of the

market.\84\ Other commenters made a similar point, saying that swap

dealers are those persons that intermediate between swap users on

either side of the market.\85\

---------------------------------------------------------------------------

\83\ See, e.g., letters from BG LNG I, EDF Trading, ISDA I,

NCGA/NGSA dated February 17, 2012 (``NCGA/NGSA II'') and WGCEF I,

and joint letter from American Farm Bureau Federation, American

Soybean Association, National Association of Wheat Growers, National

Cattlemen's Beef Association, National Corn Growers Association,

National Council of Farmer Cooperatives, National Grain and Feed

Association, National Milk Producers Federation and National Pork

Producers Council (``Farmers' Associations'').

\84\ See letters from COPE I, Edison Int'l, Hess, ISDA I, Shell

Trading I, Utility Group, Vitol and WGCEF I; see also Roundtable

Transcript at 43-45 (remarks of Ed Prosser, Gavilon). However, other

commenters questioned whether profiting from a bid/ask spread is a

relevant test of dealer status, and emphasized that dealers are

those persons who take risk by entering into swaps or security-based

swaps on both sides of the market. See Roundtable Transcript at 21,

56 (remarks of Richard Ostrander, Morgan Stanley) and 43 (remarks of

Russ Wasson, National Rural Electric Cooperative Association

(``NRECA'')). Another commenter pointed out that it could be

difficult to determine how a person is profiting from entering into

swaps. See Roundtable Transcript at 42 (remarks of Michael Masters,

Better Markets).

\85\ See letters from API I, BG LNG I and NCGA/NGSA II.

---------------------------------------------------------------------------

The commenters were not all in agreement on this, however. Several

commenters (including some of those that said swap dealers enter into

swaps on both sides of the market) also stated that there are a variety

of situations in which a person's activity of contemporaneously

entering into swaps on both sides of the market is not indicative of

dealing activity.\86\ One commenter said that it would not be

appropriate to require that a person enter into swaps or security-based

swaps on both sides of the market as a litmus test for dealer status,

because to do so would create loopholes in the definition.\87\ Two

commenters also supported rejection of any interpretation that would

limit the dealer definitions to encompass only those entities that

solely or predominately act as dealers.\88\

---------------------------------------------------------------------------

\86\ The examples cited were: entering into swaps on either side

of a market depending on a firm's commercial purpose for entering

each particular swap (see letters from the Industrial Energy

Consumers of America (``IECA-Consumers'') and WGCEF I, and letter

from the Not-For-Profit Electric End User Coalition (``NFPEEU''),

consisting of NRECA, American Public Power Association (``APPA'')

and Large Public Power Council (``LPPC''); see also Roundtable

Transcript at 44 (remarks of Ed Prosser, Gavilon)); entering into

swaps on both sides of an illiquid market for purposes of price

discovery or to elicit bids and offers from other market

participants (see letters from Hess, Vitol and WGCEF I); and

entering into swaps on both sides of the market as part of an

investment strategy (see letter from ABC/CIEBA).

\87\ See letter from AFR.

\88\ See letters from AFR and Better Markets I.

---------------------------------------------------------------------------

In addition, commenters were particularly divided as to whether

acting as an intermediary always is indicative of swap dealing, as some

commenters said that a person is not a swap dealer when it simply

stands between two parties by entering into offsetting swaps with each

party.\89\

---------------------------------------------------------------------------

\89\ See letters from BOKF, National Association (``BOK'') dated

January 13, 2012 (``BOK V''), MFX I, Newedge and Northland Energy

Trading LLC (``Northland Energy''); see also Roundtable Transcript

at 48 (remarks of John Nicholas, Newedge). One commenter queried

whether the final rule should clarify whether a customer

relationship between the parties to a swap is necessary in order for

the swap to be relevant in determining whether either of the parties

is a swap dealer. See letter from Representative Scott Desjarlais

(``Rep. Desjarlais'').

---------------------------------------------------------------------------

ii. ``Accommodating Demand'' and ``Facilitating Interest''

A number of commenters addressed the Proposing Release's view that

a tendency to accommodate demand for swaps and a general availability

to enter into swaps to facilitate other parties' interest in swaps

(referred to here as ``accommodating demand'' and ``facilitating

interest'') are characteristic of swap dealers. Some commenters stated

that accommodating demand and facilitating interest would not be

effective factors to identify swap dealers, particularly in bilateral

negotiations where it is difficult to say which party is accommodating

demand for swaps.\90\ Other commenters said the activities of

accommodating demand or facilitating interest are indicative of swap

dealing only in certain circumstances, such as when they are not

related to a person's commodity business,\91\ or when done with the

purpose of serving the needs of the other party to the swap.\92\ Some

commenters argued that the statement in the Proposing Release that swap

dealers are likely involved in most or all significant parts of the

swap markets is incorrect in the market for energy swaps. There, the

commenters said, persons can find counterparties for swaps without the

intermediation of a swap dealer, and swaps entered into directly by two

end users are more frequent.\93\

---------------------------------------------------------------------------

\90\ See letters from NextEra I and Peabody and meeting with

Vitol on February 15, 2011.

\91\ See letter from Shell Trading I.

\92\ See letters from IECA-Credit I, National Association of

Insurance Commissioners (``NAIC''), Vitol and WGCEF I. One of these

commenters also said that entering into a bespoke swap with a

registered swap dealer, in which the swap dealer lays off risk,

should not be viewed as accommodating demand or facilitating

interest. See letter from Vitol.

\93\ See letter from BG LNG I, NCGA/NGSA I, NFPEEU, NRG Energy,

Inc. (``NRG Energy'') and WGCEF I and meeting with Vitol on February

16, 2011.

---------------------------------------------------------------------------

Other commenters, though, said that the proposal's focus on

accommodating demand and facilitating interest strikes the right

balance and that the proposed approach is generally correct.\94\

Another commenter did not object to including accommodating demand and

facilitating risk as factors in the definition, but said that those

factors should be applied flexibly.\95\

---------------------------------------------------------------------------

\94\ See letters from AFR and MFX I.

\95\ See letter from National Grain and Feed Association

(``NGFA'') dated February 22, 2011 (``NGFA I'').

---------------------------------------------------------------------------

iii. Application of Objective Criteria, and Additional Factors

Some commenters, specifically addressing the CFTC's proposed

interpretive approach to the ``swap dealer'' definition, said that the

final rule should set out objective criteria that market participants

could use to determine whether or not they are covered by the

definition and therefore required to register as swap dealers.\96\

[[Page 30603]]

Others focused especially on statements in the Proposing Release to the

effect that swap dealers are those persons who ``tend to'' engage in

certain activities, and that persons who engage in certain activities

are ``likely'' to be swap dealers, as being overly subjective and

difficult to interpret.\97\

---------------------------------------------------------------------------

\96\ See letters from BG LNG I, EEI/EPSA, Peabody, Rep.

Desjarlais and Utility Group. Some commenters said that the CFTC's

interpretive approach to the swap dealer definition should be

codified in the text of the final rule. See letters from Alternative

Investment Management Association Limited (``AIMA'') dated February

22, 2011 (``AIMA I'') and COPE I.

\97\ See letters from BG LNG I, Chesapeake Energy Corporation

(``Chesapeake Energy''), COPE I, ISDA I, Vitol and WGCEF I. Some

commenters focused on particular aspects of the swap dealer

definition as requiring further detail, such as, for example, what

it means to be ``commonly known in the trade'' as a swap dealer (see

letter from Peabody) and the definition of market making (see

letters from Midsize Banks and Peabody).

---------------------------------------------------------------------------

Certain commenters suggested specific objective criteria to use to

identify swap dealers. One commenter said that swap dealing activity is

characterized by more frequent use of swaps; having substantial staff

and technological resources devoted to swaps; a larger portion of

revenue and profit being derived from swap activity; and owning fewer

physical assets related to the type of swaps entered into.\98\ Another

commenter said that to identify swap dealers, the CFTC should compare a

person's revenue or profits generated by swap activity to its overall

revenue or profits; compare a person's total business volume to the

volume, VaR and exposure associated with the swap activity; compare a

person's total business resources to the resources devoted to swap

activity; and consider ownership or control of physical assets in the

specific market or region to which the person's swap activity is

tied.\99\

---------------------------------------------------------------------------

\98\ See letter from Hess.

\99\ See letter from NextEra I.

---------------------------------------------------------------------------

More generally, some commenters supported codification of more

concrete tests in connection with the dealer definitions.\100\ However,

other commenters said that the use of bright line rules to determine

whether a person is a dealer would be inappropriate given the dynamic

nature of the swap and security-based swap markets. These commenters

supported a facts and circumstances approach to the dealer definition

as a better approach.\101\ One commenter also raised issues about the

sources of information that may be considered as part of a dealer

determination.\102\

---------------------------------------------------------------------------

\100\ See, e.g., letters from EEI/EPSA, FSR I, ISDA I, NextEra I

and WGCEF I.

\101\ See letters from Better Markets I, Chris Barnard

(``Barnard'') and Prof. Michael Greenberger, University of Maryland

School of Law (``Greenberger'').

\102\ See letter from ISDA I (stating that sources of

information considered by the Commissions in determining dealer

status should be revealed to the entity being evaluated).

---------------------------------------------------------------------------

e. Application of Exchange Act ``Dealer-Trader'' distinction

i. Security-Based Swap Dealer Definition

A number of commenters supported the proposed use of the dealer-

trader distinction under the Exchange Act to interpret the ``security-

based swap dealer'' definition.\103\ Two commenters, however,

specifically opposed use of the distinction in the context of security-

based swaps, arguing that use of the distinction would create confusion

or would be inconsistent with the goal of improved transparency.\104\

---------------------------------------------------------------------------

\103\ See, e.g., letters from Coalition for Derivatives End-

Users (``CDEU''), CCMR I, ISDA I and MetLife.

\104\ See letters from AFR and AFSCME.

---------------------------------------------------------------------------

ii. Swap Dealer Definition

Some commenters said that the CFTC should apply the dealer-trader

distinction as it has been interpreted with respect to the definition

of ``dealer'' under the Exchange Act to identify swap dealers.\105\

Some commenters said that the applicable interpretations under the

Exchange Act mean that swaps a person uses for proprietary trading

(including for speculative purposes) should not be considered in

determining if the person is a swap dealer because dealers enter into

transactions in order to profit from spreads or fees regardless of

their view of the market for the underlying item, whereas traders enter

into transactions in order to take a view on the direction of the

market or to obtain exposure to movements in the price of the

underlying item.\106\ Two commenters said that if the CFTC applied the

distinction, traders should be subject to potential registration as

major swap participants, and dealers should be subject to regulation as

swap dealers.\107\ Commenters acknowledged differences between the

market for swaps and the market for securities, but said that the

Exchange Act interpretations are still relevant.\108\

---------------------------------------------------------------------------

\105\ Some of these commenters said that, since some provisions

in the statutory swap dealer definition are similar to the

definition of a ``dealer'' under the Exchange Act, Congress intended

that the two definitions would be applied in the same way. See

letters from API I, BG LNG I, CDEU, IECA-Consumers and WGCEF I.

Others said that the CFTC should apply these interpretations because

they have been effectively applied for a long time in the context of

securities. See letters from CCMR I and MFA I.

\106\ See letters from Gavilon II, and Next Era I, and meetings

with Electric Companies on April 13, 2011 and WGCEF on April 28,

2011. Another commenter said the interpretations mean that dealers

and traders can be distinguished by their activities: dealers hold

themselves out as buying and selling on a regular basis, derive

income from providing services in the chain of distribution, and

profit from price spreads, while traders do not provide services or

extend credit but, rather, profit from changes in the market value

of underlying items. See letter from API I.

\107\ See letters from EDF Trading and IECA-Consumers.

\108\ See letters from API I, Gavilon I and IECA-Consumers.

---------------------------------------------------------------------------

On the other hand, some commenters agreed with the CFTC's view not

to apply Exchange Act interpretations to the definition of the term

``swap dealer.'' These commenters said that it is appropriate not to

apply the interpretations under the Exchange Act to identify persons

that meet the swap dealer definition under the CEA.\109\

---------------------------------------------------------------------------

\109\ See letters from AFR and AFSCME; see also joint meeting

with AFR and Better Markets on March 17, 2011 (dealer-trader

distinction not helpful in identifying swap dealers because the

transparency and operational robustness of the swap market is much

lower than in the securities market). One commenter said the

precedents should be applied only by the SEC to identify security-

based swap dealers. See letter from NAIC.

---------------------------------------------------------------------------

e. Application to Particular Swap Markets

i. Aggregators

Certain commenters addressed persons who enter into swaps as

aggregators, with most of those commenters discussing agricultural

cooperatives. Commenters said that agricultural cooperatives that hedge

their own risks or the risks of their members regarding agricultural

commodities should be excluded from the swap dealer definition because

Congress did not intend to treat agricultural cooperatives as swap

dealers and because agricultural cooperatives are in effect an

extension of their members.\110\ Some commenters said that the

agricultural cooperatives' use of swaps allows their members to hedge

risks when the members' transactions are too small for (or otherwise

not qualified for) the futures markets.\111\

---------------------------------------------------------------------------

\110\ See letters from Dairy Farmers of America (``DFA''),

Growmark, Land O'Lakes, Inc. (``Land O'Lakes'') dated February 22,

2011 (``Land O'Lakes II''), National Council of Farmer Cooperatives

(``NCFC'') dated February 22, 2011 (``NCFC I'') and NMPF. One

commenter also said that a subsidiary of an agricultural cooperative

that enters into swaps with its parent cooperative, and the members

of the parent cooperative, should be excluded from the swap dealer

definition for the same reason. See meeting with Agrivisor. Another

commenter said that an agricultural cooperative's swaps with farmers

and other persons for risk management should be disregarded in

determining if the cooperative is a swap dealer so long as the swaps

relate to the marketing function of the cooperative, even if the

swaps are not with members of the cooperative. See letter from NMPF.

\111\ See letters from DFA and Growmark.

---------------------------------------------------------------------------

Some commenters said that an exclusion from the swap dealer

definition also should be available to private companies that serve as

aggregators for swaps in agricultural commodities or otherwise offer

swaps

[[Page 30604]]

for agricultural risk management.\112\ These commenters said that such

an exclusion would reduce the costs and regulatory burdens imposed on

such companies and therefore provide a broader choice of swap providers

to farmers and other agricultural market participants, which they said

would reduce risks.\113\

---------------------------------------------------------------------------

\112\ See letters from Farmers' Associations, NGFA I and NMPF.

\113\ See id.

---------------------------------------------------------------------------

One commenter discussed a small energy firm that aggregates demand

for swaps from small energy retailers and consumers. This commenter

said that such aggregators should be excluded from the swap dealer

definition because imposing the swap dealer regulations (which would be

promulgated with large financial firms in mind) on such firms would

increase costs for the aggregators, discourage the aggregators'

offering of swaps, and thereby reduce choice and efficiency in the

market.\114\ Another commenter said that a firm that enters into swaps

with microfinance lenders and offsetting swaps with commercial banks is

akin to an introducing broker or FCM, and should be excluded from the

swap dealer definition on the grounds that it does not enter into swaps

on its own initiative, but rather to provide access to the swap markets

to smaller counterparties.\115\

---------------------------------------------------------------------------

\114\ See letter from Northland Energy. This commenter defined

an ``aggregator'' as a person who: (i) Enters into swaps

predominantly in one direction with counterparties that are using

swaps to establish bona fide hedges; and (ii) offsets risks

associated with such swaps using regulated futures contracts or

cleared swaps.

\115\ See letter from MFX dated June 3, 2011 (``MFX II''). This

commenter said that the exclusion should be available to a person

who operates primarily on a not-for-profit basis and limits its swap

activities to offering swaps to persons in underserved markets and

offsetting such swaps, and who meets other requirements to limit the

scope of the exclusion.

---------------------------------------------------------------------------

Another commenter said that there is no need for any special

treatment of aggregators in the swap dealer definition. According to

this commenter, the CFTC's guidance regarding the definition and the de

minimis exception from the definition address the relevant issues

properly and completely.\116\

---------------------------------------------------------------------------

\116\ See letter from Better Markets I.

---------------------------------------------------------------------------

ii. Physical Commodity Swaps

Commenters that discussed physical commodity swaps primarily

focused on swaps related to energy commodities such as oil, natural gas

and electricity. The commenters said that the market for these swaps is

different from the market for swaps on interest rates and other

financial commodities because, among other things, the swaps are used

to mitigate price and delivery risks directly linked to a commercial

enterprise; less swap activity flows through intermediaries; the

markets for the underlying physical commodities are separately

regulated; and the failure of a commodity market participant is not

likely to impact financial markets as a whole.\117\ Therefore, these

commenters believe, the application of the swap dealer definition to

participants in these physical commodity swap markets should be

different from the application to participants in the financial

commodity swap markets.\118\ Some commenters said that imposing the

costs of swap dealer regulation on participants in the markets for

physical commodity swaps would discourage participation in the market,

thereby reducing liquidity and increasing market concentration.\119\

---------------------------------------------------------------------------

\117\ See letters from BG LNG I, Dominion Resources, National

Energy Marketers Association (``NEM''), NFPEEU, Vitol and WGCEF I

joint letter from Senator Debbie Stabenow and Representative Frank

Lucas (many commercial end-users of swaps with inherent physical

commodity price risk use swaps to hedge such risk and otherwise for

their own trading objectives and not for the benefit of others) and

meetings with Bunge on May 18, 2011 and Electric Companies on April

13, 2011.

\118\ See id.

\119\ See letters from Dominion Resources, NEM and NFPEEU.

---------------------------------------------------------------------------

iii. Electricity Swaps

Commenters on the use of swaps in connection with the generation

and transmission of electricity addressed a variety of issues. First,

commenters said that markets related to electricity are different from

markets for other physical commodities in that electricity must be

generated and transmitted at the time it is needed (it cannot be stored

for future use); the overall demand for electricity is inelastic but

demand at any particular time is subject to external variables, such as

weather; the generation, transmission and use of electricity is widely

dispersed and geographically specific; the markets are overseen by

regulators such as state Public Utility Commissions, regional

transmission organizations (``RTOs'') and the Federal Energy Regulatory

Commission (``FERC''); and government mandates require continuous

supply of electricity and treat electricity as a ``public good.'' \120\

Commenters said that because of these differences, the use of swaps

related to electricity is different from the use of swaps on other

physical commodities in that electricity swaps: Are more highly

customized to a particular place and time; are more likely to relate to

a short time period or be more frequently entered into; typically can

be tied to a specific generation, transmission or use of electricity;

are more likely to be entered into directly by end-users rather than

through dealers; are likely to be entered into by electricity companies

on both sides of the market; and in many cases were subject to

regulatory oversight prior to the Dodd-Frank Act.\121\

---------------------------------------------------------------------------

\120\ See letters from Edison Int'l, the staff of the FERC

(``FERC Staff''), National Association of Regulatory Utility

Commissioners (``NARUC''), NEM, NextEra I, NFPEEU and National Rural

Utilities Cooperative Finance Corporation (``NRU CFC'') dated

February 14, 2011 (``NRU CFC I''), joint letter from NRECA, APPA,

LPPC, EEI and EPSA (``Electric Trade Associations'') and meetings

with Electric Companies on April 13, 2011 and NFPEEU on January 29,

2011.

\121\ See letters from Edison Int'l, EEI/EPSA, Electric Trade

Associations, FERC Staff, NextEra I and NFPEEU and meeting with

Electric Companies on April 13, 2011.

---------------------------------------------------------------------------

Commenters made various points regarding how swaps related to

electricity should be treated for purposes of the swap dealer

definition. A coalition of not-for-profit power utilities and electric

cooperatives said that electricity cooperatives should be excluded from

the swap dealer definition because they are non-profit entities that

enter into swaps for the benefit of their members, they do not hold

themselves out as swap dealers, they do not make markets, and their

swaps are not necessarily reflective of market rates.\122\ Other

commenters said that swaps related to transactions on tariff schedules

approved by FERC or the Electric Reliability Council of Texas should be

disregarded in determining if a person is a swap dealer.\123\ And, some

commenters said that any special treatment of swaps related to

electricity should apply not only to companies that generate, transmit

or distribute electricity, but also to energy marketing companies that

use swaps to benefit from price changes in the underlying energy

commodities or to hedge related risks.\124\

---------------------------------------------------------------------------

\122\ See letter from NFPEEU. This commenter said the exclusion

from the swap dealer definition should extend to persons acting as

an operating or purchasing agent for other utilities in connection

with energy infrastructure products, or otherwise entering into

energy commodity swaps on behalf of other end users.

\123\ See letters from EDF Trading, FERC Staff and NARUC.

\124\ See letters from DC Energy, EDF Trading and EEI/EPSA.

---------------------------------------------------------------------------

On the other hand, some commenters acknowledged that a person who

makes a market in swaps related to electricity by standing ready to

enter into such swaps in order to profit from a bid/ask spread would be

a swap dealer, even if the person was in the business of generating,

transmitting or distributing

[[Page 30605]]

electricity and owned physical facilities for that purpose.\125\

---------------------------------------------------------------------------

\125\ See letter from EEI/EPSA and meeting with Electric

Companies on April 13, 2011.

---------------------------------------------------------------------------

f. Suggested Exlusions From the Dealer Definitions

Several commenters took the view that the swap dealer and security-

based swap dealer definitions should categorically exclude, or should

be interpreted in a way that would be expected to exclude, a variety of

types of persons or transactions. Commenters particularly suggested

that the following categories of persons should be excluded from the

dealer definitions: Agricultural cooperatives and electric cooperatives

(as addressed above), employee benefit plans as defined in the Employee

Retirement Income Security Act of 1974 (``ERISA''),\126\ farm credit

system institutions,\127\ Federal Home Loan Banks,\128\ insured

depository institutions that limit their swap dealing activity to

riskless principal transactions,\129\ FCMs and broker-dealers that

limit their swap dealing activity to riskless principal

transactions,\130\ financial guaranty insurers and their affiliates

that do not enter into new swaps,\131\ asset managers,\132\ non-

financial companies offering swaps related to their physical commodity

business,\133\ any person who enters into swaps or security-based swaps

only with registered dealers and major participants,\134\ persons that

do not pose systemic risk,\135\ hedge funds \136\ and entities that

enter into swaps or security-based swaps solely in a fiduciary

capacity.\137\

---------------------------------------------------------------------------

\126\ See letter from ABC/CIEBA.

\127\ See letter from Farm Credit Council dated February 22,

2011 (``Farm Credit Council I'').

\128\ See letters from Credit Union National Association

(``CUNA'') and Federal Home Loan Banks (``FHLB'') dated February 22,

2011 (``FHLB I'').

\129\ See letter from BOK dated January 31, 2011 (``BOK I'');

but see letter from Vitol at 7 (riskless principal transactions are

a ``good model for true swap dealing activity'').

\130\ See letter from Newedge.

\131\ See letter from Association of Financial Guaranty Insurers

(``AFGI'').

\132\ See letter from BlackRock, Inc. (``BlackRock'') dated

February 22, 2011 (``BlackRock I'').

\133\ Commenters making this point varied in their phrasing of

potential exclusions, and particularly suggested exclusions for:

Agricultural firms offering swaps as risk management tools related

to physical commodities (see letter from NGFA I); all firms, other

than financial entities whose primary business is swap dealing (see

letter from NEM); any person that uses swaps only to reduce price

volatility, enters into a volume of swaps relating to any physical

commodity that is less than the volume of its trading in that

commodity, and is not making a market (see letter from Chesapeake

Energy); or any person that limit its use of swaps to hedging or

speculating (see letters from API I).

\134\ See letter from ISDA I.

\135\ See letters from NARUC and NCGA/NGSA I.

\136\ See letter from MFA I.

\137\ See letters from FSR dated February 22, 2011 and Midsize

Banks.

---------------------------------------------------------------------------

Commenters also suggested that the dealer definitions categorically

exclude, or should be interpreted to exclude, the following types of

swaps and security-based swaps: Exchange-cleared swaps and security-

based swaps,\138\ options to make or receive delivery of physical

commodities,\139\ cash forward transactions with embedded swaps and

book-out transactions,\140\ swaps or security-based swaps that are used

for hedging or mitigating commercial risk,\141\ swaps entered into to

profit from future changes in the price of the underlying

commodity,\142\ swaps or security-based swaps entered into as a

fiduciary or agent for another person,\143\ swaps or security-based

swaps entered into for purposes of price discovery,\144\ and, as noted

above, swaps related to items that are covered by a tariff approved by

FERC or the Electric Reliability Council of Texas.\145\

---------------------------------------------------------------------------

\138\ See letters from Commodity Markets Council (``CMC''), EEI/

EPSA, IECA-Credit I, NextEra I, Shell Trading I, Utility Group and

Vitol.

\139\ See letters from NextEra I and WGCEF I. The commenters

acknowledged that such options may or may not be included in the

definition of ``swap.''

\140\ See letter from CMC.

\141\ See, e.g., letters from Edison Int'l and WGCEF I and joint

letter from Senator Stabenow and Representative Lucas (also saying

that definition of ``hedging'' should be consistent with respect to

the dealer and major participant definitions and the end-user

exception from clearing).

\142\ See letters from EEI/EPSA, NextEra I, Utility Group and

WGCEF I.

\143\ See letters from Midsize Banks, NFPEEU and FSR I.

\144\ See letters from EEI/EPSA, Vitol and WGCEF I.

\145\ See letters from EDF Trading, FERC Staff and NARUC.

---------------------------------------------------------------------------

In contrast, some commenters opposed providing any categorical

exclusions from the dealer definitions. One commenter stated that the

definitions' focus on a person's activities--as opposed to whether that

person falls within a particular category--is a better means of

determining whether the person is a swap dealer.\146\ Another commenter

described the requested exclusions as attempts to achieve carve-outs

that are not provided for in the statute.\147\

---------------------------------------------------------------------------

\146\ See letter from Better Markets I.

\147\ See letter from AFSCME. Additional commenters emphasized

the need for transparency about swaps and swap activities. See

letters from Jason Cropping and BJ D'Milli.

---------------------------------------------------------------------------

Lastly, several commenters addressed the extraterritorial

application of the definitions of the terms ``swap dealer,''

``security-based swap dealer,'' ``major swap participant,'' ``major

security-based swap participant,'' and ``eligible contract

participant.'' In general, the commenters addressed when and how the

definitions should be applied to persons based outside the U.S. and how

the definitions should take account of non-U.S. requirements that may

be applicable to such persons.\148\ The Commissions intend to

separately address issues related to the application of these

definitions to non-U.S. persons in the context of the application of

Title VII to non-U.S. persons.

---------------------------------------------------------------------------

\148\ See, e.g., letters from FSR I, Institute of International

Bankers, ISDA I, Investment Management Association, Japan Financial

Services Agency, Securities Industry and Financial Markets

Association (``SIFMA'') dated February 3, 2011 (``SIFMA I''), and

the World Bank Group, joint letter from the Autorit[eacute] de

contr[ocirc]le prudential and the Autorit[eacute] des marches

financiers, joint letter from Bank of America Merrill Lynch,

Barclays Capital, BNP Paribas S.A. (``BNP Paribas''), Citi,

Cr[eacute]dit Agricole Corporate and Investment Bank, Credit Suisse

Securities (USA), Deutsche Bank AG (``Deutsche Bank''), HSBC, Morgan

Stanley, Nomura Securities International, Inc. (``Nomura

Securities''), Soci[eacute]t[eacute] G[eacute]n[eacute]rale and UBS

Securities LLC (``Twelve Firms''), joint letter from the Bank of

Tokyo-Mitsubishi UFJ, Ltd., Mizuho Corporate Bank, Ltd. and Sumitomo

Mitsui Banking Corporation, and joint letter from Barclays Bank PLC,

BNP Paribas, Credit Suisse AG, Deutsche Bank, HSBC, Nomura

Securities, Rabobank Nederland, Royal Bank of Canada, the Royal Bank

of Scotland Group pLc, Soci[eacute]t[eacute] G[eacute]n[eacute]rale,

the Toronto-Dominion Bank and UBS AG.

---------------------------------------------------------------------------

g. Cost-Benefit Issues and Hedging Deterrence

Several commenters emphasized the cost of being regulated as a

dealer, and emphasized that an overbroad scope of the dealer

definitions would impose significant unwarranted costs on entities

contrary to the goals of the Dodd-Frank Act, and would deter the use of

swaps and security-based swaps for hedging.\149\ Some commenters also

noted that impact of the provisions of section 716 of the Dodd-Frank

Act on entities that are deemed to be swap

[[Page 30606]]

dealers or security-based swap dealers.\150\ Also, one commenter

suggested that using a qualitative test for the dealer definition might

increase costs due to regulatory uncertainty.\151\

---------------------------------------------------------------------------

\149\ See joint letter from Representatives Spencer Bachus and

Frank Lucas at 2 (``Casting an overly-broad net in defining [dealer

and major participant] could force some smaller participants to

leave the marketplace as a result of increased costs, or eliminate

certain types of contracts used for hedging. If either occurs,

businesses will be left exposed to market volatility and the

consequences will ultimately be felt by Americans in the form of

increased consumer costs.'') and letters from ISDA Iat 7 (``The

substantial additional burdens and costs of Dealer regulation must

be reserved for those whose business it is to `make the market,'

that is, those who consistently both buy and sell. This is in accord

with Dodd-Frank Act's market regulatory goals, as well as the

legislation's obvious intent to preserve healthy growth and

innovation in the U.S. swap markets.'' (footnote omitted)), Peabody

at 2-3 (``Legal uncertainty over the application to end users of the

significant regulatory requirements for [swap dealers] could lead

end users to minimize their use of swaps in order to avoid the risk

of being deemed to be [a swap dealer].''), and Church Alliance

(stating that the risk of incurring the costs of dealer regulation

would harm employee benefit plans by reducing their use of swaps and

security-based swaps for hedging and risk mitigation).

\150\ See letters from American Bankers Association (``ABA'')

dated November 3, 2011 (``ABA I''), BOK I, and ISDA I. Section 716

of the Dodd-Frank Act prohibits any ``swaps entity''--a term that

encompasses swap dealers and security-based swap dealers--from

receiving Federal assistance with respect to any swap, security-

based swap, or other activity of the swaps entity.

\151\ See letter from API I (stating that costs of regulatory

uncertainty stem from the use of qualitative factors for identifying

dealing, and from regulatory efforts to reach beyond ``true'' swap

dealers); see also letter from Dominion Resources (the opportunity

costs associated with regulatory uncertainty should be considered).

---------------------------------------------------------------------------

One commenter specifically suggested that in considering the final

rules, the Commissions should consider empirical data regarding the

costs and benefits flowing from the rules and issue a second analysis

of the costs and benefits of the rules for public comment,\152\ while

other commenters said that the consideration of cost and benefits

should include the cumulative cost of interrelated regulatory burdens

arising from all the rules proposed under the Dodd-Frank Act.\153\

Other commenters said the Commissions should consider alternatives that

would impose fewer costs.\154\

---------------------------------------------------------------------------

\152\ See letter from WGCEF I.

\153\ See letters from ABA I, NFPEEU and WGCEF dated December

20, 2011, enclosing a report prepared by NERA Economic Consulting

(``NERA'') (``WGCEF VIII''); see also letter from NERA dated March

13, 2012.

\154\ See letters from NextEra I (referring to alternative de

minimis tests) and NFPEEU.

---------------------------------------------------------------------------

Another commenter said that the cost-benefit analyses in the

Proposing Release may have understated the benefits of the proposed

rules, because focusing on individual aspects of all the rules proposed

under the Dodd-Frank Act prevents consideration of the full range of

benefits that arise from the rules as a whole, in terms of providing

greater financial stability, reducing systemic risk and avoiding the

expense of assistance to financial institutions in the future.\155\

This commenter said the consideration of benefits of the proposed rules

should include the mitigated risk of a financial crisis.\156\

---------------------------------------------------------------------------

\155\ See letter from Better Markets dated June 3, 2011

(``Better Markets II'').

\156\ Better Markets cited estimates that the worldwide cost of

the 2008 financial crisis in terms of lost output was between $60

trillion and $200 trillion, depending primarily on the long term

persistence of the effects. See letter from Better Markets II.

---------------------------------------------------------------------------

3. Final Rules and Interpretation--General Principles

Consistent with the Proposing Release, the final rules that define

the terms ``swap dealer'' and ``security-based swap dealer'' closely

follow the statutory definitions' four tests and exclusion for

activities that are not part of a ``regular business.'' \157\ In

addition, this Adopting Release sets forth interpretive guidance

regarding various elements of the final rules.

---------------------------------------------------------------------------

\157\ See CFTC Regulation Sec. 1.3(ggg)(1), (2); Exchange Act

rule 3a71-1(a), (b).

---------------------------------------------------------------------------

Because the definitions of the terms ``swap dealer'' in the CEA and

``security-based swap dealer'' in the Exchange Act are substantially

similar, the rules further defining those terms and the accompanying

interpretations in this Adopting Release reflect common underlying

principles. At the same time, the interpretations regarding the

application of the definitions differ in certain respects given the

differences in the uses of and markets for swaps and security-based

swaps.\158\ For example, because security-based swaps may be used to

hedge or gain economic exposure to underlying individual securities

(while recognizing distinctions between security-based swaps and other

types of securities, as discussed below), there is a basis to build

upon the same principles that presently are used to identify dealers

for other types of securities. These same principles, though

instructive, may be inapplicable to swaps in certain circumstances or

may be applied differently in the context of dealing activities

involving commodity, interest rate, or other types of swaps.

---------------------------------------------------------------------------

\158\ Section 712(a)(7)(A) of the Dodd-Frank Act provides that

in adopting rules and orders implementing Title VII, the Commissions

shall treat functionally or economically similar products or

entities in a similar manner. Section 712(a)(7)(B), though, provides

that the Commissions need not act in an identical manner.

---------------------------------------------------------------------------

For these reasons, we separately are addressing the interpretation

of the ``swap dealer'' and ``security-based swap dealer'' definitions.

Also, as discussed below, the Commissions are directing their

respective staffs to report separately regarding the rules being

adopted in connection with the definition and related interpretations.

These staff reports will help the Commissions evaluate the ``swap

dealer'' and ``security-based swap dealer'' definitions in all

respects, including whether new or revised tests or approaches would be

appropriate for identifying swap dealers and security-based swap

dealers.\159\

---------------------------------------------------------------------------

\159\ See part V, infra.

---------------------------------------------------------------------------

4. Final Rules and Interpretation--Definition of ``Swap Dealer''

The Dodd-Frank Act contains a comprehensive definition of the term

``swap dealer,'' based upon types of activities. As noted above, we are

adopting a final rule under the CEA that, like the proposed rule,

defines the term ``swap dealer'' using terms from the four statutory

tests and the exclusion for swap activities that are not part of ``a

regular business.'' \160\ The final rule includes modifications from

the proposed rule that are described below, including provisions

stating that swaps entered into for hedging physical positions as

defined in the rule, swaps between majority-owned affiliates, swaps

entered into by a cooperative with its members, and certain swaps

entered into by registered floor traders, are excluded from the swap

dealer determination.\161\ The Commissions, in consideration of

comments received, are also making certain modifications to the

interpretive guidance set out in the Proposing Release with respect to

various elements of the statutory definition of the term ``swap

dealer,'' as described below.

---------------------------------------------------------------------------

\160\ See CFTC Regulation Sec. 1.3(ggg)(1), (2).

\161\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii), (iii).

---------------------------------------------------------------------------

The determination of whether a person is covered by the statutory

definition of the term ``swap dealer'' requires application of various

provisions of the rule further defining that term, as well as the

interpretive guidance in this Adopting Release, depending on the

person's particular circumstances. We intend that the determination

with respect to a particular person would proceed as follows.

The person would begin by applying the statutory definition, and

the provisions of the rule which implement the four statutory tests and

the exclusion for swap activities that are not part of ``a regular

business,'' \162\ in order to determine if the person is engaged in

swap dealing activity. In that analysis, the person would apply the

interpretive guidance described in this part II.A.4, which provides for

consideration of the relevant facts and circumstances. As part of this

consideration, the person would apply elements of the dealer-trader

distinction, as appropriate, including as described in part II.A.4.a,

below.

---------------------------------------------------------------------------

\162\ See CFTC Regulation Sec. 1.3(ggg)(1), (2).

---------------------------------------------------------------------------

The rule provides that certain swaps are not considered in the

determination of whether a person is a swap dealer.\163\ In particular,

swaps entered into by an insured depository institution with a customer

in connection with originating a loan with that customer, \164\ swaps

[[Page 30607]]

between majority-owned affiliates, \165\ swaps entered into by a

cooperative with its members,\166\ swaps entered into for hedging

physical positions as defined in the rule,\167\ and certain swaps

entered into by registered floor traders \168\ are excluded from the

swap dealer determination.

---------------------------------------------------------------------------

\163\ See CFTC Regulation Sec. 1.3(ggg)(5), (6).

\164\ See CFTC Regulation Sec. 1.3(ggg)(5); see also part II.B,

infra.

\165\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); see also part

II.C, infra.

\166\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii); see also part

II.C, infra.

\167\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii); see also part

II.B.4.e, infra.

\168\ See CFTC Regulation Sec. 1.3(ggg)(6)(iv); see also part

II.B.4.f, infra.

---------------------------------------------------------------------------

If, after completing this review (taking into account the

applicable interpretive guidance and excluding any swaps as noted

above), the person determines that it is engaged in swap dealing

activity, the next step is to determine if the person is engaged in

more than a de minimis quantity of swap dealing.\169\ If so, the person

is a swap dealer. When the person registers, it may apply to limit its

designation as a swap dealer to specified categories of swaps or

specified activities of the person in connection with swaps.\170\

---------------------------------------------------------------------------

\169\ See CFTC Regulation Sec. 1.3(ggg)(4); see also part II.D,

infra.

\170\ See CFTC Regulation Sec. 1.3(ggg)(3); see also part II.E,

infra.

---------------------------------------------------------------------------

In this part II.A.4., we provide interpretive guidance on the

application of the ``swap dealer'' definition, modified from the

Proposing Release as appropriate based on comments received. This

guidance separately addresses the following: application of the dealer-

trader framework; the ``holding out'' and ``commonly known'' criteria;

market making; the not part of ``a regular business'' exception; the

exclusion of swaps entered into for hedging physical positions as

defined in the rule; and the overall interpretive approach to the

definition.\171\

---------------------------------------------------------------------------

\171\ The Commissions note that interpretations of the

applicability of the dealer-trader distinction to the ``swap

dealer'' definition under the CEA do not affect existing, or future,

interpretations of the dealer-trader distinction under the Exchange

Act.

---------------------------------------------------------------------------

a. Use of the Dealer-Trader Distinction

We believe that the dealer-trader distinction \172\--which already

forms a basis for identifying which persons fall within the

longstanding Exchange Act definition of ``dealer''--in general provides

an appropriate framework for interpreting the statutory definition of

the term ``swap dealer.'' \173\ While there are differences in the

structure of those two statutory definitions,\174\ we believe that

their parallels--particularly their exclusions for activities that are

``not part of a regular business''--warrant analogous interpretive

approaches for distinguishing dealers from non-dealers.\175\ Thus, the

dealer-trader distinction forms the basis for a framework that

appropriately distinguishes between persons who should be regulated as

swap dealers and those who should not. We also believe that the

distinction affords an appropriate degree of flexibility to the

analysis, and that it would not be appropriate to seek to codify the

distinction in rule text.

---------------------------------------------------------------------------

\172\ See note 31, supra. The principles embedded within the

``dealer-trader distinction'' are also applicable to distinguishing

dealers from non-dealers such as hedgers or investors. See note 250,

infra.

\173\ The Commissions note that interpretations of the

applicability of the dealer-trader distinction to the ``swap

dealer'' definition under the CEA do not affect existing, or future,

interpretations of the dealer-trader distinction under the Exchange

Act.

\174\ For example, while the ``dealer'' definition encompasses

certain persons in the business of ``buying and selling''

securities, the ``swap dealer'' definition does not address either

``buying'' or ``selling.'' We also note that the ``dealer''

definition requires the conjunctive ``buying and selling''--which

connotes a degree of offsetting two-sided activity. In contrast, the

swap dealer definition (particularly the ``regularly enters into''

swaps language of the definition's third prong) lacks that

conjunctive terminology.

\175\ In the Proposing Release, the CFTC did not propose to use

principles from the dealer-trader distinction to interpret the

definition of the term ``swap dealer,'' instead proposing an

interpretive approach that focused on, among other things, a

person's functional role in the swap markets and its relationships

with swap counterparties. See Proposing Release, 75 FR at 80177.

There was, however, some overlap in practice between the factors

identified in the Proposing Release relating to a swap dealer's

functional role and relationships and the principles of the dealer-

trader distinction that were proposed to be applied to identify

security-based swap dealers. Moreover, the changes to the

interpretive approach to the swap dealer definition that we are

adopting here and discussed in this part II.A.4 are in many respects

similar to the principles of the dealer-trader distinction. We also

acknowledge the commenters who asked for additional guidance

regarding the application of the definitions. See, e.g., letters

from Gavilon II, Peabody and the Utility Group, and meeting with

CDEU on April 7, 2011.

Thus, while the incorporation of the dealer-trader distinction

in the interpretation of the term ``swap dealer'' constitutes a

change from the Proposing Release, this is simply reflective of the

other changes to the CFTC's interpretive approach that we are

adopting for the final rule and the overlap between the factors

relating to a swap dealer's functional role and counterparty

relationships and the principles of the dealer-trader distinction.

---------------------------------------------------------------------------

The Commissions recognize that the dealer-trader distinction needs

to be adapted to apply to swap activities in light of the special

characteristics of swaps and the differences between the ``dealer''

definition, on the one hand, and the ``swap dealer'' definition, on the

other. Relevant differences between the swap market and the markets for

securities (other than security-based swaps) include:

Level of activity--Swap markets are marked by less

activity than markets involving certain types of securities (while

recognizing that some debt and equity securities are not actively

traded). This suggests that in the swap context, concepts of

``regularity'' should account for a participant's level of activity in

the market relative to the total size of the market.

No separate issuer--Each counterparty to a swap in essence

is the ``issuer'' of that instrument; in contrast, dealers in cash

market securities generally transact in securities issued by another

party. This distinction suggests that the concept of maintaining an

``inventory'' of securities is inapposite in the context of swaps.

Moreover, this distinction--along with the fact that the ``swap

dealer'' definition lacks the conjunctive ``buying and selling''

language of the ``dealer'' definition--suggests that concepts of two-

sided markets at times would be less relevant for identifying swap

dealers than they would be for identifying dealers.\176\

---------------------------------------------------------------------------

\176\ The analysis also should account for the fact that a party

to a swap can use other derivatives or cash market instruments to

hedge the risks associated with the swap position, meaning that two-

way trading is not necessary to maintain a flat risk book.

---------------------------------------------------------------------------

Predominance of over-the-counter and non-standardized

instruments--Swaps an thus far are not significantly traded on

exchanges or other trading systems, in contrast to some cash market

securities (while recognizing that many cash market securities also are

not significantly traded on those systems).\177\ These attributes--

along with the lack of ``buying and selling'' language in the swap

dealer definition, as noted above--suggest that concepts of what it

means to make a market need to be construed flexibly in the contexts of

the swap markets.

---------------------------------------------------------------------------

\177\ Even though we expect trading of swaps on exchanges

following the implementation of Title VII, we expect there to remain

a significant amount of over-the-counter activity involving swaps.

---------------------------------------------------------------------------

Mutuality of obligations and significance to ``customer''

relationship--In contrast to a secondary market transaction involving

equity or debt securities, in which the completion of a purchase or

sale transaction can be expected to terminate the mutual obligations of

the parties to the transaction, the parties to a swap often will have

an ongoing obligation to exchange cash flows over the life of the

agreement. In light of this attribute, some market participants have

expressed the view that they have ``counterparties'' rather than

``customers'' in the context of their swap activities.

In applying the dealer-trader distinction, it also is necessary to

apply

[[Page 30608]]

the statutory provisions that will govern swap dealers in an effective

and logical way. Those statutory provisions added by the Dodd-Frank Act

advance financial responsibility (e.g., the ability to satisfy

obligations, and the maintenance of counterparties' funds and assets)

associated with swap dealers' activities,\178\ other counterparty

protections,\179\ and the promotion of market efficiency and

transparency.\180\ 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.

---------------------------------------------------------------------------

\178\ E.g., capital and margin requirements (CEA section 4s(e)),

and requirements for segregation of collateral (CEA sections 4d(f),

4s(l)).

\179\ E.g., requirements with respect to business conduct when

transacting with special entities (CEA sections 4s(h)(2), 4s(h)(4),

4s(h)(5)); disclosure requirements (CEA section 4s(h)(3)(B));

requirements for fair and balanced communications (CEA section

4s(h)(3)(D)); other requirements related to the public interest and

investor protection (CEA section 4s(h)(3)(D)); and conflict of

interest provisions (CEA section 4s(j)(5)).

\180\ E.g., reporting and recordkeeping requirements (CEA

section 4s(f)); daily trading records requirements (CEA section

4s(g)); regulatory standards related to the confirmation,

processing, netting, documentation and valuation of security-based

swaps (CEA section 4s(i)); position limit monitoring requirements

(CEA section 4s(j)(1)); risk management procedure requirements (CEA

section 4s(j)(2)); and requirements related to the disclosure of

information to regulators (CEA section 4s(j)(3)).

---------------------------------------------------------------------------

There are several aspects of our interpretive approach to the swap

dealer definition that are particularly similar to the dealer-trader

distinction as it will be applied to determine if a person is a

security-based swap dealer. In particular, the following activities,

which are indicative of dealing activity in the application of the

dealer-trader distinction,\181\ similarly are indicative that a person

is acting as a swap dealer: \182\ (i) Providing liquidity by

accommodating demand for or facilitating interest in the instrument

(swaps, in this case), holding oneself out as willing to enter into

swaps (independent of whether another party has already expressed

interest), or being known in the industry as being available to

accommodate demand for swaps; (ii) advising a counterparty as to how to

use swaps to meet the counterparty's hedging goals, or structuring

swaps on behalf of a counterparty; (iii) having a regular clientele and

actively advertising or soliciting clients in connection with swaps;

\183\ (iv) acting in a market maker capacity on an organized exchange

or trading system for swaps; \184\ and (v) helping to set the prices

offered in the market (such as by acting as a market maker) rather than

taking those prices, although the fact that a person regularly takes

the market price for its swaps does not foreclose the possibility that

the person may be a swap dealer.

---------------------------------------------------------------------------

\181\ See generally part II.A.5, infra.

\182\ To clarify, the activities listed in the text are

indicative of acting as a swap dealer. Engaging in one or more of

these activities is not a prerequisite to a person being covered by

the swap dealer definition.

\183\ As with the interpretation of the dealer-trader

distinction with respect to securities, a nomenclature distinction

between ``counterparties'' and ``customers'' is not significant for

purposes of applying the dealer-trader distinction to swap

activities. Contractual provisions related to nomenclature, such as

a provision stating that no ``customer'' relationship is present,

would not be significant if the reality of the situation is

different. See note 271, infra, and accompanying text.

\184\ As with the dealer-trader distinction as it has been

interpreted under the Exchange Act with respect to securities (and

as noted below in the discussion of the ``makes a market in swaps''

prong of the swap dealer definition), the presence of an organized

exchange or trading system is not a prerequisite to being a market

maker for purposes of the swap dealer definition, nor is acting as a

market maker a prerequisite to being a swap dealer.

---------------------------------------------------------------------------

The Commissions further note that the following elements of the

interpretive approach to the swap dealer definition are also generally

consistent with the dealer-trader distinction as it will be applied to

determine if a person is a security-based swap dealer: (i) A

willingness to enter into swaps on either side of the market is not a

prerequisite to swap dealer status; (ii) the swap dealer analysis does

not turn on whether a person's swap dealing activity constitutes that

person's sole or predominant business; (iii) a customer relationship is

not a prerequisite to swap dealer status; and (iv) in general, entering

into a swap for the purpose of hedging, absent other activity, is

unlikely to be indicative of dealing. Last, under the interpretive

approach to the definition of both the terms ``swap dealer'' and

``security-based swap dealer,'' whether a person is acting as a dealer

will turn upon the relevant facts and circumstances, as informed by the

interpretive guidance set forth in this Adopting Release.

At the same time, the Commissions recognize that the dealer-trader

distinction is not static, but rather has evolved over time through

interpretive materials. 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. Prior interpretations and future developments in the law

regarding securities or security-based swaps may inform the

interpretation of the swap dealer definition, but will not be

dispositive in identifying dealers in the swap markets.\185\

---------------------------------------------------------------------------

\185\ In interpreting the term ``swap dealer,'' we intend to

consider, but do not formally adopt, the body of court decisions,

SEC releases, and SEC staff no-action letters that have interpreted

the dealer-trader distinction.

---------------------------------------------------------------------------

b. Indicia of Holding Oneself Out as a Dealer in Swaps or Being

Commonly Known in the Trade as a Dealer in Swaps

The final rule further defining the term ``swap dealer'' includes

the provisions in the proposed rule which incorporate the statutory

requirements that the term includes a person that is holding itself out

as a dealer in swaps or is engaging in any activity causing it to be

commonly known in the trade as a dealer or market maker in swaps.\186\

---------------------------------------------------------------------------

\186\ See CFTC Regulation Sec. 1.3(ggg)(1)(i) and (iv).

---------------------------------------------------------------------------

We continue to believe that the Proposing Release appropriately

identifies a number of factors as indicia of ``hold[ing] itself out as

a dealer in swaps'' and ``engag[ing] in any activity causing [itself]

to be commonly known in the trade as a dealer or market maker in

swaps.'' \187\ In our view, those factors thus are relevant to

determining if a person is a swap dealer. For example, regarding the

proposed factor of ``membership in a swap association in a category

reserved for dealers,'' we note that the bylaws of the International

Swaps and Derivatives Association (``ISDA'') provide that any business

organization that:

\187\ These factors are as follows: Contacting potential

counterparties to solicit interest; developing new types of swaps or

security-based swaps and informing potential counterparties of their

availability and of the person's willingness to enter into the swap

or security-based swap; membership in a swap association in a

category reserved for dealers; providing marketing materials

describing the type of swaps or security-based 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

or security-based swaps. See Proposing Release, 75 FR at 80178.

Directly or through an affiliate, as part of its business

(whether for its own account or as agent), deals in derivatives

shall be eligible for election to membership in the Association as a

Primary Member, provided that no person or entity shall be eligible

for membership as a Primary Member if such person or entity

participates in derivatives transactions solely for the purpose of

risk hedging or asset or liability management.\188\

---------------------------------------------------------------------------

\188\ See By-laws of ISDA at 3, available at: https://www.isdadocs.org/membership. The Commissions note that the Primary

Members of ISDA are not limited to only financial firms.

We believe that in circumstances such as this, where a category of

association

[[Page 30609]]

membership requires that a person deal in derivatives and not limit its

participation in derivative transactions to solely risk hedging,

membership in the category is an indicator of swap dealer status.\189\

---------------------------------------------------------------------------

\189\ However, while such membership is an indicator of swap

dealer status, a person holding such membership could nonetheless be

excluded by other provisions of the definition of the term ``swap

dealer.'' For example, an insured depository institution that limits

its activity to offering swaps in connection with the origination of

loans, as discussed below in part II.B, would not be covered by the

definition simply because it holds such membership.

---------------------------------------------------------------------------

We take note, however, of the comments that these activities may be

insufficient to establish that a person is a swap dealer. In

particular, we generally agree with commenters that many commercial end

users of swaps do, from time to time, actively seek out and negotiate

swaps. Yet, based on the applicable facts and circumstances, these end

users do not necessarily fall within the definition of a swap dealer

solely because they actively seek out and negotiate swaps from time to

time.

The activities described in the Proposing Release as indicia of

holding oneself out as a swap dealer or engaging in any activity

causing oneself to be commonly known as a swap dealer should not be

considered in a vacuum, but should instead be considered in the context

of all the activities of the swap participant. While the activities

listed in the Proposing Release are indicators that a person is holding

itself out or is commonly known as a swap dealer, these are factors to

be considered in the analysis. They are not per se conclusive, and

could be countered by other factors indicating that the person is not a

swap dealer.\190\ Because of the flexibility--including the

consideration of applicable facts and circumstances--needed for such an

analysis, we do not believe that it is appropriate to codify this

guidance in rule text, as suggested by some commenters.

---------------------------------------------------------------------------

\190\ The statutory definition of the term ``swap dealer''

contains four separate clauses, or ``prongs,'' joined by the

disjunctive ``or,'' the ordinary meaning of which is that the prongs

are stated as alternative types of swap dealer. Accordingly, where

an assessment of all the activities of a swap participant

demonstrates that the person is not holding itself out as a swap

dealer or engaging in any activity that causes it to be commonly

known as a swap dealer, that person may, nonetheless, be a swap

dealer based on the market making or regular business prongs of the

swap dealer definition, discussed below. The Commissions note,

however, that as discussed below in part II.A.4.g, the CFTC's

overall interpretive guidance, including guidance regarding the

dealer-trader framework, applies to identify swap dealers under all

four prongs of the statutory ``swap dealer'' definition.

---------------------------------------------------------------------------

c. Market Making

The final rule defining ``swap dealer'' includes the provision from

the proposed rule which incorporates the statutory requirement that

this term include a person that ``makes a market in swaps.'' \191\

---------------------------------------------------------------------------

\191\ See CFTC Regulation Sec. 1.3(ggg)(1)(ii). Because the

statutory swap dealer definition contains four disjunctive prongs,

the CFTC does not agree with a commenter (see letter from ISDA I)

who asserted that status as a market maker in swaps is a

prerequisite to a person being a swap dealer.

---------------------------------------------------------------------------

We have considered the comments suggesting various descriptions of

activities that should and should not be deemed to be market making in

swaps for purposes of this rule. In consideration of these comments, we

clarify that making a market in swaps is appropriately described as

routinely standing ready to enter into swaps at the request or demand

of a counterparty. In this regard, ``routinely'' means that the person

must do so more frequently than occasionally, but there is no

requirement that the person do so continuously.\192\

---------------------------------------------------------------------------

\192\ A person that occasionally, or less than routinely, enters

into a swap at the request of a counterparty is not a maker of a

market in swaps, and therefore is not a swap dealer on that basis.

However, we reiterate, as stated in the Proposing Release, that

since many types of swaps are not entered into on a continuous

basis, it is not necessary that a person enter into swaps at the

request or demand of counterparties on a continuous basis in order

for the person to be a market maker in swaps and, therefore, a swap

dealer.

---------------------------------------------------------------------------

It is appropriate, in response to comments asking for further

guidance regarding what activities constitute making a market in swaps,

to describe some of the activities indicative of whether a person is

routinely standing ready to enter into swaps at the request or demand

of a counterparty. Such activities include routinely: (i) Quoting bid

or offer prices, rates or other financial terms for swaps on an

exchange; (ii) 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; (iii) placing limit orders for swaps; or (iv) receiving

compensation for acting in a market maker capacity on an organized

exchange or trading system for swaps.\193\ These examples are not

exhaustive, and other activities also may be indicative of making a

market in swaps if the person engaging in them routinely stands ready

to enter into swaps as principal at the request or demand of a

counterparty.

---------------------------------------------------------------------------

\193\ In addition, section 619 of the Dodd-Frank Act (the

``Volcker Rule'') generally prohibits banking entities from engaging

in proprietary trading, but contains an exception for certain market

making-related activities. The Commissions have proposed an approach

to the Volcker Rule under which a person could seek to avoid the

Volcker Rule in connection with swap activities by asserting the

availability of that market making exception. See SEC, Board, Office

of the Comptroller of the Currency (``OCC''), and Federal Deposit

Insurance Corporation (``FDIC''), Prohibitions and Restrictions on

Proprietary Trading and Certain Interests in, and Relationships

With, Hedge Funds and Private Equity Funds; Proposed Rule, 76 FR

68846 (Nov. 7, 2011); CFTC, Prohibitions and Restrictions on

Proprietary Trading and Certain Interests in, and Relationships

With, Hedge Funds and Private Equity Funds; Proposed Rule, 77 FR

8332 (Feb. 14, 2012). Under this approach, such a person would

likely also be required to register as a swap dealer (unless the

person is excluded from the swap dealer definition, such as by the

exclusion of certain swaps entered into in connection with the

origination of a loan). The SEC has proposed to adopt the same

approach with respect to the interplay of the Volcker Rule and the

definition of the term ``security-based swap dealer.'' See note 272,

infra.

---------------------------------------------------------------------------

In determining whether a person's routine presence in the market

constitutes market making under these four factors, the dealer-trader

interpretative framework may be usefully applied.\194\ Under the

dealer-trader distinction, seeking to profit by providing liquidity to

the market is an indication of dealer activity.\195\ Thus, in applying

these four factors, it is useful to consider whether the person is

seeking, through 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.\196\ If not, such activity would not be indicative of market

making.

---------------------------------------------------------------------------

\194\ We recognize that routine presence in the swap market is

not necessarily indicative of making a market in swaps. For example,

persons may be routinely present in the market in order to engage in

swaps for purposes of hedging, to advance their investment

objectives, or to engage in proprietary trading.

\195\ See note 265, infra, and accompanying text.

\196\ In this case, the spread from which a person profits may

be between two or more swaps, or it may be between a swap and

another position or financial instrument. In contrast, entering into

swaps in order to obtain compensation attributable to changes in the

value of the swaps is indicative of using swaps for a hedging,

investment or trading purpose.

---------------------------------------------------------------------------

Some commenters suggested that, in order to be a market maker in

swaps, a person must make a two-way market in swaps.\197\ Nonetheless,

it is possible for a person making a one-way market in swaps to be a

maker of a market in swaps and, therefore, within the swap dealer

definition. This may be true, for example, where a person routinely

[[Page 30610]]

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). The relevant

indicator of market maker status is the willingness of the person to

routinely stand ready to enter into swaps at the request or demand of a

counterparty (as opposed to entering into swaps to accommodate one's

own demand or desire to participate in a particular market), be it on

one or both sides of the market, and then to enter into offsetting

positions, either in the swap market or in other markets.

---------------------------------------------------------------------------

\197\ See letters cited in notes 52 to 58, supra. Although swaps

are notional contracts requiring the performance of agreed upon

terms by each party, it is possible to describe swap users in

practical terms as being on either ``side'' of a market. For

example, for many swaps the party paying a fixed amount is on one

``side'' of the market and the party paying a floating amount is on

the other ``side.''

---------------------------------------------------------------------------

The Commissions disagree with the commenters who said that swaps

executed on an exchange should not be considered in determining if a

person is a market maker in swaps and thus a swap dealer.\198\ First,

the statutory definition of the term ``swap dealer'' makes no

distinction between swaps executed on an exchange and swaps that are

not, suggesting that the same protections should apply regardless of

the method of executing the swap. Second, from the perspective of an

end user seeking to execute a swap on an exchange, the important

consideration under our analysis is whether a market maker is ready to

enter into swaps, not whether the market maker is aware of the

counterparty's identity. A market maker in swaps routinely stands ready

to enter into swaps at the request or demand of a counterparty,

regardless of whether the counterparty and the market maker meet on a

disclosed basis through bilateral negotiations or anonymously through

an exchange.\199\ Similarly, the issue of whether a person is a

registered FCM or broker-dealer is not necessarily relevant to whether

the person is a maker of a market in swaps, if the person is routinely

standing ready to enter into swaps at the request or demand of a

counterparty. Third, we believe it would be inappropriate to disregard

swaps executed on exchanges in order, as some commenters

suggested,\200\ to encourage market participants to use, or to provide

liquidity to, exchanges. Finally, variety of exchanges, markets, and

other facilities for the execution of swaps are likely to evolve in

response to the requirements of the Dodd-Frank Act, and there is no

basis for any bright-line rule excluding swaps executed on an exchange,

given the impossibility of obtaining information about how market

participants will interact and execute swaps in the future, after the

requirements under the Dodd-Frank Act are fully in effect. For all

these reasons, we have determined that it is inappropriate to restrict

the ``making a market in swaps'' prong of the swap dealer definition

(i.e., routinely standing ready to enter into swaps at the request or

demand of a counterparty) to swaps that are not executed on an

exchange.\201\

---------------------------------------------------------------------------

\198\ See, e.g., letters cited in note 62, supra.

\199\ As discussed above, in many cases routine presence in the

swap market, without more, would not constitute market making

activity. Nevertheless, the CFTC will, in connection with

promulgation of final rules relating to capital requirements for

swap dealers and major swap participants, consider institution of

reduced capital requirements for entities or individuals that fall

within the swap dealer definition and that execute swaps only on

exchanges, using only proprietary funds. Similarly, the CFTC also

will consider the applicability to such entities or individuals of

the other requirements imposed on swap dealers (e.g., internal

business conduct standards, external business conduct standards with

counterparties), and may adjust those swap dealer requirements as

appropriate.

\200\ See, e.g., letters cited in note 66, supra. Since the

structures of the markets on which swaps will be executed are still

in development, and market obligations have not been established,

there is little support for comments asserting that market makers

should be defined as only those persons who receive benefits from

the market (such as reduced trading fees) in return for the

obligation to transact when the market requires liquidity.

\201\ By contrast, it may be appropriate, over time, to tailor

the specific requirements imposed on swap dealers depending on the

facility on which the swap dealer executes swaps. For example, the

application of certain business conduct requirements may vary

depending on how the swap is executed, and it may be appropriate, as

the swap markets evolve, to consider adjusting certain of those

requirements for swaps that are executed on an exchange or through

particular modes of execution.

---------------------------------------------------------------------------

d. Exception for Activities Not Part of ``a Regular Business''

The final rule includes the provisions in the proposed rule that

incorporate the provisions of the statutory definition regarding

activities that are not part of ``a regular business'' of entering into

swaps. One provision states that the term ``swap dealer'' includes a

person that ``regularly enters into swaps with counterparties as an

ordinary course of business for its own account''; the other provision

states that the term ``swap dealer'' does not include 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.''

\202\

---------------------------------------------------------------------------

\202\ Final CFTC Regulation Sec. 1.3(ggg)(2) is modified from

the proposal to include the word ``a'' before the words ``regular

business,'' to conform the text of the rule to the text of the

statute. See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C).

As stated in the Proposing Release, we interpret the reference

in the definition of the term ``swap dealer'' to a person entering

into swaps ``with counterparties * * * for its own account'' to

refer to a person who enters into a swap as a principal, and not as

an agent. A person who enters into swaps as an agent for customers

(i.e., for the customers' accounts) would be required to register as

either an FCM, introducing broker, commodity pool operator or

commodity trading advisor, depending on the nature of the person's

activity.

---------------------------------------------------------------------------

The Commissions continue to believe, as stated in the Proposing

Release, that the phrases ``ordinary course of business'' and ``a

regular business'' are, for purposes of the definition of ``swap

dealer'' essentially synonymous. In this context, we interpret these

phrases to focus on activities of a person that are usual and normal in

the person's course of business and identifiable as a swap dealing

business. It is not necessarily relevant whether the person conducts

its swap-related activities in a dedicated subsidiary, division,

department or trading desk, or whether such activities are a person's

``primary'' business or an ``ancillary'' business, so long as the

person's swap dealing business is identifiable.\203\

---------------------------------------------------------------------------

\203\ We recognize, as noted by one commenter (see letter from

ISDA I), that the ``regular business'' exclusion is not limited

solely to the ``ordinary course of business'' test of the swap

dealer definition. Our interpretations of the other three tests are,

and should be read to be, consistent with the exclusion of

activities that are not part of a regular business.

---------------------------------------------------------------------------

We have taken into consideration comments seeking additional

guidance regarding the types and levels of activities that constitute

having ``a regular business'' of entering into swaps.\204\ In this

regard, any one of the following activities would generally constitute

both entering into swaps ``as an ordinary course of business'' and ``as

a part of a regular business'': \205\ (i) 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); (ii)

maintaining a separate profit and loss statement reflecting the results

of swap activity or treating swap activity as a separate profit center;

or (iii) 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.\206\

---------------------------------------------------------------------------

\204\ See, e.g., letters from BG LNG I, COPE I, IECA-Credit I,

Shell Trading I, WGCEF I and Vitol (stating that the proposed

approach was overly subjective and requesting guidance as to the

specific activities that are covered by the statutory definition).

\205\ These activities are inconsistent with entering into a

swap to hedge a physical position as defined in Sec.

1.3(ggg)(6)(iii). As discussed below, such hedging is not dealing

activity.

\206\ The three indicators of being engaged in ``a regular

business'' of entering into swaps described here are set forth in

the alternative. Any one of these indicators may be sufficient,

based on a facts and circumstances analysis, to reach a conclusion

that an entity is engaged in ``a regular business'' of entering into

swaps.

---------------------------------------------------------------------------

[[Page 30611]]

The Commissions see merit in the comments saying that ``a regular

business'' of entering into swaps can be characterized by entering into

swaps to satisfy the business or risk management needs of the other

party to the swap, and so incorporate this element into our

interpretation of the rule.\207\ Also, an objective indicator of a

person being engaged in ``a regular business'' of entering into swaps

is when the person accounts for the results of its swap activities

separately, by maintaining a separate profit and loss statement for

those activities or treating them as a separate profit center. Our

interpretation incorporates this indicator of activity that is ``a

regular business'' of entering into swaps.

---------------------------------------------------------------------------

\207\ This element of the interpretation reflects our agreement

with those commenters who said that ``a regular business'' of

entering into swaps is characterized by having a business of

accommodating demand or facilitating interest in swaps (see letter

from IECA-Credit I), and those commenters who said that ``a regular

business'' does not encompass the use of swaps to serve a person's

own business needs, as opposed to serving the business needs of the

counterparty (see letters cited in note 71, supra).

---------------------------------------------------------------------------

Other comments suggesting specific criteria to identify ``a regular

business'' also were helpful. We agree with commenters \208\ that ``a

regular business'' of entering into swaps can be characterized by

having staff and resources allocated to the types of activities in

which swap dealers must engage with their counterparties, such as those

noted above (e.g., credit analysis, confirmation generation, collateral

calls, and covenant monitoring). However, we understand that some end

users of swaps engage in some of these activities and, in certain

circumstances, may have staff and resources available for these

activities. Therefore, this element of the definition should be applied

in a reasonable manner, taking all appropriate circumstances into

account. This element does not depend on whether a specific amount or

percentage of expenses or employee time are related to these swap

activities. Instead, it is appropriate to objectively examine a

person's use of staff and resources related to swap activities. Using

staff and resources to a significant extent in conducting credit

analysis, opening and monitoring accounts and the other activities

noted above, is an indication that the person is engaged in ``a regular

business'' of entering into swaps.

---------------------------------------------------------------------------

\208\ See letters cited in note 80, supra.

---------------------------------------------------------------------------

Regarding the commenters' assertion that the activity of entering

into swaps in connection with a person's physical commodity business

cannot constitute ``a regular business'' of the person, we believe that

while in most cases this is not dealing activity,\209\ a per se

exclusion of this type is not appropriate because it is possible that

in some circumstances a person might enter into swaps that are

connected to a physical commodity business but also serve market

functions characteristic of the functions served by swap dealers. Also,

again, the statutory definition does not contain any such exclusion,

but rather includes any person who ``regularly enters into swaps with

counterparties as an ordinary course of business for its own account,''

without regard to the person's particular type of business.

---------------------------------------------------------------------------

\209\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii) (swaps entered

into for hedging physical positions as defined in the rule are not

considered in the determination of whether a person is a swap

dealer).

---------------------------------------------------------------------------

Consistent with the statutory definition, we interpret ``a regular

business'' of entering into swaps in a manner that applies equally to

all market participants that engage in the activities set forth in the

statutory definition. This will ensure that all participants in the

swap markets are regulated in a fair and consistent manner, regardless

of whether their underlying business is primarily physical or financial

in nature.\210\

---------------------------------------------------------------------------

\210\ Regulation of firms engaged in an underlying physical

business is also consistent with regulatory practices outside the

U.S. For example, non-financial entities register with the Financial

Services Authority in the U.K. as ``Oil Market Participants'' and

``Energy Market Participants.'' See Financial Services Authority

Handbook EMPS and OMPS, available at http://fsahandbook.info/FSA/html/handbook.

---------------------------------------------------------------------------

Finally, as noted above, the manner in which persons negotiate,

execute and use swaps is likely to evolve in response to the

requirements of the Dodd-Frank Act and the other forces that will shape

the swap markets going forward. For this reason, it would be

inappropriate to craft per se exclusions from the swap dealer

definition at a time when the only available information about the use

of swaps relates to the period prior to implementation of the Dodd-

Frank Act.\211\

---------------------------------------------------------------------------

\211\ For the same reasons, we do not believe it would be

appropriate, in determining whether a person has a ``regular

business'' of entering into swaps, to consider whether a person

engages in activities normally associated with financial

institutions, as some commenters suggested. See letters cited in

note 76, supra.

---------------------------------------------------------------------------

e. Interim Final Rule Excluding Swaps Entered Into for Hedging Physical

Positions

We note that some commenters said that swaps used to hedge or

mitigate commercial risks should not be considered in determining

whether a person is a swap dealer.\212\ We understand that swaps are

used to hedge risks in numerous and varied ways, and we expect that the

number of persons covered by the definition will be very small in

comparison to the thousands of persons that use swaps for hedging.

---------------------------------------------------------------------------

\212\ See, e.g., letters cited in note 72, supra.

---------------------------------------------------------------------------

In terms of the statutory definition of the term ``swap dealer,''

the CFTC notes as an initial matter that there is no specific provision

addressing hedging activity. Thus, the statutory definition leaves the

treatment of hedging swaps to the CFTC's discretion; it neither

precludes consideration of a swap's hedging purpose, nor does it

require an absolute exclusion of all swaps used for hedging.\213\

---------------------------------------------------------------------------

\213\ In this regard, the statutory definition of the term

``swap dealer'' stands in contrast to the statutory definition of

the term ``major swap participant'' which, as discussed further

below, explicitly provides that positions in swaps held for hedging

or mitigating commercial risk are to be excluded in certain parts of

that definition. See CEA section 1a(33)(A)(i)(1), 7 U.S.C.

1a(33)(A)(i)(1). The absence of any explicit requirement in the

``swap dealer'' definition to exclude swaps held for hedging or

mitigating commercial risk does not support the view that Congress

intended to categorically exclude all swaps that may serve as hedges

in determining whether a person is covered by the definition.

Similarly, the absence of any limitation in the statutory

definition of the term ``swap dealer'' to financial entities, when

such limitation is included elsewhere in Title VII, indicates that

no such limitation applies to the swap dealer definition. CEA

section 2(h)(7), 7 U.S.C. 2(h)(7), specifically limits the

application of the clearing mandate, in certain circumstances, to

only ``financial entities.'' That section also provides a detailed

definition of the term ``financial entity.'' See CEA section

2(h)(7)(C), 7 U.S.C. 2(h)(7)(C). That such a limitation is included

in this section, but not in the swap dealer definition, does not

support the view that the statutory definition of the term ``swap

dealer'' should encompass only financial entities.

---------------------------------------------------------------------------

In general, entering into a swap for the purpose of hedging is

inconsistent with swap dealing.\214\ The practical

[[Page 30612]]

difficulty lies in determining when a person has entered into a swap

for the purpose of hedging, as opposed to other purposes for entering

into swaps, such as accommodating demand for swaps or as part of making

a market in swaps, and in distinguishing a swap with a hedging purpose

from a swap with a hedging consequence. In view of these uncertainties,

the CFTC believes it is appropriate to adopt an interim final rule that

draws upon the principles of bona fide hedging that the CFTC has long

applied to identify when a financial instrument is used for hedging

purposes, and excludes from the swap dealer analysis swaps entered into

for the purpose of hedging physical positions that meet the

requirements of the rule.

---------------------------------------------------------------------------

\214\ For example, under the dealer-trader distinction, the

Commissions would expect persons that use security-based swaps to

hedge their business risks, absent other activity, likely would not

be dealers. See part II.A.5.b, infra. Under the CFTC's interpretive

guidance, making a market in swaps is appropriately described as

routinely standing ready to enter into swaps at the request or

demand of a counterparty, and the indicia of swap dealing as a

``regular business'' include entering into swaps to satisfy the

business or risk management needs of the counterparty. Entering into

swaps for the purpose of hedging one's own risks generally would not

be indicative of this form of swap activity. See also, e.g., joint

letter from Senator Stabenow and Representative Lucas (the final

rule should distinguish using swaps for hedging from swap dealing).

---------------------------------------------------------------------------

Specifically, the CFTC is adopting as an interim final rule CFTC

Regulation Sec. 1.3(ggg)(6)(iii), which provides that the

determination of whether a person is a swap dealer will not consider a

swap that the person enters into, if:

(i) The person enters into the swap for the purpose of offsetting

or mitigating the person's price risks that arise from the potential

change in the value of one or several (a) assets that the person owns,

produces, manufactures, processes, or merchandises or anticipates

owning, producing, manufacturing, processing, or merchandising; (b)

liabilities that the person owns or anticipates incurring; or (c)

services that the person provides, purchases, or anticipates providing

or purchasing;

(ii) the swap represents a substitute for transactions made or to

be made or positions taken or to be taken by the person at a later time

in a physical marketing channel;

(iii) the swap is economically appropriate to the reduction of the

person's risks in the conduct and management of a commercial

enterprise;

(iv) the swap is entered into in accordance with sound commercial

practices; and

(v) the person does not enter into the swap in connection with

activity structured to evade designation as a swap dealer.\215\

---------------------------------------------------------------------------

\215\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii). All five

requirements set forth in the regulation must be met with respect to

the swap, in order for the swap to be excluded from the swap dealer

determination by the regulation.

---------------------------------------------------------------------------

Thus, although the CFTC is not incorporating the bona fide hedging

provisions of the CFTC's position limits rule here, the exclusion from

the swap dealer analysis draws upon language in the CFTC's definition

of bona fide hedging.\216\ For example, the exclusion expressly

includes swaps hedging price risks arising from the potential change in

value of existing or anticipated assets, liabilities, or services, if

the hedger has an exposure to physical price risk. And, as in the bona

fide hedging rule, the exclusion utilizes the word ``several'' to

reflect that there is no requirement that swaps hedge risk on a one-to-

one transactional basis in order to be excluded, but rather they may

hedge on a portfolio basis.\217\ For these reasons, swaps that qualify

as enumerated hedging transactions and positions are examples of the

types of physical commodity swaps that are excluded from the swap

dealer analysis if the rule's requirements are met.\218\

---------------------------------------------------------------------------

\216\ See CFTC Regulation Sec. 151.5(a)(1). The definition of

bona fide hedging in CFTC Regulation Sec. 1.3(z), which applies for

excluded commodities, is not relevant here, because it does not

contain the requirement that the swap represents a substitute for a

transaction made or to be made or a position taken or to be taken in

a physical marketing channel, as required by CFTC Regulation Sec.

1.3(ggg)(6)(iii)(B). We believe that this requirement is an

important aspect of how principles from the bona fide hedging

definition are useful in identifying swaps that are entered into for

the purpose of hedging as opposed to other purposes.

\217\ See CFTC, Position Limits for Futures and Swaps; Final

Rule, 76 FR 71626, 71649 (Nov. 18, 2011).

\218\ The swaps that qualify as enumerated hedging transactions

and positions are those listed in CFTC Regulation Sec. 151.5(a)(2)

and appendix B to part 151. These examples are illustrative of the

types of ``assets,'' ``liabilities,'' and ``services'' contemplated

in CFTC Regulation Sec. 1.3(ggg)(6)(iii), because the price risk

arising from changes in their value could be offset or mitigated

with a swap that represents a substitute for transactions made or to

be made or positions taken or to be taken by the person at a later

time in a physical marketing channel. To be clear, notwithstanding

that a swap does not fit precisely within such examples, it may

still satisfy CFTC Regulation Sec. 1.3(ggg)(6)(iii).

Regarding commenters' queries about dynamic hedging, which one

commenter described as the ability to modify the hedging structure

related to physical assets or positions when relevant pricing

relationships applicable to that asset change (see joint letter from

WGCEF and CMC), we note that qualification as bona fide hedging has

never been understood to require that hedges, once entered into,

must remain static. We expect that entites would move to update

their hedges periodically when pricing relationships or other market

factors applicable to the hedge change.

---------------------------------------------------------------------------

This provision in the final rule is consistent with our overall

interpretive approach to the definition of the term ``swap dealer.''

The interpretations of the statutory dealer definitions by both

Commissions focus on a person's activities in relation to its

counterparties and other market participants.\219\ As noted above, for

example, one indicator that a person enters into swaps as part of ``a

regular business'' is that the person does so to satisfy the business

or risk management needs of the counterparty. This aspect of the swap

dealer analysis turns on the accommodation of a counterparty's needs or

demands. If a person enters into swaps for the purpose of hedging a

physical position as defined in CFTC Regulation Sec. 1.3(ggg)(6)(iii),

by contrast, then the swap can be identified as not having been entered

into for the purpose of accommodating the counterparty's needs or

demands.\220\ Also, a person's activity of seeking out swap

counterparties in order to hedge a physical position as defined in the

rule generally would not warrant regulations to promote market

stability and transparency or to serve the other purposes of dealer

regulation.\221\

---------------------------------------------------------------------------

\219\ See parts II.A.4.e and II.A.5.a, infra. For example, the

conclusion that a person's relationship with its counterparties can

lead to associated obligations is consistent with the ``shingle

theory,'' which implies a duty of fair dealing when a person hangs

out its shingle to do business. See note 260, infra.

\220\ In this way, the exclusion from the swap dealer analysis

of swaps hedging physical positions as defined in CFTC Regulation

Sec. 1.3(ggg)(6)(iii) is similar to the exclusions, discussed

below, of swaps between affiliates and swaps between a cooperative

and its members. See CFTC Regulation Sec. 1.3(ggg)(6)(i)(ii); see

also part II.C, infra. However, to the extent a person engages in

dealing activities involving swaps, the presence of offsetting

positions that hedge those dealing activities would not excuse the

requirement that the person register as a swap dealer.

\221\ Thus, the CFTC's interpretation of the swap dealer

definition in this regard draws upon principles in the dealer-trader

distinction. See part II.A.4.a. Additional authority for CFTC

Regulation Sec. 1.3(ggg)(6)(iii) is provided by subparagraph (B) of

the swap dealer definition. This subparagraph provides that a person

``may be designated 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.'' CEA Section 1a(49)(B), 7 U.S.C. 1a(49)(B). It thereby

authorizes a review of a person's various activities with respect to

swaps, and a determination that some of the person's activities are

covered by a designation as a swap dealer, while other of the

person's activities are not. Thus, a person who enters into some

swaps for hedging physical positions as defined in CFTC Regulation

Sec. 1.3(ggg)(6)(iii), and also enters into other swaps in

connection with activities covered by the swap dealer definition,

could be designated as a swap dealer only for the latter activities.

---------------------------------------------------------------------------

At the same time, however, there may be circumstances where a

person's activity of entering into swaps is encompassed by the

statutory definition of the term ``swap dealer,'' notwithstanding that

the swaps have the effect of hedging or mitigating the person's

commercial risk.\222\ Although these swaps could, in theory, be

excluded from the swap dealer analysis, we believe that a broader, per

se exclusion for all swaps that hedge or mitigate commercial risk is

[[Page 30613]]

inappropriate for the swap dealer definition.

---------------------------------------------------------------------------

\222\ For example, ``pay floating/receive fixed'' swaps entered

into by a swap dealer with long exposure to the floating side of a

market would have the effect of hedging the dealer's exposure.

---------------------------------------------------------------------------

First, the hedging exclusion that we are adopting is in the nature

of a safe harbor; i.e., it describes activity that will not be

considered swap dealing activity. As such, the CFTC believes that it is

appropriate that the interim final rule not be cast broadly.\223\ This

does not mean that other types of hedging activity that do not meet the

requirements of the interim final rule are necessarily swap dealing

activity. Rather, such hedging activity is to be considered in light of

all other relevant facts and circumstances to determine whether the

person is engaging in activity (e.g., accommodating demand for swaps,

making a market for swaps, etc.) that makes the person a swap dealer.

---------------------------------------------------------------------------

\223\ While we recognize that a rule delineating the swap

activities that do not constitute swap dealing would simplify and

make more certain, at least in some contexts, the application of the

swap dealer definition, there are also reasons for caution in

incorporating a categorical exclusion for hedging.

---------------------------------------------------------------------------

Second, the usefulness of an exclusion of all swaps that hedge or

mitigate commercial risk for certain aspects of the major swap

participant definition \224\ is not a reason to use the same exclusion

in the swap dealer definition, since the swap dealer definition serves

a different function. The definition of the term ``major swap

participant,'' which applies only to persons who are not swap

dealers,\225\ is premised on the prior identification, by the swap

dealer definition, of persons who accommodate demand for swaps, make a

market in swaps, or otherwise engage in swap dealing activity. The

major swap participant definition performs the subsequent function of

identifying persons that are not swap dealers, but hold swap positions

that create an especially high level of risk that could significantly

impact the U.S. financial system.\226\ Only for this subsequent

function is it appropriate to apply the broader exclusion of swaps held

for the purpose of hedging or mitigating commercial risk.\227\

---------------------------------------------------------------------------

\224\ See part IV.C, infra.

\225\ See CEA Sec. 1a(33)(A)(i), 7 U.S.C. 1a(33)(A)(i).

\226\ See CEA Sec. 1a(33)(B), 7 U.S.C. 1a(33)(B).

\227\ We do not believe that the differences between the

exclusion in the major participant definitions for swaps held for

the purpose of hedging or mitigating commercial risk and the

exclusion in the swap dealer definition for certain swaps entered

into for the purpose of hedging risks related to physical positions

mean that the Commissions, or the CFTC in particular, have

implemented two different definitions of hedging. In fact, neither

of these exclusions define the term ``hedging.'' Rather, the

differences between the two exclusions reflect differences in the

parameters that must be satisfied in order to ensure that hedging

swaps are appropriately excluded from the two different definitions.

---------------------------------------------------------------------------

The CFTC believes that since the over-the-counter swap markets have

operated largely without regulatory oversight and encompass swaps used

for a wide variety of commercial purposes, no method has yet been

developed to reliably distinguish, through a per se rule, between: (i)

Swaps that are entered into for the purpose of hedging or mitigating

commercial risk; and (ii) swaps that are entered into for the purpose

of accommodating the counterparty's needs or demands or otherwise

constitute swap dealing activity, but which also have a hedging

consequence.\228\ In contrast, the CFTC notes that it has set forth and

modified standards for bona fide hedging transactions and granted

exemptions in compliance with such standards for decades.\229\ These

historically-developed standards form the basis of the interim final

rule excluding from the swap dealer analysis certain swaps that hedge

the risks associated with a physical position.

---------------------------------------------------------------------------

\228\ As noted in the preceding paragraph, it is not necessary

to make this distinction for purposes of the major swap participant

definition.

\229\ See, e.g., 42 FR 42751 (Aug. 8, 1977). Although the latest

formulation of the definition of bona fide hedging--CFTC Regulation

Sec. 151.5(a)--was recently adopted, see CFTC, Position Limits for

Futures and Swaps; Final Rule and Interim Final Rule, 76 FR 71626

(Nov. 18, 2011), the bona fide hedging test has been in use for

decades.

---------------------------------------------------------------------------

The exclusion in CFTC Regulation Sec. 1.3(ggg)(6)(iii) depends not

on the effect or consequences of the swap, but on whether the purpose

for which a person enters into a swap is to hedge a physical position

as defined in the rule. If so, then the swap is excluded from the

dealer analysis because using swaps for that purpose is inconsistent

with, and is not, dealing activity.\230\ On the other hand, if, at the

time the swap is entered into, the person's purpose for entering into

the swap is not as defined in CFTC regulation Sec. 1.3(ggg)(6)(iii),

or if it is unclear whether the swap is for such purpose, then the fact

that the swap hedges the person's exposure in some regard does not

preclude consideration of that swap in the dealer analysis.\231\ In

this latter case, all relevant facts and circumstances regarding the

swap and the person's activity with respect to the swap would be

relevant in the determination of whether the person is a swap

dealer.\232\

---------------------------------------------------------------------------

\230\ To be clear, the swaps a person enters into for hedging

physical positions as defined in CFTC Regulation Sec.

1.3(ggg)(6)(iii) are not indicative of dealing activity under any of

the prongs of the swap dealer definition.

\231\ In this regard, CFTC Regulation Sec. 1.3(ggg)(6)(iii) is

different from certain of the CFTC's rules regarding bona fide

hedging, where a person's purpose in entering into a swap may not be

relevant.

\232\ We believe that, in practice, the difficulty of

distinguishing, in applying the swap dealer definition, swaps

entered into for the purpose of hedging from other types of swaps

will be resolvable when the facts and circumstances of a person's

swap activities are taken into consideration in light of our

interpretive guidance.

---------------------------------------------------------------------------

We believe that, based on the CFTC's experience in applying bona

fide hedging principles with respect to swaps hedging risks related to

physical positions, the exclusion in CFTC Regulation Sec.

1.3(ggg)(6)(iii) at this time is the best means of providing certainty

to market participants regarding which swaps may be disregarded in the

dealer analysis. However, commenters presented a range of views as to

the exclusions from the dealer analysis that may be appropriate in this

regard.\233\ Accordingly, the CFTC is implementing this exclusion on an

interim rule basis and is seeking comments on all aspects of the

interim rule, including any adjustments that may be appropriate in the

rule or accompanying interpretive guidance.

---------------------------------------------------------------------------

\233\ See, e.g., letters cited in note 141, supra.

---------------------------------------------------------------------------

The CFTC also seeks comments on whether a different approach to

swaps entered into for the purpose of hedging risk is appropriate to

implement the statutory definition of the term ``swap dealer.''

For example, the CFTC invites commenters to address whether any

exclusion of hedging swaps from the swap dealer analysis is

appropriate, and if so, how swaps that are entered into for purposes of

hedging may be identified and distinguished from other swaps.

Commenters are encouraged to address whether it is relevant to

distinguish swaps entered into for purposes of hedging from swaps that

have a consequential result of hedging, and if so, how such swaps may

be distinguished. Also, commenters may address whether the exclusion

should be limited to swaps hedging risks related to physical positions

or extended to encompass swaps hedging financial risks or other types

of risks.

Commenters should address whether the exclusion in CFTC Regulation

Sec. 1.3(ggg)(6)(iii) should be consistent with the exclusion in CFTC

Regulation Sec. 1.3(kkk). If so, why, and if not, why not? If the two

exclusions should be consistent, does consistency require that that

exclusions be identical, or would there be variations in application of

the two exclusions? Are there market participants whose swap positions

would be classified as held for the purpose of hedging or mitigating

commercial risk under CFTC Regulation

[[Page 30614]]

Sec. 1.3(kkk) but would not qualify for the exclusion under CFTC

Regulation Sec. 1.3(ggg)(6)(iii)? If so, specifically identify the

types of market participants and swaps. If the CFTC were to apply in

the swap dealer definition the exclusion in CFTC Regulation Sec.

1.3(kkk) in lieu of the exclusion in CFTC Regulation Sec.

1.3(ggg)(6)(iii), would there be negative market impacts? If so, what

are they? Would there be positive market impacts? If so, what are they?

In particular, what type(s) of swaps that ``hedge or mitigate

commercial risk,'' but that are not excluded under the interim rule,

may constitute dealing activity in light of the rules and interpretive

guidance regarding the swap dealer definition set forth in this

Adopting Release?

Comments regarding the costs and benefits related to the interim

final rule and any alternative approaches, including in particular the

quantification of such costs and benefits, are also invited.

Commenters are encouraged, to the extent feasible, to be

comprehensive and detailed in providing their approach and rationale.

The comment period for the interim final rule will close July 23, 2012.

f. Swaps Entered Into by Persons Registered as Floor Traders

Commenters discussed whether the swap dealer definition encompasses

the activity of entering into swaps on or subject to the rules of a DCM

or SEF, and submitted for clearing to a derivatives clearing

organization (``DCO''), particularly when firms engage in that activity

using only proprietary funds.\234\ Because Title VII of the Dodd-Frank

Act amended the definition of floor trader specifically to encompass

activities involving swaps,\235\ the CFTC believes that it would lead

to potentially duplicative regulation if floor traders engaging in

swaps in their capacity as floor traders were also required to register

as swap dealers. Accordingly, the CFTC believes that it is appropriate

not to consider such swaps when determining whether a person acting as

a floor trader, as defined under CEA section 1a(23),\236\ and

registered with the CFTC under CFTC Regulation Sec. 3.11, is a swap

dealer if the floor trader meets certain conditions. Specifically, the

final rule provides that, in determining whether a person is a swap

dealer, each swap that the person enters into in its capacity as a

floor trader as defined by CEA section 1a(23) or on a SEF shall not be

considered for the purpose of determining whether the person is a swap

dealer, provided that the person:

---------------------------------------------------------------------------

\234\ See letter from Trading Coalition. One commenter

specifically discussed floor traders and floor brokers and the

regulatory regime that should apply to them following implementation

of the Dodd Frank Act. See letter from Christopher K. Hehmeyer.

We note that other commenters suggested that all swaps cleared

on an exchange should be excluded from the dealer definitions. See

letters cited in note 138, supra. However, the discussion here is

limited to persons who are registered as floor traders and meet

other conditions. Also, the final rule provision discussed here does

not exclude floor traders from the definition of the term ``swap

dealer;'' rather, it provides that if the stated conditions are met,

certain swaps entered into by floor traders are excluded from the

swap dealer analysis.

\235\ See section 721(a)(11) of the Dodd-Frank Act (amending the

definition of the term ``floor trader'' in CEA section 1a(23)). The

Exchange Act does not have an equivalent regulatory category to

floor trader under the CEA, and thus Congress did not make a similar

amendment to the Exchange Act.

\236\ The definition of the term ``floor trader'' includes a

person entering into swaps on a ``contract market.'' See CEA section

1a(23). This exclusion also encompasses swaps that a registered

floor trader enters into on or subject to the rules of a SEF, in

addition to on or subject to the rules of a DCM, so long as the swap

meets the conditions stated in the exclusion.

---------------------------------------------------------------------------

(i) Is registered with the CFTC as a floor trader pursuant to CFTC

Regulation Sec. 3.11;

(ii) enters into swaps solely with proprietary funds for that

trader's own account on or subject to the rules of a DCM or SEF, and

submits each such swap for clearing to a DCO;

(iii) is not an affiliated person of a registered swap dealer;

(iv) does not directly, or through an affiliated person, negotiate

the terms of swap agreements, other than price and quantity or to

participate in a request for quote process subject to the rules of a

DCM or SEF;

(v) does not directly or through an affiliated person offer or

provide swap clearing services to third parties;

(vi) does not directly or through an affiliated person enter into

swaps that would qualify as hedging physical positions pursuant to CFTC

Regulation Sec. 1.3(ggg)(6)(iii) or hedging or mitigating commercial

risk pursuant to CFTC Regulation Sec. 1.3(kkk), with the exception of

swaps that are executed opposite a counterparty for which the

transaction would qualify as a bona fide hedging transaction;

(vii) does not participate in any market making program offered by

a DCM or SEF; and

(viii) complies with the record keeping and risk management

requirements of CFTC Regulation Sec. Sec. 23.201, 23.202, 23.203, and

23.600 with respect to each such swap as if it were a swap dealer.\237\

---------------------------------------------------------------------------

\237\ See CFTC Regulation Sec. 1.3(ggg)(6)(iv).

---------------------------------------------------------------------------

This rule permits floor traders who might otherwise be required to

register as a swap dealer to be registered solely as floor traders with

the CFTC. Given the limitations on the scope of the rule, the

requirements for floor traders using the relief to comply with

recordkeeping and risk management rules applicable to swap dealers as a

condition of the relief, and the fact that swaps subject to the rule

are traded on a DCM or SEF and cleared through a DCO, the CFTC believes

it is not necessary to have floor traders subject to this rule register

as both floor traders and swap dealers as a result of swaps activities

covered by the rule.\238\

---------------------------------------------------------------------------

\238\ The Commissions note the rule applies only to CFTC-

registered floor traders engaging in swaps on DCMs or SEFs and

cleared through DCOs. As noted above, the SEC does not have a

regulatory category under the Exchange Act equivalent to floor

trader under the CEA and none of these provisions apply in the

context of security-based swap dealers or any entity regulated under

the Exchange Act. Any person engaging in security-based swap

transactions, whether or not these activities are similar to those

engaged in by floor traders, will need to independently consider

whether they need to register as security-based swap dealers as a

result of their activities.

---------------------------------------------------------------------------

g. Additional Interpretive Issues Relating to the ``Swap Dealer''

Definition

As noted above, the Commissions, in consideration of comments

received, are making certain modifications to the interpretive guidance

concerning the definition of the term ``swap dealer'' set out in the

Proposing Release. However, the Commissions are retaining certain

elements of their proposed interpretation of the term ``swap dealer,''

as discussed below.

First, with respect to the comments asserting that the proposed

interpretive approach is overly broad,\239\ we note that the statute

provides that the term ``swap dealer'' means ``any person'' who engages

in the activities described in any of the four prongs of the

definition, subject to the exceptions and qualifications set out in the

statute. In view of this statutory text, these comments effectively

assert that the statute should be interpreted to include preconditions

to swap dealer status that are not set forth in the statute. For

example, the assertion that the swap dealer definition must be limited

to persons who enter into swaps on both sides of the market would

impose a requirement that does not exist in the statute. Similarly, the

comments to the effect that swap dealers are only those persons who

seek to profit by intermediating between swap market participants adds

a requirement not set forth in the statute.

---------------------------------------------------------------------------

\239\ See letters cited at notes 83 to 84, supra.

---------------------------------------------------------------------------

We believe, though, that the activities that cause a person to be

covered by the

[[Page 30615]]

swap dealer definition should be addressed in the context of the four

prongs of the statutory definition. That is, the relevant question is

whether a person engages in any of the types of activities enumerated

in the statute, and not whether the person meets any additional,

supposedly implicit preconditions to swap dealer status.

Second, the Commissions continue to believe, as stated in the

Proposing Release, that accommodating demand and facilitating interest

are appropriately used as factors in identifying swap dealers. As noted

by commenters, however, the mere fact that a person entering into a

particular swap has the effect of ``accommodating demand'' or

``facilitating interest'' in swaps does not conclusively establish that

the person is a swap dealer. Instead, the person's overall activities

in the swap market (or particular sector of the swap market if the

person is active in a variety of sectors) should be compared against

these factors. If, in the context of its overall swap activities, a

person fulfills a function of accommodating demand or facilitating

interest in swaps for other parties, then these factors would be

significant in the analysis and the person is likely to be a swap

dealer.\240\

---------------------------------------------------------------------------

\240\ The language of the four statutory tests for swap dealer

status (which refer to a person who holds itself out as a dealer, is

commonly known as a dealer, makes a market in swaps or regularly

enters into swaps with counterparties) contemplate that a dealer is

a person who, through its swap activities, functions to create legal

relationships that transfer risk between independent persons. See

CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).

See also Proposing Release, 75 FR at 80177 (describing swap

dealers as those persons whose function is to serve as the points of

connection in the swap markets); letter from COPE I at 4 (``Simply

stated, dealers are in the regular business of being a point of

connection to the market for others that need access to the market

to hedge risk.''): Roundtable Transcript at 21 (remarks of Richard

Ostrander, Morgan Stanley; ``a dealer is someone who is out there

willing to enter into trades'').

---------------------------------------------------------------------------

Third, as discussed above, we have adopted some of the objective

criteria suggested by commenters with respect to the indicia of holding

oneself out as a dealer or being commonly known as a dealer, market

making, and the ``regular business'' prongs of the swap dealer

definition.\241\ For instance, allocating staff and technological

resources to swap activity, deriving revenue and profit from swap

activity, or responding to customer-initiated orders for swaps can all

be indicative of having ``a regular business'' of entering into swaps

and, therefore, indicative of being a swap dealer. In addition,

activities such as providing advice about swaps or offering oneself as

a point of connection to other parties needing access to the swap

market are indicative of a person holding itself out as a swap dealer,

if the person also enters into swaps in conjunction with such

activities.

---------------------------------------------------------------------------

\241\ See part II.B.2.d.iii, supra.

---------------------------------------------------------------------------

The guidance we have provided about these indicia is responsive to

concerns expressed by commenters about the application of the swap

dealer definition to energy markets. As described above, some

commenters stated that in energy markets, unlike in some other markets,

end-users often enter into swaps directly with each other, on both

sides of the market, without the involvement of a separate category of

businesses serving as intermediaries.\242\ As a result, according to

these commenters, energy swap market participants often engage in some

of the activities that are indicative of swap dealer status. Some of

these commenters contended that our activity-based interpretation of

the swap dealer definition could therefore result in the inappropriate

inclusion of energy market participants in the coverage of the

definition of the term ``swap dealer.'' \243\

---------------------------------------------------------------------------

\242\ See parts II.A.2.f.ii and iii, supra.

\243\ See letters cited in note 117, supra. Comments expressing

concern that the definition of the term ``swap dealer'' could

include physical commodities businesses also were presented to

Congress during consideration of legislation leading to passage of

the Dodd-Frank Act. See Proposed Legislation by the U.S. Department

of the Treasury Regarding the Regulation of Over-The-Counter

Derivatives Markets: Hearing Before the H. Comm. On Agriculture,

111th Cong. 103 (2009) (submitted report on behalf of the Working

Group of Commercial Energy Firms). However, as noted above, there is

no exclusion in the statutory definition for such businesses.

---------------------------------------------------------------------------

We believe that the language of the statutory ``swap dealer''

definition supports our activity-based interpretation and does not

support categorical exclusions of particular types of persons from the

``swap dealer'' definition based on the general nature of their

businesses. Further evidence that such a categorical exclusion is

unwarranted is provided by the fact that a number of energy market

participants--BP Plc., Cargill, Incorporated, Centrica Energy Limited,

ConocoPhillips, EDF Trading Limited, GASELYS, Hess Energy Trading

Company, LLC, Hydro-Quebec, Koch Supply & Trading, LP, RWE Supply &

Trading GmbH, Shell Energy North America (US), L.P., STASCO, Totsa

Total Oil Trading S.A., and Vattenfall Energy Trading Netherlands

N.V.--have voluntarily joined ISDA as primary dealers.\244\ As

previously noted, any business organization that ``deals in derivatives

shall be eligible for election to membership in the Association as a

primary member, provided that no person or entity shall be eligible for

membership as a Primary Member if such person or entity participates in

derivatives transactions solely for the purpose of risk hedging or

asset or liability management.'' \245\ Hence, a categorical exclusion

from the ``swap dealer'' definition based on any particular type of

business or general market activity also would be inconsistent with

current industry structure and practice.

---------------------------------------------------------------------------

\244\ The list of ISDA Primary Members is available at http://www.isda.org/membership/isdamemberslist.pdf.

\245\ See note 188, supra.

---------------------------------------------------------------------------

At the same time, however, the fact that a person engages in some

swap activities that are indicative of swap dealer status does not, by

itself, mean that the person is covered by the definition of the term

``swap dealer.'' The ``not as part of a regular business'' exception

and our guidance about its meaning address the issue of swap market

participants that engage to some extent in the activities

characteristic of swap dealers. The guidance we have provided here

therefore provides the appropriate approach to addressing these issues

in energy markets as elsewhere.

Although several commenters attempted to articulate bright-line

tests that would differentiate swap dealers from other swap market

participants, the suggested bright-line tests generally could not be

applied across the board to all types of swap market activity. For

example, some commenters suggested that swap dealers can be identified

as those who profit from entering into swaps on both sides of the

market (and under the interpretive approach set forth in this Adopting

Release, such activity may be an indicator of swap dealing).\246\ But

other commenters said that, in certain circumstances, entering into

swaps on both sides of the market is not necessarily indicative of swap

dealing.\247\

---------------------------------------------------------------------------

\246\ See letters cited in note 84, supra.

\247\ See letters cited in note 86, supra. As noted above in the

discussion of market making, a swap dealer may in some circumstances

enter into swaps on only one side of the market.

---------------------------------------------------------------------------

The ways in which participants throughout the market use swaps are

simply too diverse for swap dealer status to be resolved with a single,

one-factor test. This is reflected in the statutory definition of the

term ``swap dealer'' itself. Focused as it is on types of activities,

with four prongs set forth in the alternative to cover different types

of swap dealing activity, the statutory swap dealer definition is not

susceptible to the bright-line test that

[[Page 30616]]

some commenters seek. For these reasons, we continue to believe that it

is appropriate to apply the multi-factor interpretive approach set

forth in this Adopting Release.

In closing, we emphasize that the purpose of in this part IV.A.4 is

to provide guidance as to how the rules further defining the term

``swap dealer'' will be applied in particular, complex situations where

a person's status as a swap dealer may be uncertain. Even though

bright-line tests and categorical exclusions are inappropriate, we

recognize that the large majority of market participants use swaps for

normal course hedging, financial, investment or trading purposes and

are not swap dealers.

5. Final Rules and Interpretation--Definition of ``Security-Based Swap

Dealer''

a. General Reliance on the Dealer-Trader Distinction

As discussed above, we are adopting a rule under the Exchange Act

that defines ``security-based swap dealer'' in terms of the four

statutory tests and the exclusion for security-based swap activities

that are not as part of a ``regular business.'' \248\ Also, we believe

that the dealer-trader distinction \249\--which already forms a basis

for identifying which persons fall within the longstanding Exchange Act

definition of ``dealer''--in general provides an appropriate framework

for interpreting the meaning of ``security-based swap dealer.'' \250\

While there are differences in the structure of those two statutory

definitions,\251\ we believe that their parallels--particularly both

definitions' exclusions for activities that are ``not part of a regular

business''--warrant analogous interpretive approaches for

distinguishing dealers from non-dealers.

---------------------------------------------------------------------------

\248\ See Exchange Act rule 3a71-1(a), (b).

\249\ See note 31, supra.

\250\ The principles embedded within the ``dealer-trader

distinction'' are not solely useful for distinguishing persons who

constitute dealers from active ``traders,'' but also are applicable

to distinguishing dealers from non-dealers such as hedgers or

investors. The ``dealer-trader'' nomenclature has been used for

decades. See Loss, Securities Regulation 722 (1st ed. 1951) (``One

aspect of the `business' concept is the matter of drawing the line

between a `dealer' and a trader--an ordinary investor who buys and

sells for his own account with some frequency.'').

\251\ For example, while the ``dealer'' definition encompasses

certain persons in the business of ``buying and selling''

securities, the ``security-based swap dealer'' definition does not

address either ``buying'' or ``selling.'' As we noted in the

Proposing Release, we do not believe that the lack of those terms in

the ``security-based swap dealer'' definition leads to material

interpretive distinctions, as the Dodd-Frank Act amended the

Exchange Act definitions of ``buy'' and ``purchase,'' and the

Exchange Act definitions of ``sale'' and ``sell,'' to encompass the

execution, termination (prior to its scheduled maturity date),

assignment, exchange or similar transfer or conveyance of, or

extinguishing of rights or obligations under, a security-based swap.

See Proposing Release, 75 FR at 80178 n.26 (citing Dodd-Frank Act

sections 761(a)(3), (4), which amend Exchange Act sections 3(a)(13),

(14)).

At the same time, we note that the ``dealer'' definition

requires the conjunctive ``buying and selling''--which connotes a

degree of offsetting two-sided activity. In contrast, the

``security-based swap dealer'' definition (particularly the

``regularly enters into security-based swaps'' language of the

definition's third test) lacks that conjunctive terminology.

---------------------------------------------------------------------------

As discussed above,\252\ the Commissions note that interpretations

of the applicability of the dealer-trader distinction to the ``swap

dealer'' definition under the CEA do not affect existing, or future,

interpretations of the dealer-trader distinction under the Exchange

Act--both with regard to the ``security-based swap dealer'' definition,

and with regard to the ``dealer'' definition.

---------------------------------------------------------------------------

\252\ See note 171, supra.

---------------------------------------------------------------------------

In interpreting the security-based swap dealer definition in terms

of the dealer-trader distinction, the Commissions have been mindful

that some commenters expressed the view that we instead should rely on

other interpretive factors that were identified in the Proposing

Release (e.g., accommodating demand). We believe, nonetheless, that the

dealer-trader distinction forms the basis for a framework that

appropriately distinguishes between persons who should be regulated as

security-based swap dealers and those who should not. We also believe

that the distinction affords an appropriate degree of flexibility to

the analysis, and that it would not be appropriate to seek to codify

the distinction.

At the same time, the Commissions recognize that the dealer-trader

distinction needs to be adapted to apply to security-based swap

activities in light of the special characteristics of security-based

swaps and the differences between the ``dealer'' and ``security-based

swap dealer'' definitions. Relevant differences include:

Level of activity--Security-based swap markets are marked

by less activity than markets involving certain other types of

securities (while recognizing that some debt and equity securities are

not actively traded). This suggests that in the security-based swap

context concepts of ``regularity'' should account for the level of

activity in the market.

No separate issuer--Each counterparty to a security-based

swap in essence is the ``issuer'' of that instrument; in contrast,

dealers in cash market securities generally transact in securities

issued by another party. This distinction suggests that the concept of

turnover of ``inventory'' of securities, which has been identified as a

factor in connection with the dealer-trader distinction, is inapposite

in the context of security-based swaps. Moreover, this distinction--

along with the fact that the ``security-based swap dealer'' definition

lacks the conjunctive ``buying and selling'' language of the ``dealer''

definition \253\--suggests that concepts of two-sided markets at times

would be less relevant for identifying ``security-based swap dealers''

than they would be for identifying ``dealers.'' \254\

---------------------------------------------------------------------------

\253\ See note 251, supra.

\254\ The analysis also should account for the fact that a party

to a security-based swap can use other derivatives or cash market

instruments to hedge the risks associated with the security-based

swap position, meaning that two-way trading is not necessary to

maintain a flat risk book.

---------------------------------------------------------------------------

Predominance of over-the-counter and non-standardized

instruments--Security-based swaps thus far are not significantly traded

on exchanges or other trading systems, in contrast to some cash market

securities (while recognizing that many cash market securities also are

not significantly traded on those systems).\255\ These attributes--

along with the lack of ``buying and selling'' language in the security-

based swap dealer definition, as noted above--suggest that concepts of

what it means to make a market need to be construed flexibly in the

context of the security-based swap market.\256\

---------------------------------------------------------------------------

\255\ Even though we expect trading of security-based swaps on

security-based swap execution facilities or exchanges following the

implementation of Title VII, we expect there to remain a significant

amount of over-the-counter activity involving security-based swaps.

\256\ For example, the definition of ``market maker'' in

Exchange Act section 3(a)(38)--which is applicable for purposes of

the Exchange Act ``unless the context otherwise requires'' (see

Exchange Act section 3(a))--defines the term ``market maker'' to

mean ``any specialist permitted to act as a dealer, any dealer

acting in the capacity of block positioner, and any dealer who, with

respect to a security, holds himself out (by entering quotations in

an inter-dealer communications system or otherwise) as being willing

to buy and sell such security for his own account on a regular or

continuous basis.'' That definition is useful in the context of

systems in which standardized securities are regularly or

continuously bought and sold, but would not be apposite in the

context of non-standardized securities or securities that are not

regularly or continuously transacted.

---------------------------------------------------------------------------

Mutuality of obligations and significance to ``customer''

relationship--In contrast to a secondary market transaction involving

equity or debt securities, in which the completion of a purchase or

sale transaction can be expected to terminate the mutual obligations of

the parties to the

[[Page 30617]]

transaction, the parties to a security-based swap often will have an

ongoing obligation to exchange cash flows over the life of the

agreement. In light of this attribute, some market participants have

expressed the view that they have ``counterparties'' rather than

``customers'' in the context of their swap activities.

It also is necessary to use the dealer-trader distinction to

interpret the security-based swap dealer definition so that the

statutory provisions that will govern security-based swap dealers are

applied in an effective and logical way. Those statutory provisions

added by the Dodd-Frank Act advance financial responsibility (e.g., the

ability to satisfy obligations, and the maintenance of counterparties'

funds and assets) associated with security-based swap dealers'

activities,\257\ other counterparty protections,\258\ and the promotion

of market efficiency and transparency.\259\ As a whole, the relevant

statutory provisions suggest that we should apply the dealer-trader

distinction to interpret the security-based swap dealer definition in a

way that identifies those persons for which regulation is warranted

either: (i) Due to the nature of their interactions with

counterparties; \260\ or (ii) to promote market stability and

transparency, in light of the role those persons occupy within the

security-based swap markets.\261\

---------------------------------------------------------------------------

\257\ E.g., capital and margin requirements (Exchange Act

section 15F(e)), and requirements for segregation of collateral

(Exchange Act section 3E).

\258\ E.g., requirements with respect to business conduct when

transacting with special entities (Exchange Act sections 15F(h)(2),

(h)(4), (h)(5)); disclosure requirements (Exchange Act section

15F(h)(3)(B)); requirements for fair and balanced communications

(Exchange Act section 15F(h)(3)(C)); other requirements related to

the public interest and investor protection (Exchange Act section

15F(h)(3)(D)); and conflict of interest provisions (Exchange Act

section 15F(j)(5)).

\259\ E.g., reporting and recordkeeping requirements (Exchange

Act section 15F(f)); daily trading records requirements (Exchange

Act section 15F(g)); regulatory standards related to the

confirmation, processing, netting, documentation and valuation of

security-based swaps (Exchange Act section 15F(i)); position limit

monitoring requirements (Exchange Act section 15F(j)(1)); risk

management procedure requirements (Exchange Act section 15F(j)(2));

and requirements related to the disclosure of information to

regulators (Exchange Act section 15F(j)(3)).

\260\ The conclusion that a person's relationship with its

counterparties can lead to associated obligations is consistent with

the ``shingle theory,'' which implies a duty of fair dealing when a

person hangs out its shingle to do business. See Securities and

Exchange Commission, Report of the Special Study of Securities

Market Part I at 238 (1963) (``An obligation of fair dealing, based

upon the general antifraud provisions of the Federal securities

laws, rests upon the theory that even a dealer at arm's length

impliedly represents when he hangs out his shingle that he will deal

fairly with the public.''; footnote omitted); Weiss, Registration

and Regulation of Brokers and Dealers 171 (1965) (``the solicitation

and acceptance by a broker-dealer of orders from customers and the

confirmation of transactions do constitute a representation by the

broker-dealer that he will deal fairly with his customers and that

such transactions will be handled promptly in the usual manner, in

accordance with trade custom'').

\261\ The importance of regulating dealers due to the centrality

of their market role was illustrated by the Government Securities

Act of 1986. When Congress provided for the regulation of government

securities dealers, Congress specifically cited the lack of

regulation as contributing to the failures of several unregulated

government securities dealers. See S. Rep. No. 99-426 (1986), as

reprinted in 1986 U.S.C.C.A.N. 5395, 5400-04. The resulting statute

provided for a definition of ``government securities dealer'' that

in relevant part is parallel to the definitions of ``dealer'' and

``security-based swap dealer,'' particularly with regard to sharing

an exclusion for activities that are not part of a ``regular

business.'' See Exchange Act section 3(a)(44).

---------------------------------------------------------------------------

b. Principles for Applying the Dealer-Trader Distinction to Security-

Based Swap Activity

In light of the statutory security-based swap dealer definition,

statutory provisions applicable to security-based swap dealers and

market characteristics addressed above, the Commissions believe that

the factors set forth below are relevant for identifying security-based

swap dealers and for distinguishing those dealers from other market

participants. This guidance seeks to address commenter requests that we

further clarify the scope of the security-based swap dealer definition,

and the Commissions believe that these factors provide appropriate

guidance without being inflexible or allowing the opportunity for

evasion that may accompany a bright-line test. At the same time, the

determination of whether a person is acting as a security-based swap

dealer ultimately depends on the relevant facts and circumstances. In

light of the overall context in which a person's activity occurs, the

absence of one or more of these factors does not necessitate the

conclusion that a person is not a security-based swap dealer.\262\

---------------------------------------------------------------------------

\262\ Similarly, depending on the relevant facts and

circumstances, the presence of certain of the illustrative

activities described here does not necessitate the conclusion that

the entity is a dealer.

---------------------------------------------------------------------------

Providing liquidity to market professionals or other

persons in connection with security-based swaps. A market participant

might manifest this indication of dealer activity by accommodating

demand or facilitating interest expressed by other market

participants,\263\ holding itself out as willing to enter into

security-based swaps, being known in the industry as being available to

accommodate demand for security-based swaps, or maintaining a sales

force in connection with security-based swap activities.\264\

---------------------------------------------------------------------------

\263\ This is to be distinguished from an entity entering into

security-based swaps for other business purposes, such as to gain

economic exposure to a particular market.

\264\ A sales force, however, is not a prerequisite to a person

being a security-based swap dealer. For example, a person that

enters into security-based swaps in a dealing capacity can fall

within the dealer definition even if it uses an affiliated entity to

market and/or negotiate those security-based swaps (e.g., the person

is a booking entity). Depending on the applicable facts and

circumstances, the affiliate that performs the marketing and/or

negotiation functions may fall within the Exchange Act's definition

of ``broker'' (which was not revised by Title VII). See Exchange Act

section 3(a)(4)(A).

---------------------------------------------------------------------------

Seeking to profit by providing liquidity in connection

with security-based swaps. A market participant may manifest this

indication of security-based swap dealer activity--which is consistent

with the definition's ``regular business'' requirement--by seeking

compensation in connection with providing liquidity involving security-

based swaps (e.g., by seeking a spread, fees or other compensation not

attributable to changes in the value of the security-based swap).\265\

The Commissions do not believe that this necessarily requires that a

person be available to take either side of the market at any time, or

that a person continuously engage in this type of activity, to be a

security-based swap dealer. Although one commenter expressed the view

that the security-based swap dealer definition requires that a person

be consistently available to take either side of the market,\266\ in

our view such an approach would be underinclusive.\267\

---------------------------------------------------------------------------

\265\ Indicia of this objective may include, but would not be

limited to, maintaining separate profit/loss statements in

connection with this type of activity, and/or devoting staff and

resources to this type of activity.

In this regard, we believe that the issue of whether a person

tends to take the prices offered in the market, rather than helping

to set those prices (such as by providing quotes, placing limit

orders, or otherwise accommodating demand), can be relevant as a

factor for distinguishing security-based swap dealers from non-

dealers. At the same time, we are mindful that a dealer may also

accept the market price as part of its dealer activity (such as when

a person enters into a security-based swap to offset the risk it

assumes in connection with its security-based swap dealing

activity); as a result, the fact that a person regularly takes the

market price as part of its security-based swap transactions does

not foreclose the possibility that the person may be a security-

based swap dealer.

\266\ See letter from ISDA I.

\267\ It is possible for a dealer to be compensated for

providing liquidity by entering into sequential offsetting

positions, or by hedging the security-based swap position by using a

different type of security-based swap, a swap or some other

financial instrument. Accordingly, a rule of decision that permitted

a person to avoid dealer regulation by providing liquidity in

connection with security-based swaps, and laying off the associated

risk using a different type of security-based swap, a swap or a

different instrument entirely, would be susceptible to abuse.

Moreover, as noted above, the definition of ``security-based swap

dealer'' does not contain the ``buying and selling'' language found

in the general Exchange Act definition of ``dealer.'' Thus, while

being regularly willing to enter into either side of the security-

based swap market would suggest that a person is engaged in dealing

activity, the absence of such activity should not necessarily lead

to an inference that a person is not acting as a dealer.

We also note that some commenters have stated that two-way

quoting by itself should not necessarily be enough to make a person

a dealer, and some of those commenters specifically stated that a

person may use two-sided quotes as part of the price discovery

process or to elicit trading interest. See, e.g., letter from MFA I.

Here too, it is important to consider whether the activity also has

a dealing business purpose, such as seeking to profit by providing

liquidity. Moreover, all participants in the security-based swap

market, whether or not security-based swap dealers, should be

mindful of the potential application of the antifraud and anti-

manipulation provisions of the federal securities laws to such

activities. Section 10(b) of the Exchange Act and Exchange Act rule

10b-5 particularly prescribe the use of any manipulative or

fraudulent device in connection with the purchase or sale of any

security, which includes manipulative trading. See Terrance

Yoshikawa, Securities Exchange Act Release No. 53731 (Apr. 26,

2006), 87 SEC Docket 2924, 2930-31 & n.19 (citing Ernst & Ernst v.

Hochfelder, 425 U.S. 185, 199 (1976)). The SEC has characterized

manipulation as ``the creation of deceptive value or market activity

for a security, accomplished by an intentional interference with the

free forces of supply and demand.'' See Swartwood, Hesse, Inc., 50

S.E.C. 1301, 1307 (1992) (citing Hochfelder, 425 U.S. at 199;

Schreiber v. Burlington Northern, Inc., 472 U.S. 1 (1985); Feldbaum

v. Avon Products, Inc., 741 F.2d 234 (8th Cir. 1984)).

---------------------------------------------------------------------------

[[Page 30618]]

Providing advice in connection with security-based swaps

or structuring security-based swaps. Advising a counterparty as to how

to use security-based swaps to meet the counterparty's hedging goals,

or structuring security-based swaps on behalf of a counterparty, also

would indicate security-based swap dealing activity. It particularly is

important that persons engaged in those activities are appropriately

regulated so that their counterparties will receive the protections

afforded by certain of the statutory business conduct rules (e.g.,

special entity requirements and communication requirements) \268\

applicable to security-based swap dealers.\269\ The Commissions

recognize commenter concerns that end-users may also develop new types

of security-based swaps,\270\ but also recognize that the activities of

end-users related to the structuring of security-based swaps for

purposes of hedging commercial risk are appreciably different than

being in the business of structuring security-based swaps on behalf of

a counterparty.

---------------------------------------------------------------------------

\268\ The SEC has proposed rules to implement Title VII

provisions relating to external business conduct standards for

security-based swap dealers (as well as major security-based swap

participants). See Exchange Act Release No. 64766 (June 29, 2011),

76 FR 42396 (July 18, 2011).

\269\ This factor would also reasonably take into account

whether a preexisting relationship involving other types of

securities or other financial instruments is present. For example,

to the extent a person has an existing broker or dealer relationship

with a counterparty in connection with other types of securities,

and also enters into a security-based swap with that counterparty, a

reasonable inference would be that the person entered into the

security-based swap in a dealer capacity. Any other approach would

invite abuse, as persons could seek to leverage existing

relationships of trust while avoiding regulation as a security-based

swap dealer.

\270\ See letter from FSR I.

---------------------------------------------------------------------------

Presence of regular clientele and actively soliciting

clients. These dealer-trader factors would reasonably appear to be

applicable in the security-based swap context, just as they are

applicable in the context of other types of securities, as indicia of a

business model that seeks to profit by providing liquidity. The

Commissions are mindful that some industry participants have

highlighted a distinction between ``counterparties'' and ``customers''

in connection with swaps, and have suggested that they have no

``customers'' in the swap context. We do not believe such points of

nomenclature are significant for purposes of identifying security-based

swap dealers, however.\271\

---------------------------------------------------------------------------

\271\ For purposes of the dealer-trader analysis, as it applies

in the context of security-based swaps or any other security, we

would not expect contractual provisions stating that the

counterparty is not relying on the person's advice to have any

significance.

---------------------------------------------------------------------------

Use of inter-dealer brokers. As with activities involving

other types of securities, the Commissions would expect that a person's

use of an inter-dealer broker in connection with security-based swap

activities to be an indication of the person's status as a dealer.

Acting as a market maker on an organized security-based

swap exchange or trading system. Acting in a market maker capacity on

an organized exchange or trading system for security-based swaps would

indicate that the person is acting as a dealer.\272\ While the

Commissions recognize that some commenters have expressed the view that

persons who solely enter into security-based swaps on an organized

security-based swap exchange or trading system should not be regulated

as security-based swap dealers,\273\ in our view such an approach would

be contrary to the express language of the definition. This is not to

say, of course, that the presence of an organized exchange or trading

system is a prerequisite to being a market maker for purposes of the

security-based swap dealer definition.\274\ Moreover, acting as a

market maker is not a prerequisite to being a security-based swap

dealer.\275\ On the other hand, being a member of an organized exchange

or trading system for purposes of trading security-based swaps does not

necessarily by itself make a person a security-based swap dealer.\276\

---------------------------------------------------------------------------

\272\ Under the proposal of the SEC, the Board, the OCC and the

FDIC to implement the provisions of section 619 of the Dodd-Frank

Act (also known as the ``Volcker Rule''), a person who claims the

benefit of the market maker exception to that section's prohibitions

and restrictions on proprietary trading in connection with security-

based swap activities would be required to register with the SEC as

a security-based swap dealer, unless the person is exempt from

registration or is engaged in a dealing business outside the U.S.,

and is subject to substantive regulation in the jurisdiction where

the business is located. See Securities Exchange Act Release No.

65545, 76 FR 68846, 68947 (Nov. 7, 2011) (proposed implementing rule

Sec. ------.4(b)(2)(iv)(C)).

\273\ See, e.g., letter from Traders Coalition.

\274\ Given the current nature of the security-based swap

market, including the present level of activity and the present lack

of significant trading of security-based swaps on exchanges or

organized trading systems, we believe that it would negate the

legislative intent to interpret the definition's use of market

making concepts to require the same use of quotation media that are

incorporated into the interpretation of market making concepts in

the context of securities that are actively traded on an organized

exchange or trading system. At the same time, we recognize that

routine activity in the security-based swap market is not

necessarily indicative of making a market in security-based swaps.

For example, persons may routinely be active in the market for

purposes of hedging, to advance their investment objectives, or to

engage in proprietary trading.

\275\ The definition of ``security-based swap dealer'' contains

four alternative tests, only two of which use market making

terminology. Moreover, the third test of the security-based swap

dealer definition--which addresses persons who regularly enter into

security-based swaps as an ordinary course of business for their own

account--appears particularly inapt as a proxy for market making

activity. Transacting with customers is not an element of this

alternative test. A person thus may be a security-based swap dealer

even if it transacts exclusively with other market professionals.

Cf. OCC, ``Risk Management of Financial Derivatives'' 3-4 (1997)

(stating that OCC has classified banks as ``Tier I'' dealers if they

act as market makers by ``providing quotes to other dealers and

brokers, and other market professionals''). Compare letter from ISDA

I (taking the view that the dealer definition should be interpreted

in the context of market-making concepts).

\276\ The analysis of the status of members of such exchanges

and trading systems in part may be influenced by the final Exchange

Act rules that govern such systems, as well as the internal rules of

such systems.

---------------------------------------------------------------------------

As with the current application of the dealer-trader distinction to the

Exchange Act ``dealer'' definition, the question of whether a person is

acting as a security-based swap dealer ultimately will turn upon the

relevant facts and circumstances, as informed by these criteria.

c. Additional Interpretive Issues

Activity by hedgers. As noted above, a number of commenters raised

concerns that an overbroad ``security-based swap dealer'' definition

would inappropriately encompass persons

[[Page 30619]]

using security-based swaps for hedging purposes.\277\ As we stated in

the Proposing Release, however, under the dealer-trader distinction the

Commissions would expect persons that use security-based swaps to hedge

their business risks, absent other activity, likely would not be

dealers.\278\ We maintain that view. In other words, to the extent that

a person engages in security-based swap activity to hedge commercial

risk, or otherwise to hedge risks unrelated to activities that

constitute dealing under the dealer-trader distinction (particularly

activities that have the business purpose of seeking to profit by

providing liquidity in connection with security-based swaps), the

Commissions would not expect those hedging transactions to lead a

person to be a security-based swap dealer.\279\ Of course, to the

extent a person engages in dealing activities involving security-based

swaps, the presence of offsetting positions that hedge those dealing

activities would not excuse the requirement that the person register as

a security-based swap dealer.\280\

---------------------------------------------------------------------------

\277\ See, e.g., letter from Church Alliance.

\278\ See Proposing Release, 75 FR at 80178 n.27. The Proposing

Release also noted that if a person's other activities satisfy the

definition of security-based swap dealer, the person must comply

with the applicable requirements with regard to all of its security-

based swap activities, absent an order to the contrary. We further

noted in the Proposing Release that we would expect end-users to use

security-based swaps for hedging purposes less commonly than they

use swaps for hedging purposes.

\279\ In addition, consistent with the exclusion from the dealer

analysis of activities involving majority-owned affiliates, see part

II.C, infra, to the extent that a person engages in activities to

hedge positions subject to the inter-affiliate exclusion, absent

other activity, the Commission would not expect those hedging

transactions to lead a person to be a security-based swap dealer.

Conversely, security-based swap activities connected with the

indicia of dealing discussed above (e.g., seeking to profit by

providing liquidity in connection with security-based swaps)

themselves would suggest security-based swap dealing activity.

\280\ For example, if a person were to use other instruments to

hedge the risks associated with its security-based swap dealing

activity, that hedging would not undermine the obligation of the

person to register as a security-based swap dealer, notwithstanding

the fact that it could be asserted that the dealing positions happen

to hedge those other positions.

---------------------------------------------------------------------------

No predominance test. As discussed in the Proposing Release, the

Commissions do not believe that the security-based swap dealer analysis

should appropriately turn upon whether a person's dealing activity

constitutes that person's sole or predominant business. The separate de

minimis exemption, however, may have the effect of excusing from dealer

regulation those persons whose security-based swap dealing activities

are relatively modest.

Presence or absence of a customer relationship. Although commenters

have expressed the view that a person that engages in security-based

swap activities on an organized market should not be deemed to be a

dealer unless it engages in those activities with customers,\281\ we do

not agree. It is true that having a customer relationship can

illustrate a business model of seeking to profit by providing

liquidity, and thus provide one basis for concluding that a person is

acting as a security-based swap dealer. Nonetheless, the presence of

market making terminology within the definition is inconsistent with

the view that a security-based swap dealer must have ``customers.''

Also, Title VII requirements applicable to security-based swap dealers

address interests apart from customer protection.\282\ Accordingly, to

the extent that a person regularly enters into security-based swaps

with a view toward profiting by providing liquidity--rather than by

taking directional positions--that person may be a security-based swap

dealer regardless of whether it views itself as maintaining a

``customer'' relationship with its counterparties.\283\

---------------------------------------------------------------------------

\281\ See letters from ISDA I and Traders Coalition.

\282\ Particularly in light of the view expressed by some market

participants that they only have ``counterparties'' in the swap

markets, and not ``customers,'' any interpretation of the

``security-based swap dealer'' definition that is predicated on the

existence of a customer relationship may lead to an overly narrow

construction of the definition.

\283\ For example, a person's activity involving entering into

security-based swaps on a SEF may cause it to be a security-based

swap dealer even in the absence of a customer relationship with any

of its counterparties.

---------------------------------------------------------------------------

Criteria associated with ``holding self out'' as a dealer or being

``commonly known in the trade'' as a security-based swap dealer. The

Proposing Release articulated a number of activities that could satisfy

the definition's tests for a person ``holding itself out'' as a dealer

or being ``commonly known in the trade'' as a dealer.\284\ Several

commenters criticized those proposed criteria, largely on the grounds

that those criteria would inappropriately encompass end-users who seek

to use security-based swaps for hedging purposes, or otherwise would be

overbroad or irrelevant.\285\ The Commissions recognize the

significance of the concerns those commenters raised, and agree that

these activities need to be considered within the context of whether a

person engages in those activities with the purpose of facilitating

dealing activity. While we do not believe that any of those activities

by themselves would necessarily indicate that a person is acting as a

security-based swap dealer, under certain circumstances they may serve

as an indicia of a business purpose of seeking to profit by providing

liquidity in connection with security-based swaps.\286\

---------------------------------------------------------------------------

\284\ As noted above, these were: contacting potential

counterparties to solicit interest; developing new types of swaps or

security-based swaps and informing potential counterparties of their

availability and of the person's willingness to enter into the swap

or security-based swap; membership in a swap association in a

category reserved for dealers; providing marketing materials

describing the type of swaps or security-based 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

or security-based swaps. See Proposing Release, 75 FR at 80178.

\285\ See part II.A.2.a, supra.

\286\ While the Proposing Release identified ``membership in a

swap association in a category reserved for dealers'' as a factor in

connection with the ``holding out'' and ``commonly known'' tests, we

recognize that, depending on the applicable facts and circumstances,

such membership may not be sufficient to cause a person to be a

security-based swap dealer if the person does nothing else to cause

it to be considered a dealer.

---------------------------------------------------------------------------

6. Requests for Exclusions From the Dealer Definitions

Certain commenters have sought to exclude entire categories of

persons from the dealer definitions, notwithstanding that some persons

in those categories may engage in the activities set forth in the

statutory definition (as further defined by the Commissions).\287\ The

final rules nonetheless do not incorporate categorical exclusions of

persons from the dealer definitions because the statutory definitions

provide that ``any person'' who engages in the activities enumerated in

the definitions is covered by the dealer definitions, unless the

person's activities fall within one of the statutory exceptions.\288\

In this regard, it is significant that the exceptions in the dealer

definitions depend on whether a person engages in certain types of swap

or security-based swap activity, not on other characteristics of the

person. That is, the exceptions apply for swaps between an insured

depository institution and its customers in connection with originating

loans,\289\ swaps or security-based swaps entered into not as a part of

a regular business,\290\ and swap or security-based swap dealing that

is below a de minimis

[[Page 30620]]

level.\291\ The Dodd-Frank Act does not exclude any category of persons

from the coverage of the dealer definitions; rather, it excludes

certain activities from the dealer analysis.

---------------------------------------------------------------------------

\287\ See part II.A.2.f, supra.

\288\ See CEA section 1a(49), 7 U.S.C. 1a(49); Exchange Act

section 3(a)(71), 15 U.S.C. 78c(a)(71).

\289\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).

\290\ See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C); Exchange

Act section 3(a)(71)(C), 15 U.S.C. 78c(a)(71)(C).

\291\ See CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange

Act section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).

---------------------------------------------------------------------------

Given that the statutory dealer definitions focus on a person's

activity, the Commissions believe that it is appropriate to determine

whether a person meets any of the tests set forth in those statutory

definitions, and thus is acting as a swap dealer or security-based swap

dealer, on a case-by-case basis reflecting the applicable facts and

circumstances.\292\ If a person's swap or security-based swap

activities are of a nature to be covered by the statutory definitions,

and those activities are not otherwise excluded, then the person is

covered by the definitions. The contrary is equally true--a person who

is not engaged in activities covered by the statutory definitions, or

whose activities are excluded from the definition, is not covered by

the definitions.\293\ The per se exclusions requested by the commenters

have no foundation in the statutory text, and have the potential to

lead to arbitrary line drawing that may result in disparate regulatory

treatment and inappropriate competitive advantages.\294\

---------------------------------------------------------------------------

\292\ The Commissions believe that a facts and circumstances

approach is particularly appropriate here, where the broad terms of

the statutory dealer definitions indicate that the Commissions

should apply their expertise and discretion to interpret the

statutory text.

\293\ For example, a manufacturer, producer, processor, or

merchant that enters into swaps to hedge its currency or interest

rate risk, absent any facts and circumstances establishing dealing

activity, is not a swap dealer.

\294\ In response to the commenters concerns, the Commissions

have adopted certain tailored exclusions of certain types of swaps

and security-based swaps in the final rule.

---------------------------------------------------------------------------

The final rules particularly do not include any exclusions for

aggregators of swaps or other persons that use swaps in connection with

the physical commodity markets, including swaps in connection with the

generation, transmission and distribution of electricity. It is likely,

though, that a significant portion of the financial instruments used

for risk management by such persons are forward contracts in

nonfinancial commodities that are excluded from the definition of the

term ``swap.'' \295\ Such forward contracts are not relevant in

determining whether a person is a swap dealer.

---------------------------------------------------------------------------

\295\ A coalition of not-for-profit power utilities and electric

cooperatives has advised that it plans to submit a request for an

exemption for transactions between entities described in section

201(f) of the Federal Power Act, as contemplated by section 722(f)

of the Dodd-Frank Act. See letter from NFPEEU. Separately, some

regional transmission organizations and independent systems

operators have expressed interest in submitting an exemption

application to the CFTC as well. See generally section 722(e) of the

Dodd-Frank Act. Such exemptions, if granted after notice and comment

pursuant to CEA section 4(c), 7 U.S.C. 6(c), could further address

commenters' concerns in this regard.

---------------------------------------------------------------------------

B. ``Swap Dealer'' Exclusion for Swaps in Connection With Originating a

Loan

1. Proposed Approach

The statutory definition of the term ``swap dealer'' excludes an

insured depository institution (``IDI'') ``to the extent it offers to

enter into a swap with a customer in connection with originating a loan

with that customer.'' \296\ This exclusion does not appear in the

definition of the term ``security-based swap dealer.''

---------------------------------------------------------------------------

\296\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).

---------------------------------------------------------------------------

Proposed CFTC Regulation Sec. 1.3(ggg)(5) would implement this

statutory exclusion by providing that an IDI's swaps with a customer in

connection with originating a loan to that customer are disregarded in

determining if the IDI is a swap dealer. In order to prevent evasion,

the proposed rule further provided that the statutory exclusion does

not apply where the purpose of the swap is not linked to the financial

terms of the loan; the IDI enters into a ``sham'' loan; or the

purported ``loan'' is actually a synthetic loan such as a loan credit

default swap or loan total return swap.

1. Commenters' Views

Nearly all the commenters on this issue were IDIs seeking a broad

interpretation of the exclusion. The commenters addressed four primary

issues: (i) The type of swaps that should be covered by the exclusion;

(ii) the time period during which parties would be required to enter

into the swap in order for the swap to be considered to be ``in

connection with originating a loan;'' (iii) which transactions should

be deemed to be ``loans'' for purposes of the exclusion; and (iv) which

entities should be included within the definition of IDI.

First, regarding the type of swap that should be covered by the

exclusion, as proposed, Sec. 1.3(ggg)(5) would require that the rate,

asset, liability or other notional item underlying the swap be, or be

directly related to, a financial term of the loan (such as the loan's

principal amount, duration, rate of interest or currency). Some

commenters agreed with the principle of limiting the exclusion to swaps

that are connected to the financial terms of the loan, stating that the

exclusion should cover any swap between a borrower and the lending IDI,

so long as the swap's notional amount is no greater than the loan

amount, the swap's duration is no longer than the loan's duration, and

the swap's index and payment dates match the index and payment dates of

the loan.\297\ Another commenter, agreeing with the proposed approach,

said that there is no basis to extend the loan origination exclusion to

swaps related to the borrower's business risks, as opposed to the

financial terms of the loan.\298\

---------------------------------------------------------------------------

\297\ See letters from Branch Banking & Trust Company (``BB&T'')

dated February 3, 2011 (``BB&T I''), B&F Capital Markets, Inc.

(``B&F Capital'') dated February 18, 2011 (``B&F Capital I''),

Capital One Financial Corporation (``Capital One'') and Capstar Bank

(``Capstar''); see also joint letter from Atlantic Capital Bank,

Cobiz Bank, Cole Taylor Bank, Commerce Bank, N.A., East West Bank,

First Business Bank, First National Bank of Pennsylvania, Heartland

Financial USA, Inc., Old National Bancorp, Peoples Bancorp of North

Carolina, Inc., Susquehanna Bank, The PrivateBank and Trust Co, The

Savannah Bank, N.A., The Washington Trust Company, Trustmark

National Bank, UMB Financial Corporation, Valley National Bank,

Webster Bank NA, WesBanco Bank (``Regional Banks'') (general support

for limitation to swaps connected to financial terms of the loan).

\298\ See letter from Better Markets I.

---------------------------------------------------------------------------

Other commenters, though, said that this limitation to swaps

connected to the financial terms of the loan was inappropriate or

inconsistent with the Dodd-Frank Act, and that any swap required by the

loan agreement or required by the IDI as a matter of prudent lending

should be covered by the exclusion.\299\ Some of the commenters arguing

for the broader exclusion emphasized that the exclusion should be

available for any swap with the lending IDI which reduces the

borrower's risks, such as a commodity swap the borrower uses for

hedging, because reduction of commodity price risks faced by the

borrower also reduces the risk that the loan will not be repaid to the

IDI.\300\ Commenters said that if the exclusion does not apply to swaps

hedging the borrower's commodity price risks, then only IDIs that are

able to create a separately capitalized affiliate will be able to offer

commodity swaps (because section 716 of the Dodd-Frank Act limits the

ability of IDIs to offer commodity swaps), thereby reducing the

availability of commodity swaps to

[[Page 30621]]

borrowers that are smaller companies.\301\

---------------------------------------------------------------------------

\299\ See letters from BOK dated February 18, 2011 (``BOK II''),

FSR I, ISDA I, Midsize Banks, OCC Staff at 6 (noting that ``[l]oan

underwriting criteria for community and mid-size banks * * * may

require, as a condition of the loan, that the borrower be hedged

against the commodity price risks incidental to its business'') and

White & Case LLP (``White & Case'') and joint letter from Senator

Stabenow and Representative Lucas.

\300\ See letters from BOK II, FSR I, OCC Staff and White &

Case.

\301\ See letters from ABA I and BOK I. Other commenters

addressed the relationship between the swap dealer definition and

section 619 of the Dodd-Frank Act (the ``Volcker Rule''). See joint

letter from Capital One, Fifth Third Bancorp and Regions Financial

Corporation.

---------------------------------------------------------------------------

Second, regarding timing, the proposed rule requested comment on

whether this exclusion should apply only to swaps that are entered into

contemporaneously with the IDI's origination of the loan (and if so,

how ``contemporaneously'' should be defined for this purpose), or

whether this exclusion also should apply to swaps entered into during

part or all of the duration of the loan. In response, commenters said

that the exclusion should apply to swaps entered into in anticipation

of a loan or at any time during the loan term.\302\ Commenters said

that application of the exclusion throughout the duration of the loan

would give IDIs and borrowers flexibility as to when to fix interest

rates in fixed/floating swaps relating to loans and would allow

borrowers to make other hedging decisions over a longer time

period.\303\ Commenters also said that loans such as construction

loans, equipment loans and committed loan facilities may allow for

draws of loan principal over an extended period of time, and that swaps

entered into by the borrower and lending IDI through the course of such

a loan should be covered by the exclusion.\304\

---------------------------------------------------------------------------

\302\ See letters from BB&T I, B&F Capital I, BOK II, Capital

One, Capstar, FSR I, Midsize Banks, Manufacturers and Traders Trust

Company (``M&T'') dated June 3, 2011 (``M&T I'') and September 28,

2011 (``M&T II''), Peoples Bank Co. (``Peoples Bank''), Regional

Banks and White & Case.

\303\ See letters from B&F Capital I, BOK II, Capital One,

Capstar and M&T I and M&T II.

\304\ See letters from FSR dated October 17, 2011 (``FSR VI''),

M&T II and Wells Fargo Bank, N.A. (``Wells Fargo'') dated August 16,

2011 (``Wells Fargo II'').

---------------------------------------------------------------------------

Third, as to which transactions should be deemed ``loans'' for

purposes of the exclusion, the proposal said that the exclusion should

be available in connection with all transactions by which an IDI is a

source of funds to a borrower, including, for example, loan

syndications, participations and refinancings. Commenters agreed that

the exclusion should be available for IDIs that are in a loan

syndicate, purchasers of a loan, assignees of a loan or participants in

a loan.\305\ On loan syndications and participations in particular, one

commenter said that the exclusion should be available even if the

notional amount of the swap is more than the amount of the loan tranche

assigned to the IDI, so long as the swap notional amount is not more

than the entire amount of the loan.\306\ Another commenter said that

the exclusion should not be available if the IDI's participation in the

loan drops below a minimum level (such as 20 percent) because such use

of the exclusion by minimally-participating IDIs would invite

abuse.\307\

---------------------------------------------------------------------------

\305\ See letters from BB&T I, Midsize Banks, Regional Banks and

White & Case; see also letter from Loan Market Association

(providing background information on loan participations).

\306\ See letter from Regional Banks.

\307\ See letter from Better Markets I.

---------------------------------------------------------------------------

Some commenters said that other types of transactions also should

be treated as ``loans'' for purposes of the exclusion. The transactions

cited by commenters in this regard include leases, letters of credit,

financings documented as sales of financial assets, bank qualified tax

exempt loans and bonds that are credit enhanced by an IDI.\308\ Other

commenters said the exclusion should apply where entities related to an

IDI provide financing, such as loans or financial asset purchases by

bank-sponsored commercial paper conduits where the IDI provides

committed liquidity,\309\ and transactions where a special purpose

entity formed by an IDI is the source of financing and enters into the

swap.\310\ Some commenters said the exclusion should encompass all

transactions where an IDI facilitates a financing,\311\ or all

extensions of credit by an IDI,\312\ or all transactions where an IDI

provides risk mitigation to a borrower.\313\

---------------------------------------------------------------------------

\308\ See letters from BB&T I, Capital One, FSR I, M&T I,

Midsize Banks and Regional Banks.

\309\ See letter from FSR I.

\310\ See letter from Midsize Banks.

\311\ See letters from Pacific Coast Bankers' Bancshares

(``PCBB'') and Regional Banks.

\312\ See letters from FSR I and Midsize Banks.

\313\ See letter from PCBB.

---------------------------------------------------------------------------

Fourth, with respect to the types of financial institutions that

are eligible for the loan origination exclusion, three commenters said

that IDIs, for purposes of this exclusion, encompass more than banks or

savings associations with federally-insured deposits. The Farm Credit

Council said the exclusion should be extended to Farm Credit System

institutions because one of these institutions enters into interest

rate swaps with borrowing customers identical in function to those

offered by commercial banks and savings associations in connection with

loans, and the institutions are subject to similar regulatory

requirements and covered by a similar insurance regime.\314\ Another

commenter said that the exclusion should be extended to other regulated

financial institutions, such as insurers, so as not to create an

unlevel playing field.\315\ And the Federal Home Loan Banks said that

the exclusion should be available to them because they are subject to

similar regulatory oversight and capital standards and engage in a

similar function of extending credit as do commercial banks and savings

associations.\316\ In addition, some commenters said the exclusion

should be broadly construed as a general matter, to encourage

competition in the swap market between smaller and larger banks and to

increase borrowers' choice among potential swap providers.\317\

---------------------------------------------------------------------------

\314\ Consequently, the Farm Credit Council argued, disallowing

these institutions from using the exclusion would give commercial

banks and savings associations a competitive advantage in

agricultural lending. See letters from Farm Credit Council I and

dated February 17, 2012 (``Farm Credit Council II''). Another

commenter argued that, to the contrary, making Farm Credit System

institutions eligible for the exclusion would confer an

inappropriate competitive advantage on those institutions. See

letter from ABA dated February 14, 2012 (``ABA II''). This commenter

said that Farm Credit System institutions have certain advantages

over other IDIs, and the commenter asserted that Farm Credit System

institutions were left out of the statutory language of the

exclusion in order that they would not receive additional

competitive advantages. See id.

\315\ See letter from NAIC.

\316\ See letter from FHLB I. The Credit Union National

Association said that the Federal Home Loan Banks should not be

covered by the swap dealer definition because they do not enter into

swaps for their own account as part of a regular business. See

letter from CUNA.

\317\ See letters from BB&T I, B&F Capital dated June 1, 2011

(``B&F Capital II''), Capital One, Capstar, M&T I and Peoples Bank.

---------------------------------------------------------------------------

Two commenters asked for clarification of the following technical

points in the proposed rule: (i) Whether a swap would be covered by the

exclusion even if it does not hedge all the risks under the loan, (ii)

whether a swap that is within the exclusion could continue to be

treated as covered by the exclusion by an IDI if the IDI transfers the

loan, and (iii) whether an IDI should count swaps covered by the

exclusion in determining if its dealing activity is above the de

minimis thresholds.\318\ Another commenter asked whether an IDI with

swaps that are covered by the exclusion could be a swap dealer based on

other dealing activity.\319\ And others asked whether the exclusion

would cover swaps used by an IDI to hedge its risks arising from a loan

(i.e., a swap which the IDI enters into with a party other than the

loan borrower).\320\

---------------------------------------------------------------------------

\318\ See letters from FSR VI and Midsize Banks.

\319\ See letter from Better Markets I.

\320\ See letters from B&F Capital I, FSR I, ISDA I, M&T I and

Midsize Banks.

---------------------------------------------------------------------------

3. Final Rule

The CFTC believes that the extent of this exclusion should be

determined by

[[Page 30622]]

the language of the statutory definition, which relates to an IDI that

``offers to enter into a swap with a customer in connection with

originating a loan with that customer.'' The expansive interpretation

of the exclusion advanced by some commenters, however, would read the

statute to exclude almost any swap that an IDI enters into with a loan

customer. That is not the exclusion that was enacted. Instead, we

interpret the statutory phrase ``enter into a swap with a customer in

connection with originating a loan with that customer'' to mean that

the swap is directly connected to the IDI's process of originating the

loan to the customer.

Because of the statute's direct reference to ``originating'' the

loan, it would be inappropriate to construe the exclusion as applying

to all swaps entered into between an IDI and a borrower at any time

during the duration of the loan. If this were the intended scope of the

statutory exclusion, there would be no reason for the text to focus on

swaps in connection with ``originating'' a loan. The CFTC recognizes

the concern expressed by commenters that: (i) there be flexibility

regarding when the IDI and borrower enter into a swap relating to a

loan, and (ii) the expectation when an IDI originates a loan with a

customer is often that the customer will enter into a swap with the IDI

when there is a subsequent advance, or a draw, of principal on the

loan. We do not believe, however, that the statutory term

``origination'' can reasonably be stretched to cover the entire term of

every loan that an IDI makes to its customers. At some point, the

temporal distance renders the link to loan origination too attenuated,

and the risk of evasion too great, to support the exclusion. In order

to balance these competing and conflicting considerations, the final

rule applies the exclusion to any swap that otherwise meets the terms

of the exclusion and is entered into no more than 90 days before or 180

days after the date of 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 from the IDI (e.g., a draw of principal) pursuant to

the loan, so long as the aggregate notional amount of the swaps in

connection with the financial terms of the loan at any time is no more

than the aggregate amount of the borrowings under the loan at that

time.\321\

---------------------------------------------------------------------------

\321\ We note that because the exclusion is available within the

specified time period around the execution of the loan agreement and

any draw of principal under the loan, any amendment, restructuring,

extension or other modification of the loan will, in itself, neither

preclude application of the exclusion nor expand application of the

exclusion.

---------------------------------------------------------------------------

Since a loan involves the repayment of funds to the IDI on

particular terms, a swap that relates to those terms of repayment

should be covered by the exclusion. In addition, we recognize that, as

stated by commenters, requirements in an IDI's loan underwriting

criteria relating to the borrower's financial stability are an

important part of ensuring that loans are repaid.\322\ Therefore, the

final rule modifies the proposed rule to provide that the exclusion

applies to swaps between an IDI and a loan borrower that are connected

to the financial terms of the loan, such as, for example, the loan's

duration, interest rate, currency or principal amount, or that are

required under the IDI's loan underwriting criteria to be in place as a

condition of the loan in order to hedge commodity price risks

incidental to the borrower's business.\323\ The first category of swaps

generally serve to transform the financial terms of a loan for purposes

of adjusting the borrower's exposure to certain risks directly related

to the loan itself, such as risks arising from changes in interest

rates or currency exchange rates. The second category of swaps mitigate

risks faced by both the borrower and the lender, by reducing risks that

the loan will not be repaid. Thus, both types of swaps are directly

related to repayment of the loan. Although some commenters said that

this exclusion should also apply to other types of swaps, we believe it

would be inappropriate to construe this exclusion as encompassing all

swaps that are connected to a borrower's other business activities,

even if the loan agreement requires that the borrower enter into such

swaps or otherwise refers to them.\324\ In contrast to a swap that

transforms the financial terms of a loan or is required by the IDI's

loan underwriting criteria to reduce the borrower's commodity price

risks, other types of swaps serve a more general risk management

purposes by reducing other risks related to the borrower or the loan.

If the purpose of the exclusion were to cover the broad range of swaps

cited by some commenters (such as all swaps reducing a borrower's

business risks), then the terms of the statute limiting the exclusion

to swaps that are ``in connection with originating a loan with that

customer'' would be superfluous.\325\ To give effect to the statutory

text, the exclusion is limited to a swap that is connected to the

financial terms of the loan or is required by the IDI's loan

underwriting criteria to to be in place as a condition of the loan in

order to hedge commodity price risks incidental to the borrower's

business.

---------------------------------------------------------------------------

\322\ See letter from OCC Staff.

\323\ The final rule provides that the second category of swaps

must hedge a price risk related to a commodity other than an

excluded commodity because if the price risk relates to an excluded

commodity (such as an interest rate) the swap must be connected to

the financial terms of the loan in order to be covered by the

exclusion.

\324\ On the other hand, there is no requirement that the loan

agreement reference a swap in order for the swap to be excluded, if

the swap otherwise qualifies for the exclusion.

\325\ Also, we believe that the broader range of swaps serving

general risk management purposes are more likely to involve concerns

regarding market transparency and appropriate business conduct

practices addressed by swap dealer regulation than are the narrower

range of swaps that are encompassed by the exclusion.

---------------------------------------------------------------------------

Regarding the types of transactions that will be treated as a

``loan'' for purposes of the exclusion, courts have defined the term

``loan'' in other statutory contexts based on the settled meaning of

the term under common law. This definition encompasses any contract by

which one party transfers a defined quantity of money and the other

party agrees to repay the sum transferred at a later date.\326\ Rather

than examine at this time the many particularized examples of financing

transactions cited by some commenters, the term ``loan'' for purposes

of this exclusion should be interpreted in accordance with this settled

legal meaning.\327\

---------------------------------------------------------------------------

\326\ See, e.g., In Re Renshaw, 222 F.3d 82, 88 (2d Cir. 2000)

(``Because Congress did not define the term ``loan'' for [11 U.S.C.]

Sec. 523(a)(8), we must interpret it according to its settled

meaning under common law. The classic definition of a loan [is] * *

* as follows: To constitute a loan there must be (i) a contract,

whereby (ii) one party transfers a defined quantity of money, goods,

or services, to another, and (iii) the other party agrees to pay for

the sum or items transferred at a later date.'') (citing In re Grand

Union Co., 219 F. 353, 356 (2d Cir. 1914)).

\327\ The final rule adopts provisions from the proposed rule

that, in order to prevent evasion, the statutory exclusion does not

apply where the IDI originates a ``sham'' loan; or the purported

``loan'' is actually a synthetic loan such as a loan credit default

swap or loan total return swap. See CFTC Regulation Sec.

1.3(ggg)(5)(iii).

---------------------------------------------------------------------------

As stated in the proposed rule, this exclusion is available to all

IDIs that are a source of a transfer of money to a borrower pursuant to

a loan. The final rule adopts provisions from the proposed rule that

the exclusion is available to an IDI that is a source of money by being

part of a loan syndicate, being an assignee of a loan, obtaining a

participation in a loan, or purchasing a loan.\328\ However, the

proposed rule did

[[Page 30623]]

not state explicitly how the notional amount of a swap subject to the

exclusion must relate to the amount of money provided by an IDI that is

in a loan syndicate or is an assignee of, participant in or purchaser

of a loan. In this regard, some commenters said that a borrower and the

IDIs in a lending syndicate need flexibility to allocate responsibility

for the swap(s) related to the loan as they may agree.\329\ We believe

that, to allow for this flexibility, the exclusion may apply to a swap

(which is otherwise covered by the exclusion) even if the notional

amount of the swap is different from the amount of the loan tranche

assigned to the IDI. However, we also agree with a commenter that the

IDI should have a substantial participation in the loan.\330\ The

requirement of substantial participation would prevent an IDI from

applying the exclusion where the IDI makes minimal lending commitments

in multiple loan syndicates where it offers swaps, causing its swap

activity to be far out of proportion to its loan activity.\331\

---------------------------------------------------------------------------

\328\ See CFTC Regulation Sec. 1.3(ggg)(5)(ii). As is also

stated in the Proposing Release, if an IDI were to transfer its

participation in a loan to a non-IDI, then the non-IDI would not be

able to claim this exclusion, regardless of the terms of the loan or

the manner of the transfer. Similarly, a non-IDI that is part of a

loan syndicate with IDIs would not be able to claim the exclusion.

\329\ See, e.g., letter from Regional Banks.

\330\ See letter from Better Markets I. This commenter suggested

a minimal threshold of at least 20 percent of the loan. However, we

believe that a 10 percent commitment constitutes a substantial

participation in the loan which supports offering of a swap up to

the loan's full amount.

\331\ For example, an IDI could act as a 0.1 percent participant

in one hundred different loans in order to serve as the sole swap

counterparty to the borrowers for hedging the borrowers' interest

rate risk on the loans. Thus, by lending or committing to lend $100

million, the IDI could apply the exclusion to swaps with an

aggregate notional amount of $100 billion.

---------------------------------------------------------------------------

Therefore, the final rule includes a provision that the exclusion

may apply regardless of whether the notional amount of the swap is the

same as the amount of the loan, but only if the IDI is the sole source

of funds under the loan or is committed to be, under the applicable

loan agreements, the source of at least 10 percent of the maximum

principal amount under the loan.\332\ If the IDI does not meet this 10

percent threshold, the final rule provides that the exclusion may apply

only if the aggregate notional amount of all the IDI's swaps with the

customer related to the financial terms of the loan is no more than the

amount lent by the IDI to the customer.\333\ We also note that, in all

cases, application of the exclusion requires that the aggregate

notional amount of all swaps entered into by the borrower with any

person in connection with the financial terms of the loan at any time

is not more than the aggregate principal amount outstanding under the

loan at that time.\334\

---------------------------------------------------------------------------

\332\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(D)(1) and (2).

\333\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(D)(3).

\334\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(E). Paragraphs

(D)(3) and (E) of this regulation refer to all swaps ``in connection

with the financial terms of the loan'' in order to clarify that only

such swaps are relevant in this regard. For example, if the IDI were

to enter into a swap with the customer that is not in connection

with the loan's financial terms, the swap would not be relevant

because the exclusion would not apply to the swap.

---------------------------------------------------------------------------

We also reiterate the interpretation in the Proposing Release that

the word ``offer'' in this exclusion includes scenarios where the IDI

requires the customer to enter into a swap, or where the customer asks

the IDI to enter into a swap, specifically in connection with a loan

made by that IDI.

We also continue to emphasize, as stated in the Proposing Release,

that the statutory language of the exclusion limits its availability to

only IDIs as defined in the statute. Regarding some commenters'

statements about the competitive effect of this interpretation of the

term ``insured depository institution,'' we believe that the scope of

application of the swap dealer definition to various entities should be

treated in the de minimis exception, which is available to all persons.

In order to provide clarification in response to certain technical

questions raised by commenters, we note that whether a swap hedges all

of the risk, or only some of the risk, of a loan is not relevant to

application of the exclusion. Nor is it relevant to the exclusion if

the IDI later transfers or terminates the loan in connection with which

the swap was entered into, so long as the swap otherwise qualifies for

the exclusion and the loan was originated in good faith and was not a

sham.\335\ Further, swaps that are covered by the exclusion should not

be considered in determining if an IDI exceeds the de minimis level of

swap dealing activity, because the statute provides that swaps covered

by the exclusion should not be considered in determining if an IDI is a

swap dealer, and the de minimis exception provides that it considers

the ``quantity of [a person's] swap dealing.'' \336\ The application of

the exclusion to swaps entered into by an IDI in connection with the

origination of loans, however, does not mean that the IDI could not be

a swap dealer because of other of the IDI's activities that constitute

swap dealing. Regarding swaps used by an IDI to hedge or lay off its

risks arising from a loan, we do not believe it is appropriate to treat

such swaps as covered by the exclusion, because the statute explicitly

limits the exclusion to swaps ``with a customer,'' which such hedging

swaps are not. However, a swap that an IDI enters into for the purpose

of hedging or laying off the risk of a swap that is covered by the IDI

exclusion will not be considered in the de minimis determination, or

otherwise in evaluating whether the IDI is covered by the swap dealer

definition.\337\

---------------------------------------------------------------------------

\335\ On the other hand, if the IDI were to transfer the swap

(but not the loan) to another IDI, and the IDI that is the

transferee of the swap is not a source of money to the borrower

under the loan, then the transferee IDI would not be able to apply

the exclusion to the swap.

\336\ See CEA sections 1a(49)(A) and 1a(49)(D), 7 U.S.C.

1a(49)(A) and 1a(49)(D).

\337\ An IDI that is seeking out swap counterparties to enter

into swaps in order to hedge or lay off the risk of a swap that is

subject to the IDI exclusion would generally not be accommodating

demand for swaps or facilitating interest in swaps.

---------------------------------------------------------------------------

Last, we believe it is appropriate to require that an IDI claiming

the exclusion report its swaps that are covered by the exclusion to a

swap data repository (``SDR''). This requirement is consistent with the

prevailing practice that IDIs handle the documentation of loans made to

borrowers, and will provide for consistent reporting of swaps that are

covered by the exclusion, thereby allowing the CFTC and other

regulators to monitor the use of the exclusion.

In sum, the final rule balances the need for flexibility in

response to existing lending practices, consistent with the constraints

imposed by the statutory text as enacted, against the risk of

establishing a gap in the regulatory framework enacted in Title

VII.\338\ It provides that the exclusion may be claimed by a person

that meets the following conditions: (i) The person is an IDI; (ii) the

IDI enters into a swap with the borrower that does not extend beyond

the termination of the loan; (iii) the swap is connected to the

financial terms of the loan or is required by the IDI's loan

underwriting criteria to to be in place as a condition of the loan in

order to hedge commodity price risks incidental to the borrower's

business; (iv) the loan is within the common law meaning of ``loan''

and it is not a sham or a synthetic loan; (v) the IDI is the source of

money to the borrower in connection with the loan either directly, or

(so long as the IDI is the source of at least 10 percent of the entire

amount of the loan) through syndication, participation, assignment,

purchase, refinancing or otherwise; (vi) the IDI

[[Page 30624]]

enters into the swap with the borrower within 90 days before or 180

days after the date the execution of the loan agreement, or within 90

days before or 180 days after any transfer of principal to the borrower

from the IDI pursuant to the loan; (vii) 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 the borrowings under the loan at that

time; and (viii) the IDI agrees to report the swap to an SDR.

---------------------------------------------------------------------------

\338\ The final rule text in CFTC Regulation Sec.

1.3(ggg)(5)(i) has been revised to conform the text of the rule to

the statutory provision which refers to ``an insured depository

institution [that] * * * enter[s] into a swap with a customer in

connection with originating a loan with that customer.'' See CEA

Sec. 1a(49)(A), 7 U.S.C. 1a(49)(A)

---------------------------------------------------------------------------

An IDI that enters into swaps that do not meet these conditions,

and thus do not qualify for the statutory exclusion, is not necessarily

required to register as a swap dealer. Rather, the IDI would apply the

statutory definition and the provisions of the rule (taking into

account the applicable interpretive guidance set forth in this Adopting

Release), solely with respect to its swaps that are not subject to the

IDI exclusion, in order to determine whether it is engaged in swap

dealing activity that exceeds the de minimis threshold.

C. Application of Dealer Definitions to Legal Persons and to Inter-

Affiliate Swaps and Security-Based Swaps

1. Proposed Approach and Commenters' Views

In the Proposing Release, the Commissions preliminarily concluded

that designation as a dealer would apply on an entity-level basis

(rather than to a trading desk or other business unit that is not

organized as a separate legal person), and that an affiliated group of

legal persons could include more than one dealer.\339\ The Proposing

Release also stated that the dealer analysis should consider the

economic reality of swaps and security-based swaps between affiliates,

and preliminarily noted that swaps or security-based swaps ``between

persons under common control may not involve the interaction with

unaffiliated persons that we believe is a hallmark of the elements of

the definitions that refer to holding oneself out as a dealer or being

commonly known as a dealer.'' \340\

---------------------------------------------------------------------------

\339\ See Proposing Release, 75 FR at 80183.

\340\ Id. The Proposing Release further noted that sections

721(c) and 761(b)(3) give the Commissions anti-evasion authority, to

the extent that an entity were to seek to use transactions between

persons under common control to avoid one of the dealer definitions.

See id. (erroneously referring to section 721(c) as section

721(b)(3).

---------------------------------------------------------------------------

Commenters supported the view that swaps and security-based swaps

among affiliates should be excluded from the dealer analysis.\341\ A

number of commenters took the view that the dealer definitions should

not apply when there is common control between counterparties, or when

common control is combined with the consolidation of financial

statements.\342\ Some commenters suggested that this interpretation

regarding the scope of the dealer definitions should incorporate

concepts of affiliation that are found in other statutory and

regulatory provisions.\343\ Several commenters also opposed the

suggestion (raised as part of the Proposing Release's request for

comments) that this interpretation be limited to transactions among

wholly owned subsidiaries.\344\

---------------------------------------------------------------------------

\341\ See, e.g., letters from API I, COPE I, ISDA I, Midsize

Banks, ONEOK, Inc. (``ONEOK'') and Peabody.

Several commenters explained the widespread use of central

hedging desks to allocate risk within affiliate groups or to gather

risk from within a group and lay that risk off on the market. See,

e.g., letters from EEI/EPSA, Kraft Foods Inc. (``Kraft''), MetLife

and Prudential Financial, Inc. (``Prudential'') dated February 17,

2011 (``Prudential I'').

Some commenters particularly stated that the use of a single

entity to face the market on behalf of an affiliate group had

several risk-reducing and efficiency-enhancing benefits, and that

those benefits would be lost if the dealer definitions were to lead

corporate groups to avoid using central trading desks and instead

require each affiliate to face the market as an independent end-

user. See letters from FSR I, Philip Morris International Inc.

(``Philip Morris''), Shell Trading dated June 3, 2011 (``Shell

Trading II'') and Utility Group, and joint letter from ABA

Securities Association, American Council of Life Insurers

(``ACLI''), FSR, Futures Industry Association (``FIA''), Institute

of International Bankers, ISDA and SIFMA (``Financial

Associations'').

Some commenters also stated that legislative history suggested

that Congress did not intend that the dealer definition capture

transactions involving the use of an affiliate to hedge commercial

risk. See letters from CDEU and Prudential I.

\342\ See letters from CDEU (common control), Financial

Associations (common control and consolidation), MetLife

(consolidation), ONEOK (common control, evaluated based on whether

the trading interests of the entities are aligned) and Prudential I

(citing CFTC letter interpretation regarding common control).

\343\ See, e.g., letters from EDF Trading (proposing definition

from regulations promulgated by the Federal Energy Regulatory

Commission) and Peabody (proposing definition of ``affiliate'' used

in federal securities laws) and joint letter from the Bank of Tokyo-

Mitsubishi UFJ, Ltd., Mizuho Corporate Bank, Ltd. and Sumitomo

Mitsui Banking Corp. (suggesting use of control definition in Bank

Holding Company Act).

\344\ See, e.g., letters from Kraft and ONEOK.

---------------------------------------------------------------------------

2. Final Interpretation and Rule

a. Application to Legal Persons

Consistent with the Proposing Release, the Commissions interpret

``person'' as used in the swap dealer and security-based swap dealer

definitions to refer to a particular legal person. Accordingly, the

dealer definitions will apply to the particular legal person performing

the dealing activity, even if that person's dealing activity is limited

to a trading desk or discrete business unit,\345\ unless the person is

able to take advantage of a limited designation as a dealer.\346\

---------------------------------------------------------------------------

\345\ Within an affiliated group of companies, however, only

those legal persons that engage in dealing activities will be

designated as dealers; that designation will not be imputed to other

non-dealer affiliates or to the group as a whole. A single affiliate

group may, however, have multiple swap or security-based swap

dealers.

\346\ Limited designation as a dealer is addressed in more

detail below in part II.E.

---------------------------------------------------------------------------

b. Application to Inter-Affiliate Swaps and Security-Based Swaps

The final rules codify exclusions from the dealer definitions for a

person's swap or security-based swap activities with certain

affiliates.\347\ These rules are consistent with the Proposing

Release's recognition of the need to consider the economic reality of

any swaps or security-based swaps that a person enters into with

affiliates. Market participants may enter into such inter-affiliate

swaps or security-based swaps for a variety of purposes, such as to

allocate risk within a corporate group or to transfer risks within a

corporate group to a central hedging or treasury entity.

---------------------------------------------------------------------------

\347\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); Exchange Act

rule 3a71-1(d). A person's market-facing swap or security-based swap

activity may still cause that person to be a dealer, even if that

market-facing activity is linked to the inter-affiliate activity, to

the extent that the market-facing activity satisfies the dealer

definition. However, a person's market-facing swap activity for

hedging purposes as defined in CFTC Regulation Sec.

1.3(ggg)(6)(iii) would not cause that person to be a dealer.

---------------------------------------------------------------------------

Under the final rules, the dealer analysis will not apply to swaps

and security-based swaps between majority-owned affiliates.\348\ When

the economic interests of those affiliates are aligned adequately--as

would be found in the case of majority-ownership--such swaps and

security-based swaps serve to allocate or transfer risks within an

affiliated group, rather than to move those risks out of the group to

an unaffiliated third party. For this reason, and as contemplated by

the Proposing Release,\349\ we do not believe that such

[[Page 30625]]

swaps and security-based swaps involve the interaction with

unaffiliated persons to which dealer regulation is intended to apply.

---------------------------------------------------------------------------

\348\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); Exchange Act

rule 3a71-1(d)(1). For the purposes of these rules, the

counterparties are majority-owned affiliates if one party directly

or indirectly holds a majority ownership interest in the other, or

if a third party directly or indirectly holds a majority interest in

both, based on holding a majority of the equity securities of an

entity, or the right to receive upon dissolution or the contribution

of a majority of the capital of a partnership. See CFTC Regulation

Sec. 1.3(ggg)(6)(i); Exchange Act rule 3a71-1(d)(2).

\349\ See Proposing Release, 75 FR at 80183 (noting that swaps

or security-based swaps between affiliates ``may not involve the

interaction with unaffiliated persons that we believe is a hallmark

of the elements of the definitions that refer to holding oneself out

as a dealer or being commonly known as a dealer'').

---------------------------------------------------------------------------

The standard in the final rules differs from the standard suggested

by the Proposing Release, which alluded to affiliates as legal persons

under ``common control.'' This change is based on our further

consideration of the issue, including consideration of comments that an

inter-affiliate exclusion should be available when common control is

combined with the consolidation of financial statements. Although we

are not including a requirement that financial statements be

consolidated--as we do not believe that the scope of this exclusion

should be exposed to the risk of future changes in accounting

standards--in our view a majority ownership standard is generally

consistent with consolidation under GAAP.\350\ Absent majority

ownership, we cannot be confident that there would be an alignment of

economic interests that is sufficient to eliminate the concerns that

underpin dealer regulation.

---------------------------------------------------------------------------

\350\ See FASB ASC Section 810-10-25, Consolidation--Overall--

Recognition (stating that consolidation is appropriate if a

reporting entity has a controlling financial interest in another

entity and a specific scope exception does not apply).

---------------------------------------------------------------------------

In taking this approach, we have also considered alternatives

suggested by commenters. For example, while one commenter suggested

that we adopt a definition of ``affiliate'' as used in the securities

laws,\351\ we believe that such an approach would be too broad for the

purpose of this exclusion from dealing activity, given that common

control by itself does not ensure that two entities' economic interests

are sufficiently aligned.\352\

---------------------------------------------------------------------------

\351\ See letter from Peabody. The commenter did not specify

which definition of ``affiliate'' in the securities laws it was

proposing. For example, Rule 405 of the Securities Act of 1933

defines affiliate in terms of common control, see 17 CFR 230.405,

and Section 20(a) of the Exchange Act takes a similar approach. The

Investment Company Act of 1940 (``ICA'') defines affiliate to

include entities with a common ownership interest as low as 5

percent, ICA section 2(a)(3). Two other commenters proposed using a

common control standard, perhaps also in reference to the Rule 405

definition of ``affiliate.''

\352\ The definitions of ``affiliate'' and ``control'' found in

Rule 405 and other securities law provisions are appropriate in the

context of the prophylactic and remedial provisions in which they

are found. Rule 405, for example, uses the terms ``affiliate'' and

``control'' to identify those persons that have the power to effect

registration of an issuer's securities, and the broad definitions

ensure that the persons with that power actually fulfill their

obligation to do so. By comparison, the exclusion of inter-affiliate

swaps and security-based swaps from the dealer analysis should be

more tightly focused to address situations in which counterparties

have similar economic interests.

Another commenter noted the definition of ``affiliate'' found

in certain Federal Energy Regulation Commission regulations--which

define ``affiliate'' in terms of a ten percent or five percent

common ownership interest. See letter from EDF Trading. Those

relatively low ownership thresholds, however, are intended to

address different concerns regarding collusion and cross-

subsidization, and do not appear appropriate for an interpretation

that has the potential to reduce the counterparty and market

protections provided by Title VII. See 18 CFR sections 35.36(a)(9),

35.39, 366.2(b), 366.3.

---------------------------------------------------------------------------

c. Application to Cooperatives

Similar considerations apply, in certain situations, to cooperative

entities that enter into swaps with their members in order to allocate

risk between the members and the cooperative. Commenters identified two

general types of such cooperatives--``cooperative associations of

producers'' as defined in section 1a(14) of the CEA \353\ and

cooperative financial entities such as Farm Credit System institutions

and Federal Home Loan Banks.\354\ As is the case for affiliated groups

of corporate entities, we believe that when one of these cooperatives

enters into a swap with one of its members,\355\ the swap serves to

allocate or transfer risks within an affiliated group, rather than to

move those risks from the group to an unaffiliated third party, so long

as the cooperative adheres to certain risk management practices.

---------------------------------------------------------------------------

\353\ 7 U.S.C. 1a(14). A cooperative association of producers is

at least 75 percent owned or controlled, directly or indirectly, by

producers of agricultural products and must comply with the Capper-

Volstead Act (referred to in the CEA as the Act of February 18,

1922, 7 U.S.C. 291 and 292). See letters from Land O'Lakes II, NCFC

I and NMPF.

\354\ See letters from Farm Credit Council I and FHLB I. The NRU

CFC qualifies as a cooperative financial entity, but we understand

that it does not enter into a significant amount of swaps with its

members; rather, it enters into swaps with unaffiliated third

parties. See letter from NRU CFC I and meeting with NRU CFC on

January 13, 2011.

\355\ The term ``cooperative association of producers'' also

includes any organization acting for a group of such associations

and owned or controlled by such associations. See CEA section

1a(14), 7 U.S.C. 1a(14). For a cooperative association of producers

that is acting for and owned or controlled by such associations, we

believe that this conclusion applies to any swap between such

cooperative association of producers and any cooperative association

of producers that is a member of it, and any producer that is a

member of any such cooperative association of producers that is

itself a member of the first cooperative association of producers.

See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(C).

However, we do not believe that this conclusion applies to any

security-based swap that a cooperative association of producers may

enter into, nor does it apply to any swap related to a non-physical

commodity (such as a rate swap). For this reason, the exclusion for

cooperative associations of producers is limited to swaps that are

primarily based on a commodity that is not an excluded commodity.

See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(A)(3). The term ``excluded

commodity'' is defined in CEA section 1a(19), 7 U.S.C. 1a(19).

---------------------------------------------------------------------------

Accordingly, the final rules specifically provide that the dealer

analysis excludes swaps between a cooperative and its members, so long

as the swaps in question are reported to the relevant SDR by the

cooperative and are subject to policies and procedures of the

cooperative which ensure that it monitors and manages the risk of such

swaps.\356\ The final rules define the term ``cooperative'' to include

cooperative associations of producers and any entity chartered under

Federal law as a cooperative and predominantly engaged in activities

that are financial in nature.\357\ The cooperatives covered by this

relief are subject to provisions of Federal law providing for their

cooperative purpose. Cooperative associations of producers have been

recognized since the passage of the Capper-Volstead Act as being

permitted to engage in certain cooperative activities without violating

antitrust laws.\358\ Cooperative financial institutions such as the

Farm Credit System institutions and Federal Home Loan Banks are

chartered under Federal laws that limit their membership and require

that they serve certain public purposes.\359\

---------------------------------------------------------------------------

\356\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii). To be clear,

these cooperatives are not excluded from the dealer definitions. See

part II.A.6, supra. Rather, swaps between a cooperative and its

members (and swaps that a cooperative enters into to hedge or lay

off the risk of such swaps) are excluded from the dealer analysis.

If a cooperative were to engage in other swap activities that are

covered by, and not otherwise excluded from, the statutory

definition of the term ``swap dealer,'' then it would be required to

register as a swap dealer.

\357\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(B).

\358\ See Capper-Volstead Act section 1, 7 U.S.C. 291.

\359\ See Farm Credit Act of 1971, 12 U.S.C. 2001 et seq. and

Federal Home Loan Bank Act, 12 U.S.C. 1421 et seq.

---------------------------------------------------------------------------

We are aware that other persons commented that their swap

activities should be excluded from the dealer analysis because they use

swaps in connection with a cooperative or non-profit purpose, or

because they aggregate demand for swaps arising from numerous small

entities.\360\ However, the key distinction drawn in granting this

relief is that cooperatives covered by the exclusion enter into swaps

with their members in order to allocate risk between the members and

[[Page 30626]]

the cooperative. By contrast, the other entities noted above enter into

swaps with unaffiliated parties in order to transfer risks between

unaffiliated parties.\361\ As noted above, the Commissions believe that

the contemplated scope of the statutory definitions does not include

instances where a person's swap activities transfer risk within an

affiliated group, but does extend to activities that create legal

relationships that transfer risk between unaffiliated parties. Thus, it

is appropriate that the dealer analysis exclude swaps between a

cooperative and its members, but such analysis should include swaps

between a cooperative or other aggregator and unaffiliated persons.

---------------------------------------------------------------------------

\360\ See letter from NFPEEU (not-for-profit power utilities,

electric cooperatives and related persons); letters from Farmers'

Associations, NGFA I and NMPF (referring to private companies that

serve as aggregators for swaps in agricultural commodities or

otherwise offer swaps for agricultural risk management); and letter

from Northland Energy (small energy firm that aggregates demand for

swaps from small energy retailers and consumers).

\361\ See, e.g., letter from NFPEEU (not-for-profit power

utilities and electric cooperatives generally enter into swaps

between themselves, with large industrial consumers, and a wide

range of other counterparties). Indeed, the Dodd-Frank Act permits

the CFTC to exempt agreements, contracts or transactions between

entities described in section 201(f) of the Federal Power Act, such

as certain not-for-profit power utilities and electric cooperatives.

See section 722(f) of the Dodd-Frank Act. As noted above, a

coalition of not-for-profit power utilities and electric

cooperatives has advised that it plans to submit a request for the

exemption contemplated by section 722(f) of the Dodd-Frank Act. See

note 295 supra.

---------------------------------------------------------------------------

D. De Minimis Exception

1. Proposed Approach

The Dodd-Frank Act's definitions of ``swap dealer'' and ``security-

based swap dealer'' require that the Commissions exempt from dealer

designation any entity ``that engages in a de minimis quantity'' of

dealing ``in connection with transactions with or on behalf of

customers.'' The statutory definitions further require the Commissions

to ``promulgate regulations to establish factors with respect to the

making of any determination to exempt.'' \362\

---------------------------------------------------------------------------

\362\ CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange Act

section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).

---------------------------------------------------------------------------

In the Proposing Release, we preliminarily concluded that the de

minimis exception ``should be interpreted to address amounts of dealing

activity that are sufficiently small that they do not warrant

registration to address concerns implicated by the regulations

governing swap dealers and security-based swap dealers. In other words,

the exception should apply only when an entity's dealing activity is so

minimal that applying dealer regulations to the entity would not be

warranted.'' \363\ In taking this view, we rejected the suggestion that

the de minimis exception should compare a person's swap or security-

based swap dealing activities to the person's non-dealing

activities.\364\

---------------------------------------------------------------------------

\363\ Proposing Release, 75 FR at 80179 (footnote omitted).

\364\ See id. at 80179-80.

---------------------------------------------------------------------------

At the same time, we recognized that this proposed approach did not

appear to ``readily translate into objective criteria.'' We further

recognized that a range of alternative approaches may be reasonable,

and we solicited comment as to what factors should be used to implement

the exception.\365\

---------------------------------------------------------------------------

\365\ See id. at 80180.

---------------------------------------------------------------------------

The proposed de minimis exception was comprised of three factors,

all of which a person would have had to satisfy to avail itself of the

exception.\366\ The first proposed factor would have limited the

aggregate effective amount, measured on a gross basis, of the swaps or

security-based swaps that a person entered into over the prior 12

months in connection with its dealing activities to $100 million \367\

(or $25 million with regard to counterparties that are ``special

entities'').\368\

---------------------------------------------------------------------------

\366\ Under the proposal, the factors would consider a person's

swap or security-based swap dealing activity as a whole, rather than

separately considering different types of swaps or security-based

swaps. See Proposing Release, 75 FR at 80181.

\367\ See proposed Exchange Act rule 3a71-2(a). The proposed

standard reflected our understanding that in general the notional

size of a small swap or security-based swap is $5 million or less,

and that the proposed threshold would reflect 20 instruments of that

size. The standard also sought to reflect the customer protection

issues implicated by swaps and security-based swaps. See Proposing

Release, 75 FR at 80180.

The proposed notional threshold would not consider the market

risk offsets associated with combining long and short positions. In

addition, the proposed notional threshold would not account for the

amount of collateral held or posted by the entity, or other risk

mitigating factors. See id.

\368\ See proposed Exchange Act rule 3a71-2(a). As set forth by

the statutory business conduct rules applicable to security-based

swap dealers (as set forth in Exchange Act section 15F(h)(2)(C)),

``special entity'' refers to: Federal agencies; States, State

agencies and political subdivisions (including cities, counties and

municipalities); ``employee benefit plans'' as defined under the

Employee Retirement Income Security Act of 1974 (``ERISA'');

``governmental plans'' as defined under ERISA; and endowments. Title

VII imposes additional business conduct requirements on security-

based swap dealers in connection with special entities. See CEA

sections 4s(h)(2), 4s(h)(4), 4s(h)(5); Exchange Act section

15F(h)(2), (4), (5).

---------------------------------------------------------------------------

The second proposed factor would have limited a person's swap or

security-based swap dealing activity to no more than 15 counterparties

over the prior 12 months (while counting counterparties that are

members of an affiliated group as one counterparty for these purposes).

The final proposed factor would have limited a person's dealing

activity to no more than 20 swaps or security-based swaps over the

prior 12 months (without counting certain amendments as new swaps or

security-based swaps).

2. Commenters' Views

a. Basis for the Exception

Some commenters sought to link the de minimis exception to systemic

risk criteria by taking the position that a person should have to

register as a dealer only if its dealing activities pose systemic

significance.\369\ One commenter specifically objected to the position

in the Proposing Release that the de minimis exception should take into

account customer protection principles.\370\ On the other hand, one

commenter supported the rejection of a risk-based de minimis test.\371\

---------------------------------------------------------------------------

\369\ See, e.g., letters from CDEU, MFX II, NCGA/NGSA II and

SIFMA--Regional Dealers Derivatives Committee (``SIFMA--Regional

Dealers'').

\370\ See letter from WGCEF I (arguing that basing the exception

on customer protection principles would be contrary to the statutory

framework, given that only ECPs are eligible to participate in off-

exchange swap transactions).

\371\ See letter from Better Markets I.

---------------------------------------------------------------------------

Some commenters argued that the de minimis test should account for

proportionality criteria that would excuse entities whose dealing

activity is relatively minor compared to their other activities.\372\

---------------------------------------------------------------------------

\372\ See, e.g., letters from FHLB I, IECA-Credit I, NCGA/NGSA

I, NRG Energy, Peabody and WGCEF I. One commenter said the

proportionality criteria should also consider an entity's activities

with respect to the physical commodity underlying its swaps. See

letter from NCGA/NGSA I. But see letter from Better Markets I

(supporting rejection of a proportionality test). Some commenters

suggested more than one alternative approach.

---------------------------------------------------------------------------

b. Significance of ``Customer'' Language

One commenter took the position that the language within the de

minimis exception that specifically referred to ``transactions with or

on behalf of customers'' meant that the exception should be available

only for persons who limit their swaps or security-based swaps to those

that are entered into with or on behalf of customers.\373\ Other

commenters posited the opposite view that the ``customer'' language

should be read to mean that a person's dealing activities with

counterparties other than customers may be disregarded for purposes of

the exception (i.e., non-customer transactions would not count against

the de minimis thresholds).\374\ Some commenters argued that

[[Page 30627]]

transactions entered into in a fiduciary capacity should be disregarded

for purposes of the exception.\375\ One commenter questioned the

proposal's use of the term ``counterparty'' in lieu of the statutory

term ``customer.'' \376\

---------------------------------------------------------------------------

\373\ See letter from Better Markets I. Another commenter said

that the ``customer'' language serves to emphasize that the de

minimis exception is available to entities that provide swaps to

customers. See letter from NGFA I.

\374\ See letters from ISDA I, Vitol and WGCEF I. Another

commenter said that the use of the term ``customer'' indicates that

all transactions with physical commodity customers should be

disregarded in determining if a person is a dealer. See letter from

EDF Trading.

\375\ See, e.g., letter from FSR I.

\376\ See letter from Vitol (suggesting that the proposed

language meant that dealing activity involved ``customers'' but not

``counterparties'').

---------------------------------------------------------------------------

c. Proposed Tests and Thresholds

Commenters criticized the proposed de minimis thresholds in a

variety of ways. These included arguments that the proposed thresholds

were inappropriately low,\377\ would harm end-users by reducing the

number of entities willing to enter into low-value swaps and security-

based swaps,\378\ would be unjustified on a cost-benefit basis,\379\

and were disproportionately low compared to the activities of

recognized dealers.\380\ Other commenters said the de minimis

thresholds should be set at a level to allow entities to engage in a

meaningful amount of customer-facing swaps or security-based swaps

without being required to register as dealers.\381\

---------------------------------------------------------------------------

\377\ See, e.g., letters from API I, CDEU, DFA, EDF Trading,

Farm Credit Council I, Growmark, Land O'Lakes dated January 13, 2011

(``Land O'Lakes I''), Midsize Banks, NCFC I, NCGA/NGSA II, New York

City Bar Association--Committee on Futures and Derivatives

Regulation (``NYCBA Committee''), Northland Energy, NRG Energy,

Regional Banks and SIFMA--Regional Dealers. Some commenters also

said that the thresholds, particularly those for swaps, should vary

according to the riskiness of the swap or type of commodity

underlying the swap. See letters from BG LNG I, Farm Credit Council

I, Gavilon II, ISDA I, NFPEEU, Vitol and WGCEF I.

\378\ See, e.g., letters from API I, BG LNG IFarm Credit Council

I, Midsize Banks, NCFC I, NGFA I, Regional Banks and SIFMA--Regional

Dealers and meetings with Electric Companies on April 13, 2011, the

Asset Management Group of SIFMA (``SIFMA--AMG'') on February 4, 2011

and WGCEF on April 28, 2011.

\379\ See, e.g., letters from CDEU and Vitol. Another commenter

noted that application of a cost-benefit analysis of the de minimis

threshold could be challenging. See Roundtable Transcript at 193-94

(remarks of Camille Rudge, The PrivateBank and Trust Company).

\380\ See letter from CDEU (citing statistics indicating that

the average respondent to an ISDA survey had an annual ``event

volume'' of over 297,000 OTC derivatives trade processing actions);

see also letter from Regional Banks.

\381\ See meetings with Electric Companies on April 13, 2011,

Gavilon on May 11, 2011 and WGCEF on April 28, 2011.

---------------------------------------------------------------------------

A number of commenters particularly criticized the proposed

notional threshold, with some commenters suggesting that the threshold

should be based on a percentage of the total swap market \382\ or some

other fixed value,\383\ or arguing in favor of an exposure-based

threshold in lieu of a notional threshold.\384\ Other commenters said

that the aggregate notional amount of swaps is not a meaningful measure

of an entity's dealing activity.\385\ A few commenters supported the

proposed notional threshold.\386\

---------------------------------------------------------------------------

\382\ See letter from COPE I (suggesting 0.001% of the total

U.S. swap market, amounting to approximately $3 billion); see also

letters from API dated June 3, 2011 (``API II''), EDF Trading,

Edison Int'l, EEI/EPSA, IECA-Credit I, NCGA/NGSA II, NextEra,

NFPEEU, Utility Group and WGCEF I (suggesting 0.001% of the total

U.S. swap market).

\383\ See, e.g., meeting with Land O'Lakes on January 6, 2011

(suggesting the threshold be increased by 2 to 5 times--i.e., to

$200 million to $500 million); letters from Growmark, FHLB I and MFX

II (each supporting $1 billion notional standard); Regional Banks

(supporting $2 billion notional standard); letter from NCFC dated

October 31, 2011 (``NCFC III'') (supporting alternative notional

standards of $1 billion or $3 billion depending on certain

assumptions); letter from FSR VI and joint letter from Capital One,

Fifth Third Bancorp and Regions Financial Corporation (suggesting

notional standard of at least $2 billion); letter from WGCEF dated

June 3, 2011 regarding the swap dealer definition (``WGCEF V'')

(suggesting notional standard of $3.5 billion); and letter from IPR-

GDF Suez Energy North America (suggesting notional standard of $10

billion). Some commenters suggested more than one possible

threshold.

\384\ See, e.g., letters from Farm Credit Council I, FSR VI and

Midsize Banks. Other commenters said the threshold should account

for the effect of netting. See letters from API II, Chesapeake

Energy, Land O'Lakes I and MFX II. On the other hand, one commenter

specifically supported the use of the gross notional amount. See

letter from Greenberger.

\385\ See letters from Farm Credit Council I, ISDA I, Land

O'Lakes I, Midsize Banks, NCFC I, SIFMA--Regional Dealers and Vitol.

\386\ See letters from AFR, Better Markets I, Greenberger and

NMPF. One of these commenters said that data on credit default swaps

analyzed by the SEC's Division of Risk, Strategy, and Financial

Innovation indicates that the $100 million proposed notional

thresholds are too high. See letters from Better Markets to CFTC and

SEC dated April 6, 2012 (``Better Markets III'').

---------------------------------------------------------------------------

Some commenters argued against basing the de minimis exception on

the number of a person's swaps or security-based swaps or the number of

a person's counterparties,\387\ or supported increasing those

thresholds above the proposed standard.\388\ Commenters also suggested

a variety of other alternatives to the proposed tests.\389\

---------------------------------------------------------------------------

\387\ See, e.g., letters from API II, Atmos Energy, Chesapeake

Energy, COPE I, EEI/EPSA, Gavilon II, IECA-Credit I, Land O'Lakes I,

NCGA/NGSA II, NEM, NextEra I, NMPF, NRG Energy, Peabody and Utility

Group.

\388\ See, e.g., letters from ISDA I (suggesting 25 transactions

over 12 months); FHLB I (suggesting 25 counterparties and 50

transactions over 12 months) FSR I and Midsize Banks (each

suggesting 75 counterparties and 200 transactions over 12 months);

Regional Banks (suggesting 100 counterparties and 300 transactions

over 12 months); Growmark and MFX II (suggesting thresholds should

be increased by a factor of 10) and meeting with Land O'Lakes on

January 6, 2011 (suggesting thresholds should be increased by a

factor of between 2 and 5).

One commenter said the number of transaction and number of

counterparty standards should be disjunctive--i.e., a dealer's

activity would be de minimis if it were below either standard. See

letter from Northland Energy. Other commenters raised questions

about how counterparties or transactions should be counted for

purposes of the standard. See letters from CDEU (novations should

not be counted as new transactions) and J.P. Morgan (members of an

affiliated group should be counted as one counterparty), joint

letter from BB&T, East West Bank, Fifth Third Bank, The PrivateBank

and Trust Company, Regions Bank, Sun Trust Bank, U.S. Bank National

Association and Wells Fargo Bank, N.A. (``Midmarket Banks'')

(questioning how to count multiple borrower counterparties to a loan

and swap) and meeting with Land O'Lakes on January 6, 2011 (members

of a cooperative should be counted as one counterparty).

Last, some commenters said that the number of transaction or

number of counterparty standards should be deleted because they are

not useful as tests of de minimis status. See letters from Gavilon

II (eliminate both standards) and SIFMA--Regional Dealers (eliminate

number of counterparties standard).

\389\ See letters from IECA-Credit I (suggesting that exception

exclude persons whose positions either are below a notional

threshold or are below a combined proportionality and revenue

threshold), SIFMA--Regional Dealers (supporting annual threshold of

500 customer-facing or riskless principal swaps, consistent with the

de minimis exception from the Exchange Act ``broker'' definition in

connection with bank brokerage activity, as well as SEC rules in

connection with the Exchange Act definition of ``dealer''), FHLB I

(supporting non-quantitative test accounting for relatively small

swap-related exposure compared to primary customer activity,

collateral that also provides credit support for other business done

with the customer, an existing relationship with customer and

inability of customer to obtain swaps from entities that primarily

are dealers), Gavilon II (alluding to use of non-quantitative

tests), MFX II (suggesting establishment of a separate qualitative

process by which a dealer may establish why registration is not

warranted) and DC Energy (thresholds should be set at a level

appropriate to support the capital levels to be required for swap

dealers).

---------------------------------------------------------------------------

d. Additional Issues

Some commenters emphasized the need to provide protections in

connection with ``special entities.'' \390\ Certain commenters sought

to identify problems related to the application of the proposed

thresholds in connection with particular types of businesses or

markets,\391\ or to aggregators or

[[Page 30628]]

cooperatives.\392\ Other commenters suggested that the exception should

focus dealer regulation toward ``financial'' entities.\393\ One

commenter emphasized the need for the exception to be available when

the end-user is a credit union, bank or thrift.\394\

---------------------------------------------------------------------------

\390\ See letters from Better Markets I (arguing that the de

minimis exception should not be available in connection with

transactions with special entities), AFR (similar), Greenberger

(supporting reduction of the notional threshold for transactions

with special entities to $5 million) and AFSCME. Some commenters

said the standard for swaps and security-based swaps with special

entities should be a notional value equal to 0.0001% of the total

U.S. swap market. See letters from COPE I, EDF Trading, EEI/EPSA,

IECA-Credit I, NFPEEU and Utility Group. One commenter said the

threshold for special entities should be eliminated because it is

not useful in determining de minimis status. See letter from Gavilon

II.

\391\ See letters from BG LNG I (small energy companies), COPE I

and Northland Energy (each discussing commodity markets, suggesting

that notional thresholds be based on the unit of a commodity), NCFC

I (commodity prices), NGFA I (grain elevators) and WGCEF I (energy

prices).

\392\ See, e.g., letters from Growmark and Land O'Lakes I.

\393\ See letters from NEM, NextEra I, and NGFA I.

\394\ See letter from CUNA.

---------------------------------------------------------------------------

Commenters sought clarification that the de minimis criteria would

not apply to transactions for hedging or proprietary trading

purposes,\395\ or to inter-affiliate transactions.\396\

---------------------------------------------------------------------------

\395\ See, e.g., letters from API I, EDF Trading, Gavilon II and

SIFMA--Regional Dealers.

\396\ See, e.g., letter from Atmos Energy Holdings, Inc (``Atmos

Holdings'').

---------------------------------------------------------------------------

Commenters also raised issues related to the exception's treatment

of the proposed use of a rolling annual period for calculations,\397\

the proposed use of ``effective notional amounts,'' \398\ the

possibility of adjusting the thresholds over time,\399\ how the de

minimis tests would apply in the context of affiliated positions,\400\

and how the exception would account for swaps or security-based swaps

entered into before the definition's effective date.\401\

---------------------------------------------------------------------------

\397\ See letters from NCGA/NGSA I (supporting measurement of

rolling period average over 12 months), NextEra I (supporting

evaluation as of the last day of each calendar quarter rather than

over the immediate preceding 12 months) and Northland Energy

(requesting clarification that if a monetary notional amount is

used, the evaluation periods should be fixed rather than rolling).

\398\ See letters from ISDA I (stating that the use of

``effective notional amount'' in the test introduces ambiguity and

uncertainty) and WGCEF I (notional amounts should be measured on a

``delta-equivalent'' basis).

\399\ See letters from Farm Credit Council I (supporting

automatic periodic increases to reflect changes in market size, the

size of typical contracts and inflation), Greenberger (supporting

reevaluation of the de minimis criteria on an ongoing basis), and BG

LNG I, EEI/EPSA, NCFC I and WGCEF I (each supporting inflation or

market size adjustments).

\400\ See meeting with Edison Int'l (requesting clarification

that an entity that is prohibited from coordinating its financial

derivatives activities should determine whether it qualifies for the

de minimis exception without considering financial derivatives

entered into by its affiliated entities).

\401\ See letter from Covington & Burling (urging clarification

that lookback period will not commence until all the relevant

regulations become effective).

---------------------------------------------------------------------------

Some commenters suggested that the de minimis thresholds be set

higher initially to provide for efficient use of regulatory

resources.\402\ One commenter requested clarification that the

exception would apply prospectively without regard to dealing

activities taken prior to the effectiveness of Title VII.\403\ One

commenter requested that a person that falls above the de minimis tests

be able to take advantage of application and re-evaluation periods akin

to those associated with the major participant definitions.\404\

---------------------------------------------------------------------------

\402\ See letters from BGLNG I and WGCEF V. See also Roundtable

Transcript at 50-51 (remarks of Ron Oppenheimer, WGCEF), 57 (remarks

of Richard Ostrander, Morgan Stanley) and 208-09 (remarks of Bella

Sanevich, NISA Investment Advisors).

\403\ See letter from FSR I.

\404\ See letter from WGCEF I; see also Northland Energy

(supporting grace period for registration if the de minimis

threshold is exceeded).

---------------------------------------------------------------------------

Two commenters expressed support for the proposed self-executing

approach of the exception.\405\ Some commenters requested clarification

that the de minimis exception is independent of the loan origination

exclusion in the CEA ``swap dealer'' definition.\406\

---------------------------------------------------------------------------

\405\ See letters from ISDA I and Northland Energy.

\406\ See letters from FSR VI and Midsize Banks.

---------------------------------------------------------------------------

A number of commenters also addressed the application of dealer

regulation to non-U.S. entities. While those comments did not

specifically address the de minimis exception, the exception may be

relevant to addressing these cross-border issues.\407\

---------------------------------------------------------------------------

\407\ Some commenters particularly took the view that the

application of the dealer definitions to non-U.S. persons should

solely address those persons' U.S. dealing activities. See letters

from FSR I, ISDA I and Soci[eacute]t[eacute] G[eacute]n[eacute]rale.

Some commenters also specifically identified concerns of

international comity in this context. See letters cited in note 148,

supra.

The Commissions intend to address the application of dealer

regulation to non-U.S. persons as part of separate releases that

generally will address the application of Title VII to non-U.S.

persons.

---------------------------------------------------------------------------

One commenter separately addressed the credit default swap data

analysis made available by CFTC and SEC staffs.\408\ The commenter

expressed the view that this data supported the adoption of a de

minimis threshold of $100 million or less, particularly focusing on the

number of entities that may be excluded under particular

thresholds.\409\

---------------------------------------------------------------------------

\408\ See letter from Better Markets III.

\409\ See id.

---------------------------------------------------------------------------

3. Final Rules--General Principles for Implementing the De Minimis

Exception

a. Balancing Regulatory Goals and Burdens

The Commissions recognize that implementing the de minimis

exception requires a careful balancing that considers the regulatory

interests that could be undermined by an unduly broad exception as well

as those regulatory interests that may be promoted by an appropriately

limited exception.

On the one hand, a de minimis exception, by its nature, will

eliminate key counterparty protections provided by Title VII for

particular users of swaps and security-based swaps.\410\ The broader

the exception, the greater the loss of protection.\411\ Moreover, in

determining the scope of the exception, it is important to consider not

only the current state of the swap and security-based swap markets, but

also to account for how those markets may evolve in the future. This is

particularly important because the full implementation of Title VII--

including enhancements to pricing transparency and the increased access

to central clearing--reasonably may be expected to facilitate new

entrants into the swap and security-based swap markets. To the extent

that such entrants engage in dealing activity below the de minimis

threshold--either for the long term or until their activity surpasses

the threshold--the relative amount of unregistered activity within the

market may be expected to increase. Accordingly, a higher de minimis

threshold may not only result in a certain percentage of unregistered

activity being transacted initially, consistent with the current

market, but also may result in an even greater proportion of

unregistered activity being transacted in the future.

---------------------------------------------------------------------------

\410\ A number of commenters expressed particular concerns as to

the threats that an overbroad exception would pose to special

entities. See letters from AFR (noting that Congress incorporated

special protections for special entities in reaction to news reports

about special entities losing millions of dollars ``after signing up

for derivatives deals they did not understand,'' and urging the

elimination of any de minimis exception for transactions with

special entities); Better Markets I (stating that history has shown

that special entities are vulnerable to abuse, and that they need

capital, collateral and business conduct protections as much as or

more than any other category of market participants); and AFSCME

(expressing skepticism as to the view that dealer status would

preclude firms from entering into transactions with special

entities). Some of those commenters also generally supported the

proposed $100 million de minimis threshold. See letters from AFR and

Better Markets I; see also letter from Greenberger (stating that the

dynamic nature of the derivatives sector of the financial markets

should counsel caution, and that the de minimis threshold should be

reevaluated on an ongoing basis).

\411\ Notwithstanding the reduction in protection, however, in

the case of swaps and security-based swaps the general antifraud

provisions of the CEA and the securities laws, respectively,

including rules to be adopted by the SEC pertaining specifically to

security-based swaps, will continue to apply to all transactions in

security-based swaps. See, e.g., CEA section 4b(2), 7 U.S.C. 6b(2).

---------------------------------------------------------------------------

On the other hand, the Commissions also recognize that Congress

included a statutorily mandated de minimis exception for certain swap

and security-based swap dealing activity, and that an appropriately

calibrated de minimis exception has the potential to advance other

interests. For example, the de minimis exception may further the

interest of regulatory efficiency when

[[Page 30629]]

the amount of a person's dealing activity is, in the context of the

relevant market, limited to an amount that does not warrant

registration to address the concerns implicated by government

regulation of swap dealers and security-based swap dealers. To advance

this interest, it is necessary to consider the benefits to the

marketplace associated with the regulation of dealers against the total

burdens and potential impacts on competition, capital formation and

efficiency associated with that regulation.\412\

---------------------------------------------------------------------------

\412\ While we are mindful that the Commissions have yet to

adopt all the final substantive rules applicable to swap dealers and

security-based swap dealers, we nonetheless believe that we have

sufficient understanding of those potential requirements to

reasonably balance the relevant factors to identify the initial

level of dealing activity that should be considered to be de

minimis. Moreover, finalizing the dealer definitions will help

provide for the orderly and informed finalization of those other

substantive rules governing swap dealers and security-based swap

dealers.

---------------------------------------------------------------------------

In addition, the exception can provide an objective test for

persons who engage in some swap or security-based swap activities that,

in their view, potentially raise the risk that they would be deemed to

be dealers.\413\ The exception also may permit persons that are not

registered as dealers to accommodate existing clients that have a need

for swaps or security-based swaps in conjunction with other financial

services or commercial activities, thus avoiding the need for such

clients to establish separate relationships with registered dealers,

which may have attendant costs. The exception further may promote

competition in dealing activity within the swap or security-based swap

markets, by helping to allow non-registered persons to commence

providing dealing services while avoiding the costs associated with

full-fledged dealers. More competition within the market for swaps and

security-based swaps may not only decrease the costs for participants

in the market, but also may help to decrease systemic risk by lessening

the current apparent concentration of dealing activity among a few

major market participants.\414\

---------------------------------------------------------------------------

\413\ ``Congress incorporated a de minimis exception to the Swap

Dealer definition to ensure that smaller institutions that are

responsibly managing their commercial risk are not inadvertently

pulled into additional regulation.'' See 156 Cong. Rec. S6192 (daily

ed. July 22, 2010) (letter from Senators Dodd and Lincoln to

Representatives Frank and Peterson).

\414\ See 478 through 487 and accompanying text, infra.

---------------------------------------------------------------------------

The statutory requirements that apply to swap dealers and security-

based swap dealers include requirements aimed at the protection of

customers and counterparties,\415\ as discussed above, as well as

requirements aimed at helping to promote effective operation and

transparency of the swap and security-based swap markets.\416\ The

overall economic benefits provided by these requirements in large part

will depend on the proportion of swaps and security-based swaps that

are transacted subject to these requirements. In other words, the

greater the dealing activity of a registered dealer, the more

significant the resulting increase in market efficiency,\417\ and the

greater the reduction in risks faced by the entity's customers and

counterparties.\418\ These benefits can be expected to accrue over the

long term and be distributed over the market and its participants as a

whole. This is not to say, however, that it would be insignificant for

any particular counterparty if its swaps or security-based swaps were

to fall outside of the ambit of dealer regulation. For example, a

customer or counterparty that is not protected by the business conduct

rules applicable to dealers might be more likely to suffer losses

associated with entering into an inappropriate or misunderstood swap or

security-based swap than if the instrument was transacted pursuant to

the business conduct rules applicable to registered dealers.

---------------------------------------------------------------------------

\415\ As discussed above, in part, these customer and

counterparty protections derive from the financial responsibility

requirements applicable to dealers, particularly: capital and margin

requirements (CEA section 4s(e); Exchange Act section 15F(e)), and

requirements for segregation of collateral (CEA sections 4d(f),

4s(l); Exchange Act section 3E).

These customer and counterparty protections also derive from

certain other requirements applicable to dealers, particularly:

requirements with respect to business conduct when transacting with

special entities (CEA sections 4s(h)(2), 4s(h)(4), 4s(h)(5);

Exchange Act sections 15F(h)(2), (h)(4), (h)(5)); disclosure

requirements (CEA section 4s(h)(3)(B); Exchange Act section

15F(h)(3)(B)); requirements for fair and balanced communications

(CEA section 4s(h)(3)(D); Exchange Act section 15F(h)(3)(C)); other

requirements related to the public interest and investor protection

(CEA section 4s(h)(3)(D); Exchange Act section 15F(h)(3)(D)); and

conflict of interest provisions (CEA section 4s(j)(5); Exchange Act

section 15F(j)(5)).

\416\ Relevant provisions are: reporting and recordkeeping

requirements (CEA section 4s(f); Exchange Act section 15F(f)); daily

trading records requirements (CEA section 4s(g); Exchange Act

section 15F(g)); regulatory standards related to the confirmation,

processing, netting, documentation and valuation of security-based

swaps (CEA section 4s(i); Exchange Act section 15F(i)); position

limit monitoring requirements (CEA section 4s(j)(1); Exchange Act

section 15F(j)(1)); risk management procedure requirements (CEA

section 4s(j)(2); Exchange Act section 15F(j)(2)); and requirements

related to the disclosure of information to regulators (CEA section

4s(j)(3); Exchange Act section 15F(j)(3)).

\417\ For example, the more swaps or security-based swaps a

dealer enters into, the more significant will be the efficiency

benefits associated with confirmation, processing, netting

documentation and valuation requirements applicable to dealers.

\418\ For example, the more swaps or security-based swaps a

dealer enters into, the more significant the number of

counterparties that will be protected by the disclosure and other

business conduct obligations imposed on dealers.

---------------------------------------------------------------------------

In contrast to the benefits associated with dealer regulation, many

of the burdens of dealer regulation will accrue in the short term and

will fall directly on registered dealers.\419\ Some of those burdens

may be expected to be independent of the amount of an entity's dealing

activity (i.e., entities that engage in minimal dealing activity would

still be expected to face certain burdens associated with the

registration process and the development of compliance and other

systems if they are required to register as dealers), while other

burdens (e.g., the impact of margin and capital rules applicable to

dealers) may be more directly linked to the amount of that entity's

dealing activity.

---------------------------------------------------------------------------

\419\ Certain commenters also have expressed concerns that the

prospect of regulation may deter certain entities from engaging in

limited swap or security-based swap dealing activities, see, e.g.,

letters from SIFMA--Regional Dealers and Midsize Banks, which could

reduce the availability of those instruments.

---------------------------------------------------------------------------

As discussed below, the Commissions have sought to balance the

various interests associated with a de minimis exception, as well as

the benefits and burdens associated with such an exception, in

developing the factors to implement the de minimis exceptions to the

``swap dealer'' and ``security-based swap dealer'' definitions.

However, in moving forward with implementing this balancing

approach, we recognize that the information that currently is available

regarding certain portions of the swap market is limited. Following the

full implementation of Title VII, more information will be available to

permit us to assess the effectiveness of this balancing for particular

markets and to revise the exception as appropriate.

In that context--and in light of the tools currently available to

us--we have been influenced, in particular, by comments taking the view

that the de minimis factors should take into account the size and

unique attributes of the market for swaps and security-based

swaps.\420\ We believe that factors that exclude entities whose dealing

activity is sufficiently modest in light of the total size,

concentration and other attributes of the applicable markets can be

useful in avoiding the imposition of

[[Page 30630]]

regulatory burdens on those entities for which dealer regulation would

not be expected to contribute significantly to advancing the customer

protection, market efficiency and transparency objectives of dealer

regulation. The Commissions note, however, that they are not of the

general view that the costs of extending regulation to any particular

entity must be outweighed by the quantifiable or other benefits to be

achieved with respect to that particular entity. The Commissions,

rather, analyze the overall benefits and costs of regulation, keeping

in mind, as noted above, that the benefits may be distributed, accrue

over the long-term, and be difficult to quantify or to measure as

easily as certain costs.\421\

---------------------------------------------------------------------------

\420\ See, e.g., letters from CDEU (comparing proposed

thresholds with statistics regarding the activities of recognized

dealers) and EEI/EPSA (recommending that thresholds be set at an

amount equal to 0.001 percent of the aggregate size of the U.S.

swaps market, and 0.0001 percent for swaps in which the counterparty

is a special entity).

\421\ For example, it does not appear possible to demonstrate

empirically--let alone quantify--the increase or decrease in the

possibility that a financial crisis would occur at a particular

future time and with a particular intensity in the absence of

financial regulation or as a result of varying levels or types of

financial regulation. It also is difficult to demonstrate

empirically that the customer protections associated with dealer

regulation would increase or decrease the likelihood that any

particular market participant would suffer injury (or the degree to

which the participant would suffer injury) associated with entering

into an inappropriate swap or security-based swap. At the same time,

certain costs may also not be readily susceptible to quantification

or measurement, for example, the costs that might be associated with

diminished presence, if any, of new entrants. The inability to

quantify these benefits and costs does not mean that the benefits

and costs of dealer regulation are any less substantial.

---------------------------------------------------------------------------

b. Specific Factors Implementing the De Minimis Exception

i. Notional Test

Consistent with the proposal, the final rules implementing the de

minimis exception take into account the notional amount of an entity's

swap or security-based swap positions over the prior 12 months arising

from its dealing activity.\422\ While the Commissions recognize that

notional amounts do not directly measure the exposure or risk

associated with a swap or security-based swap position, such measures

do reflect the relative amount of an entity's dealing activity.\423\

Moreover, although some commenters have posited measures of risk or

exposure as alternatives to notional measures, such risk or exposure

measures could, to the extent they allow for netting or collateral

offsets, potentially allow an unregistered entity to engage in large

amounts of swap or security-based swap dealing activity while remaining

within the de minimis exception so long as that entity nets or

collateralizes its swap or security-based swap positions. Such an

outcome could undermine the customer protection and market operation

benefits associated with dealer regulation. As with the proposed rules,

the notional factor in the final rules is based on the notional

positions of an entity over a 12 month period, rather than capping the

current notional amount of a position at any time, to better reflect

the amount of an entity's current activity.

---------------------------------------------------------------------------

\422\ See CFTC Regulation Sec. 1.3(ggg)(4); Exchange Act rule

3a71-2(a)(1). Over the first year following the effective date of

the final rules implementing the statutory definition of ``swap''

and ``security-based swap'' as set forth in CEA section 1a(47) and

Exchange Act section 3(a)(68), respectively, this notional test will

be based on the person's dealing activity following that effective

date. See id. Accordingly, the analysis of whether a person may take

advantage of the de minimis exception will not encompass the

person's dealing activity prior to that effective date, given the

need for the person to know whether an instrument is a swap or

security-based swap for purposes of the analysis.

\423\ ``Changes in notional volumes are generally reasonable

reflections of business activity, and therefore can provide insight

into potential revenue and operational issues. However, the notional

amount of derivatives contracts does not provide a useful measure of

either market or credit risks.'' OCC Quarterly Report at 8.

---------------------------------------------------------------------------

The final rules, like the proposed rules, include lower notional

thresholds for dealing activities in which the counterparty is a

``special entity.'' \424\ This is consistent with the fact that Title

VII's requirements applicable to swap dealers and security-based swap

dealers provide heightened protection to those types of entities.\425\

It is important that the de minimis exception not undermine those

statutory protections.\426\ Also, consistent with the Proposing

Release, these notional standards will be based on ``effective

notional'' amounts when the stated notional amount is leveraged or

enhanced by the structure of the swap or security-based swap.\427\

---------------------------------------------------------------------------

\424\ For these purposes, ``special entity'' means: (i) A

Federal agency; (ii) a state, state agency, city, county,

municipality, or other political subdivision of a state; (iii) any

employee benefit plan, as defined in section 3 of the Employee

Retirement Income Security Act of 1974 (``ERISA''); (iv) any

governmental plan, as defined in section 3 of ERISA; or (v) any

endowment, including an endowment that is an organization described

in section 501(c)(3) of the Internal Revenue Code of 1986. See CEA

section 4s(h)(2)(C) and CFTC Regulation Sec. 23.401(c); Exchange

Act section 15F(h)(2)(C).

\425\ See CEA sections 4s(h)(2), (4), (5); see also CFTC,

Business Conduct Standards for Swap Dealers and Major Swap

Participants with Counterparties; Final Rule, 77 FR 9733 (Feb. 17,

2012); Exchange Act sections 15F(h)(2), (4), (5) (providing

additional requirements for dealers that advise special entities or

that enter into swaps or security-based swaps with special

entities).

\426\ The importance of the statutory protections for special

entities has been highlighted by the SEC's recent action in

connection with the inappropriate sale of notes linked to the

performance of synthetic collateralized debt obligations to a number

of school districts. According to a complaint filed in federal

district court, these securities were unsuitable for the investment

needs of the school districts, were sold to school districts that

lacked the requisite sophistication and experience to independently

evaluate the risks of the investment, and exposed the school

districts to a heightened risk of catastrophic loss ultimately led

to a complete loss of their investments. ``SEC Charges Stifel,

Nicolaus and Former Executive with Fraud in Sale of Investments to

Wisconsin School Districts,'' SEC Litigation Release No. 22064 (Aug.

10, 2011) (http://www.sec.gov/litigation/litreleases/2011/lr22064.htm).

\427\ For example, if an exchange of payments associated with a

$1 million notional equity swap was based on three times the return

associated with the underlying equity, the effective notional amount

of the equity swap would be $3 million.

---------------------------------------------------------------------------

ii. Other Tests From the Proposing Release

The proposed rules limited the number of swaps or security-based

swaps that an entity could enter into in a dealing capacity, and the

number of an entity's counterparties in a dealing capacity. The final

rules do not include those measures. In part, this reflects commenter

concerns that a standard based on the number of swaps or security-based

swaps or counterparties can produce arbitrary results by giving

disproportionate weight to a series of smaller transactions or

counterparties.\428\

---------------------------------------------------------------------------

\428\ See, e.g., letter from COPE I.

---------------------------------------------------------------------------

c. Significance of Statutory ``Customer'' Language

Consistent with the Proposing Release, the final rules implementing

the de minimis exception do not require the presence of any type of

defined ``customer'' relationship.

In adopting these rules the Commissions have considered alternative

approaches suggested by commenters, including one commenter's

suggestion that the de minimis exception should be available only in

connection with swaps or security-based swaps entered into as part of a

``customer'' relationship.\429\ In considering that alternative view,

however, we believe that it is significant that the statutory exception

lacks terminology such as ``existing'' or ``preexisting'' that limits

the availability of the exception or otherwise to distinguishes a

``customer'' relationship from other types of counterparty

relationship. Also, while that alternative view could still permit an

unregistered person to provide limited dealer services as an

accommodation to an existing customer or counterparty, an

interpretation that predicates the exception on the presence of a

particular type of ``customer'' relationship would not advance other

potential benefits associated with a de minimis exception, including

the

[[Page 30631]]

benefit of providing certainty in connection with the swap or security-

based swap activities of end-users.\430\ Accordingly, we do not believe

that the ``customer'' reference standing alone provides a sufficient

basis to conclude that the exception should only be available if there

is an existing relationship of some type, and the final rules neither

require that a dealer accommodate the demand of an existing customer

nor require the presence of a preexisting relationship for the

exception to apply.

---------------------------------------------------------------------------

\429\ See letter from Better Markets I.

\430\ As discussed above, see note 413, supra, there is

legislative history that suggests that an intended purpose of the

exception would be to ensure that the dealer definition does not

encompass ``smaller institutions that are responsibly managing their

commercial risk.''

---------------------------------------------------------------------------

We also are not persuaded by the different commenter suggestion

that the statutory de minimis exception's ``customer'' language means

that an unregistered dealer should be permitted to engage in unlimited

dealing activity so long as its counterparties are not customers.\431\

Such an unlimited exception would appear to be contrary to the express

language of the statutory exception. In addition, such an approach

would lead to the perverse result of discouraging entities from

entering into swaps or security-based swaps to facilitate risk

management activities of customers (while encouraging other dealing

activities), which appears contrary to Title VII's general approach of

seeking to limit undue impacts on the swap and security-based swap

activities of commercial end-users.

---------------------------------------------------------------------------

\431\ See, e.g., letter from ISDA I.

---------------------------------------------------------------------------

d. Focus on ``Dealing'' Activity

Some commenters suggested that we clarify that the limitations

associated with the de minimis exception apply only in connection with

a person's dealing activities, and not to the person's hedging or

proprietary trading activities.\432\ The Commissions agree that the de

minimis exception is intended to permit an unregistered person to

engage in a limited amount of dealing activity without regard to the

person's non-dealing activity. Thus, to the extent that a particular

swap or security-based swap position is not connected to dealing

activity under the applicable interpretation of the statutory dealer

definition, it will not count against the de minimis thresholds.

Conversely, if a swap or security-based swap position is connected to

the person's dealing activity, the position will count against those

thresholds.\433\

---------------------------------------------------------------------------

\432\ See, e.g., letters from SIFMA--Regional Dealers and EDF

Trading.

\433\ For purposes of the de minimis exception to the security-

based swap dealer definition, we note that one indicator of dealing

activity under the dealer-trader distinction is that a person profit

by providing liquidity in connection with security-based swaps.

Accordingly, for purposes of the de minimis exception to the

security-based swap dealer definition, a security-based swap

position that hedges or otherwise offsets a position that was

entered into as part of dealing activity would itself comprise part

of the person's dealing activity, and hence count against the de

minimis thresholds.

For purposes of the de minimis exception to the swap dealer

definition, we take the view that the relevant question in

determining whether swaps count as dealing activity against the de

minimis thresholds is whether the swaps fall within the swap dealer

definition under the statute and the final rules, as further

interpreted by this Adopting Release. If hedging or proprietary

trading activities did not fall within the definition, including

because of the application of CFTC Regulation Sec. 1.3(ggg)(6),

they would not count against the de minimis thresholds.

---------------------------------------------------------------------------

Commenters also requested clarification that the de minimis

thresholds do not apply to a person's inter-affiliate swaps and

security-based swaps, nor apply to swaps covered by the exclusion for

swaps entered into by insured depository institutions in connection

with the origination of loans to customers.\434\ Consistent with the

discussion above,\435\ such swaps or security-based swaps do not

constitute dealing activity and should not be counted against the de

minimis thresholds. Similarly, swaps between a cooperative and its

members, as provided in CFTC Regulation Sec. 1.3(ggg)(6)(ii), and

swaps entered into for the hedging purpose defined in CFTC Regulation

Sec. 1.3(ggg)(6)(iii) should not be counted against the de minimis

threshold.\436\

---------------------------------------------------------------------------

\434\ See, e.g., letters from Atmos Holdings and FSR I.

\435\ See parts II.B and II.C, supra.

\436\ Swaps and security-based swaps that hedge, mitigate, or

offset the types of swaps and security-based swaps discussed in the

foregoing paragraph, which do not constitute dealing activity,

similarly should not be counted against the de minimis thresholds.

---------------------------------------------------------------------------

In light of the increased notional thresholds of the final rules,

and the resulting opportunity for a person to evasively engage in large

amounts of dealing activity if it can multiply those thresholds, the

final rules provide that the notional thresholds to the de minimis

exception encompass swap and security-based swap dealing positions

entered into by an affiliate controlling, controlled by or under common

control with the person at issue.\437\ This is necessary to prevent

persons from avoiding dealer regulation by dividing up dealing activity

in excess of the notional thresholds among multiple affiliates.\438\

---------------------------------------------------------------------------

\437\ See CFTC Regulation Sec. 1.3(ggg)(4)(i); Exchange Act

rule 3a71-2(a)(1). For these purposes, we interpret control to mean

the possession, direct or indirect, of the power to direct or cause

the direction of the management and policies of a person, whether

through the ownership of voting securities, by contract or

otherwise. This is consistent with the definition of ``control'' and

``affiliate'' in connection with Exchange Act rules regarding

registration statements. See Exchange Act rule 12b-2.

The final rules use a control standard in connection with the

de minimis notional thresholds as a means reasonably designed to

prevent evasion of the limitations of that exception. This contrasts

with the majority-ownership standard used by the inter-affiliate

exclusions from the dealer and major participant definitions. See

parts II.C.2 and IV.G.2, infra. That majority-ownership standard,

which in application will not be expected to be satisfied in all

circumstances in which a control standard is satisfied, is

reasonably designed to reflect the economic alignment that

appropriately underpins those exclusions.

\438\ In other words, for example, if a parent entity controls

two subsidiaries which both engage in activities that would cause

the subsidiaries to be covered by the dealer definitions, then each

subsidiary must aggregate the swaps or security-based swaps that

result from both subsidiaries' dealing activities in determining if

either subsidiary qualifies for the de minimis exception.

The SEC expects to address the application of this principle to

the security-based swap activities of non-U.S. persons in a separate

release.

---------------------------------------------------------------------------

e. Alternative Approaches We Are Not Following

Certain commenters have suggested alternative approaches to

implementing the de minimis exception. While the Commissions have

considered those suggested alternatives, we do not believe that they

provide the optimal framework for implementing the exception.

For example, some commenters took the position that the de minimis

exception should focus dealer regulation on those entities whose

dealing activities pose systemic risk, and excuse other dealers from

having to register.\439\ Such an approach, however, would fail to

account for regulatory interests apart from the control of systemic

risk that are addressed by dealer regulation, including statutory

provisions that protect customers and counterparties in other ways, and

that promote effective market operations and transparency.\440\

---------------------------------------------------------------------------

\439\ See, e.g., letters from CDEU and SIFMA--Regional Dealers.

\440\ We also disagree with the suggestion that it would be

inconsistent with the Title VII framework to consider customer

protection issues in setting the de minimis factors. See letter from

WGCEF I. While the restrictions on the availability of swaps and

security-based swaps to non-ECPs help to mitigate certain customer

protection concerns, Title VII includes specific safeguards designed

to protect dealers' customers and counterparties regardless of

whether those are ECPs. It would not be consistent with Title VII to

ignore those interests.

---------------------------------------------------------------------------

Some commenters also have suggested that the de minimis exception

should subsume a proportionality

[[Page 30632]]

standard, whereby an entity may be excluded from dealer regulation if

its dealing activity comprises only a relatively small portion of its

overall activities (or its overall swap or security-based swap

activities), or if its dealing activity is ``tangential'' to its

principal business.\441\ We are not incorporating that type of approach

into the de minimis factors, however, because that approach would not

appear to provide a logical way to balance the benefits and burdens of

dealer regulation. A proportionality approach could permit a large

entity to engage in a significant amount of dealing activity without

being subject to dealer regulation, thus undermining the benefits of

dealer regulation. Moreover, a proportionality approach could lead to

arbitrary results by excusing a large entity from dealer regulation

while requiring the registration of a smaller entity that engages in

less total dealing activity (if that smaller amount of dealing activity

comprises a greater portion of the smaller entity's total

activity).\442\

---------------------------------------------------------------------------

\441\ See letter from FHLB I.

\442\ As discussed below, if an entity is a dealer, the

regulations applicable to dealers in general will govern all of the

entity's swap or security-based swap activities and positions.

Depending on the applicable facts and circumstances, however, the

entity may be able to avail itself of a limited purpose designation

as a dealer. See part II.E, infra.

---------------------------------------------------------------------------

Some commenters also supported the use of non-quantitative

standards in connection with the de minimis exception.\443\ Although we

recognize that such an approach may help us weigh the facts and

circumstances associated with a particular person's dealing activity,

we believe that it is more appropriate to base the exception on an

objective quantitative standard, to allow the exception to be self-

executing, and to promote predictability among market participants and

the efficient use of regulatory resources. Unlike the overall

definitions of ``swap dealer'' and ``security-based swap dealers,''

which consider the entirety of a person's activities with respect to

swaps, the de minimis exception is only relevant to persons who have

determined that they are engaged in swap or security-based swap

dealing, and are looking to determine whether the quantity of their

dealing activity is de minimis. For this more particular and focused

determination, an objective quantitative standard is more appropriate.

---------------------------------------------------------------------------

\443\ See letters from FHLB I, Gavilon II, and MFX II.

---------------------------------------------------------------------------

Commenters also made various suggestions as to the types of factors

and accompanying thresholds that should be used in connection with the

de minimis exception. Those suggestions are addressed more specifically

below in the specific context of the swap dealer and security-based

swap dealer de minimis exceptions.

4. Final Rules--De Minimis Exception to Swap Dealer Definition

a. Overview of the Final Rule

After considering commenters' views, the final rule implementing

the de minimis exception caps an entity's dealing activity involving

swaps at $3 billion over the prior 12 months.\444\ This amount is based

on input from commenters and is supported by several rationales,

including the estimated size of the domestic swap market, among others.

---------------------------------------------------------------------------

\444\ CFTC Regulation Sec. 1.3(ggg)(4). As noted above, for the

first year following the effective date of the rules implementing

the definition of ``swap'' the analysis would only address activity

following that effective date. For clarity, the final rule also has

been revised from the proposal to provide that persons taking

advantage of the exception ``shall be deemed not to be'' swap

dealers (the proposed rule used the phrasing ``shall not be deemed

to be'' swap dealers) The final rule also reflects certain

structural changes consistent with the substantive changes from the

proposed rule. In addition, as discussed above, see part II.D.3.d,

supra, the final rule has been revised to provide that the notional

thresholds to the de minimis exception encompass swap dealing

positions entered into by an affiliate controlling, controlled by or

under common control with the person at issue.

---------------------------------------------------------------------------

As noted above, commenters who suggested a fixed notional standard

proposed that the standard be set at a level between $200 million and

$3.5 billion in notional amount of swaps entered into over a period of

twelve months.\445\ In considering these comments, we are mindful of

the variety of uses of swaps in various markets and therefore it is

understandable that various commenters would reach different

conclusions regarding the appropriate standard. At the same time, we

see value in setting a single standard for all swaps so that there is a

``level playing field'' for all market participants and so that the

standard can be implemented easily without the need to categorize

swaps. Considering the written input of the commenters as well as the

discussions of the de minimis standard at the Commissions' joint

roundtable and numerous meetings with market participants, and the

benefits of the regulation of swap dealers (i.e., protection of

customers and counterparties, and promotion of the effective operation

and transparency of the swap markets), we believe a notional standard

at a level of $3 billion appropriately balances the relevant regulatory

goals.

---------------------------------------------------------------------------

\445\ One commenter suggested a threshold of $3 billion. See

letter from COPE I (suggesting 0.001% of the total U.S. swap market,

amounting to approximately $3 billion). Other commenters also

supported a threshold of 0.001% of the total U.S. swap market. See

letters cited in note 382, supra.

---------------------------------------------------------------------------

As noted above, several commenters suggested that the standard be

set at an amount equal to 0.001 percent of the overall domestic market

for swaps. The Commissions note, however, that comprehensive

information regarding the total size of the domestic swap market is

incomplete, with more information available with respect to certain

asset classes than others. The CFTC evaluated data regarding one

particular type of swap--credit default swaps (``CDS'') based on

indices of debt securities known as ``index CDS''--that was provided by

the SEC.\446\ As noted in the CFTC analysis of this data, however, the

information is not filtered to reflect activity that would constitute

swap dealing under the Dodd-Frank Act, so it is not possible to use the

data to draw conclusions regarding any specific entity's status as a

swap dealer.\447\ The data reflects only activity relating to index

CDS, which constitute a very narrow part of the overall swap market,

and, as noted in the CFTC analysis, similar data regarding other types

of swaps is not available.\448\ Subject to these limitations, the data

may help evaluate the impact of alternative approaches to implementing

the de minimis exception.

---------------------------------------------------------------------------

\446\ The CFTC analysis was made available to the public. See

memorandum to the public comment file from the CFTC Office of the

Chief Economist.

\447\ See id.

\448\ See id.

---------------------------------------------------------------------------

One often-cited measure of the market, the Quarterly Report on Bank

Trading and Derivatives Activities issued by the OCC (``OCC Quarterly

Report'') is both limited, in that it includes only data related to the

activities of U.S. bank holding companies, commercial banks and trust

companies, and over-inclusive, in that it includes activities related

to instruments that are not or may not be included in the final

definition of ``swap'' (including futures, forwards, certain foreign

exchange instruments, and certain options) and it includes both swaps

and security-based swaps. Nonetheless, the Commissions believe that the

available (imperfect) data suggests that a $3 billion notional standard

is generally consistent with the commenters' suggestion of basing the

standard on a percentage of the overall domestic market for swaps.

The total notional value of $333.1 trillion in ``derivatives''

stated in the most recent OCC Quarterly Report includes approximately

$221.1 trillion

[[Page 30633]]

in ``swaps'' and ``credit derivatives.'' \449\ Since some instruments

that are security-based swaps are included in this total,\450\ the

total notional value of swap positions at U.S. bank holding companies,

commercial banks and trust companies at the end of the second quarter

of 2011 of may be estimated to be somewhat less than $221.1 trillion.

---------------------------------------------------------------------------

\449\ See Office of the Comptroller of the Currency, ``Quarterly

Report on Bank Trading and Derivatives Activities, Second Quarter

2011'' at tables 1 and 2 (http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq211.pdf). These totals

reflect the sum of the amounts reported for the top 25 bank holding

companies reported in table 1 and for all but the top 25 commercial

banks and trust companies reported in table 2.

However, this adjustment is only approximate, because the

definitions of ``swap'' and ``credit derivative'' used in the OCC

Quarterly Report are likely to be significantly different from the

final definition of ``swap'' and ``security-based swap'' for

purposes of the Dodd-Frank Act. For the same reason, it is uncertain

how many of the notional value of $54.5 trillion in options reported

in the OCC Quarterly Report are swaps or security-based swaps.

Also, data from the CDS trade information warehouse maintained

by the Depository Trust & Clearing Corporation (``DTCC'') indicates

that total global notional CDS positions on indices amount to

approximately $10.47 trillion. See http://dtcc.com/products/derivserv/data_table_i.php?tbid=3 (data for the week ending

October 7, 2011, obtained on October 17, 2011).

\450\ See part II.D.5, infra, for a discussion of the size of

the security-based swap market.

---------------------------------------------------------------------------

This total notional value is by nature under-inclusive, because it

reflects only swap positions at U.S. bank holding companies, commercial

banks and trust companies and not the swap positions of other market

participants. However, there are also reasons that the information from

the OCC Quarterly Report may overstate the notional value of swaps that

would be relevant to estimating the size of the domestic swap market

for purposes of the de minimis standard. While we believe the data is

not sufficiently precise at this time to serve as the sole basis for

the notional standard, a standard of $3 billion seems that it is likely

generally consistent with 0.001 percent of the domestic swap market

that would be relevant to a potential dealer's de minimis swap activity

figure. First, the large majority of derivatives in the OCC Quarterly

Report (approximately $229 trillion in notional value for commercial

banks and trust companies) are derivatives between ``dealers'' (as

defined for the purposes of the report.) \451\ Thus, it is likely that

a large part of the derivatives in the OCC Quarterly Report reflect

transactions between financial institutions that will be swap dealers.

It is also notable that approximately $204.6 trillion in notional value

of the derivatives (i.e., not only swaps) reported by U.S. commercial

banks were interest rate contracts, many of which are swaps entered

into by IDIs with customers in connection with the origination of loans

which will be excluded from the determination of whether the IDIs are

swap dealers.\452\ Finally, the OCC Quarterly Report measures swap

positions held at a certain point in time, rather than the level of

swap activity over a certain time period, again indicating that the

figures are broader than those that would be subject to the de minimis

figure. Accordingly, it appears that notional amount of the overall

domestic market for swaps that actually would be relevant to

determining the notional standard, and thus the appropriate basis for

the 0.001 percent calculation, may be significantly lower than $331

trillion.

---------------------------------------------------------------------------

\451\ See OCC Quarterly Report at Graph 1.

\452\ See OCC Quarterly Report at Graph 3.

---------------------------------------------------------------------------

Because there is merit in the 0.001 percent ratio suggested by

several commenters, we believe an appropriate balance of the goal of

promoting the benefits of regulation (while recognizing the

unquantifiable nature of those benefits) against the competing goal of

avoiding the imposition of burdens on those entities for which

regulation as a dealer would not be associated with achieving those

benefits in a significant way, would be reached by setting the notional

standard for swaps at a level that is near (taking into account the

uncertainties noted above) 0.001 percent of a reasonable estimate of

the overall domestic market for all swaps between all counterparties.

We believe a $3 billion notional value standard is appropriate taking

all these considerations into account.

b. Dealing Activity Involving Special Entities

For swaps in which the counterparty is a special entity, the final

rules set a notional standard consistent with the proposal of $25

million over the prior 12 months.\453\ The Commissions believe that

this notional standard is appropriate in light of the special

protections that Title VII affords to special entities. In adopting

this threshold, we recognize the serious concerns raised by commenters

stating that the de minimis exception should not permit any dealing

activities (by persons who are not registered as swap dealers)

involving special entities, in light of losses that special entities

have incurred in the financial markets.\454\ However, the final rule

does not fully exclude such dealing activity from the exception, in

light of the potential benefits that may arise from a de minimis

exception. In this way, the threshold would not completely foreclose

the availability of swaps to special entities from unregistered

dealers, but the threshold would limit the financial and other risks

associated with those positions for a special entity, which would in

turn limit the possibility of inappropriately undermining the special

protections that Title VII provides to special entities.

---------------------------------------------------------------------------

\453\ CFTC Regulation Sec. 1.3(ggg)(4)(i).

\454\ See letters from AFR and Better Markets I.

---------------------------------------------------------------------------

c. Phase-in Procedure

The Commissions believe that a phase-in period for the de minimis

threshold would facilitate the orderly implementation of Title VII by

permitting market participants and the Commissions to familiarize

themselves with the application of the swap dealer definition and swap

dealer requirements and to consider the information that will be

available about the swap market, including real-time public reporting

of swap data and information reported to swap data repositories. In

addition, a phase-in period would afford the Commissions additional

time to study the swap markets as they evolve in the new regulatory

framework and allow potential swap dealers that engage in smaller

amounts of activity (relative to the current size of the market)

additional time to adjust their business practices, while at the same

time preserving a focus on the regulation of the largest and most

significant swap dealers. The Commissions also recognize that the data

informing their current view of the de minimis threshold is based on

the markets as they exist today, and that the markets will evolve over

the coming years in light of the new regulatory framework and other

developments.

We have also considered that there may be some uncertainty

regarding the exact level of swap dealing activity, measured in terms

of a gross notional amount of swaps, that should be regarded as de

minimis. While some quantitative data regarding the usage of swaps is

available, there are many aspects of the swap markets for which

definitive data is not available. We have also considered comments

suggesting that the de minimis thresholds should be set higher

initially to provide for efficient use of regulatory resources,\455\ or

that implementation of the dealer requirements should be phased.\456\

For

[[Page 30634]]

all these reasons, the Commissions believe it is appropriate that the

final rules provide for a phase-in period following the effective date

during which higher de minimis thresholds would apply.

---------------------------------------------------------------------------

\455\ See letters cited in footnote 402, supra.

\456\ See, e.g., Roundtable Transcript at 35 (remarks of Ron

Filler, New York Law School) and letters from FSR dated May 12, 2011

(``FSR III'') and WGCEF V.

---------------------------------------------------------------------------

In particular, during this phase-in period, a person's swap dealing

activity over the prior 12 months is capped at a gross notional value

of $8 billion.\457\ With respect to swaps with special entities, the

Commissions believe it is appropriate that the $25 million gross

notional value threshold apply during the phase-in period.\458\ In

light of the available data--and the limitations of that data in

predicting how the full implementation of Title VII will affect dealing

activity in the swap markets--the Commissions believe that the

appropriate threshold for the phase-in period is an annual gross

notional level of swap dealing activity of $8 billion or less. In

particular, the $8 billion level should still lead to the regulation of

persons responsible for the vast majority of dealing activity within

the swap markets.

---------------------------------------------------------------------------

\457\ See CFTC Regulation Sec. 1.3(ggg)(4)(i).

\458\ This limitation regarding swaps with special entities

during the phase-in period is consistent with the Dodd-Frank Act's

goal of helping special entities be in a position to benefit from

the counterparty protections associated with the regulation of

registered swap dealers under Title VII.

---------------------------------------------------------------------------

Accordingly, the Commissions believe that while a $3 billion

notional threshold reflects an appropriate long-term standard based on

the available data,\459\ it also is appropriate to allow a degree of

latitude in applying the threshold over time in the event that

subsequent developments in the markets or the evaluation of new data

from swap data reporting facilities suggest that the thresholds should

be adjusted. In particular, the implementation of swap data reporting

under the Dodd-Frank Act may result in new data that would be useful in

confirming the Commissions' determination to establish the $3 billion

threshold which applies after the phase-in period.

---------------------------------------------------------------------------

\459\ See, e.g., part II.D.4.a, supra.

---------------------------------------------------------------------------

For these reasons, review of the de minimis exception will comprise

an important part of the reports that the CFTC is directing its staff

to conduct with regard to the swap dealer definition during the phase-

in period. Among other topics, the report should consider market data

addressing swap dealing activity over a period of approximately two

years, and any resulting changes in swap dealing activity, by dealers

above and below the $8 billion phase-in threshold, and above and below

the $3 billion level applicable after the phase-in period. The report

is required to be completed by the CFTC staff no later than 30 months

following the date that a swap data repository first receives swap data

under the CFTC's regulations, and the report will be published for

public comment.\460\ The CFTC will take this report, in conjunction

with any public comment on it, into account in weighing further action

on the de minimis exception at the end of the phase-in period.

---------------------------------------------------------------------------

\460\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(C).

---------------------------------------------------------------------------

The final rules provide that nine months after publication of its

staff report, the CFTC may, in its discretion, either promulgate an

order that the phase-in period will end as of the date set forth by the

CFTC in that order, or issue for public comment a notice of proposed

rulemaking to modify the de minimis threshold, in which case the CFTC

would also issue an order establishing the date that the phase-in

period will end.\461\ The period of nine months provided in the rule is

intended to provide the CFTC an opportunity to consider its staff

report, public comments on the staff report and any other relevant

information.

---------------------------------------------------------------------------

\461\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(C).

---------------------------------------------------------------------------

The CFTC recognizes that the determination of the appropriate de

minimis threshold is a significant issue requiring thorough

consideration of a variety of regulatory and market factors. At the

same time, the CFTC recognizes the need for predictability in how the

de minimis exception will apply. Therefore, the final rules include a

finality provision, stating that the phase-in period will end no later

than five years after the date that a swap data repository first

receives swap data under the CFTC's regulations.\462\

---------------------------------------------------------------------------

\462\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(D).

---------------------------------------------------------------------------

Persons who are able to avail themselves of the higher de minimis

threshold that applies during the phase-in period will not be required

to do so. In particular, a person that is engaged in dealing activity

involving swaps in excess of the $3 billion threshold may choose to

commence the process for registering as a swap dealer during the phase-

in period.\463\

---------------------------------------------------------------------------

\463\ See CFTC Regulation Sec. 1.3(ggg)(4)(vi).

---------------------------------------------------------------------------

d. CFTC Staff Report

As noted above, the CFTC is directing its staff to report to the

CFTC as to whether changes are warranted to the rules implementing the

swap dealer definition, including the rule implementing the de minimis

exception. We are mindful that following the full implementation of

Title VII--which itself is contingent on the implementation of the

dealer definition--more data will be available to the CFTC via swap

data repositories. We expect that this additional data will assist the

CFTC in testing the assumptions and addressing the effects of the final

rule we are adopting to implement the de minimis exception. For

example, this data should help the CFTC assess, among other things, the

nature and amount of unregulated dealing activity that occurs under the

$3 billion threshold. The CFTC will make this report available for

public comment so that it may benefit from additional input and

analysis regarding the swap dealer definition.

By making use of post-implementation data, the staff report

(together with public comment on the report) will help the CFTC better

evaluate the exception in light of potential market changes resulting

from the full implementation of Title VII--including market changes

resulting from the de minimis exception itself--as part of determining

whether revised de minimis thresholds would be appropriate. The report

and public comment thereon will also be taken into consideration by the

CFTC in determining what action, if any, to take with respect to the

phase-in period associated with the de minimis exception.

The final rules provide, moreover, that the CFTC may change the

requirements of the de minimis exception by rule or regulation.\464\

Through this mechanism, the CFTC may revisit the rule implementing the

exception and potentially change that rule, for example, if data

regarding the post-implementation swap market suggests that different

de minimis thresholds would be appropriate.\465\ In determining whether

to revisit the thresholds, the CFTC intends to pay particular attention

to whether the de minimis exception results in a swap dealer definition

that encompasses too many entities whose activities are not

[[Page 30635]]

significant enough to warrant full regulation under Title VII, or,

alternatively, whether the de minimis exception leads an undue amount

of dealing activity to fall outside of the ambit of the Title VII

regulatory framework, or leads to inappropriate reductions in

counterparty protections (including protections for special entities).

The CFTC also intends to pay particular attention to whether

alternative approaches would more effectively promote the regulatory

goals that may be associated with a de minimis exception.

---------------------------------------------------------------------------

\464\ CFTC Regulation Sec. 1.3(ggg)(4)(v). CEA section

1a(49)(D) (like Exchange Act section 3(a)(71)(D)) particularly

states that the ``Commission''--meaning the CFTC--may exempt de

minimis dealers and promulgate related regulations. We do not

interpret the joint rulemaking provisions of section 712(d) of the

Dodd-Frank Act to require joint rulemaking here, because such an

interpretation would read the term ``Commission'' out of CEA section

1a(49)(D) (and Exchange Act section 3(a)(71)(D)), which themselves

were added by the Dodd-Frank Act.

\465\ See letter from Greenberger (stating that the dynamic

nature of the derivatives sector of the financial markets should

counsel caution, and that the de minimis threshold should be

reevaluated on an ongoing basis).

---------------------------------------------------------------------------

5. Final Rules--De Minimis Exception to ``Security-Based Swap Dealer''

Definition

a. Overview of the Final Rule

The final rule implementing the de minimis exception to the

``security-based swap dealer'' definition has been revised from the

proposal in a number of ways. As discussed above, the final rule does

not incorporate proposed limits on the number of security-based swaps

that a person may enter into in a dealing capacity, or on the number of

security-based swap counterparties a person may have when acting in a

dealing capacity.\466\ Moreover, the provisions of the exception that

cap an unregistered person's annual notional dealing activity with

counterparties other than ``special entities'' have been increased from

the proposed $100 million threshold.\467\ Instead, the final rule caps

such dealing activity involving security-based swaps that are credit

default swaps--which largely would consist of single-name credit

default swaps--at $3 billion in notional amount over the prior 12

months.\468\ For other types of security-based swaps (e.g., single-name

or narrow-based equity swaps or total return swaps), the exception caps

an unregistered person's dealing activity at $150 million in notional

amount over the prior 12 months.\469\ Also, as addressed below, the

final rule provides for phase-in levels in excess of those $3 billion

and $150 million thresholds for a certain period of time.

---------------------------------------------------------------------------

\466\ See part II.D.3.b, supra.

\467\ For clarity, the final rule also has been revised from the

proposal to provide that persons taking advantage of the exception

``shall be deemed not to be'' dealers (the proposed rule used the

phrasing ``shall not be deemed to be'' dealers), and to provide that

such persons ``shall not be subject to Section 15F of the Exchange

Act and the rules, regulations and interpretations issued

thereunder.'' See Exchange Act rule 3a71-2(a). The final rule also

reflects certain structural changes consistent with the substantive

changes from the proposed rule.

In addition, as discussed above, see part II.D.3.d, supra, the

final rule has been revised to provide that the notional thresholds

to the de minimis exception encompass swap and security-based swap

dealing positions entered into by an affiliate controlling,

controlled by or under common control with the person at issue.

\468\ Exchange Act rule 3a71-2(a)(1)(i). The final rule, like

the proposal, requires the analysis of de minimis levels to be based

on effective notional amounts to the extent that the stated notional

amount is leveraged or enhanced by the structure of the security-

based swap (such as, for example, if the exchange of payments

associated with an equity swap was based on a multiple of the return

associated with the underlying equity). See Exchange Act rule 3a71-

2(a)(3).

It is important to recognize that while these types of de

minimis principles are relevant to the ``security-based swap

dealer'' definition, they are not applicable to the general

definitions of ``broker'' and ``dealer'' under the Exchange Act, or

the broker-dealer registration requirements of Exchange Act section

15(a). Unlike the ``security-based swap dealer'' definition, those

other definitions, with the exception of the bank-broker definition

in section 3(a)(4)(B)(xi) of the Exchange Act, lack de minimis

exceptions.

\469\ Exchange Act rule 3a71-2(a)(1)(ii).

---------------------------------------------------------------------------

In addition, consistent with the proposal, the final rule caps an

unregistered person's security-based swap dealing activity involving

counterparties that are ``special entities'' at $25 million in notional

amount over the prior 12 months.\470\ The final rule further provides

that the SEC may establish alternative methods of determining the scope

of the de minimis exception by rule or regulation.\471\

---------------------------------------------------------------------------

\470\ Exchange Act rule 3a71-2(a)(1)(iii).

\471\ Exchange Act rule 3a71-2(d); see part II.D.5.f, infra.

---------------------------------------------------------------------------

b. Interests Associated With a De Minimis Exception

In developing this final rule, we have sought to balance the

interests advanced by the de minimis exception against the protections

that would be weakened were the exception applied in an overbroad

manner. In making this evaluation, we have taken into account data

regarding the security-based swap market and especially data regarding

the activity--including activity that may be suggestive of dealing

behavior--of participants in the single-name credit default swap

market.\472\

---------------------------------------------------------------------------

\472\ Certain data has been addressed by an analysis regarding

the market for single-name credit default swaps performed by the

SEC's Division of Risk, Strategy, and Financial Innovation. See

``Information regarding activities and positions of participants in

the single-name credit default swap market'' (Mar. 15, 2012)

(available at http://www.sec.gov/comments/s7-39-10/s73910-154.pdf)

(``CDS Data Analysis''). We believe that the data underlying this

analysis provides reasonably comprehensive information regarding the

credit default swap activities and positions of U.S. market

participants, but note that the data does not encompass those credit

default swaps that both: (i) do not involve U.S. counterparties; and

(ii) are based on non-U.S. reference entities. Our reliance on this

data, which we believe to be the best available, should not be

interpreted to indicate our views as to the nature or extent of the

application of Title VII to non-U.S. persons; instead, the SEC

anticipates that issues regarding the extraterritorial application

of Title VII will be addressed in a separate release.

As discussed below, see notes 476 and 485, infra, we also have

considered more limited publicly available data regarding equity

swaps.

The CDS Data Analysis also included an appendix of data

regarding index credit default swaps. We do not consider that data

for purposes of the analysis described in this section because the

statutory definition of ``security-based swap'' in relevant part

encompasses swaps based on single securities or on narrow-based

security indices. See Exchange Act sec. 3(a)(68)(A); see also

Exchange Act Release No. 64372, 76 FR 29818 (May 23, 2011) (proposed

rules further defining ``security-based swap'' and certain other

terms).

---------------------------------------------------------------------------

As discussed above, a de minimis exception eliminates key Title VII

protections for some market participants by regulating less dealer

activity. Conversely, an appropriately applied de minimis exception may

provide an objective test when there is doubt as to whether particular

activities may cause a person to be deemed to be a dealer; \473\ allow

non-dealers to accommodate the incidental security-based swap needs of

existing clients; and help to facilitate competition by allowing the

entry of new dealers into the market. In addition, as discussed above,

a de minimis exception may promote regulatory efficiency by providing a

framework to help focus dealer regulation upon those entities for which

such regulation is warranted, rather than upon entities that engage in

relatively limited amounts of dealing activity.\474\

---------------------------------------------------------------------------

\473\ We believe that the application of the dealer-trader

distinction and the guidance we have provided that distinguishes

hedging activities from dealing activities in the security-based

swap market will also help dealers meet their obligations.

\474\ See part II.D.3.a, supra.

---------------------------------------------------------------------------

i. Providing for Regulatory Coverage of the Vast Majority of Dealing

Activity

In seeking to develop a de minimis exception that preserves key

counterparty and market protections while promoting regulatory

efficiency, we have considered the comparative amount of security-based

swap dealing activity that could fall outside the ambit of dealer

regulation as a result of the exception. In doing so we have considered

not only the security-based swap market as it currently exists, but

also how the market reasonably may be expected to change after the full

implementation of Title VII.

In performing this comparative exercise we are, in part, drawing

inferences from the CDS Data Analysis, a dataset released by the SEC

staff that characterizes nearly all transactions in single-name credit

default swaps during the 2011 calendar year.\475\ Though the final

rules apply to all security-based swaps, not just single-name credit

[[Page 30636]]

default swaps, the SEC believes that these data are sufficiently

representative of the market to help inform the analysis because an

estimated 95 percent of all security-based swap transactions appear

likely to be single-name credit default swaps.\476\ The SEC also

recognizes that although the de minimis exception is applicable to

persons only with respect to their dealing activity, the CDS Data

Analysis contains transactions reflecting both dealing activity and

non-dealing activity, including transactions by persons who may engage

in no dealing activity whatsoever.\477\

---------------------------------------------------------------------------

\475\ See note 472, supra.

\476\ While recognizing that the Commissions have yet to adopt

final rules defining a ``security-based swap,'' we believe that

single-name credit default swaps will constitute roughly 95 percent

of the market, as measured on a notional basis, for instruments that

will fall within that definition, with certain equity swaps (in

other words, total return swaps based on single equities or narrow-

based indices of equities) constituting the primary example of

security-based swaps that are not credit default swaps.

In particular, according to data published by BIS, the global

notional amount outstanding in equity forwards and swaps as of June

2011 was $2.03 trillion, and the notional amount outstanding in

credit default swaps was approximately $32.4 trillion. See

Statistical Annex, BIS Quarterly Review (December 2011), at A10

(available at http://www.bis.org/publ/qtrpdf/r_qs1112.pdf).

Although the BIS data reflects the global OTC derivatives market,

and not just U.S. market, we have no reason to believe that these

ratios differ significantly in the U.S. market. In fact, OCC data

regarding U.S. entities generally confirms these ratios, in that as

of June 30, 2011, U.S. commercial banks and trust companies held

$15.23 trillion in notional outstanding credit derivative positions

and $677 billion in equity derivative positions, meaning that credit

derivatives accounted for approximately 95 percent of the total

credit and equity derivative positions held by these entities. See

OCC Quarterly Report at tables 1 and 10. Cf. letter from Greenberger

(referencing OCC data as relevant to determining size of swap

market).

\477\ A person that is engaged in security-based swap dealing

activity, for example, may also engage in proprietary trading

involving security-based swaps that would be reflected in the

transaction data. Even accounting for such possibilities, however,

the SEC believes that the data nonetheless support the broad

conclusion described below that dealing activity within the

security-based swap market is highly concentrated.

---------------------------------------------------------------------------

As described more fully in the CDS Data Analysis, to ascertain

which entities might be transacting as dealers, and which may not be,

various criteria were employed as indicia of possible dealing activity.

In each case, the results suggest the great extent to which there is

currently a high degree of concentration of potential dealing activity

in the single-name credit default swap market. For example, using the

criterion that dealers are likely to transact with many counterparties

who themselves are not dealers, analysis of 2011 transaction data show

that only 28 out of 1,084 market participants have three or more

counterparties that themselves are not recognized as dealers by

ISDA.\478\ As the data show, 15 of these 28 potential dealers exceeded

a threshold of $100 billion notional transacted in single-name credit

swaps during 2011, which accounts for over 98 percent of the 28

entities' total activity.\479\ At a lower threshold of $10 billion

notional, 21 of the 28 potential dealers are included (representing

99.7 percent of the activity of potential dealers), and at an even

lower threshold of $3 billion notional, 25 potential dealers are

included (representing 99.9 percent).\480\

---------------------------------------------------------------------------

\478\ See CDS Data Analysis at table 3c. The SEC recognizes that

the analysis of this transaction data is imperfect as a tool for

identifying dealing activity, given that the presence or absence of

dealing activity ultimately turns upon the relevant facts and

circumstances of an entity's security-based swap transactions, as

informed by the dealer-trader distinction. Criteria based on the

number of an entity's counterparties that are not recognized as

dealers nonetheless appear to be useful for identifying apparent

dealing activity in the absence of full analysis of the relevant

facts and circumstances, given that engaging in security-based swap

transactions with non-dealers would be consistent with the conduct

of seeking to profit by providing liquidity to others, as

anticipated by the dealer-trader distinction. In emphasizing this

criterion for identifying dealing activity, we are not seeking to

predict with precision how many entities ultimately may register as

security-based swap dealers. The ultimate number of dealers that may

register can also be expected to reflect growth in the market, new

dealing entrants, and in some cases the registration of multiple

dealing entities within an affiliated group.

\479\ See CDS Data Analysis at table 3c. In particular, those 15

entities engaged in a total of $11.01 trillion in notional single-

name credit default swap transactions over 2011, which reflects 98.5

percent of the total $11.18 trillion in notional transactions over

2011 for the 28 total identified possible dealers.

\480\ See id. The 21 possible dealers with a 2011 notional in

excess of $10 billion account for a total of $11.15 trillion in

notional single-name credit default swap transactions in 2011, or

over 99.7 percent of the total. The 25 possible dealers in excess of

$3 billion account for almost $11.18 in notional transactions in

2011, or over 99.9 percent of the total.

---------------------------------------------------------------------------

Other criteria for identifying possible dealing activity based on

the number of an entity's non-dealer counterparties similarly suggest a

high degree of concentration of dealing activity within the current

security-based swap market.\481\ Criteria that consider the number of

an entity's total single-name security-based swap counterparties,\482\

criteria that consider alternative factors for identifying dealing

activity,\483\ and certain combined criteria \484\ further

[[Page 30637]]

suggest a high concentration of dealing activity within the security-

based swap market.

---------------------------------------------------------------------------

\481\ For example, two other criteria consider the number of an

entity's non-dealer counterparties (in those cases identifying as

dealers those persons that have seven or more, or five or more,

counterparties not recognized as dealers by ISDA) also indicate that

potential dealers with notional amounts in excess of $100 billion in

2011 account for over 98 percent of the notional transactions of all

entities meeting the applicable criteria in 2011. Potential dealers

with notional transactions above $10 billion in 2011 (let alone

those with notional transactions above $3 billion) reflect all or

virtually the entire notional amount of all dealers identified by

those criteria. See id. at tables 3a and 3b.

\482\ The CDS Data Analysis also sought to identify dealing

activity based on the total number of an entity's counterparties.

See id. at tables 2a through 2c. Those criteria similarly suggest a

high degree of concentration of dealing activity within the single-

name credit default swap market:

i. A criterion that identifies potential dealing activity based

on an entity having twenty or more counterparties in single-name

security-based swaps identified 16 possible dealers. Fourteen of

those entities had notional transactions in excess of $100 billion

in 2011, reflecting over 99 percent of the total associated with all

16. The remaining two identified entities had notional transactions

in excess of $10 billion in 2011. See id. at table 2a.

ii. A criterion that identifies potential dealing activity based

on an entity having 15 or more counterparties in single-name

security-based swaps identified 33 possible dealers. Fifteen of

those entities had notional transactions in excess of $100 billion

in 2011, reflecting over 97 percent of the total associated with all

33. A total of 27 of those entities had notional transactions in

excess of $10 billion in 2011, and a total of 32 of those entities

had notional transactions in excess of $3 billion in 2011, both

reflecting over 99 percent of the total. See id. at table 2b.

iii. A criterion that identifies potential dealing activity

based on an entity having 10 or more counterparties in single-name

security-based swaps identified 154 possible dealers. Fifteen of

those exceeded $100 billion in notional transactions in 2011,

reflecting over 90 percent of the total; 49 of those exceeded $10

billion in notional transactions in 2011, reflecting over 97 percent

of the total; and 93 exceeded $3 billion in notional transactions in

2011, reflecting over 99 percent of the total. See id. at table 2c.

In considering the data we are weighing these criteria less

heavily than we are weighing the criteria based on the number of

counterparties who are not identified by ISDA as dealers. This is

because it is reasonable to foresee a non-dealer making use of

multiple dealers to get the best possible price or to make use of

special expertise possessed by certain dealers, meaning that the

criteria discussed in this footnote are more likely to identify

entities not engaged in dealing activity.

\483\ Other criteria in the CDS Data Analysis sought to identify

dealing activity based on whether an entity maintains a relatively

flat book. Those criteria also indicated that entities with notional

transactions in excess of $100 billion in 2011 represented over 97

percent of the total for all entities identified by those criteria,

while entities with notional transactions in excess of $10 billion

in 2011 represented over 99 of the total for all entities identified

by those criteria. See id. at tables 4 and 5. We are weighing those

criteria less heavily than we are weighing the counterparty-based

criteria discussed above because an entity that engages in

directional trades could also appear to have a flat book if its

portfolio contained transactions representing various directional

bets, but of similar aggregate notional sizes on both sides of the

market. See id. at 3.

The analysis also included one criterion that considers

potential dealing activity based on a low propensity to post margin.

See id. at table 6. While we do not believe that this analysis

deserves the same degree of weight as the others, given concerns

about the completeness of the data (see id. at 4), we note that this

criterion nonetheless also indicates a high concentration of dealing

activity in the market. See id. at table 6 (indicating that of the

473 entities identified by this criterion, the 14 entities with

notional transactions in excess of $100 billion in 2011 account for

roughly 94 percent of the total notional transaction activity

associated with all 473 entities over 2011).

\484\ Finally, the CDS Data Analysis also included criteria that

identified potential dealing activity based on an entity meeting two

or three of the other criteria considered. See id. at tables 7 and

8. These criteria again indicate a high degree of concentration of

dealing activity in the market. The analysis that addressed whether

an entity met two of the other criteria identified 92 possible

dealers, with the 15 entities having notional transactions in excess

of $100 billion in 2011 representing over 96 percent of the total

activity of those 92 entities in 2011. See id. at table 7. The

analysis that addressed whether an entity met three of the other

criteria identified 41 possible dealers, with the 15 entities having

notional transactions in excess of $100 billion in 2011,

representing over 98 percent of the total activity of those 41

entities in 2011. See id. at table 8.

---------------------------------------------------------------------------

While less data are available in connection with other types of

instruments constituting security-based swaps, such as equity swaps,

the available data similarly suggest a high concentration of positions

in those instruments among potential dealers.\485\

---------------------------------------------------------------------------

\485\ For example, OCC data shows that, of the five largest bank

or trust companies, four have notional equity derivative positions

of above $1 billion, and that those four entities account for $630

billion in notional positions out of $677 billion for all U.S.

commercial banks or trust companies, which constitutes approximately

93 percent of the total. See OCC Quarterly Report at table 10.

Similarly, a review of the equity swaps positions of the 50 largest

U.S. bank holding companies shows that nine bank holding companies

have notional equity swap positions exceeding $1 billion, and

account for 99.5 percent of the total positions held by such

companies, and 29 have no positions in equity swaps. (Data was

compiled from each bank holding company's FR 9-YC, available at

http://www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx). Cf. letter

from WGCEF V (referencing swap position data from bank holding

companies' Forms FR Y-9C as relevant to determining size of the swap

market).

---------------------------------------------------------------------------

Though inspection of the data does not seem to suggest a single

precise de minimis threshold, the above analysis of potential dealing

activity is useful in that it reveals a range of possible thresholds

from $100 billion to $3 billion that would cover anywhere from 98

percent through 99.9 percent of the total activity of all potential

dealers in 2011. However, these thresholds--and their implied market

coverage ratios--only reflect levels of activity that exist in today's

highly concentrated market. In order to further narrow the range of

possible thresholds, and to select an appropriate level for the de

minimis exception, the analysis must consider the potential state of

the market as it might reasonably exist after the implementation of

Title VII.

ii. Avoiding Gaps Resulting From the Regulatory Changes in Conjunction

With the Exception

Although the overall portion of security-based swap activity that

would appear to be subject to dealer regulation based on current

measures of dealing concentration in the market constitutes an

important factor to consider in balancing the regulatory burdens and

benefits associated with a de minimis exception, analysis of the

current market should not serve as the sole mechanism for setting the

exception.

In particular, sole reliance on an approach that focuses on current

measures of market concentration would not adequately account for

likely changes to the market associated with the implementation of

regulation. In part, these changes may be a direct result of the full

implementation of Title VII--including enhancements to transparency and

increases in central clearing--as those changes reasonably may be

expected to reduce the concentration of dealing activity within the

market over time.\486\ Also, to the extent implementation of Title VII

permits new dealers to enter the market, the availability of a de

minimis exception would mean those new dealing entrants would fall

outside the ambit of dealer regulation, either for the long term or

until their dealing activity surpasses the applicable notional

threshold.\487\ Accordingly, de minimis thresholds that are based

solely on the current state of the market, including the current

concentration of dealing activity within the market, may reasonably be

expected to fail to account for the amount of dealing activity that in

the future could fall outside of the ambit of dealer regulation due to

the exception.\488\

---------------------------------------------------------------------------

\486\ Cf. Bessembinder and Maxwell, ``Transparency and the

Corporate Bond Market,'' Journal of Economic Perspectives, Spring

2008, at 217, 226 (noting that after reporting of U.S. OTC bond

transactions through the Trade Reporting and Compliance Engine

(``TRACE'') became mandatory, the portion of trades completed by the

12 largest dealers fell from 56 percent to 44 percent).

\487\ We understand that large dealers have competitive

advantages under the current market, in light of the desire of

counterparties to engage in security-based swap transactions with

large, well capitalized and highly rated dealers. See, e.g., Craig

Pirrong, Rocket Science, Default Risk and The Organization of

Derivatives Markets, Working Paper, University of Houston (2006)

(available at http://www.cba.uh.edu/spirrong/Derivorg1.pdf). The

lower business costs associated with being unregulated may prove to

partially offset that advantage. At the same time, we reasonably may

expect that informed counterparties will take into account the lower

protections--and higher risks--associated with transactions with

unregulated dealers in determining whether to use regulated or

unregulated dealers as counterparties.

\488\ We note that there also are benefits to increased

competition and a decrease in concentration of dealer activity, as

contemplated by Title VII, including potentially lower costs for

market participants and a decrease in systemic risk.

---------------------------------------------------------------------------

For example, as discussed above, when possible dealers in single-

name credit default swaps are identified by an entity having three or

more counterparties that are not recognized by ISDA as being dealers,

entities with notional transactions in excess of $100 billion over a 12

month period represent over 98 percent of the total activity of all

such possible dealers over that period, leaving two percent of possible

dealing activity below that level.\489\ However, a de minimis threshold

of $100 billion would allow new entrants to commence engaging in

unregulated dealing in competition with persons who are regulated as

dealers pursuant to Title VII, which, depending on the number and size

of such entrants, could significantly decrease the portion of dealing

activity in the market done by registered dealers (at least until the

point that new entrants cross the de minimis threshold, if they do at

all). For example, if 15 new entrants \490\ were to engage in security-

based swap dealing activity up to a $100 billion threshold, the result

could be that nearly 15 percent of dealing activity within the single-

name credit default swap market would be left outside of the ambit of

dealer regulation.\491\

---------------------------------------------------------------------------

\489\ See CDS Data Analysis at table 3c; see also note 479,

supra. As noted above, these amounts may not only reflect dealing

activity by an entity. Thus, even putting aside the possibility of

new unregulated entrants into the market, the portion of dealing

activity in the market that is represented by entities whose

trailing notional dealing activity exceeds $100 billion may in fact

be less than 98 percent.

\490\ The illustrative use of new entrants for purposes of this

discussion is intended to reflect the potential that new entrants to

the market could take advantage of a de minimis threshold in a way

that leads to a higher level of unregulated dealing activity within

the market. In using this illustration we are not seeking to

explicitly predict how many new entrants may come into the market in

response to any particular de minimis threshold, nor are we seeking

to predict how many new entrants may seek to stay under the de

minimis thresholds and how many instead would seek to use the

exception as a step on the way to eventually registering as a

security-based swap dealer. Rather, we simply are illustrating why

it is important to account for market changes in connection with

setting the de minimis threshold.

The OTC Derivatives Supervisors Group--a group chaired by the

Federal Reserve Bank of New York and consisting of the CFTC and SEC

as well as other international supervisors and major over-the-

counter derivatives market participants--currently recognizes 15

major OTC derivatives dealers. Accordingly, as an illustrative

example, we have assumed that this number of significant security-

based swap dealers would approximately double--i.e., include 15 new

dealers--in the wake of the various regulatory changes contemplated

by the Dodd-Frank Act, many of which may result in increased access

and competition in the security-based swap market (e.g., enhanced

priced transparency and increased access to central clearing).

However, we emphasize that this number has been selected as an

illustrative example, and have accordingly provided similar examples

assuming ten and five new entrants.

\491\ Fifteen new entities that each engage in $100 billion in

dealing activity would reflect $1.5 trillion in additional dealing

activity outside the ambit of dealer regulation, which could lead to

roughly 14.9 percent of total dealing activity being outside the

ambit of dealing regulation (with that $1.5 trillion being added to

the existing $168 billion reflected by entities that fall below the

$100 billion threshold, and that sum divided by $11.18 trillion,

under the assumption that the new entrants displace business from

the fifteen entities above the de minimis threshold). To further

illustrate, under the same assumptions and analysis, the implied

unregulated market share would be roughly 10.4 percent for ten new

entities and 6.0 percent for five new entities.

In certain regards these illustrations, on the one hand, may

overestimate the effect of new entrants because of the assumption

that such entrants engage in dealing activities up to, but not

surpassing, the de minimis threshold. While it is not impossible

that some entities may seek to use the de minimis exception to

conduct business as an unregulated niche dealer, it also is

plausible that entities generally may seek to use the exception to

commence engaging in dealing activity, with the goal of ultimately

becoming registered dealers that are not constrained by the de

minimis threshold.

On the other hand, these illustrations in certain respects may

underestimate the amount of dealing activity that can fall outside

of the regulatory ambit. For example, the amounts of security-based

swap activity of persons identified in the analysis as dealers may

not exclusively constitute dealing activity, meaning that persons

whose notional transactions over a 12-month period exceed a

particular threshold in fact may not be engaged in that amount of

dealing activity, and hence may still be able to take advantage of

the de minimis exception. Also, these illustrations do not seek to

reflect increased activity by existing dealers that already fall

below the assumed threshold.

---------------------------------------------------------------------------

[[Page 30638]]

Similarly, a de minimis threshold of $25 billion may also lead to a

material reduction in the portion of the market covered by registered

dealers. For example, using the same assumptions as above, 15 new

entrants up to a $25 billion threshold could leave over four percent of

dealing activity in the market outside of the ambit of dealing

regulation.\492\ When other metrics are used to identify possible

dealing activity, the possibility of a significant regulatory gap

remains.\493\

---------------------------------------------------------------------------

\492\ Fifteen new entities each engaged in $25 billion in

dealing activity would reflect $375 billion in additional dealing

activity outside the ambit of dealer regulation, which could lead to

4.1 percent of total dealing activity being outside the ambit of

dealing regulation (with that $375 billion being added to the

existing $80.2 billion reflected by entities that fall below the $25

billion threshold, and that sum divided by $11.18 trillion, under

the assumption that the new entrants displace business from the

seventeen entities above the de minimis threshold). To further

illustrate, under the same assumptions and analysis, the implied

unregulated market share would be 3.0 percent for 10 new entities

and 1.8 percent for 5 new entities. Obviously, these illustrations

are subject to the same limitations as are discussed above in the

context of the $100 million threshold illustration.

\493\ For example, similar results are obtained when possible

dealing activity is identified based on whether an entity passes at

least three of the other metrics discussed above. See CDS Data

Analysis at table 8. Using the same types of assumptions as are

discussed above, with fifteen new entities, a de minimis threshold

of $100 billion could lead to 15.0 percent of dealing activity

falling outside the ambit of dealer regulation, while a de minimis

threshold of $25 billion could lead to 4.2 percent of dealing

activity falling outside of regulation.

---------------------------------------------------------------------------

Overall, it is reasonable to conclude that the higher the de

minimis threshold, the greater the likelihood that the exception,

combined with other changes resulting from the implementation of Title

VII that may encourage new entrants, will lead to a proportionately

larger amount of unregulated (except with respect to antifraud and

anti-manipulation prohibitions) dealing activity.\494\ We believe that

it is reasonable to interpret the statutory language of the de minimis

exception in a way that prevents a proportionately large amount of

dealing activity within the security-based swap market from falling

outside the ambit of dealer regulation. Accordingly, choosing to set a

lower de minimis threshold from among the range of potential thresholds

would limit the amount of potential future dealing activity that could

be transacted without being subject to dealer rules and

regulations.\495\

---------------------------------------------------------------------------

\494\ As noted above, encouraging new entrants also has benefits

flowing from increased competition and a decrease in concentration

of dealer activity. See note 488, supra.

\495\ For example, 15 new dealer entrants engaged in up to $3

billion in dealing activity would account for up to $45 billion in

dealing activity. This result would mean approximately 0.4 percent

of total potential future dealing activity could be transacted by

unregistered dealers, as opposed to the potential for approximately

15 percent of potential future dealing activity to be transacted by

unregistered dealers if the de minimis were set to $100 billion. See

CDS Data Analysis at table 3c. As with the illustrative examples

above, these calculations assume that the new entrants displace

business from the entities above the de minimis threshold.

---------------------------------------------------------------------------

iii. Promoting Statutory Counterparty Protections

Sole reliance on an approach based on overall market coverage in

balancing regulatory burdens and benefits would also threaten to unduly

discount important counterparty protection interests, as discussed

above and highlighted in the proposal.\496\ For example, in light of

data indicating that $5 million constitutes a common notional size for

a single-name credit default swap position,\497\ a de minimis notional

threshold of $25 billion annually would permit an unregistered dealer

to engage in as many as 5000 trades of that size. The counterparties to

these unregistered dealers would not receive the benefit of the

protections that Title VII affords to the counterparties of registered

dealers. These include, among others, the segregation protections

afforded to persons who post margin to dealers in connection with over-

the-counter security-based swap transactions.\498\ Accordingly, this

consideration also suggests that choosing a de minimis threshold closer

to the lower end of the range of potential thresholds would better

preserve the counterparty protections contemplated by Title VII.

---------------------------------------------------------------------------

\496\ See part II.D.3.a, supra; see also Proposing Release at

80180 (highlighting ``customer protection issues raised by swaps and

security-based swaps--including risks that counterparties may not

fully appreciate when entering into swaps and security-based

swaps'').

\497\ See Federal Reserve Bank of New York staff report, ``An

Analysis of CDS Transactions: Implications for Public Reporting''

(2011) at 8 (stating that for dollar-denominated single name CDS on

corporate or sovereign reference entities, $5 million represented

the most common notional size) (available at http://www.newyorkfed.org/research/staff_reports/sr517.pdf); see also

Proposing Release at 80180 (noting ``that in general the notional

seize of a small swap or security-based swap is $5 million or

less'').

We note, by comparison, that Congress has determined that a de

minimis amount of securities broker activity by banks entails 500

trades annually. See Exchange Act section 3(a)(4)(B)(xi) (excluding

from the ``broker'' definition a bank that annually effects no more

than 500 securities transactions, other than transactions subject to

certain other exceptions, so long as the transaction is not effected

by a bank employee that also is a broker-dealer employee).

We further note that, while the number of counterparties or

transactions potentially implicated by unregistered dealing activity

is an important consideration in establishing an initial de minimis

level, it does not alter our view, described above, that a single de

minimis standard based on notional value--rather than the proposal's

framework of three distinct standards based on notional value,

number of counterparties, and number of transactions--is an

appropriate choice in light of concerns expressed by commenters that

a standard based on the number of transactions or counterparties can

produce arbitrary results. See part II.D.3.b.ii, supra.

\498\ Exchange Act section 3E, which was added by section 763(d)

of the Dodd-Frank Act, provides a series of requirements in

connection with the segregation of assets held as collateral in

security-based swap transactions. These include requirements that

security-based swap dealers and major security-based swap

participants provide their counterparties with notice that they have

the right to require segregation, and that such segregation must be

at an independent third-party custodian.

---------------------------------------------------------------------------

c. Balancing Reflected in the Final Rules--Credit Default Swaps That

Constitute Security-Based Swaps

The final thresholds that implement the de minimis exception (and

corresponding phase-in levels) address security-based swaps that are

credit default swaps separately from other types of security-based

swaps, in light of differences in the respective markets.

i. General Threshold for Credit Default Swaps That Constitute Security-

Based Swaps

We conclude that $3 billion over the prior 12 months constitutes an

appropriate notional threshold for applying the de minimis exception in

connection with dealing activity involving credit default swaps that

constitute security-based swaps.

[[Page 30639]]

In reaching this conclusion, we recognize the significance of

comments that supported the proposed $100 million threshold,\499\ and

that urged caution in raising that proposed threshold,\500\ as well as

commenters who supported increases to the threshold.\501\ We further

recognize the importance of applying the de minimis exception in a way

that promotes regulatory efficiency. We also recognize the range of

potential thresholds suggested by the data currently available. Based

on the competing factors described above, we believe that $3 billion

reflects a reasonable notional threshold--though not necessarily the

only such threshold.

---------------------------------------------------------------------------

\499\ See letters from Better Markets I and AFR.

\500\ See letter from Greenberger.

\501\ See, e.g., letter from COPE I.

---------------------------------------------------------------------------

In our view, the currently available data regarding the single-name

credit default swap market indicates that a notional threshold of $3

billion would be expected to result in the regulation, as dealers, of

persons responsible for the vast majority of dealing activity within

that market, both as of today and, as described above, in the future as

the benefits of the other Title VII rules are implemented and new

dealer entrants come to market.\502\

---------------------------------------------------------------------------

\502\ Of the 28 market participants that have three or more

security-based swap counterparties that themselves are not

recognized by dealers by ISDA, 25 had notional single-name credit

default swap positions in excess of $3 billion in 2011. The

remaining three entities in total accounted for only $3.59 billion

in notional transactions in 2011, reflecting less than 0.1 percent

of the $11.18 trillion total for those 28 market participants. See

CDS Data Analysis at table 3c.

The other criteria set forth in the analysis for identifying

possible dealing activity in general similarly indicate that

entities with notional transactions in excess of $3 billion in 2011

account for more than 99 percent of the total notional transactions

of all identified entities in 2011. See id. at tables 2a-c, 3a-b, 4,

5, 7 and 8. While the criterion based on the posting of initial

margin only indicates 98 percent coverage for all of the 473

identified entities, see id. at table 6, as discussed above we

believe it is appropriate to provide less weight to that criterion,

which is based on voluntary reporting.

As noted above, see note 478, supra, we recognize that the

underlying market data encompasses all of the security-based swap

activity of persons identified as dealers, not only their dealing

activity. Because the thresholds that implement the de minimis

exception address only a person's dealing activity, this raises the

possibility that the analysis overstates the extent to which a $3

billion threshold would encompass persons responsible for dealing

activity within the single-name security-based swap market. Even

with that possibility, however, we believe that the data indicates

such a high concentration of dealing activity within the market that

it is reasonable to conclude that a $3 billion threshold likely

would encompass persons responsible for the vast majority of dealing

activity within the market.

---------------------------------------------------------------------------

In providing for a $3 billion notional threshold, we also recognize

the threshold would permit an unregistered dealer annually to engage in

up to 600 security-based swaps (as opposed to 20 transactions under the

proposed threshold, assuming a $5 million average notional size). In

this regard, we note that Congress, in another statutory de minimis

exception within the Exchange Act, determined that 500 securities

transactions annually constituted a de minimis amount of transactions

for banks under the ``broker'' definition.\503\ We further believe that

a $3 billion threshold appropriately addresses commenter concerns

regarding the de minimis exception being unduly narrow.\504\

---------------------------------------------------------------------------

\503\ See Exchange Act section 3(a)(4)(B)(xi); see also letter

from SIFMA--Regional Dealers (supporting a threshold of 500 trades

consistent with the statutory de minimis exception in connection

with bank brokerage activity).

\504\ For example, $3 billion is equal to the threshold

suggested by many commenters in the context of the swap market,

which is much larger than the security-based swap market. See letter

from COPE (supporting a 0.001 percent notional threshold based on

the overall swaps market, which would amount to $3 billion). Indeed,

this $3 billion threshold appears to reflect roughly 0.024 percent

of the overall market for single-name credit default swaps, a

percentage that is much greater than the 0.001 percent multiplier

that a number of commenters (see, e.g., letters cited in note 382,

supra) suggested in the swap market context. See CDS Data Analysis

at table 1 (indicating that participants in the single-name credit

default swap market engage in a total of $12.6 trillion in single-

name credit default swap transactions in 2011).

---------------------------------------------------------------------------

In adopting this $3 billion threshold, we have carefully considered

one commenter's view that the CDS Data Analysis suggests that the

proposed $100 million threshold in fact is too high, and that any

increase in that proposed $100 million threshold would be arbitrary and

capricious.\505\ In reaching these conclusions, the commenter focused

on the number of entities that potentially are engaged in dealing

activity but that could be excluded based on particular de minimis

thresholds. For example, the commenter indicated that pursuant to one

of the CDS Data Analysis's combined metrics for identifying dealing

activity, a de minimis threshold of $3 billion could lead to the

exclusion of up to 58 percent of all persons engaged in possible

dealing activity. The commenter further suggested that some entities

engaged in dealing activity may reduce their activities to take

advantage of the de minimis exception and hence reduce liquidity, and

argued that there would be no basis for the exception to be based on a

market participant's percentage of total security-based swap

activity.\506\

---------------------------------------------------------------------------

\505\ See letter from Better Markets III.

\506\ The letter also raised issues regarding the ``customer''

language of the exception and argued that the de minimis exception

should not represent a risk-based test. We address those issues

elsewhere. See parts II.D.3.c (regarding ``customer'' language) and

II.D.3.e (regarding rejection of risk-based and proportionality

tests), infra.

In addition, the letter expressed the view that a percentage-

based formula would be difficult to implement, by requiring market

participants to repeatedly calculate the ratio of their activity to

total market activity. We concur. The $3 billion threshold we are

adopting reflects a fixed dollar amount, and does not share the

complications that would arise from an approach based on a

particular percentage of the market.

---------------------------------------------------------------------------

It is important to recognize that while the commenter focused on

the number of entities that might be excluded pursuant to the

exception, and suggested that higher notional dollar amount thresholds

could lead to the exclusion of a larger number of entities, the

statutory provision for the de minimis exception does not require the

exemption of a ``de minimis number'' of dealers. The statute instead

requires the exemption of persons engaged in a ``de minimis quantity''

of dealing activity.\507\ The statutory language therefore indicates

that the focus of the rule implementing the exception should be the

amount of an entity's dealing activity, not how many entities

ultimately may be able to take advantage of the exception.

---------------------------------------------------------------------------

\507\ See Exchange Act section 3(a)(71)(D).

---------------------------------------------------------------------------

Also, although the commenter implied that there would be no basis

for the rule implementing the exception to take into account a market

participant's security-based swap dealing activity compared to total

dealing activity in the market, for the reasons discussed in this

section we believe that such an approach can appropriately provide for

the regulatory coverage of the vast majority of dealing activity in a

way that promotes regulatory efficiency, without leading to unwarranted

regulatory gaps. In contrast, in our view the commenter did not

persuasively articulate a strong rationale for adopting the alternative

approach proposed in the letter, which would appear to lead to the

registration of a number of dealers that proportionately engage in a

very small amount of dealing activity.\508\

---------------------------------------------------------------------------

\508\ The commenter correctly pointed out that the regulatory

requirements applicable to registered dealers encompass counterparty

protection requirements, and that the de minimis exception should

not defeat those requirements. We recognize that the implementation

of the exception should take those counterparty protections into

account, and we have sought to do so. We do not believe, however,

that those important counterparty protection goals require a de

minimis approach that focuses on the number of entities that would

be excluded, in lieu of the statutory focus on whether a particular

entity engages in a de minimis quantity of dealing activity.

---------------------------------------------------------------------------

In support of its approach, the commenter emphasized data regarding

persons who meet certain combined criteria outlined in the CDS Data

[[Page 30640]]

Analysis. As discussed above, we believe that criteria based on the

number of an entity's counterparties that are not recognized as dealers

deserve special weight due to the potential consistency of those

criteria with the dealer-trader distinction.\509\ Identifying dealer

activity using those criteria does not support the view that a $3

billion threshold would lead to the exclusion of a large number of

entities engaged in dealing activity.\510\

---------------------------------------------------------------------------

\509\ See notes 478, 482, and 483, supra.

\510\ For example, the CDS Data Analysis identifies:

Three possible dealers with notional transactions below

$3 billion in 2011--out of a total of 28 possible dealers--when

possible dealing activity is based on having three or more

counterparties that themselves are not identified as dealers;

One possible dealer with notional transactions below $3

billion in 2011- out of a total of 20 possible dealers--when

possible dealing activity is based on having five or more

counterparties that themselves are not identified as dealers; and

Zero possible dealers with notional transactions below

$3 billion in 2011--out of a total of 16 possible dealers--when

possible dealing activity is based on having seven or more

counterparties that themselves are not identified as dealers.

See CDS Data analysis at tables 3c, 3b and 3a.

In addition, as described above, an approach focused on the

quantity of activity is supported by relatively consistent results

depending on which criterion from the CDS Data Analysis is applied--

i.e., each criterion shows a high amount of concentration and a

commensurately low quantity of activity below the $3 billion

threshold. By contrast, applying different criteria results in very

different numbers of entities excluded under any specified

threshold, suggesting that an approach focused on the number of

entities may be highly dependent on how the possible dealing

activity of those entities is defined.

---------------------------------------------------------------------------

Finally, we also are not persuaded by the commenter's suggestion

that a number of entities engaged in dealing activity would reduce

those activities to take advantage of a $3 billion de minimis

threshold, and hence reduce liquidity in the market by five percent. To

reach that figure, the commenter needed to exclude the vast majority of

dealing activity in the market.\511\ While we recognize that it is

possible that current market participants may adjust their dealing

activity in light of the de minimis threshold, and that this

potentially could reduce the liquidity provided by certain entities, we

also recognize that the de minimis exception has the potential to

promote liquidity by facilitating new entrants into the market.

---------------------------------------------------------------------------

\511\ In particular, in arguing that this incentive would reduce

liquidity by five percent, the commenter excluded all business done

by entities within the top two brackets (i.e., above $100 billion

notional), on the grounds that those entities ``are assumed to

transact mostly with larger entities.'' Based on the criteria on

which the commenter relied, those 15 entities are responsible for

over 96 percent of the activity of all possible dealers. See CDS

Data Analysis at tables 7 and 8. Absent that exclusion, the

estimated reduction of liquidity would amount to a small fraction of

a percent.

---------------------------------------------------------------------------

ii. Phase-in Period in Connection With Dealing Activity Involving

Credit Default Swaps That Constitute Security-Based Swaps

The final rules further provide that persons with notional dealing

activity of $8 billion or less over the prior 12 months involving

credit default swaps that constitute security-based swaps would be able

to avail themselves of a phase-in period.\512\ Those persons would not

be subject to the generally applicable compliance date that occurs no

later than 60 days following publication of these final rules in the

Federal Register.\513\

---------------------------------------------------------------------------

\512\ Exchange Act rule 3a71-2(a)(2).

\513\ Even with the general 60 day compliance period, however,

market participants will not necessarily be security-based swap

dealers at the end of 60 days. In particular, for the first year

following the effective date of the final rules implementing the

definition of ``security-based swap'' pursuant to the Exchange Act

section 3(a)(68), the de minimis analysis would only address

security-based swap dealing activity following that effective date.

See Exchange Act rule 3a71-2(a)(1). Among other things, this means

that until the rules defining ``security-based swap'' are effective,

no market participants would be deemed to be security-based swap

dealers.

---------------------------------------------------------------------------

The use of a phase-in period--in connection with a person's status

as a security-based swap dealer and in connection with the other

regulatory requirements that are appurtenant to dealer status--is

intended to facilitate the orderly implementation of Title VII. In

addition, the phase-in period will afford the SEC additional time to

study the security-based swap market as it evolves in the new

regulatory framework and will allow potential dealers that engage in

smaller amounts of activity (relative to the current size of the

market) additional time to adjust their business practices, while at

the same time preserving the focus of the regulation on the largest and

most significant dealers. The SEC also recognizes that the data

informing its current view of the de minimis threshold is based on the

market as it exists today, and that the market will evolve over the

coming years in light of the new regulatory framework and other

developments.

Accordingly, while the SEC believes that a $3 billion notional

threshold reflects an appropriate long-term standard based on the

currently available data,\514\ it also is appropriate to provide for a

phase-in period for those entities with $8 billion or less in dealing

activity, because subsequent developments in the market or the

evaluation of new data from the security-based swap reporting

facilities contemplated by the Dodd-Frank Act may suggest that the

threshold should be increased or decreased. In particular, the

implementation of security-based swap data reporting under the Dodd-

Frank Act will result in significant new data and afford an opportunity

to review the Commission's determination to establish a $3 billion

threshold.

---------------------------------------------------------------------------

\514\ See note 502, supra.

---------------------------------------------------------------------------

For these reasons, an important part of the report that the SEC is

directing its staff conduct with regard to the definitions of

``security-based swap dealer'' and ``major security-based swap

participant'' (described in detail below) will be a consideration of

the operation of the de minimis exception following the full

implementation of Section 15F under Title VII.\515\ The SEC will take

into account this report, along with public comment on the report, in

determining whether to propose any changes to the rule implementing the

de minimis exception, including any increases or decreases to the $3

billion threshold. The report will be linked to the availability of

data regarding the activity of regulated security-based swap market

participants in that it must be completed no later than three years

\516\ following a ``data collection initiation date'' that is the later

of: the last compliance date for the registration and regulatory

requirements for security-based swap dealers and major security-based

swap participants under Section 15F of the Exchange Act; or the first

date on which compliance with the trade-by-trade reporting rules for

credit-related and equity-related security-based swaps to a registered

security-based swap data repository is required.\517\

---------------------------------------------------------------------------

\515\ See Exchange Act rule 3a71-2A(a)(1); see also part V,

infra.

\516\ See Exchange Act rule 3a71-2A(b).

\517\ The SEC will announce the data collection initiation date

on its Web site and publish it in the Federal Register. See Exchange

Act rule 3a71-1(a)(2)(iii).

---------------------------------------------------------------------------

In light of the available data--and the limitations of that data in

predicting how the full implementation of Title VII will affect dealing

activity in the security-based swap market--the SEC believes that $8

billion constitutes an appropriate level for the availability of the

phase-in period. The available data indicate that such a level

generally comports with the balance of interests that informed the

determination of the appropriate long-term threshold of $3 billion

described above. In particular, the $8 billion level should still lead

to the regulation of persons responsible for the vast majority of

dealing activity

[[Page 30641]]

within the market.\518\ In addition, we do not believe that providing a

phase-in period for persons with notional dealing activity over the

prior 12 months of less than $8 billion would lead to a risk of an

undue portion of the market falling outside of the ambit of dealer

regulation, even after considering the potential entry of unregulated

new dealers into the market.\519\

---------------------------------------------------------------------------

\518\ Of the 28 market participants that have three or more

security-based swap counterparties that themselves are not

recognized by dealers by ISDA, 23 had notional single-name credit

default swap transactions in excess of $8 billion in 2011. The

remaining five entities in total accounted for only $12.3 billion in

notional transactions in 2011, reflecting roughly 0.1 percent of the

$11.18 total for the 28 market participants. See CDS Data Analysis

at table 3c. Only two of the 28 entities identified as possible

dealers by that criterion had annual notional transactions between

$3 billion and $8 billion in 2011.

Most of the other criteria set forth in the analysis for

identifying possible dealing activity in general similarly indicate

that entities with notional transactions in excess of $8 billion in

2011 account for more than 99 percent of the total notional

transactions of all identified entities that year. See id. at tables

2a-b, 3a-b, 4 and 5. While the criterion based on an entity having

10 or more counterparties only indicates 98 percent coverage for all

of the 154 identified entities at an $8 billion transaction level,

see id. at table 2c, as noted above this criterion may identify

persons who in reality are not engaged in dealing activity. See note

482, supra. Also, while the criterion based on the posting of

initial margin only indicates 97 percent coverage for all of the 473

identified entities at an $8 billion transaction level, see id. at

table 6, as discussed above that criterion is based on voluntary

reporting.

\519\ For example, 15 new dealer entrants up to $8 billion in

annual notional dealing activity would account for $120 billion in

dealing activity. This would amount to roughly 1.2 percent of the

total notional single-name security-based swap activity over 12

months of entities identified as possible dealers by virtue of

having three or more counterparties that are not recognized by

dealers by ISDA. See CDS Data Analysis at table 2c.

---------------------------------------------------------------------------

The final rule provides that the phase-in period will continue

until the ``phase-in termination date'' that the SEC will publish on

its Web site and in the Federal Register.\520\ In particular, the rule

provides that nine months following publication of that report, and

after giving due consideration of the report and associated public

comment, the SEC may either: (1) Terminate the phase-in period and by

order establish and publish the phase-in termination date; or (2)

determine that it is necessary or appropriate in the public interest to

propose an alternative de minimis threshold, in which case the SEC, by

order published in the Federal Register, will provide notice of that

determination and establish the phase-in termination date.\521\ If the

SEC does not establish the phase-in termination date in either of those

ways, the phase-in termination date shall automatically occur in any

event on what would be a date certain, which will be five years

following the data collection initiation date.\522\

---------------------------------------------------------------------------

\520\ Exchange Act rule 3a71-2(a)(2)(i).

\521\ Exchange Act rule 3a71-2(a)(2)(iii)(A).

\522\ Exchange Act rule 3a71-2(a)(2)(iii)(B).

---------------------------------------------------------------------------

These provisions should allow sufficient time for the staff to

complete its report, for the SEC to receive and review public comment

on the report, and for the SEC to draw conclusions regarding

establishing the phase-in termination date or proposing potential

changes to the rule implementing the de minimis exception, in a way

that also promotes the orderly and predictable termination of the

phase-in period.\523\

---------------------------------------------------------------------------

\523\ This approach balances the fact that the SEC believes that

its $3 billion and $150 million de minimis thresholds are

appropriate in light of the currently available data and the

market's need for a degree of certainty as to the length of this

phase-in period, on the one hand, against the possibility that the

staff report and the accompanying public comment may demonstrate

that revision to these thresholds is necessary, on the other hand.

---------------------------------------------------------------------------

This phase-in period will not be available in connection with the

$25 million threshold for dealing activity involving special entities,

discussed below. In addition, the final rule provides that this phase-

in period will not be available in connection with security-based swap

dealing activities involving natural persons, other than natural

persons who qualify as ECPs by virtue of CEA section 1a(18)(A)(xi)(II),

which addresses natural persons who have $5 million or more invested on

a discretionary basis and who enter into a security-based swap to

manage the risk associated with their assets and liabilities.\524\

These limitations to the availability of the phase-in period are

consistent with the Dodd-Frank Act's goal of helping special entities

be in a position to benefit from the counterparty protections

associated with the regulation of registered security-based swap

dealers under Title VII, as well as the SEC's mandate to protect

participants in the securities markets.

---------------------------------------------------------------------------

\524\ See Exchange Act rule 3a71-2(a)(2)(i). In other words, the

phase-in period will still be available in connection with dealing

activities with natural persons who are ECPs because they have

entered into a security-based swap for hedging purposes. While we

recognize the importance of Title VII protections to natural persons

who engage in security-based swap activity, we also recognize the

benefit of facilitating such persons' use of security-based swaps as

hedges. Accordingly, persons who engage in dealing activity with

natural persons who are ECPs under other provisions of the ECP

definition will be subject to the applicable de minimis threshold

for all of their dealing activity, without the availability of the

phase-in period.

Persons who engage in dealing activity with natural persons who

are not ECPs will fall within the Exchange Act definition of

``dealer,'' which has no de minimis exception. See Exchange Act

section 3(a)(5)(A) (generally excluding dealers in security-based

swaps from the Exchange Act definition of ``dealer,'' unless the

counterparty is not an ECP).

---------------------------------------------------------------------------

Persons who are able to avail themselves of the phase-in period, of

course, will not be required to do so. Any person that chooses to

register with the SEC as a security-based swap dealer shall be deemed

to be a security-based swap dealer subject to all applicable regulatory

requirements for such registrants, regardless of whether the person

engages in security-based swap dealing activity in an amount that is

below the applicable de minimis threshold or phase-in level.\525\

---------------------------------------------------------------------------

\525\ See Exchange Act rule 3a71-2(e).

---------------------------------------------------------------------------

d. Balancing Reflected in the Final Rules--Other Types of Security-

Based Swaps

The final rule provides that the de minimis exception for dealing

activity involving security-based swaps other than credit default swaps

will be based on a threshold of $150 million notional over the prior 12

months.\526\ In addition, a phase-in period will be available in

connection with persons whose dealing activity involving those

instruments is $400 million or less in notional amount over the prior

12 months.

---------------------------------------------------------------------------

\526\ Exchange Act rule 3a71-2(a)(1)(ii). The proposal requested

comment on whether different segments of the security-based swap

market should be treated differently. See Proposing Release at 80101

(``Commenters further are requested to address * * * whether the [de

minimis] exemption's factors should vary depending on the type of

swap or security-based swap at issue.'').

---------------------------------------------------------------------------

These amounts reflect roughly one-twentieth of the corresponding

amounts associated with the exception for credit default swaps that

constitute security-based swaps. As discussed above, while less data is

available regarding other types of security-based swaps than is

available regarding single-name credit default swaps, the available

data is consistent in indicating that those other types of security-

based swaps on a notional basis currently comprise roughly one-

twentieth of the total amount of instruments that will be expected to

constitute security-based swaps.\527\ In light of this significantly

smaller market, we believe that a $3 billion notional threshold would

threaten to cause an overly large portion of dealing activity within

the market to fall outside the ambit of dealer regulation.

---------------------------------------------------------------------------

\527\ See note 476, supra.

---------------------------------------------------------------------------

In this regard, we note that it is likely that there are fewer

barriers to entry in connection with acting as a dealer in security-

based swaps such as equity swaps and total return swaps on debt than

there are in connection with acting as a dealer in single-name credit

default

[[Page 30642]]

swaps.\528\ We also note that because equity swaps and total return

swaps on debt can serve as close economic proxies for equity and debt

securities, an overly broad de minimis threshold in connection with

such instruments could threaten to undermine the Exchange Act framework

for regulating persons who act as dealers in equity and debt.

---------------------------------------------------------------------------

\528\ For example, persons registered with the SEC as broker-

dealers in connection with other types of securities would appear to

be well positioned to act as dealers in connection with equity

swaps, as such broker-dealers already would be expected to have

systems in place to enter into equity positions to hedge their

equity swap dealing positions.

---------------------------------------------------------------------------

At the same time--notwithstanding the smaller scope of this market

and the lesser availability of data regarding dealing activity within

the market--we do not believe that it is necessary to make the de

minimis exception unavailable in connection with dealing activity

involving security-based swaps that are not credit default swaps. In

this regard we particularly note that the limited available data

regarding equity swaps suggests a high degree of concentration in

dealing activity involving those instruments,\529\ which indicates that

an appropriately sized de minimis threshold can be expected to promote

regulatory efficiency.

---------------------------------------------------------------------------

\529\ As noted above, four commercial banks and trust companies

accounted for 93 percent of all equity positions held by such

companies as of June 30, 2011, and nine bank holding companies

accounted for over 99 percent of all equity positions held by the

fifty largest such companies as of December 2011. See note 485,

supra.

---------------------------------------------------------------------------

Balancing those factors, we conclude that a $150 million annual

notional threshold is appropriate to implement the de minimis exception

in connection with security-based swaps that are not credit default

swaps, consistent with our understanding of the comparative size of

that market as applied to the threshold applicable to credit default

swap dealing activity. For reasons similar to those described above, we

conclude that there should be a phase-in period available to persons

whose annual notional dealing activity in connection with security-

based swaps that are not credit default swaps is no more than $400

million in annual 12-month notional amount. This phase-in period is

subject to the same limitations regarding transactions involving

special entities and natural persons as apply to the phase-in period

for credit default swaps. It also will be subject to the same

provisions regarding the termination of the phase-in period as apply in

connection with credit default swaps.\530\ The comparative lack of data

involving these markets--in contrast to the market for single-name

credit default swaps--particularly highlights how the use of a phase-in

period that is linked to the availability of post-implementation data

is appropriate.\531\

---------------------------------------------------------------------------

\530\ See Exchange Act rule 3a71-2(a)(2); see also notes 520

through 522, supra, and accompanying text.

\531\ The SEC expects that the staff report should be especially

helpful for providing data regarding dealing activity in connection

with those other types of security-based swaps to consider the

impact of the termination of the phase-in period, as well as

potential changes to the de minimis exception in connection with

these instruments.

---------------------------------------------------------------------------

As above, a person who is eligible to take advantage of the phase-

in period in connection with these types of security-based swaps may

nonetheless register as a security-based swap dealer.

e. Dealing Activity Involving Special Entities

Consistent with the proposal, the final rules in general will cap

an entity's dealing activity involving security-based swaps at no more

than $25 million notional amount over the prior 12 months when the

counterparty to the security-based swap is a special entity.\532\ There

will be no phase-in period in connection with transactions involving

special entities. In adopting this threshold, we recognize the serious

concerns raised by commenters that stated that the de minimis exception

should not permit any dealing activities involving special entities in

light of losses that special entities have incurred in the financial

markets,\533\ as well as the special protection that Title VII affords

special entities.\534\

---------------------------------------------------------------------------

\532\ Exchange Act rule 3a71-2(a)(1)(iii).

\533\ See letters from AFR and Better Markets I.

\534\ In this regard we note that Title VII authorizes the SEC

to impose special business conduct requirements when a security-

based swap dealer is counterparty to a special entity. See Exchange

Act section 15F(h)(5). In proposing rules to implement these

requirements, the SEC requested comment regarding the scope of the

``special entity'' definition, including, for example, regarding

whether the SEC should interpret ``special entity'' to exclude a

collective investment vehicle in which one or more special entities

have invested. See Exchange Act Release No. 64766 (June 29, 2011),

76 FR 42396, 42422 (July 18, 2011). For purposes of interpreting

this special entity threshold to the de minimis exception--

particularly with regard to when a special entity would be a

counterparty to a person that is engaged in dealing activity--the

SEC believes that it will be appropriate to be guided by final

interpretations regarding when a dealer will be a counterparty to a

special entity for purposes of those business conduct requirements.

---------------------------------------------------------------------------

At this time, the final rule does not fully exclude such dealing

activity from the exception, in light of the potential benefits that

may arise from a de minimis exception. In this way, the threshold would

not completely foreclose the availability of security-based swaps to

special entities from unregistered dealers--as $25 million would

annually accommodate up to five single-name credit default swaps of a

$5 million notional size--but the threshold would limit the financial

and other risks associated with those positions for a special entity,

which would in turn limit the possibility of inappropriately

undermining the special protections that Title VII provides to special

entities.

In reaching this conclusion we recognize that special entities do

participate in the single-name credit default swap market, given that

an analysis of market data indicates that in 2011 special entities were

parties to over $40 billion in single-name credit default swap

transactions.\535\ At the same time, the impact of this $25 million

threshold--particularly concerns that the threshold may foreclose the

ability of special entities to access dealers in the market--appears to

be mitigated by the fact that the counterparties to those special

entities tend to engage in notional transactions in single-name credit

default swap well in excess of the general de minimis standards.\536\

In light of the underlying counterparty protection issues, we see no

basis to distinguish between types of security-based swaps in setting

this special entity threshold.

---------------------------------------------------------------------------

\535\ See CDS Data Analysis at table 9.

\536\ See id. at n.8 (noting that the average notional activity

of those 16 counterparties was $680 billion, with the lowest being

approximately $9 billion).

---------------------------------------------------------------------------

For similar reasons, in the future as we consider whether to amend

the de minimis exception we expect to pay particular attention to

whether the threshold for transactions involving special entities

should further be lowered.

f. Future Revisions to the Rule

As noted above and described in detail below in part V, the SEC is

directing its staff to report on whether changes are warranted to the

rules and interpretations implementing the security-based swap dealer

definition, including the rule implementing the de minimis

exception.\537\ The SEC will take the report and associated public

comment into account in determining whether to propose any changes to

the rule implementing the exception.\538\ Consistent with that

possibility, the final rule provides that the SEC may change the

requirements of the de minimis exception by rule or regulation.\539\

Through this mechanism,

[[Page 30643]]

the SEC may revisit the rule implementing the exception and potentially

change that rule, for example, if data regarding the security-based

swap market following the implementation of Section 15F under Title VII

suggests that different de minimis thresholds would be

appropriate.\540\ In determining whether to revisit the thresholds, the

SEC intends to pay particular attention to whether the de minimis

exception results in a dealer definition that encompasses too many

entities whose activities are not significant enough to warrant full

regulation under Title VII, or, alternatively, whether the de minimis

exception leads an undue amount of dealing activity to fall outside of

the ambit of the Title VII regulatory framework, or leads to

inappropriate reductions in counterparty protections (including

protections for special entities). The SEC also intends to pay

particular attention to whether alternative approaches would more

effectively promote the regulatory goals that may be associated with a

de minimis exception.

---------------------------------------------------------------------------

\537\ See Exchange Act rule 3a71-2A(a)(1).

\538\ See notes 520 through 522, supra, and accompanying text.

\539\ Exchange Act rule 3a71-2(d). Exchange Act section

3(a)(71)(D) particularly states that the ``Commission''--meaning the

SEC--may exempt de minimis dealers and promulgate related

regulations. We do not interpret the joint rulemaking provisions of

section 712(d) of the Dodd-Frank Act to require joint rulemaking

here, because such an interpretation would read the term

``Commission'' out of Exchange Act section 3(a)(71)(D), which itself

was added by the Dodd-Frank Act.

\540\ See letter from Greenberger (stating that the dynamic

nature of the derivatives sector of the financial markets should

counsel caution, and that the de minimis threshold should be

reevaluated on an ongoing basis).

---------------------------------------------------------------------------

6. Registration Period for Entities That Exceed the De Minimis Factors

The de minimis exception raises implementation issues akin to those

associated with the major participant definition, in that both

provisions use tests that have retrospective elements to determine

whether an entity must register and be subject to future regulation. As

a result, some commenters have suggested that entities that surpass the

de minimis thresholds should be able to take advantage of a grace

period to undertake the process of registering as swap dealers or

security-based swap dealers.\541\ Otherwise, absent such a ``roll-in''

period, entities whose dealing activities surpass the relevant de

minimis factors would immediately be in violation of dealer

registration requirements. In light of these concerns, and the interest

of avoiding undue market disruptions, the Commissions believe that it

is appropriate to provide entities that exceed applicable the de

minimis factors a period of time to register as dealers.

---------------------------------------------------------------------------

\541\ See letters from Northland Energy and WGCEF I.

---------------------------------------------------------------------------

Accordingly, the final rules have been revised from the proposal to

provide for a timing standard that is similar to what we are using in

connection with the major participant definition.\542\ That is, if an

entity that has relied on the de minimis exception no longer is able to

rely on the exception because its dealing activity exceeds a relevant

threshold, the entity would have two months, following the end of the

month in which it no longer is able to take advantage of the exception,

to submit a completed application to register as a swap dealer or

security-based swap dealer.\543\

---------------------------------------------------------------------------

\542\ Compare CFTC Regulation Sec. 1.3(hhh)(3); Exchange Act

rule 3a67-8(a) (providing that persons who meet the criteria to be

major participants will have two months to submit a completed

registration application).

\543\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii); Exchange Act

rule 3a71-2(b). As discussed below with regard to the implementation

period for the major participant definitions, persons will have

additional time to comply with the applicable requirements following

the submission of a completed application. See part IV.L.3, infra.

---------------------------------------------------------------------------

Also, akin to the major participant definitions,\544\ a person

registered as a swap dealer or security-based swap dealer may apply to

withdraw that registration, while continuing to engage in a limited

amount of dealing activity in reliance on the de minimis exception, if

that person has been registered as a dealer for at least 12

months.\545\ This should help ensure that persons do not rapidly move

in and out of dealer status based on short-term fluctuations in their

swap or security-based swap activities.

---------------------------------------------------------------------------

\544\ Compare CFTC Regulation Sec. 1.3(hhh)(5); Exchange Act

rule 3a67-8(c) (providing that a major participant may be deemed to

no longer be a major participant if its swap or security-based swap

positions are below the relevant thresholds for four quarters).

\545\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii); Exchange Act

rule 3a71-2(c). Consistent with this approach, moreover, the final

rule has been revised from the proposal to clarify that the de

minimis exception in general is not available to a registered swap

dealer or security-based swap dealer. See CFTC Regulation Sec.

1.3(hhh)(1)(i); Exchange Act rule 3a71-2(a)(1) (revised language

clarifying availability of exception to a person that is not a swap

dealer or security-based swap dealer).

---------------------------------------------------------------------------

The final rules implementing the de minimis exception do not

provide any reevaluation period for entities that engage in a level of

dealing activity above the de minimis thresholds, in contrast to the

major participant definitions.\546\ We do not believe that there is an

appropriate basis for such a provision, particularly given that dealer

regulation addresses customer protection and market operation and

transparency concerns apart from risk concerns.

---------------------------------------------------------------------------

\546\ Compare CFTC Regulation Sec. 1.3(hhh)(4); Exchange Act

rule 3a67-8(b) (providing for a reevaluation period in connection

with the major participant definitions when a person does not exceed

any applicable threshold by more than 20 percent in a calendar

quarter).

---------------------------------------------------------------------------

E. Limited Purpose Designation as a Dealer

1. Proposed Approach

The definitions of the terms ``swap dealer'' and ``security-based

swap dealer'' provide that the Commissions may designate a person 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.\547\

---------------------------------------------------------------------------

\547\ CEA section 1a(49)(B); Exchange Act section 3(a)(71)(B).

---------------------------------------------------------------------------

In the Proposing Release, we noted that these provisions represent

permissive grants of authority that do not require the Commissions to

provide limited designations.\548\ We further stated that a person that

is covered by the definitions of the terms ``swap dealer'' or

``security-based swap dealer'' would be considered a dealer for all

types, classes or categories of the person's swaps or security-based

swaps, or activities involving swaps or security-based swaps, in light

of the difficulty of seeking to separate a person's dealing activities

from their non-dealing activities involving swaps or security-based

swaps, unless such person sought and received designation as a dealer

for only specified categories of swaps or security-based swaps, or

specified activities.\549\ We explained that this would provide persons

the opportunity to seek a limited designation based on applicable facts

and circumstances, and that we anticipated that a dealer could seek a

limited designation at the time of its initial registration or

later.\550\

---------------------------------------------------------------------------

\548\ See Proposing Release, 75 FR at 80182.

\549\ See id.; see also proposed CFTC Regulation Sec.

1.3(ggg)(3); proposed Exchange Act rule 3a71-1(c).

\550\ See Proposing Release, 75 FR at 80182.

---------------------------------------------------------------------------

In the Proposing Release, the CFTC further noted that non-financial

entities such as physical commodity firms potentially may conduct

dealing activity through a division rather than through a separately

incorporated subsidiary, and that such an entity's swap dealing

activity would not be a core component of its overall business. The

CFTC added that if this type of entity registered as a dealer, certain

swap dealer requirements would apply to the dealing activities of the

division, but not necessarily to the swap activities of other parts of

the entity.\551\

---------------------------------------------------------------------------

\551\ See id.

---------------------------------------------------------------------------

[[Page 30644]]

2. Commenters' Views

A number of commenters addressed the limited designation of dealers

in conjunction with the limited designation of major participants. Many

of the issues those commenters raised thus are relevant to both sets of

definitions.

a. Presumption of Full Designation

A number of commenters objected to the proposed presumption that an

entity would be designated as a dealer (or major participant) for all

categories of swaps or security-based swaps and all of the person's

activities connected to swaps or security-based swaps. Several

commenters argued that this approach would be contrary to Congressional

intent,\552\ conflict with the statutory language,\553\ or conflict

with underlying policy concerns.\554\ One commenter suggested that the

Commissions lack the statutory authority to apply swap dealer

requirements to an entity's non-swap dealing activities.\555\

---------------------------------------------------------------------------

\552\ See letters from Cargill Incorporated (``Cargill''), CDEU

and Investment Company Institute (``ICI'') dated February 22, 2011

(``ICI I'').

\553\ See letters from MetLife and WGCEF I.

\554\ See letter from Cargill (stating that limited designation

promotes the policy of encouraging non-financial firms that

primarily are engaged in non-dealing businesses to continue to

conduct limited dealing activities, adding that such firms ``do not

present the potential systemic risks of financial firms,'' and that

their full designation as dealers would discourage them from

providing risk management products).

\555\ See letter from EDF Trading.

---------------------------------------------------------------------------

b. Potential Types of Limited Designations

A number of commenters addressed potential types of limited

designations. One expressed support for limited swap dealer

designations for particularized business units and for particular swap

categories,\556\ while another requested that limited swap dealer

designations be available based on any reasonable commercial

groupings.\557\ Some commenters urged that limited dealer designations

should be available for the branches or business units of foreign swap

dealers and security-based swap dealers with U.S.-based customers or

U.S. business lines.\558\

---------------------------------------------------------------------------

\556\ See letter from Capital One.

\557\ See letters from NCGA/NGSA II (particularly referring to

groupings based on individual physical commodities) and WGCEF dated

June 9, 2011 (``WGCEF VII'') (limited designation should permit

firms to structure organization of limited purpose registrans as

appropriate in particular circumstances).

\558\ See letters cited in note 148, supra.

---------------------------------------------------------------------------

c. Applications for Limited Designations

A number of commenters addressed issues relating to the application

process for limited designations. Some commenters supported the ability

of a person to apply for limited designations at the time of initial

registration,\559\ while one commenter sought clarification on how and

when a person could apply for limited swap dealer status.\560\ Some

commenters suggested that entities should be considered to have a

provisional limited designation upon the filing of a completed

application for limited dealer designation.\561\

---------------------------------------------------------------------------

\559\ See letters from MFA I (specifically requesting that the

rules provide that an entity can receive a limited purpose

designation at the time of their initial registration) and FSR I.

\560\ See letter from National Futures Association (``NFA'').

\561\ See letters from Capital One, Farm Credit Council I and

FHLB I.

---------------------------------------------------------------------------

Some commenters requested further clarification as to what factors

or criteria would be considered relevant to limited designation

determinations.\562\ One commenter stated that non-financial companies

should have a presumption of limited swap dealer designation under

certain circumstances.\563\ Another commenter took the view that

commercial firms should be able to determine whether to register a

legal entity or a division as a dealer.\564\ One commenter suggested

the analysis consider the complexity of an entity's dealing and non-

dealing activities, and further suggested that limited designations

should automatically be available if an entity's dealing activities do

not exceed 50 percent of its total swap activities.\565\ Commenters

also raised issues related to how a person's status as a financial or a

non-financial entity affects a person's eligibility for limited

designations.\566\

---------------------------------------------------------------------------

\562\ See letters from BG LNG I and ISDA I.

\563\ See letter from Cargill (arguing that a firm should be

presumptively entitled to limited swap dealer status if: it is a

non-financial company; its non-dealing activities include (but need

not be limited to) production, merchandising or processing of

physical commodities; the firm's dealing activities take place in a

separately identifiable division or business unit with separate

management; and dealing revenues are less than 30 percent of the

firm's total revenues in the firm's most recent fiscal year).

\564\ See letter from WGCEF VII (stating that so long as a

registered swap dealer bears the onus of demonstrating compliance

with regulatory requirements, regulators ``should not dictate''

whether the firm registers a legal entity or a division as a dealer;

also requesting guidance as to how applicable regulatory

requirements may apply to a subdivision of a legal entity that

registers as a dealer, and requesting a safe harbor from enforcement

action when a decision to register only a particular desk or

division as a dealer is made in good faith).

\565\ See letter from Capital One.

\566\ Compare letter from Capital One (stating that all market

participants, including financial institutions, should be allowed to

apply for limited swap dealer designations) with letter from Cargill

(suggesting that an entity's status as a financial company should be

relevant to limited dealer determinations).

---------------------------------------------------------------------------

d. Application of Regulatory Requirements to Limited Dealers

Commenters also addressed issues related to the application of

regulatory requirements to limited dealers. One commenter recommended

that dealer regulatory requirements generally should apply only to a

division undertaking limited dealing activities; that commenter further

stated that capital requirements should be calculated based only on the

activities of that division, while recognizing that capital must be

held by the entity as a whole.\567\ Other commenters argued that

capital and margin requirements should only be applied to an entity on

a limited basis.\568\

---------------------------------------------------------------------------

\567\ See letter from Cargill.

\568\ See letter from FSR I (recommending that to the extent

that capital requirements are tied to swap activity or exposures,

that only activities or exposures in the designated category be

reflected in the calculation).

---------------------------------------------------------------------------

e. Miscellaneous Issues

One commenter recommended that non-financial entities that are

deemed to be limited dealers (or major participants) be permitted to be

treated as end-users for the aspects of their businesses that are not

subject to the limited designation.\569\ The commenter further

suggested that the swaps ``push-out'' rule requirements of section 716

of the Dodd-Frank Act be interpreted so that an insured depository

institution that is a limited purpose dealer would only have to push

out the dealing portion of its swap business, and be allowed to retain

the other aspects of its swaps business.\570\ One commenter requested

clarification as to whether a person that is a limited purpose dealer

in connection with one category of swap could be a major participant in

connection with another category (in light of the statutory language

excluding dealers from the major participant definitions).\571\

---------------------------------------------------------------------------

\569\ See id. (recommending that the corporate treasurer of an

entity with a limited designation as a swap dealer for ``other

commodity swaps'' as a result of its energy derivatives activity be

able to hedge the entity's interest rate and currency risk without

being subject to the business conduct, reporting, recordkeeping or

other rules applicable to dealers and major participants).

\570\ See id.

\571\ See letter from NFA. As discussed below, see 752, infra, a

person who is designated as a dealer in connection with particular

types of swaps or security-based swaps may be major participants

with regard to other types.

---------------------------------------------------------------------------

3. Final Rules and General Principles

Consistent with the proposal, the final rules retain the

presumption that a

[[Page 30645]]

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, unless the CFTC or SEC exercises its authority to limit the

person's designation as a dealer to specified categories of swaps or

security-based swaps, or specified activities.\572\ As discussed in the

Proposing Release, moreover, a person may apply for a limited

designation when it submits a registration application, or at a later

time.\573\ The final rules also contain a technical change from the

proposed rules to clarify that limited designations may be based on a

particular type, class or category of swap or security-based-swap.\574\

---------------------------------------------------------------------------

\572\ CFTC RegulationSec. 1.3(ggg)(3); Exchange Act rule 3a71-

1(c).

\573\ The SEC expects to address the process for submitting an

application for limited designation as a security-based swap dealer,

along with principles to be used by the SEC in analyzing such

applications, as part of separate rulemakings.

\574\ The rules particularly have been revised from the proposal

to add ``type'' and ``class'' language to supplement the use of the

term ``category.'' This change is consistent with the statutory

language. In addition, the final rules related to limited

designations for ``security-based swap dealers'' corrects an

erroneous reference to major participant designation.

---------------------------------------------------------------------------

a. Default Presumption of Full Designation

Consistent with the proposal, the final rules retain the standard

that a person that satisfies the ``swap dealer'' or ``security-based

swap dealer'' definition in general would be considered a dealer for

all types, classes or categories of the person's swaps or security-

based swaps, or all activities involving swaps or security-based swaps.

The Commissions are not persuaded by the suggestion that this

presumption is inconsistent with the statute, legislative intent or

underlying policy. Not only is the relevant statutory language written

as a grant of authority rather than a specific mandate to designate

certain entities as limited purpose dealers, but the presumption also

reasonably reflects the difficulty of separating a dealer's dealing

activities from its non-dealing activities, and the challenges of

applying dealer regulatory requirements to only a portion of a dealer's

swap or security-based swap activities.\575\

---------------------------------------------------------------------------

\575\ This approach also is consistent with the treatment of

dealers of other types of securities under the Exchange Act. When a

person's securities activities cause them to be a ``dealer'' for

purposes of the Exchange Act, the statutory requirements and

regulations applicable to dealers will apply to all of that person's

securities activities, regardless of whether particular activities

would not have caused the entity to fall within the ``dealer''

definition. For example, Exchange Act section 15(c)(3)(A) prohibits

brokers and dealers from engaging in certain securities-related

activity in contravention of SEC-prescribed rules with respect to

financial responsibility or related practices. This provision does

not distinguish between those activities that cause a person to fall

within the ``broker'' or ``dealer'' definitions, and other

activities that themselves do not cause that person to be a broker

or dealer. The SEC's authority extends to all securities activities

by those brokers or dealers.

---------------------------------------------------------------------------

We similarly are not persuaded by the view that the Commissions

lack the authority to apply dealer regulation to non-dealing activities

of a registered swap dealer or security-based swap dealer.\576\ Certain

of the statutory requirements applicable to swap dealers and security-

based swap dealers--such as capital requirements--simply do not

distinguish between a person's dealing activities and their non-dealing

activities.\577\ In other words, absent a limited designation, the

statutory requirements applicable to dealers address the regulation of

all of a dealer's swap or security-based swap activities.\578\

---------------------------------------------------------------------------

\576\ See letter from EDF Trading.

\577\ See, e.g., CEA section 4s(e); Exchange Act section 15F(e).

\578\ The substantive regulations applicable to dealers, of

course, can account for the nature of a dealer's particular swap or

security-based swap activities.

The SEC also intends to address limited designation issues in

the context of a separate release addressing the application of

Title VII to non-U.S. entities.

---------------------------------------------------------------------------

b. Demonstration of Compliance With Dealer Requirements

The Commissions will consider limited purpose applications on an

individual basis through analysis of the unique circumstances of each

applicant, given that the types of entities that engage in swap or

security-based swap dealing are diverse and their organization and

activities are varied.\579\

---------------------------------------------------------------------------

\579\ Consistent with this approach, applications to limit a

person's dealer designation to ``specified categories'' of swaps or

security-based swaps (see CFTC Regulation Sec. 1.3(ggg)(3);

Exchange Act rule 3a71-1(c)), would not be required to interpret the

term ``category'' consistently with the use of that term in

connection with the major participant definitions. CFTC Regulation

Sec. 1.3(iii) and Exchange Act rule 3a67-2, defining the terms

``major swap category'' and ``major security-based swap category,''

respectively, do not apply for this purpose.

---------------------------------------------------------------------------

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 dealers.

Certain of the statutory requirements applicable to dealers

particularly focus on the entity's swap or security-based swap

activities and positions. These include, among other aspects,

requirements related to trading records, documentation and

confirmations.\580\ An applicant for a limited purpose designation

would have to demonstrate how it would satisfy those transaction-

specific requirements in the context of a limited designation.

---------------------------------------------------------------------------

\580\ See, e.g., CEA section 4s(h)(3), Exchange Act section

15F(h)(3) (business conduct standards, including disclosure

requirements, for dealers); CEA section 4s(g), Exchange Act section

15F(g) (daily trading record requirements for dealers); CEA section

4s(i); Exchange Act section 15F(i) (documentation requirements for

dealers).

---------------------------------------------------------------------------

Other statutory requirements applicable to dealers particularly

focus on the entity itself. These include requirements related to

registration, capital, risk management, supervision, and chief

compliance officers.\581\ Here too, an applicant for a limited purpose

designation would have to demonstrate how it would satisfy those

requirements in the context of limited designations.

---------------------------------------------------------------------------

\581\ See, e.g., CEA section 4s(a)(1), Exchange Act section

15F(a)(1) (registration requirements for dealers); CEA section

4s(e), Exchange Act section 15F(e) (capital and margin requirements

for dealers). The Dodd-Frank Act provides that in setting the

capital requirements for swap dealers and security-based swap

dealers (as well as major participants) that are subject to a

limited designation, the Commissions and the prudential regulators

must take into account the risks associated with other types,

classes, or categories of swaps or security-based swaps engaged in,

and the other swap or security-based swap activities conducted by,

that person ``that are not otherwise subject to regulation

applicable to that person by virtue of the status of the person'' as

a dealer or major participant. See CEA section 4s(e)(2)(C); Exchange

Act section 15F(e)(2)(C). In the case of a commercial agricultural

or energy company that obtains a limited purpose designation for a

particular business unit, the CFTC does not expect that this

provision will generally require the limited purpose designee to

calculate its required capital on the basis of swaps engaged in, or

activities conducted by, other business units within the company, to

the extent those swaps or activities do not generate risk beyond the

agricultural or energy company's ordinary commercial line of

business.

---------------------------------------------------------------------------

A limited purpose designation might be appropriate, for example,

where a commercial agricultural company is a dealer in swaps related to

a thinly-traded commodity, such as a particular fertilizer, but is not

a dealer in, and does not wish to be subject to the swap dealer

requirements with respect to its swaps that relate to broadly-traded

commodities like corn or wheat (or where, say, a commercial energy

company is a dealer in swaps involving a commodity to be delivered at a

particular location and does not wish to be subject to the swap dealer

requirements for its swaps involving that commodity to be delivered at

other locations, for which it is not a swap dealer). A limited

designation might also be appropriate so that the swap dealer

requirements do not apply to interest rate or currency swaps that the

agricultural or energy company enters into in managing its financial

risk.

[[Page 30646]]

A limited purpose designee could be a particular business unit

within a company. Additionally, a limited designation might be

considered to ``split the desk'' by applying the swap dealer

requirements solely to the designee's limited activities involving

swaps not entered into for the purpose of hedging a physical position

as defined in CFTC Regulation Sec. 1.3(ggg)(6)(iii). Any particular

limited purpose application will be analyzed in light of the unique

circumstances presented by the applicant.

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.

III. Amendments to the Definition of Eligible Contract Participant

A. Background

The Dodd-Frank Act makes it unlawful for a person that is not an

eligible contract participant (``ECP'') to enter into a swap other than

on, or subject to the rules of, a DCM.\582\ In addition, section 763(e)

of the Dodd-Frank Act makes it unlawful for a person to effect a

transaction in a security-based swap with or for a person that is not

an ECP unless the transaction is effected on a national securities

exchange registered with the SEC.\583\ Moreover, section 768(b) of the

Dodd-Frank Act makes it unlawful for a person to offer to sell, offer

to buy or purchase, or sell a security-based swap to a person that is

not an ECP unless a registration statement under the Securities Act of

1933 (``Securities Act'') \584\ is in effect with respect to that

security-based swap.\585\ These provisions mean that persons can engage

in neither swaps nor security-based swaps transactions with persons

that are not ECPs on SEFs, on security-based SEFs, or on a bilateral,

off-exchange basis.

---------------------------------------------------------------------------

\582\ In particular, section 723(a)(2) of the Dodd-Frank Act

adds new subsection (e) to CEA section 2 (7 U.S.C. 2(e)), providing

that ``[i]t shall be unlawful for any person, other than an eligible

contract participant, to enter into a swap unless the swap is

entered into on, or subject to the rules of, a board of trade

designated as a contract market under section 5.''

\583\ In particular, section 763(e) of the Dodd-Frank Act adds

paragraph (l) to Exchange Act section 6 (15 U.S.C. 78f(l)),

providing that ``[i]t shall be unlawful for any person to effect a

transaction in a security-based swap with or for a person that is

not an eligible contract participant, unless such transaction is

effected on a national securities exchange registered pursuant to

subsection (b).''

\584\ 15 U.S.C. 77a et seq.

\585\ In particular, section 768(b) of the Dodd-Frank Act adds

paragraph (d) to Securities Act section 5 (15 U.S.C. 77e(d)),

providing that ``[n]otwithstanding the provisions of section 3 or 4,

unless a registration statement meeting the requirements of section

10(a) is in effect as to a security-based swap, it shall be unlawful

for any person, directly or indirectly, to make use of any means or

instruments of transportation or communication in interstate

commerce or of the mails to offer to sell, offer to buy or purchase

or sell a security-based swap to any person who is not an eligible

contract participant as defined in section 1a(18) of the Commodity

Exchange Act (7 U.S.C. 1a(18)).'' The Commissions note that market

participants must make the determination of ECP status with respect

to the parties to transactions in security-based swaps and mixed

swaps prior to the offer to sell or the offer to buy or purchase the

security-based swap or mixed swap.

---------------------------------------------------------------------------

The Dodd-Frank Act also amended the ECP definition by: \586\ (i)

Providing that, for purposes of CEA sections 2(c)(2)(B)(vi) and

2(c)(2)(C)(vii), the term ECP does not include a commodity pool in

which any participant is not itself an ECP; (ii) raising the monetary

threshold that governmental entities may use to qualify as ECPs, in

certain situations, from $25 million in investments owned and invested

on a discretionary basis to $50 million in investments owned and

invested on a discretionary basis; \587\ and (iii) replacing the

``total asset'' standard for individuals to qualify as ECPs with an

``amounts invested on a discretionary basis'' standard.\588\

---------------------------------------------------------------------------

\586\ See Sections 741(b)(10) and 721(a)(9) of the Dodd-Frank

Act; see also Financial Regulatory Reform, A New Foundation:

Rebuilding Financial Supervision and Regulation, available at http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf, at 48-

49 (June 17, 2009).

\587\ See CEA section 1a(18)(A)(vii), 7 U.S.C. 1a(18)(A)(vii).

\588\ See CEA section 1a(18)(A)(xi), 7 U.S.C. 1a(18)(A)(xi). The

Dodd-Frank Act did not amend the monetary thresholds for individuals

to qualify as ECPs. As such, an individual can qualify as an ECP if

such individual has amounts invested on a discretionary basis, the

aggregate of which is in excess of (i) $10,000,000, or (ii)

$5,000,000 if such individual also enters into the agreement,

contract, or transaction in order to manage the risk associated with

an asset owned or liability incurred, or reasonably likely to be

owned or incurred, by such individual.

---------------------------------------------------------------------------

Commodity pools may, among other things, enter into transactions

involving foreign currency. ECP status is important for commodity pools

that enter into the following types of foreign currency transactions

(such commodity pools, ``Forex Pools''): (i) Off-exchange foreign

currency futures; (ii) off-exchange options on foreign currency

futures; (iii) off-exchange options on foreign currency; (iv) leveraged

or margined foreign currency transactions; and (v) foreign currency

transactions that are financed by the offeror, the counterparty or a

person acting in concert with the offeror or counterparty on a similar

basis.\589\ In some cases, discussed below in detail, if a Forex Pool

does not satisfy the ECP definition applicable to commodity pools

engaging in the types of foreign currency transactions noted above

\590\ and it engages in these types of foreign currency transactions

(such transactions, ``retail forex transactions'' and such commodity

pools, ``Retail Forex Pools''), the transactions will be subject to a

regulatory regime that imposes certain requirements and restrictions on

the counterparties to the Retail Forex Pool, and, if the Retail Forex

Pool engages in retail forex transactions other than with certain

counterparties, on the commodity pool operator (``CPO'') who operates

the Retail Forex Pool. These requirements and restrictions do not apply

if the Forex Pool satisfies the ECP definition applicable to commodity

pools engaging in the types of foreign currency transactions noted

above.

---------------------------------------------------------------------------

\589\ See CEA sections 2(c)(2)(B)(vi) and 2(c)(2)(C)(vii), 7

U.S.C. 2(c)(2)(B)(vi) and 7 U.S.C. 2(c)(2)(C)(vii). In this context,

the term ``off-exchange'' means other than on or subject to the

rules of an organized exchange, as defined in CEA section 1a(37), 7

U.S.C. 1a(37).

\590\ See CEA section 1a(18)(A)(iv), 7 U.S.C. 1a(18)(A)(iv); see

also CFTC Regulation Sec. 1.3(m)(5) (exporting the look-through

language of CEA section 1a(18)(A)(iv) to CEA section 1a(18)(A)(v)).

The Dodd-Frank Act amended the ECP definition to include a provision

that specifically applies to Forex Pools engaging in these types of

foreign currency transactions. See Section 741(b)(10) of the Dodd-

Frank Act (adding a provision to CEA section 1a(18)(A)(iv), 7 U.S.C.

1a(18)(A)(iv), stating ``provided, however, that for purposes of

section 2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term

`eligible contract participant' shall not include a commodity pool

in which any participant is not otherwise an eligible contract

participant.''). See part III.B below for a discussion of this

provision. This provision applies only with respect to retail forex

transactions. This means that a Retail Forex Pool, as defined above,

that is not an ECP for retail forex transaction purposes could be an

ECP for other transactions it enters into that are not retail forex

transactions.

---------------------------------------------------------------------------

The Commissions are adopting further definitions of the term

``eligible contract participant'' in the following six respects: (i)

Generally prohibiting a Forex Pool from qualifying as an ECP if such

Forex Pool directly enters into retail forex transactions \591\ and has

one or more direct participants that are not ECPs; \592\ (ii)

clarifying that, in determining whether a direct participant in a Forex

Pool is an ECP, the indirect participants in the Forex Pool will not be

considered unless such Forex Pool, a commodity pool holding a direct or

indirect (through one or more intermediate tiers of pools) interest in

[[Page 30647]]

such Forex Pool, or any commodity pool in which such Forex Pool holds a

direct or indirect interest has been structured to evade Subtitle A of

Title VII of the Dodd-Frank Act; \593\ (iii) prohibiting a commodity

pool from qualifying as an ECP unless it has total assets exceeding $5

million and is operated by a person described in CEA section

1a(18)(A)(iv)(II);\594\ (iv) explicitly including swap dealers,

security-based swap dealers, major swap participants, and major

security-based swap participants in the definition of ECP; (v)

permitting a non-ECP to qualify as an ECP, with respect to certain

swaps, based on the collective net worth of its owners, subject to

several conditions, including that the owners are ECPs; and (vi)

permitting a Forex Pool to qualify as an ECP notwithstanding that it

has one or more direct participants that are not ECPs if the Forex Pool

(a) is not formed for the purpose of evading regulation under CEA

sections 2(c)(2)(B) or (C) or related rules, regulations or orders, (b)

has total assets exceeding $10 million and (c) is formed and operated

by a registered CPO or by a CPO who is exempt from registration as such

pursuant to Sec. 4.13(a)(3). In addition, the Commissions are issuing

interpretive guidance regarding the definition of ECP to correct an

inaccurate statutory cross-reference with respect to the ability of

government entities to qualify as ECPs under CEA section

1a(18)(A)(vii).\595\ The Commissions also are issuing interpretive

guidance with respect to the ECP status of Forex Pools whose

participants are limited solely to non-U.S. persons and which are

operated by CPOs located outside the United States, its territories or

possessions.

---------------------------------------------------------------------------

\591\ In many commodity pool structures, this is the master fund

alone.

\592\ But see note 652, infra, with respect to single level

Forex Pools using retail forex transactions solely to hedge.

\593\ Section 721(c) of the Dodd-Frank Act requires the CFTC to

adopt a rule to further define the terms ``swap,'' ``swap dealer,''

``major swap participant,'' and ``eligible contract participant,''

in order ``[t]o include transactions and entities that have been

structured to evade'' subtitle A of Title VII (or an amendment to

the CEA made by subtitle A).

\594\ 7 U.S.C. 1a(18)(A)(iv)(II).

\595\ 7 U.S.C. 1a(18)(A)(vii).

---------------------------------------------------------------------------

The Commissions note that commenters raised interpretive and other

issues related to the ECP definition that the Commissions may consider

in the future.\596\

---------------------------------------------------------------------------

\596\ These issues include: (i) The ECP status of jointly and

severally liable borrowers and counterparties, non-ECPs guaranteed

by ECPs, and non-ECP swap collateral providers; (ii) whether bond

proceeds count toward the ``owns and invests on a discretionary

basis $50,000,000 or more in investments'' element of the

governmental ECP prong (CEA section 1a(18)(A)(vii), 7 U.S.C.

1a(18)(A)(vii)); (iii) the relationship between the ECP and eligible

commercial entity definitions for purposes of CEA section

1a(18)(A)(vii), 7 U.S.C. 1a(18)(A)(vii); (iv) the scope of the

``proprietorship'' element of the entity prong of the ECP definition

in CEA section 1a(18)(A)(v), 7 U.S.C. 1a(18)(A)(v) (which the

Commissions are addressing to a limited extent in the discussion of

the new line of business ECP category in part III.F, infra, and in

Regulation Sec. 1.3(m)(7)(ii)(C) under the CEA); (v) the meaning of

the new ``amounts invested on a discretionary basis'' element of the

individual prong of the ECP definition (CEA section 1a(18)(A)(xi), 7

U.S.C. 1a(18)(A)(xi)); (vi) whether persons can be ECPs in

anticipation of receiving, but before they have, the necessary

assets; and (vii) that swap dealers are not among the entities

listed in CEA section 2(c)(2)(B)(i)(II), 7 U.S.C. 2(c)(2)(B)(i)(II),

as acceptable counterparties to non-ECPs engaging in retail forex

transactions.

---------------------------------------------------------------------------

B. Commodity Pool Look-Through for Retail Forex Transactions

1. Statutory Provisions

Prior to the Dodd-Frank Act, clause (A)(iv) of the ECP definition

provided that a commodity pool was an ECP if it had $5 million in total

assets and was operated by a person regulated under the CEA, regardless

of whether each participant in the commodity pool was itself an

ECP.\597\ Section 741(b)(10) of the Dodd-Frank Act added a proviso to

clause (A)(iv) \598\ stating that a Forex Pool will not qualify as an

ECP, solely for purposes of CEA sections 2(c)(2)(B)(vi) or

2(c)(2)(C)(vii) (i.e., retail forex transactions) if any participant in

the Forex Pool is itself not an ECP.\599\

---------------------------------------------------------------------------

\597\ Clause (A)(iv) of the pre-Dodd-Frank Act ECP definition

also included a commodity pool operated by a foreign person

performing a similar role or function as a person regulated under

the CEA and subject as such to foreign regulation (regardless of

whether the foreign person was itself an ECP).

\598\ The proviso states ``provided, however, that for purposes

of section 2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term

`eligible contract participant' shall not include a commodity pool

in which any participant is not otherwise an eligible contract

participant.'' CEA section 1a(18)(A)(iv); 7 U.S.C. 1a(18)(A)(iv).

\599\ See CEA section 1a(18)(A)(iv), 7 U.S.C. 1a(18)(A)(iv). In

other words, the proviso in section 1a(18)(A)(iv) does not reference

or implicate ECP status for purposes of (i) CEA section 2(e), 7

U.S.C. 2(e) (which, as discussed above, permits non-ECPs to trade

swaps only on or subject to the rules of a DCM); (ii) Securities Act

section 5(d) (which, as discussed above, makes it unlawful for a

person to offer to sell, offer to buy or purchase, or sell a

security-based swap to a person that is not an ECP unless a

registration statement under the Securities Act is in effect with

respect to that security-based swap); or (iii) Exchange Act section

6(l) (which as discussed above, makes it unlawful for a person to

effect a transaction in a security-based swap with or for a person

that is not an ECP unless the transaction is effected on a national

securities exchange registered with the SEC). The look-through

proviso does not expressly state that indirect participants, as well

as direct participants, in the Forex Pool must be ECPs for the Forex

Pool to be an ECP. But see notes 636 and 638, infra (discussing the

authority for such an approach).

---------------------------------------------------------------------------

Thus, for purposes of retail forex transactions, the Dodd-Frank Act

imposed a requirement to ``look through'' a Forex Pool--meaning that

ECP status would be limited to Forex Pools in which each participant is

itself an ECP. This is important for two reasons. First, a Forex Pool

that does not qualify as an ECP can enter into a retail forex

transaction described in CEA section 2(c)(2)(B)(i)(I) only with one of

the federally-regulated counterparties enumerated in CEA sections

2(c)(2)(B)(i)(II)(aa) (U.S. financial institutions),\600\ (bb) (certain

brokers, dealers and their associated persons),\601\ (cc) (certain

futures commission merchants (``FCMs'') and their affiliated

persons),\602\ (dd) (certain financial holding companies) \603\ or (ff)

(certain retail foreign exchange dealers (``RFEDs'')) \604\ (each an

``Enumerated Counterparty'' and collectively ``Enumerated

Counterparties''); the counterparty restriction does not apply to

retail forex transactions described in CEA section 2(c)(2)(C)(i)(I)(bb)

\605\ entered into by a Forex Pool that does not qualify as an ECP,

though such transactions are subject to antifraud protections and

related enforcement provisions if entered into with a

[[Page 30648]]

counterparty other than an Enumerated Counterparty described in CEA

section 2(c)(2)(B)(i)(II)(aa), (bb) or (dd).\606\ Second, the operator

of a Retail Forex Pool engaging in retail forex transactions with an

Enumerated Counterparty that is an FCM, specified affiliated person of

an FCM or RFED must register with the CFTC as a CPO,\607\ unless the

CPO also is an Enumerated Counterparty under 2(c)(2)(B)(i)(II)(aa),

(bb) or (dd) \608\ or an exemption from CPO registration applies.\609\

Moreover, CEA section 2(c)(2)(E)(ii)(I),\610\ which was added by

section 742(c)(2) of the Dodd-Frank Act, prohibits an Enumerated

Counterparty from entering into retail forex transactions described in

CEA section 2(c)(2)(B)(i)(I) with a person that is not an ECP ``except

pursuant to a rule or regulation of [the appropriate Federal regulator

of such Enumerated Counterparty allowing such transactions] under such

terms and conditions as [such regulator] shall prescribe.'' CEA section

2(c)(2)(E)(iii)(II) \611\ requires that such rules or regulations treat

similarly all agreements, contracts, and transactions in foreign

currency that are functionally or economically similar to CEA section

2(c)(2)(B)(i)(I) agreements, contracts, and transactions.

---------------------------------------------------------------------------

\600\ 7 U.S.C. 2(c)(2)(B)(i)(II)(aa). The term ``financial

institution'' is defined in CEA Section 1a(21), 7 U.S.C. 1a(21).

\601\ 7 U.S.C. 2(c)(2)(B)(i)(II)(bb). This category is comprised

of each:

(AA) [] broker or dealer registered under section 15(b) (except

paragraph (11) thereof) or 15C of the Securities Exchange Act of

1934 (15 U.S.C. 78o(b), 78o-5); [and] (BB) [ ] associated person of

a broker or dealer registered under section 15(b) (except paragraph

(11) thereof) or 15C of the Securities Exchange Act of 1934 (15

U.S.C. 78o(b), 78o-5) concerning the financial or securities

activities of which the broker or dealer makes and keeps records

under section 15C(b) or 17(h) of the Securities Exchange Act of 1934

(15 U.S.C. 78o-5(b), 78q(h)).

\602\ 7 U.S.C. 2(c)(2)(B)(i)(II)(cc). This category is comprised

of each:

(cc)(AA) []futures commission merchant that is primarily or

substantially engaged in the business activities described in

section 1a of this Act, is registered under this Act, is not a

person described in item (bb) of this subclause, and maintains

adjusted net capital equal to or in excess of the dollar amount that

applies for purposes of clause (ii) of this subparagraph; [and] (BB)

[ ] affiliated person of a futures commission merchant that is

primarily or substantially engaged in the business activities

described in section 1a of this Act, is registered under this Act,

and is not a person described in item (bb) of this subclause, if the

affiliated person maintains adjusted net capital equal to or in

excess of the dollar amount that applies for purposes of clause (ii)

of this subparagraph and is not a person described in such item

(bb), and the futures commission merchant makes and keeps records

under section 4f(c)(2)(B) of this Act concerning the futures and

other financial activities of the affiliated person.

\603\ 7 U.S.C. 2(c)(2)(B)(i)(II)(dd). The enumerated

counterparty in this category is ``a financial holding company (as

defined in section 2 of the Bank Holding Company Act of 1956).''

\604\ 7 U.S.C. 2(c)(2)(B)(i)(II)(ff). This category is comprised

of each:

retail foreign exchange dealer that maintains adjusted net

capital equal to or in excess of the dollar amount that applies for

purposes of clause (ii) of this subparagraph and is registered in

such capacity with the [CFTC], subject to such terms and conditions

as the [CFTC] shall prescribe, and is a member of a futures

association registered under section 17 [of the CEA].

\605\ 7 U.S.C. 2(c)(2)(C)(i)(I)(bb).

\606\ The counterparty limitation with respect to CEA section

2(c)(2)(B)(i)(I) retail forex transactions is a function of the fact

that the CEA's exchange-trading requirement generally applies with

respect to foreign currency futures, foreign currency options on

futures, and foreign currency options. See CEA section 4(a), 7

U.S.C. 6(a) (generally requiring futures contracts to be traded on

or subject to the rules of a DCM); CEA section 4c(b), 7 U.S.C. 6c(b)

(prohibiting trading options subject to the CEA contrary to CFTC

rules, regulations or orders permitting such trading); Part 32 of

the CFTC's rules, 17 CFR part 32 (generally prohibiting entering

into options subject to the CEA) and CFTC Regulation Sec. 33.3(a),

17 CFR 33.3(a) (prohibiting entering into options on futures other

than on or subject to the rules of a DCM). Because CEA section 4(a)

would render an off-exchange futures contract illegal but for CEA

section 2(c)(2)(B) permitting such transactions with an Enumerated

Counterparty, it would be illegal for a non-Enumerated Counterparty

to enter into a futures contract described in 2(c)(2)(B)(i)(I) with

a non-ECP. Similarly, because options can be conducted only pursuant

to CFTC authority and the CFTC has proposed to treat commodity

options within its jurisdiction as swaps, CEA section 2(e) would

prohibit such options, if on foreign exchange and entered into with

a non-ECP, but for the fact that 2(c)(2)(B) permits them if traded

with an Enumerated Counterparty.

The lack of a counterparty limitation with respect to CEA

section 2(c)(2)(C)(i)(I)(bb) retail forex transactions is a function

of the different structures of CEA sections 2(c)(2)(B) and (C).

Whereas CEA section 2(c)(2)(B)(i) covers transactions that would be

illegal but for compliance with CEA section 2(c)(2)(B) (due to such

section's incorporation of the entire CEA, including, for example,

the exchange-trading requirement discussed above), falling within

CEA section 2(c)(2)(C)(i)(I), by that section's own terms, merely

brings a covered transaction within the scope of CEA section

2(c)(2)(C), which does not include the exchange-trading requirement

of CEA section 4(a). Because CEA section 2(c)(2)(C)(i)(I) covers

transactions that may or may not also be transactions described in

section 2(c)(2)(B)(i)(I) and the far fewer requirements imposed by

CEA section 2(c)(2)(C) invite characterization of such difficult-to-

categorize transactions as falling solely within CEA section

2(c)(2)(C), the CFTC will interpret such dually characterizable

transactions as governed by CEA section 2(c)(2)(B). If such

transactions fall only within CEA section 2(c)(2)(C), however,

because they would be subject to neither the exchange-trading

requirement of CEA section 4(a) nor the CFTC's plenary options

authority under CEA section 4c(b) (while CEA section

2(c)(2)(C)(ii)(I), 7 U.S.C. 2(c)(2)(C)(ii)(I), reserves the CFTC's

section 4c(b) authority, in this scenario, the contract in question

is not an option), a person other than an Enumerated Counterparty

may act as counterparty to a non-ECP. Such contracts would, however,

be subject to two of the CEA's antifraud provisions, sections 4(b)

and 4b, 7 U.S.C 6(b) and 7 U.S.C 6b, respectively, as if they were

futures contracts. See CEA section 2(c)(2)(C)(iv), 7 U.S.C.

2(c)(2)(C)(iv). Such contracts also would be subject to related

enforcement provisions. See CEA section 2(c)(2)(C)(ii)(I), 7 U.S.C.

2(c)(2)(C)(ii)(I).

\607\ See CEA sections 2(c)(2)(B)(iv)(I) and (C)(iii)(I)

(requiring registration for CPOs of Retail Forex Pools entering into

retail forex transactions with FCMs, specified affiliated persons

thereof or RFEDs). By contrast, those sections exclude from the CPO

registration requirement CPOs of Retail Forex Pools engaging in

retail forex transactions with Enumerated Counterparties described

in CEA section 2(c)(2)(B)(i)(II)(aa), (bb), (ee) and (ff). While the

cited CEA sections refer to counterparties not described in ``any of

item (aa), (bb), (ee), or (ff)'' of subparagraph (B)(i)(II), the

CFTC Reauthorization Act of 2008 (``CRA''), included as Title XIII

of the Food, Conservation and Energy Act of 2008, Pub.L. 110-246,

122 Stat. 1651 changed item (ee) to item (dd) (a financial holding

company as defined in section 2 of the Bank Holding Company Act of

1956) and removed item (ff) (formerly an investment bank holding

company (as defined in section 17(i) of the Exchange Act (15 U.S.C.

78q(i))). Therefore, the Commissions interpret the reference in CEA

sections 2(c)(2)(B)(iv)(I)(cc) and 2(c)(2)(C)(iii)(I)(cc) to items

(aa), (bb), (ee), or (ff) to be references to items (aa), (bb) and

(dd). Cf. Retail Foreign Exchange Transactions; Conforming Changes

to Existing Regulations in Response to the Dodd-Frank Wall Street

Reform and Consumer Protection Act, 76 FR 56103 (Sept. 12, 2011)

(providing background on related incorrect internal references in

CEA sections 2(c)(2)(B) and (C)). See also CFTC Regulation Sec.

5.3(a)(2)(i), 17 CFR 5.3(a)(2)(i), which requires a CPO, as defined

in CFTC Regulation Sec. 5.1(d)(1), 17 CFR 5.1(d)(1), to register as

such. CFTC Regulation Sec. 5.1(d)(1), in turn, defines a CPO, for

purposes of Part 5 of the CFTC's Regulations, 17 CFR part 5, as

``any person who operates or solicits funds, securities or property

for a pooled investment vehicle that is not an [ECP] as defined in

section 1a(18) of the Act, and that engages in retail forex

transactions.'' The CFTC interprets the references in Regulation

Sec. 5.1(d)(1) to ECPs as defined in CEA section 1a(18) to include

the ECP definition as further defined or interpreted by the

Commissions under authority conferred by the Dodd-Frank Act or

otherwise amended or interpreted by the Commissions or a court.

While the statutory CPO definition in CEA section 1a(11)(A), 7

U.S.C. 1a(11)(A), does not include transactions described in CEA

section 2(c)(2)(B)(i), the Commissions believe this was an

oversight. In any case, CEA section 1a(11)(B), 7 U.S.C. 1a(11)(B),

grants the CFTC the authority to further define the term CPO, which

the CFTC has done in CFTC Regulation Sec. 5.1(d)(1). Therefore, a

person operating a commodity pool engaging in transactions described

in CEA section 2(c)(2)(B)(i) is a CPO.

\608\ See CEA sections 2(c)(2)(B)(iv)(II) and

2(c)(2)(C)(iii)(II). While CEA sections 2(c)(2)(B)(iv)(II) and

2(c)(2)(C)(iii)(II) refer to counterparties described in item (aa),

(bb), (ee), or (ff) of subparagraph (B)(i)(II), the CFTC

Reauthorization Act of 2008 changed item (ee) to item (dd) and

removed item (ff). Therefore, the Commissions interpret the

reference in CEA sections 2(c)(2)(B)(iv)(II) and 2(c)(2)(C)(iii)(II)

to items (aa), (bb), (ee), or (ff) to be references to items (aa),

(bb) and (dd). Cf. Retail Foreign Exchange Transactions; Conforming

Changes to Existing Regulations in Response to the Dodd-Frank Wall

Street Reform and Consumer Protection Act, 76 FR 56103 (Sept. 12,

2011) (providing background on related incorrect internal references

in 2(c)(2)(B) and (C)).

\609\ See, e.g., CFTC Regulation Sec. 4.13(a)(3) (exempting

from CPO registration operators of commodity pools engaged in a de

minimis amount of trading in CFTC-jurisdictional contracts).

\610\ 7 U.S.C. 2(c)(2)(E)(ii)(I).

\611\ 7 U.S.C. 2(c)(2)(E)(iii)(II).

---------------------------------------------------------------------------

Separately, subclause (A)(v)(III) of the ECP definition, both

before and after enactment of the Dodd-Frank Act, provides that a

corporation, partnership, proprietorship,\612\ organization, trust or

other business entity may qualify as an ECP if it has a net worth

exceeding $1 million and ``enters into an agreement, contract, or

transaction in connection with the conduct of the entity's business or

to manage the risk associated with an asset or liability owned or

incurred or reasonably likely to be owned or incurred by the entity in

the conduct of the entity's business.'' \613\

---------------------------------------------------------------------------

\612\ Individuals also are covered by a different prong of the

ECP definition. An individual can qualify as an ECP under clause

(A)(xi) of the ECP definition. See CEA section 1a(18)(A)(xi), 7

U.S.C. 1a(18)(A)(xi).

\613\ There are two other ways a person can qualify as an ECP

under clause (A)(v): (i) being an entity with total assets exceeding

$10 million; or (ii) being an entity the obligations of which under

an agreement, contract, or transaction are guaranteed or otherwise

supported by a letter of credit or keepwell, support, or other

agreement by an entity with total assets exceeding $10 million or an

entity described in clause (A)(i), (ii), (iii), (iv) or (vii), or

paragraph (C), of the ECP definition. See CEA section

1a(18)(A)(v)(I) and (II), 7 U.S.C. 1a(18)(A)(v)(I) and (II),

respectively.

---------------------------------------------------------------------------

2. Proposed Approach

The Commissions stated in the Proposing Release that ``in some

cases commodity pools unable to satisfy the conditions of clause

(A)(iv) of the ECP definition may rely on clause (A)(v) to qualify as

ECPs instead for purposes of retail forex'' and that permitting such

reliance would frustrate the intent of Congress in imposing the look-

through requirement on Forex Pools in clause (A)(iv) of the ECP

definition.\614\

---------------------------------------------------------------------------

\614\ Proposing Release, 75 FR at 80185.

---------------------------------------------------------------------------

The Commissions proposed to further define the term ``eligible

contract participant'' to preclude a Forex Pool from qualifying as an

ECP for purposes of retail forex transactions in reliance on clause

(A)(v) of the ECP definition if

[[Page 30649]]

such Forex Pool has any participant that is not an ECP and, therefore,

is not an ECP due to the look-through provision added to clause

(A)(iv). Further, because commodity pools can be structured in various

ways and can have one or more feeder funds and/or pools, the

Commissions proposed to preclude a Forex Pool from being an ECP for

purposes of retail forex transactions if there was any non-ECP

participant at any level of the pool structure (e.g., the pool itself,

a direct participant that invests in the pool, or any indirect

participant that invests in that pool through other pools or vehicles).

3. Commenters' Views

One commenter supported the Commissions' efforts to close the

potential loophole of Forex Pools that are unable to qualify as ECPs

due to the new look-through provision in clause (A)(iv) of the ECP

definition instead qualifying as ECPs under clause (A)(v) of the ECP

definition.\615\ This commenter indicated that it shares the

Commissions' concern that Forex Pools that do not satisfy the amended

ECP definition due to the look-through provision for commodity pools in

clause (A)(iv) may alternatively rely upon clause (A)(v) of the ECP

definition to qualify as an ECP for purposes of retail forex

transactions.\616\ This commenter further stated that Congressional

intent in requiring a look-through for Forex Pools would be frustrated

if fraudulent pool operators could avail themselves of this

alternative.\617\

---------------------------------------------------------------------------

\615\ See letter from the NFA. The NFA indicated that it

recently took separate emergency actions against two firms that did

not qualify under the NFA's requirements for retail forex

transactions. In one case, the commodity pool fell short of the $5

million total asset requirement in clause (A)(iv) of the ECP

definition; in the other case, the firm never properly formed a

commodity pool. The NFA cautioned in its letter, ``these cases

illustrate that firms will attempt to obtain ECP status to shield

themselves from the jurisdiction of regulators to the detriment of

pool participants.''

\616\ Id.

\617\ Id.

---------------------------------------------------------------------------

However, several commenters recognized the importance of the

concern about a potential loophole \618\ but stated that the

Commissions should revise the proposal to mitigate the potential

adverse consequences to market participants. One commenter, for

example, commented on the expected effects of the proposed rule on

funds of funds (``FOFs'').\619\ According to this commenter, FOFs (i)

normally face as counterparties foreign subsidiaries of U.S. banks and

foreign banks, and (ii) would incur substantial counterparty,

documentation and operational costs in moving their retail forex

transactions onto DCMs or toward the Enumerated Counterparties.

---------------------------------------------------------------------------

\618\ See, e.g., letters from SIFMA--AMG dated September 15,

2011 (``SIFMA AMG IV'') (acknowledging some form of ECP look-through

is appropriate to prevent evasion where circumvention otherwise

could occur and stating that it is sympathetic to the Commissions'

implicit objective of ensuring that a person that would not qualify

as an ECP not be permitted to accomplish indirectly what it is not

permitted to do directly), Sidley Austin LLP (``Sidley'') (stating

that the commenter fully appreciates that Congress added the look-

through language to the ECP definition to prevent unscrupulous forex

market participants from avoiding the retail forex provisions of the

CEA and the CFTC's rules by ``engineering'' an ECP by pooling the

capital of a large group of retail customers, thus depriving those

investors of the protections otherwise afforded to them), AIMA I

(stating that ``we understand Congress has made a decision to try to

protect retail investors by amending the definition of ECP under

Section 1a(1[8]) of the [CEA] to include that, for a commodity pool

to qualify as an ECP under sub-section (A)(iv), the pool's

underlying participants must also qualify as ECPs under section

1a(1[8])).''

\619\ See letter from Sidley. Sidley noted that FOF managers'

retail forex transactions are largely undertaken for hedging

purposes and that most FOF managers offer investments to non-U.S.

persons, a significant number of which pay for their investments in

FOF interests using their own currency. Sidley further noted that,

because most FOFs accept investments only in U.S. dollars, FOF

managers must convert to U.S. dollars the foreign currency received

from such investors and invest those dollars in underlying funds,

and that they enter into a hedging transaction to reduce the risk of

exchange rate changes between an investor's currency and the U.S.

dollar.

---------------------------------------------------------------------------

In a similar vein, two commenters advised that a substantial number

of hedge funds, as well as publicly offered commodity pools, would,

under the Commissions' proposal, fail to qualify as ECPs for purposes

of retail forex transactions, as most such funds have at least one

direct or indirect non-ECP participant.\620\ These commenters indicated

that this would disrupt the trading strategies employed by many

commodity trading advisors (``CTAs'') on behalf of commodity

pools.\621\ One of these commenters suggested an anti-evasion approach

combining a lower level of pool assets with a requirement that the

commodity pool not be formed for the purpose of evading the regulatory

requirements applicable to retail forex transactions.\622\

---------------------------------------------------------------------------

\620\ See letters from Willkie Farr & Gallagher LLP (``Willkie

Farr'') and the NYCBA Committee.

\621\ Id.

\622\ See letter from Willkie Farr.

---------------------------------------------------------------------------

Another commenter argued that Congress did not include the look-

through provision in clause (A)(v) of the ECP definition because of its

effect on bona fide hedgers.\623\ This commenter also advised that the

primary entities affected are hedge fund and private equity fund

managers investing in securities who use retail forex transactions

solely to hedge investment portfolio currency risks, and/or because

they accept subscriptions in currencies other than U.S. dollars.\624\

---------------------------------------------------------------------------

\623\ See letter from Akin Gump Strauss Hauer & Feld LLP (``Akin

Gump'').

\624\ Id.

---------------------------------------------------------------------------

Several commenters disagreed with the Commissions' statement in the

proposal that extending the look-through provision in clause (A)(iv) of

the ECP definition to clause (A)(v) would effectuate Congressional

intent. Two commenters noted that there is no specific Dodd-Frank Act

provision requiring such a change.\625\ Two other commenters argued

that clause (v) of the ECP definition provides an independent basis for

qualification as an ECP, which should not be affected by the changes in

clause (A)(iv) of the ECP definition.\626\

---------------------------------------------------------------------------

\625\ See letters from AIMA I and Ropes & Gray LLP (``Ropes &

Gray'').

\626\ See letters from Akin Gump, Sidley and Skadden, Arps,

Slate, Meagher & Flom LLP (``Skadden''). Sidley also indicated that

there seems to be no compelling reason to treat commodity pools

worse than other sophisticated market participants with respect to

retail forex transactions with non-Enumerated Counterparties, and no

reason to treat them worse than a corporation or other entity with

only $10 million in total assets that therefore qualifies as an ECP

under clause (A)(v) of the ECP definition to trade retail forex

transactions although it may have no particular expertise in such

markets.

---------------------------------------------------------------------------

One commenter indicated that the extraterritorial application of

the proposed rules regarding the ECP definition is unclear.\627\ Among

other things, this commenter indicated it is unnecessary to extend the

scope of the look-through to protect possible retail investors outside

of the U.S., especially where a CPO has not marketed a pool in the U.S.

and does not otherwise have any U.S. investors.\628\

---------------------------------------------------------------------------

\627\ See letter from AIMA I.

\628\ Id.

---------------------------------------------------------------------------

Commenters proposed several alternative approaches that they

believed would address the Commissions' concerns. One commenter

suggested that the Commissions create a new category of ECPs for Forex

Pools comprised entirely of qualified eligible persons (``QEPs'') \629\

and operated by persons subject to regulation under the CEA.\630\ This

commenter also suggested that the Commissions create a new category of

ECPs for Forex Pools that satisfy a monetary threshold for total assets

or for the minimum initial investment of a Forex Pool to be

sufficiently large that, in general, only legitimate pools would exceed

such thresholds.\631\ Finally, this commenter suggested that the

Commissions create a category of ECPs

[[Page 30650]]

for non-U.S. persons.\632\ A second commenter suggested that the

Commissions create a category of ECPs for commodity pools that are

operated by a CPO or advised by a CTA subject to regulation by a

foreign regulator comparable to the CFTC.\633\

---------------------------------------------------------------------------

\629\ The term ``qualified eligible person'' is defined in CFTC

Regulation Sec. Sec. 4.7(a)(2) and (3).

\630\ See letter from Sidley.

\631\ Id.

\632\ Id. Sidley cited to the approach in Regulation S under the

Securities Act (17 CFR 230.901 et seq.), Sections 3(c)(1) and (7) of

the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1) and (7)),

and CFTC Regulation Sec. 4.7(a)(2)(xi).

\633\ See letter from Willkie Farr.

---------------------------------------------------------------------------

One commenter suggested (i) allowing commodity pools and their

counterparties to rely, for the duration of an investment and each time

commodity pool participants make an investment decision, on participant

ECP representations provided in connection with an initial investment,

provided that each participant covenants to update such representations

if they become inaccurate, and (ii) providing specific relief for FOFs

because they generally invest all or substantially all of their assets

in underlying portfolio funds and use retail forex transactions to

reduce foreign exchange exposure.\634\

---------------------------------------------------------------------------

\634\ See letter from Sidley.

---------------------------------------------------------------------------

4. Final Rule

After considering commenters' concerns, the Commissions are

adopting final rules that have been revised from the proposal. In

particular, consistent with the statutory text of the Dodd-Frank Act,

CFTC Regulation Sec. 1.3(m)(5)(i) further defines the term ``eligible

contract participant'' to prohibit a Forex Pool that directly enters

into a retail forex transaction (i.e., a transaction-level commodity

pool) \635\ from qualifying as an ECP under clause (A)(iv) or clause

(A)(v) of the ECP definition, solely for purposes of entering into

retail forex transactions, if the pool has one or more direct

participants that are not ECPs. In response to commenters' concerns

described above, CFTC Regulation Sec. 1.3(m)(5)(ii) is revised to

provide that, in determining whether a commodity pool that is a direct

participant in a transaction-level Forex Pool is an ECP, the indirect

participants in the transaction-level Forex Pool \636\ will not be

considered unless such Forex Pool, a commodity pool holding a direct or

indirect (through one or more intermediate tiers of pools) interest in

such Forex Pool, or any commodity pool in which such Forex Pool holds a

direct or indirect interest has been structured to evade Subtitle A of

Title VII of the Dodd-Frank Act by permitting persons that are not ECPs

to participate in agreements, contracts, or transactions described in

section 2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Commodity

Exchange Act. That is, absent evasion, the Commissions are changing the

proposed ``indefinite look-through'' to an ``evasion-based look-

through'' in the final rule.\637\

---------------------------------------------------------------------------

\635\ Commodity pool structures can take various forms. One

common commodity pool structure is a ``master-feeder'' fund

structure. In such a structure, investors purchase interests in

``feeder funds,'' which in turn purchase interests in a ``master

fund.'' Typically, the only fund in a commodity pool structure that

enters into retail forex transactions (and other transactions)

directly is the master fund; the feeder funds (and their investors)

typically would participate indirectly by receiving the profit or

loss from such retail forex transactions (and other transactions) as

distributions based on the feeder funds' interests in the master

fund. Notwithstanding that the master-feeder structure is common,

other structures exist. Thus, each fund in a commodity pool

structure that directly enters into retail forex transactions is a

transaction-level commodity pool.

\636\ A fund that does not itself engage in retail forex

transactions but that holds an interest in a transaction-level Forex

Pool that engages in retail forex transactions is itself a commodity

pool. Cf. U.S. Regulation of the International Securities and

Derivatives Markets--Greene, Beller, Rosen, Silverman, Braverman and

Sperber, Sec. 12.13[1], n.351 and related text.

\637\ The Commissions caution, however, that they will closely

monitor developments in this part of the market and will not

hesitate to revisit their decision to limit the look-through

provision pursuant to 1.3(m)(5)(ii) should they observe a pattern of

evasion or misconduct.

---------------------------------------------------------------------------

In adding the look-through provision to the commodity pool prong of

the ECP definition, Congress made a decision to protect retail foreign

exchange investors by requiring that the participants in a Forex Pool

qualify as ECPs for the Forex Pool itself to qualify as an ECP. The

Commissions believe that the intent of the look-through provision--

protecting Forex Pool participants from fraudulent and abusive

conduct--must be given effect to comply with this Congressional

mandate. Nevertheless, the Commissions acknowledge commenters' concerns

about potential unintended consequences of applying an indefinite look-

through to every direct and indirect participant of a Forex Pool, as

proposed. Accordingly, to avoid unintended consequences and related

costs for Forex Pools whose operators and managers have not

historically presented the risks that the look-through provision was

intended to address,\638\ the Commissions are replacing the proposed

indefinite look-through of every participant in a Forex Pool with a

limited, evasion-based look-through pursuant to which a transaction-

level Forex Pool will qualify as an ECP, for purposes of retail forex

transactions, if all of such Forex Pool's direct participants are ECPs,

and will look through a commodity pool participant in such Forex Pool

only if it, at any level, has been structured to evade the look-through

provision in clause (A)(iv) of the ECP definition.

---------------------------------------------------------------------------

\638\ The proposed rule was based on the CFTC's longstanding,

broad view of what constitutes a ``pool,'' a view recently codified

in the ``commodity pool'' definition by section 721(a)(5) of the

Dodd-Frank Act in CEA section 1a(10), 7 U.S.C. 1a(10), and

recognized by courts, and thus applied the look-through provision at

each level of a Forex Pool's investment structure. See CFTC,

Commodity Pool Operators and Commodity Trading Advisors: Amendments

to Compliance Obligations, 77 FR 11252 (Feb. 24, 2012) (``CPO/CTA

Compliance Release'') (advising that ``it is the position of the

[CFTC] that a fund investing in an unaffiliated commodity pool it

itself a commodity pool'' and ``[t]his interpretation is consistent

with the statutory definition of commodity pool, which draws no

distinction between direct and indirect investments in commodity

interests''); CFTC v. Equity Financial Group, 572 F.3d 150, 157-158

(July 13, 2009) (concluding, in the context of a commodity pool that

invested all of its assets with a commodity pool operated by a

different CPO, that the CFTC's commodity pool regulations ``cover

pools that invest in other pools'' and that ``the remedial purposes

of the statute would be thwarted if the operator of a fund could

avoid the regulatory scheme simply by investing in another pool

rather than trading''). The same logic applies to a master-feeder

structure operated by the same CPO: the remedial purpose of the

look-through proviso in clause (A)(iv) of the statutory ECP

definition would be thwarted if the look-through could be defeated

simply by funneling pool participants into a master fund through a

feeder fund.

The proposed rule also was borne of the CFTC's long history of

combating fraudulent practices by typically unregistered individuals

or entities that prey upon often unsophisticated retail customers

through complex and highly leveraged off-exchange transactions in

foreign currency. However, the operators and managers of commodity

pool FOFs, master-feeder structures and hedge funds for

sophisticated investors have not generally been the subject of CFTC

enforcement actions with respect to retail forex transactions. For

an in depth discussion of the history of the CFTC's authority over

retail forex transactions, the abuses giving rise to that authority,

and related enforcement actions, see CFTC, Regulation of Off-

Exchange Retail Foreign Exchange Transactions and Intermediaries, 75

FR 3282 (Jan. 20, 2010). Congress acted three times in a decade to

clarify the CFTC's authority to prosecute the rampant fraud seen in

this area--first in the Commodity Futures Modernization Act of 2000,

Public Law 106-554, 114 Stat. 2763 (Dec. 21, 2000) in 2000, then

again in the CRA, and finally in the Dodd-Frank Act in 2010.

---------------------------------------------------------------------------

The Commissions believe the final rule strikes the right balance

between implementing strong protections for non-ECP commodity pool

participants and not imposing undue burdens or costs on CPOs, CTAs and

commodity pool participants related to retail forex transactions. In

addition, the Commissions believe that replacing the indefinite look-

through with the limited, evasion-based look-through alleviates many of

the commenters' concerns. Accordingly, the Commissions believe it is

appropriate to limit the look-through provision to the level of a

commodity pool structure that enters into retail forex transactions and

to look through commodity pools to their ultimate participants only in

those

[[Page 30651]]

cases in which it is required to prevent evasion of the protections for

those persons whom Congress intended to be subject to retail forex

transactions restrictions.

At the same time, the Commissions do not believe that Forex Pools

failing to qualify as ECPs due to the look-through provision in clause

(A)(iv) of the ECP definition should, nonetheless, be permitted

unfettered access to ECP status under clause (A)(v).\639\ The look-

through provision for Forex Pools provides heightened investor

protection from forex fraud for Forex Pool participants that are not

themselves ECPs. Thus, the Commissions believe that permitting Forex

Pools with one or more non-ECP participants to achieve ECP status by

relying on clause (A)(v) of the ECP definition, which applies to

business entities generally, would serve to undermine the look-through

provision that Congress specifically imposed on Forex Pools under

clause (A)(iv).\640\

---------------------------------------------------------------------------

\639\ In section 712(d)(2)(A) of the Dodd-Frank Act, Congress

granted the Commissions the authority to adopt such rules regarding

the ECP definition as the Commissions determine are necessary and

appropriate, in the public interest, and for the protection of

investors.

\640\ The Commissions note that several commenters requested

clarification regarding the relationship between the look-through

provision set forth in CFTC Regulation Sec. 1.3(m)(5) and the

prohibition on a commodity pool qualifying as an ECP under clause

(A)(v) of the ECP definition if it does not qualify as an ECP under

clause (A)(iv) of the ECP definition set forth in CFTC Regulation

Sec. 1.3(m)(6). See, e.g., meeting with SIFMA--AMG on August 2,

2011. The look-through provision is limited to determining ECP

status under clause (A)(iv) or clause (A)(v) of the ECP definition

for purposes of retail forex transactions entered into by Forex

Pools. The look-through provision does not reference or implicate

ECP status for purposes of CEA section 2(e) (which prohibits non-

ECPs from entering into swaps other than on or subject to the rules

of a DCM), Securities Act section 5(d) (which prohibits a person

from offering to sell, offering to buy or purchase, or selling a

security-based swap to a person that is a non-ECP unless a

registration statement under the Securities Act is in effect with

respect to that security-based swap), or Exchange Act section 6(l)

(which prohibits a person from effecting a transaction in a

security-based swap with or for a person that is a non-ECP unless

the transaction is effected on a national securities exchange

registered with the SEC). The prohibition in CFTC Regulation Sec.

1.3(m)(6) on a commodity pool qualifying as an ECP under clause

(A)(v) of the ECP definition if it does not qualify as an ECP under

clause (A)(iv) of the ECP definition does not involve any look-

through. Rather, in contrast with CFTC Regulation Sec. 1.3(m)(5),

CFTC Regulation Sec. 1.3(m)(6) applies for purposes of all

agreements, contracts and transactions for which ECP status is

relevant. See part III.C, infra, for a discussion of the prohibition

on a commodity pool qualifying as an ECP under clause (A)(v) of the

ECP definition if it does not qualify as an ECP under clause (A)(iv)

of the ECP definition.

---------------------------------------------------------------------------

Moreover, developments subsequent to the issuance of the Proposing

Release should ameliorate commenters' concerns that CEA section

2(c)(2)(E)(ii)(I) significantly limits the universe of possible retail

forex transaction counterparties.\641\ At the time the Commissions

issued the Proposing Release and throughout the comment period, the

CFTC was the only Federal regulatory agency that had issued final rules

governing retail forex transactions by its regulated persons and

entities.\642\ Since then, though, both the OCC and the FDIC finalized

(effective July 15, 2011) rules governing retail forex transactions by

Enumerated Counterparties regulated by those agencies.\643\ In

addition, the SEC has issued interim temporary final rules (also

effective July 15, 2011) governing retail forex transactions by

registered broker-dealers.\644\ Also, the Federal Reserve Board

proposed rules to govern retail forex transactions by its regulated

banks on August 3, 2011.\645\ As a result of these regulatory actions,

Forex Pools that are not ECPs due to the look-through provision and who

are subject to a counterparty limitation \646\ may enter into retail

forex transactions with any Enumerated Counterparty but for those

regulated by the Federal Reserve Board.\647\

---------------------------------------------------------------------------

\641\ See also part III.G, infra, discussing CFTC Regulation

Sec. 1.3(m)(8), one effect of which is to eliminate the retail

forex transaction counterparty restriction for Forex Pools

qualifying as ECPs.

\642\ See generally Part 5 of the CFTC's regulations, 17 CFR 5,

and CFTC, Regulation of Off-Exchange Retail Foreign Exchange

Transactions and Intermediaries, 75 FR 55410 (Sept. 10, 2010). See

also CFTC, Retail Foreign Exchange Transactions; Conforming Changes

to Existing Regulations in Response to the Dodd-Frank Wall Street

Reform and Consumer Protection Act 76 FR 56103 (Sept. 12, 2011).

\643\ See FDIC, Retail Foreign Exchange Transactions, 76 FR

40779 (July 12, 2011) (final FDIC retail forex rules); OCC, Retail

Foreign Exchange Transactions, 76 FR 41375 (July 14, 2011) (final

OCC retail forex rules); see also OCC, Retail Foreign Exchange

Transactions, 76 FR 56094 (Sept. 12, 2011) (interim final OCC retail

forex rules for federal savings associations and their operating

subsidiaries).

\644\ See SEC, Retail Foreign Exchange Transactions, 76 FR 41676

(July 15, 2011). In the release accompanying the rules, the SEC

requested comment on broker-dealers' involvement in retail forex

transactions to inform the SEC in developing permanent rules to

regulate these activities. See id. at 46181-83.

\645\ See Board, Retail Foreign Exchange Transactions

(Regulation NN), 76 FR 46652 (Aug. 3, 2011) (proposed Board rules

for retail forex transactions).

\646\ See part III.B.1, supra, discussing the applicability of

the counterparty limitation.

\647\ Of course, upon the Board's finalization of its retail

forex rules, U.S. financial institutions regulated by the Board also

will be acceptable counterparties.

---------------------------------------------------------------------------

The Commissions believe that the final rules reasonably address

commenters' concerns. In this regard, the Commissions note that in

applying the look-through provision, the Commissions will consider the

indirect participants in a transaction-level Forex Pool if such Forex

Pool, a commodity pool holding a direct or indirect (through one or

more intermediate tiers of pools) interest in such Forex Pool, or any

commodity pool in which such Forex Pool holds a direct or indirect

interest has been structured to evade Subtitle A of Title VII of the

Dodd-Frank Act by permitting persons that are not ECPs to participate

in agreements, contracts, or transactions described in section

2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Commodity Exchange Act.

One example of a scheme to evade would be if a commodity pool tier has

been included in the structure of the Forex Pool primarily to provide

non-ECP participants exposure to retail forex transactions rather than

to achieve any other legitimate business purpose.\648\ One example of a

``legitimate business purpose'' that would not trigger the look-through

provision is a FOF operated primarily for the purpose of investing in

underlying funds and using retail forex transactions solely to hedge

the currency risk posed by an unfavorable change in the exchange rate

between the currency in which underlying funds accept investments and

the currency in which FOF investors pay for their investments in the

FOF.\649\ Similarly, the Commissions would not consider a commodity

pool using retail forex transactions solely for bona fide hedging

purposes \650\ with

[[Page 30652]]

respect to currency risk as being structured to avoid the look-through

provision.\651\ The ``participate in agreements, contracts, or

transactions described in section 2(c)(2)(B)(i) or section

2(c)(2)(C)(i) of the Act'' language of CFTC Regulation Sec.

1.3(m)(5)(ii) is aimed at exposure to retail forex transactions as an

asset class, investment strategy, or an end in itself, not at exposure

to retail forex transactions solely designed for bona fide hedging

purposes with respect to foreign exchange exposure arising in the

course of a commodity pool's business.\652\

---------------------------------------------------------------------------

\648\ Feeder funds are usually added to commodity pool

structures for purposes such as tax efficiency. A master-feeder

structure ``[permits] U.S. taxable investors to take advantage of

investing in a U.S. limited partnership feeder fund, which[,]

through certain elections made at the time the structure is

established, is tax effective for such U.S. taxable investors'' and

``[permits] [n]on-U.S. and U.S. tax-exempt investors [to] subscribe

via a separate offshore feeder company so as to avoid coming

directly within the U.S. tax regulatory net applicable to U.S.

taxable investors.'' Effie Vasilopoulos & Katherine Abrat, The

Benefits of Master-Feeder Fund Structures for Asian-based Hedge Fund

Managers, Hedge Fund Monthly (April 2004), available at http://www.eurekahedge.com/news/04apr_archive_Sidley_master_feeder.asp.

Other benefits can include efficiencies gained by the use of only a

single trading entity, avoiding the need to split trade tickets,

eliminating the need to duplicate agreements with counterparties and

greater economies of scale in administering the fund. Id.

\649\ Sidley notes that the typical FOF operates in this manner.

See generally letter from Sidley for a more detailed discussion of

these transactions.

\650\ In this context, bona fide hedging purposes means bona

fide hedging purposes within the meaning and intent of CFTC

Regulation Sec. 1.3(z)(1), except that the requirement therein that

the transaction or position be on a DCM or SEF that is a trading

facility will not be a factor in the bona fide hedging purpose

analysis. Compare CFTC Regulation Sec. 4.5(c)(2)(iii)(A) (relying

in part on the bona fide hedging concepts in CFTC Regulations

Sec. Sec. 1.3(z)(1) and 151.5 to provide relief from the CPO

definition). See also CPO/CTA Compliance Release at 11256-11257

(discussing and declining to adopt commenters' request to expand the

definition of bona fide hedging to include risk management). Where a

Forex Pool's counterparty, but not the Forex Pool, is hedging its

risks, it is not the case that the Forex Pool is entering the retail

forex transaction solely to hedge its own risk.

\651\ The examples mentioned in text should not be construed to

mean that any other fact pattern does or does not constitute

evasion, which must be determined on a case-by-case basis.

\652\ Based on the same reasoning, the Commissions do not

believe it was the intent of the look-through proviso in CEA section

1a(18)(A)(iv) to subject to a retail forex regime a single level

commodity pool engaging in retail forex transactions solely for bona

fide hedging purposes with respect to foreign exchange exposure

arising in the course of a commodity pool's operations.

Consequently, the Commissions will interpret such a commodity pool

as an ECP if it otherwise satisfies the terms of CEA section

1a(18)(A)(iv) even if such a pool has one or more non-ECP

participants.

---------------------------------------------------------------------------

In applying the limited look-through provision in the final rule,

the Commissions would consider a Forex Pool's direct participants to

include not only persons that initially hold interests in the level of

the commodity pool structure that enters into retail forex

transactions, but also persons that can acquire those interests or that

subsequently hold those interests. As applied to exchange-traded

products (``ETPs'') that are Forex Pools, any person that acquires an

interest in the ETP Forex Pool in secondary market transactions would

be a direct participant. ETPs typically issue shares only in the large

aggregations or blocks (such as 50,000 ETP shares) called ``Creation

Units.'' An authorized purchaser, usually an investment bank, broker

dealer or large institutional investor, may purchase a Creation Unit.

After purchasing a Creation Unit, the authorized purchaser may hold the

Creation Unit, or sell some or all of the ETP shares in the Creation

Unit to investors in secondary market transactions by splitting up the

Creation Unit and selling the individual ETP shares on a national

securities exchange or in off-exchange transactions. The ability to

break up the Creation Unit into ETP shares permits other investors,

such as non-ECPs, to purchase the individual ETP shares in secondary

market transactions.

All participants in an ETP Forex Pool must be ECPs when they

purchase or otherwise acquire an interest in the ETP Forex Pool. In

addition, an ETP Forex Pool will not be able to verify whether the

persons that acquire interests in the ETP Forex Pool in exchange

transactions are ECPs. The ability of non-ECPs to acquire interests in

an ETP Forex Pool and the inability of the ETP Forex Pool to verify ECP

status with respect to exchange transactions create a presumption that

ETP Forex Pools are not ECPs and, therefore, are Retail Forex Pools.

This presumption would not apply in the case of a Forex Pool that is

structured in a manner that does not involve exchange trading and in

which the Forex Pool would be able to verify the ECP status of its

participants.

One commenter suggested that the Commissions allow commodity pools

and their counterparties to rely on participant ECP representations

provided in connection with an initial investment.\653\ The Commissions

note that the obligation to determine that the parties to retail forex

transactions are ECPs is imposed on the CPOs of Forex Pools and the

counterparties looking to enter into retail forex transactions with

Forex Pools. In making that determination, the Commissions expect CPOs

and retail forex transaction counterparties to Forex Pools to be guided

by the principles for verifying the ECP status of a swap dealer's or

major swap participant's counterparty discussed in the CFTC's recently

adopted external business conduct standards, including the safe

harbor.\654\ Thus, solely for purposes of CEA section 1a(18)(A)(iv) and

CFTC Regulation Sec. 1.3(m)(5), the Commissions will permit CPOs and

retail forex transaction counterparties to rely on written

representations from, as applicable, pool participants or potential

pool participants that the person making the representation is an ECP

(or is a non-U.S. person; as discussed below in this section III.B.4.,

solely for purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation

Sec. 1.3(m)(5), the Commissions will consider Forex Pools whose

participants are limited solely to non-U.S. persons (and which are

operated by CPOs located outside of the U.S., its territories or

possessions) to be ECPs), or from Forex Pools that the Forex Pool is an

ECP, provided that the CPO or retail forex transaction counterparty has

a reasonable basis to so rely, just as swap dealers and major swap

participants are permitted to do pursuant to the safe harbor in new

CFTC Regulation Sec. 23.430(d), 17 CFR 23.430(d). Solely for purposes

of CEA section 1a(18)(A)(iv) and CFTC Regulation Sec. 1.3(m)(5), a CPO

or retail forex transaction counterparty will have a reasonable basis

to rely on such written representations if the person making the

representation specifies therein the provision(s) of, as applicable,

section 1a(18) of the CEA or CFTC Regulation Sec. 4.7(a)(1)(iv)

pursuant to which the person qualifies as an ECP or a non-U.S. person,

respectively, unless it has information that would cause a reasonable

person to question the accuracy of the representation.\655\ Solely for

purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation Sec.

1.3(m)(5), persons representing that they qualify as non-U.S. persons

based on CFTC Regulation Sec. 4.7(a)(1)(iv)(D) must represent that

they are relying on such provision as modified as discussed below

(i.e., without the 10% carve-out for U.S. persons).

---------------------------------------------------------------------------

\653\ See letter from Sidley.

\654\ See CFTC, Business Conduct Standards for Swap Dealers and

Major Swap Participants With Counterparties; Final Rule, 77 FR 9733

(Feb. 17, 2012).

\655\ Cf. CFTC Regulation Sec. Sec. 23.430(d), 23.402(d).

---------------------------------------------------------------------------

Furthermore, the CFTC recognizes that, despite a counterparty's

reasonable good faith efforts to ensure that Forex Pools do not in fact

have any U.S. participants, a situation may arise where a Forex Pool

does turn out to have U.S. participants. If a counterparty has

reasonable policies and procedures in place to verify the ECP status of

Forex Pool counterparties and, notwithstanding such reasonable good

faith efforts and following such policies and procedures, enters into

retail forex transactions with such a Forex Pool in good faith and it

was subsequently determined that U.S. participants represented no more

than a de minimis number of participants or amount of ownership of the

Forex Pool, absent other material factors, the CFTC would not expect to

bring an enforcement action against the counterparty for entering into

a retail forex transaction in contravention of the requirements of the

retail forex regime. For purposes of this analysis only, and without

this being viewed as a de minimis threshold for purposes of this rule

or otherwise, the CFTC would consider as de minimis, ownership of units

of participation of a Forex Pool held by U.S. participants of less than

10% of the beneficial interest in the Forex Pool. The fact that, absent

other material factors, the CFTC would not expect to bring an

enforcement action against a forex transaction counterparty in such

case does not

[[Page 30653]]

relieve any obligation on the part of the CPO of the Forex Pool either

to register as a CPO, claim the 4.13(a)(3) exemption therefrom or

redeem the U.S. participants as described above.

One commenter suggested that the Commissions allow commodity pools

and their counterparties to rely on participant ECP representations

provided in connection with an initial investment.\656\ The Commissions

believe that if participants make ECP representations in connection

with an initial investment in a Forex Pool, absent an additional

investment (which would require a new ECP verification, other than in

the case of automatically reinvested distributions), the subsequent

loss of a participant's ECP status would not cause the Forex Pool to

lose its own ECP status for purposes of retail forex transactions so

long as the operating agreement of the Forex Pool or the subscription

or other agreement pursuant to which the participant invested in the

Forex Pool requires the participant to advise the CPO of the Forex Pool

promptly of a loss of the participant's ECP status. In the event of the

loss of ECP status of a participant, the CPO would be required to

redeem the non-ECP from the Forex Pool at the first opportunity

following notification to avoid the Forex Pool losing its ECP status

for subsequent retail forex transactions.

---------------------------------------------------------------------------

\656\ See letter from Sidley. The Commissions note that the

obligation to determine that the parties to retail forex

transactions are ECPs is imposed on the CPOs of Forex Pools and the

persons looking to engage in retail forex transactions with Forex

Pools.

---------------------------------------------------------------------------

The Commissions are mindful that several commenters indicated that

CPOs do not customarily include a question or representation as to ECP

status in subscription agreements for pool participants, and stated

that requiring CPOs to qualify or redeem existing participants due to

the new look-through provision would be expensive, burdensome and

disruptive.\657\ In this regard, the Commissions note that the look-

through requirement for commodity pools was imposed by statute. As a

result of the Commissions adopting the limited look-through in the

final rule (as compared to the proposed indefinite look-through),

however, the number of commodity pools subject to the look-through

provision should be dramatically reduced, reducing the number of pools

subject to regulation of their retail forex transactions, and the

associated costs, accordingly.\658\

---------------------------------------------------------------------------

\657\ See, e.g., letter from SIFMA AMG IV.

\658\ The adoption of CFTC Regulation Sec. 1.3(m)(8), discussed

in part III.G, infra, also should reduce the number of pools subject

to regulation of their retail forex transactions, and the associated

costs, accordingly.

---------------------------------------------------------------------------

Also, in response to commenter concerns that the look-through

provision would be applied to entities other than commodity pools

(e.g., operating companies),\659\ the Commissions revised the text of

CFTC Regulation Sec. 1.3(m)(5)(i) to reflect their intent to apply the

look-through provision solely to commodity pools qualifying as ECPs, if

at all, under clause (A)(iv) and clause (A)(v) of the ECP

definition.\660\ This is consistent with the statutory text, which is

limited to looking through commodity pools under clause (A)(iv) of the

ECP definition, and the intent behind the look-through provision, as it

relates to clause (A)(v) thereof.

---------------------------------------------------------------------------

\659\ See, e.g., letter from Sandalwood Securities, Inc.

(expressing concern that ``the Proposed Rule extends Dodd-Frank's

limited look-through provision to all sub-sections of section

la(12)'').

\660\ Thus, for example, investment companies qualifying under

clause (A)(iii) of the ECP definition and employee benefit plans

qualifying under clause (A)(vi) of the ECP definition (and, as

stated in each clause, ``a foreign person performing a similar role

or function subject as such to foreign regulation'') would not be

covered by the look-through provision. To the extent that other

entities would otherwise be captured by the look-through as proposed

(such as collective investment trusts whose investors are ERISA

plans not excluded from the commodity pool definition by CFTC

Regulation Sec. 4.5(a)(4) and which qualify as ECPs under clause

(A)(v) of the ECP definition), the Commissions believe that focusing

on the level of the Forex Pool entering into the retail forex

transactions, and such Forex Pool's direct participants (absent

evasion), should alleviate such concerns.

---------------------------------------------------------------------------

Commenters also stated that Retail Forex Pools will no longer be

able to enter into retail forex transactions with foreign financial

institutions.\661\ As discussed in section III.B.1. above, however,

this is not the case with respect to retail forex transactions

described in CEA section 2(c)(2)(C)(i)(I)(bb). With respect to retail

forex transactions described in CEA section 2(c)(2)(B)i)(I), this is a

consequence of the express statutory text of the Dodd-Frank Act, which

removed non-U.S. financial institutions from the list of Enumerated

Counterparties eligible to enter into retail forex transactions with

non-ECPs.\662\

---------------------------------------------------------------------------

\661\ Cf. letters from Sidley and Millburn Ridgefield

Corporation (``Millburn'').

\662\ See section 742(c) of the Dodd-Frank Act, amending CEA

section 2(c)(2)(B)(i)(II)(aa), 7 U.S.C. 2(c)(2)(B)(i)(II)(aa).

---------------------------------------------------------------------------

Commenters further suggested generally that the Commissions create

additional categories of ECPs to address the Commissions' concerns

regarding the potential loophole of Retail Forex Pools that are unable

to qualify as ECPs due to the new look-through provision in clause

(A)(iv) of the ECP definition qualifying as an ECP under clause (A)(v)

of the ECP definition. While one commenter proposed adopting a new rule

clarifying that Forex Pools comprised entirely of QEPs and operated by

persons subject to regulation under the CEA are ECPs,\663\ Congress

chose to look to ECP status of Forex Pool participants, not QEP status,

as the basis for determining whether such Forex Pools are ECPs.

Therefore, it is more appropriate to rely on Retail Forex Pool

participants' ECP status than to rely on QEP status to establish ECP

status.

---------------------------------------------------------------------------

\663\ See letter from Sidley. This commenter also suggested

deeming non-U.S. persons to be ECPs by definition. The Commissions

have addressed this comment below in this section in response to the

comment regarding the extraterritorial impact of the proposed ECP

rules.

---------------------------------------------------------------------------

One commenter stated a concern regarding what it characterized as

the lack of clarity surrounding the extraterritoriality impact of the

proposed ECP rules.\664\ The Commissions recognize the potential

consequences of the broad look-through language in CEA section

1a(18)(A)(iv) \665\ and are providing guidance as to the application of

the look-through to Forex Pools whose participants are limited solely

to non-U.S. persons and which are operated by CPOs located outside the

United States, its territories or possessions.

---------------------------------------------------------------------------

\664\ See letter from AIMA I.

\665\ 7 U.S.C. 1a(18)(A)(iv).

---------------------------------------------------------------------------

As discussed below, while foreign entities are not necessarily

immune from U.S. jurisdiction for commercial activities undertaken with

U.S. counterparties or in U.S. markets, canons of statutory

construction ``assume that legislators take account of the legitimate

sovereign interests of other nations when they write American laws,''

\666\ particularly when limited U.S. interests are at stake.\667\

---------------------------------------------------------------------------

\666\ See F. Hoffman-LaRoche, Ltd. v. Empagran S.A., 542 U.S.

155, 164 (2004), citing Murray v. Schooner Charming Betsy, 2 Cranch

64, 118, 2 L.Ed. 208 (1804) (``[A]n act of congress ought never to

be construed to violate the law of nations if any other possible

construction remains''); Hartford Fire Insurance Co. v. California,

509 U.S. 764 (1993) (Scalia, J., dissenting). See also Restatement

(Third) Foreign Relations Law Sec. 403 (scope of a statutory grant

of authority must be construed in the context of international law

and comity including, as appropriate, the extent to which regulation

is consistent with the traditions of the international system).

\667\ See also CFTC, Exemption From Registration for Certain

Foreign Persons, 72 FR 63976 (Nov. 14, 2007) (where the CFTC stated

that:

Given this agency's limited resources, it is appropriate at this

time to focus [the Commission's] customer protection activities upon

domestic firms and upon firms soliciting or accepting orders from

domestic users of the futures markets and that the protection of

foreign customers of firms confining their activities to areas

outside this country, its territories, and possessions may best be

for local authorities in such areas)

(citing CFTC, Introducing Brokers and Associated Persons of

Introducing Brokers, Commodity Trading Advisors and Commodity Pool

Operators; registration and Other Regulatory Requirements, 48 FR

35248, 35261 (Aug. 3, 1983)).

---------------------------------------------------------------------------

[[Page 30654]]

The Commissions do not believe that Congress intended for Forex

Pools with no U.S. participants and operated by CPOs located outside

the United States, its territories or possessions to be subject to a

U.S. retail forex regime and, therefore, will consider Forex Pools

whose participants are limited solely to non-U.S. persons and which are

operated by CPOs located outside the United States, its territories or

possessions to be ECPs for purposes of CFTC Regulation Sec. 1.3(m)(5).

For this purpose, a Forex Pool participant is a non-U.S. person if it

satisfies the definition of ``Non-United States person'' in CFTC

Regulation 4.7(a)(1)(iv); provided, however, that, if a participant is

an entity organized principally for passive investment, such as a pool,

investment company or other similar entity, such entity will be

considered to be a Non-United States person under paragraph (D) of CFTC

Regulation 4.7(a)(1)(iv) for purposes of CFTC Regulation Sec.

1.3(m)(5) solely if all units of participation in such passive

investment vehicle participant are held by Non-United States

persons.\668\ A broader interpretation or relief is not appropriate at

this time.\669\

---------------------------------------------------------------------------

\668\ CFTC Regulation Sec. 4.7(a)(i)(iv)(D) lists the following

as one category of non-United States person:

An entity organized principally for passive investment such as a

pool, investment company or other similar entity; Provided, That

units of participation in the entity held by persons who do not

qualify as Non-United States persons or otherwise as qualified

eligible persons represent in the aggregate less than 10% of the

beneficial interest in the entity, and that such entity was not

formed principally for the purpose of facilitating investment by

persons who do not qualify as Non-United States persons in a pool

with respect to which the operator is exempt from certain

requirements of part 4 of the Commission's regulations by virtue of

its participants being Non-United States persons.

It would be inappropriate to disregard the presence of U.S.

persons constituting as much as 10% of such entities' participants

in the context of this interpretive guidance. As discussed elsewhere

herein, however, entities described in CEA section 1a(18)(A)(iii) or

(vi), 7 U.S.C. 1a(18)(A)(iii) or (vi), are not subject to the look-

through and are ECPs irrespective of the ECP status of their

participants.

\669\ Cf. CPO/CTA Compliance Release at 11264 (stating that ``it

is prudent to withhold consideration of a foreign advisor exemption

until the [CFTC] has received data regarding such firms on Forms

CPO-PQR and/or CTA-PR * * * to enable the [CFTC] to better assess

[which] firms * * * may be appropriate to include within the

exemption, should the [CFTC] decide to adopt one'').

---------------------------------------------------------------------------

C. ECP Status for Commodity Pools Under Clause (A)(v) vs. Under Clause

(A)(iv) of the ECP Definition

1. Proposed Approach

The Commissions stated in the Proposing Release that they believe

``some commodity pools unable to satisfy the total asset or regulated

status components of clause (A)(iv) of the ECP definition may rely on

clause (A)(v) to qualify as ECPs instead.'' \670\ The Commissions

further stated in the Proposing Release that ``a commodity pool that

cannot satisfy the monetary and regulatory status conditions prescribed

in clause (A)(iv) should not qualify as an ECP in reliance on clause

(A)(v) of the ECP definition.'' \671\ Based on those views, the

Commissions proposed to further define the term ``eligible contract

participant'' to prevent such a commodity pool from qualifying as an

ECP pursuant to clause (A)(v) of the ECP definition. This proposal

applied to all commodity pools, not just Forex Pools engaged in retail

forex transactions.

---------------------------------------------------------------------------

\670\ Proposing Release, 75 FR at 80185.

\671\ Id.

---------------------------------------------------------------------------

2. Commenters' Views

Two commenters argued that, had Congress wished to prevent

commodity pools from relying on the general ECP provision for business

entities in clause (A)(v), it could have expressly excluded commodity

pools from clause (A)(v).\672\ Another commenter attempted to

illustrate that clause (A)(v) of the ECP definition is an independent

basis for qualifying as an ECP by distinguishing clause (A)(v) from

clause (A)(iv).\673\

---------------------------------------------------------------------------

\672\ See letters from Sidley and Skadden.

\673\ See letter from Akin Gump. Akin Gump noted that ``[a]s

opposed to [clause] (A)(iv), [clause] (A)(v) includes as one means

of satisfying its criteria that the entity be entering into a

contract for hedging purposes.'' While correct, clause (A)(v) also

includes as another means of satisfying its criteria that an entity

enter into agreements, contracts or transactions in connection with

the conduct of the entity's business, which would be a much lower

standard.

---------------------------------------------------------------------------

One commenter expressed the view that it is unclear whether

``subject to regulation under this Act'' in CEA section

1a(18)(A)(iv)(II) \674\ means a registered CPO or something else (e.g.,

a person excluded from the definition of a CPO, a CPO exempt from

registration conditioned in part upon making a filing to claim such

relief).\675\

---------------------------------------------------------------------------

\674\ 7 U.S.C. 1a(18)(A)(iv)(II).

\675\ See letter from SIFMA AMG IV. CEA Section

1a(18)(A)(iv)(II) refers to a commodity pool that ``is formed and

operated by a person subject to regulation under this Act or a

foreign person performing a similar role or function subject as such

to foreign regulation (regardless of whether each investor in the

commodity pool or the foreign person is itself an eligible contract

participant) provided, however, that for purposes of section

2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term `eligible

contract participant' shall not include a commodity pool in which

any participant is not otherwise an eligible contract participant.''

---------------------------------------------------------------------------

3. Final Rule

The Commissions are adopting CFTC Regulation Sec. 1.3(m)(6) as

proposed, which states that ``[a] commodity pool that does not have

total assets exceeding $5,000,000 or that is not operated by a person

described in subclause (A)(iv)(II) of section 1a(18) of the Act is not

an eligible contract participant pursuant to clause (A)(v) of such

Section.'' \676\ As noted, the Commissions are concerned that clause

(A)(v) of the ECP definition may undermine the protections that

specifically apply to commodity pool participants pursuant to the

limitations on ECP status for commodity pools set forth in clause

(A)(iv) of the ECP definition. Allowing a commodity pool that cannot

satisfy the monetary and regulatory status conditions prescribed for

commodity pools in clause (A)(iv) to qualify as an ECP under clause

(A)(v) would undermine these protections.

---------------------------------------------------------------------------

\676\ The Commissions have made certain technical corrections to

proposed CFTC Regulation Sec. 1.3(m)(6)(i) as concerns its

citations to the CEA.

---------------------------------------------------------------------------

The Commissions acknowledge the comments stating that clause (A)(v)

of the ECP definition is an independent basis for qualifying as an ECP

and that Congress did not explicitly provide that a commodity pool that

fails to qualify as an ECP under clause (A)(iv) cannot do so under

clause (A)(v). However, when specifically legislating for commodity

pools, Congress determined that total assets of $5 million and

operation by a person subject to regulation under the CEA (or a foreign

equivalent) are necessary to assure appropriate protection for non-ECP

participants in a commodity pool. Furthermore, the commenters' view

that Congress's use of the disjunctive term ``or'' between clauses

(A)(x) and (A)(xi) of the ECP definition means that an entity can rely

on clause (A)(v) of the ECP definition, notwithstanding that such

entity cannot satisfy a prong more specific to it, would largely render

superfluous each clause under subparagraph (A) of the ECP definition

other than clause (v) and clause (xi) (for individuals).\677\ As such,

the Commissions believe that the final rule adopted in this release is

consistent with Congressional intent.

---------------------------------------------------------------------------

\677\ Interpreting statutory language as surplusage is

disfavored. Effect should be given to every clause and word of a

statute. See Negonsott v. Samuels, 507 U.S. 99 (1993).

---------------------------------------------------------------------------

The Commissions also are mindful that one commenter expressed a

concern that the Commissions' reliance on clause (A)(iv) of the ECP

definition

[[Page 30655]]

might cause commodity pools to lose their ability to claim ECP status

under clauses of the ECP definition, other than clause (v), and asked

the Commissions to clarify the meaning of the phrase ``formed and

operated by a person subject to regulation under the [CEA]'' in clause

(A)(iv).\678\ In response, the Commissions note that a commodity pool

that does not qualify for ECP status under clause (A)(iv) of the ECP

definition may still qualify as an ECP under either of the two clauses

of the ECP definition other than clause (A)(v) applicable to

subcategories of commodity pools. Thus, registered investment companies

and foreign equivalents may qualify as ECPs under clause (A)(iii) of

the ECP definition, and ERISA plans and the other entities described in

clause (A)(vi) of the ECP definition may qualify as ECPs thereunder.

The Commissions' actions in this release do not change that result.

---------------------------------------------------------------------------

\678\ See letter from SIFMA AMG IV.

---------------------------------------------------------------------------

Also, with regard to that commenter's request for clarification,

for purposes of CFTC Regulation Sec. 1.3(m)(6), the Commissions

interpret the language ``subject to regulation under the [CEA]'' in

clause (A)(iv) of the ECP definition as requiring lawful operation of

the commodity pool by a person excluded from the CPO definition, a

registered CPO, or a person properly exempt from CPO registration.\679\

Congress did not limit ECP status under clause (A)(iv) to commodity

pools operated by persons registered as CPOs; it used the more

encompassing phrase ``subject to regulation'' under the CEA.\680\ On

the other hand, to construe that phrase to include any person operating

a commodity pool would render the phrase superfluous.\681\ The

commenters' view would enable a CPO that fails to register as required

to claim that the commodity pool it operates is an ECP under clause

(A)(v) and thus is not subject to regulation of its retail forex

transactions. The Commissions believe that construing the phrase

``formed and operated by a person subject to regulation under the

[CEA]'' to refer to a person excluded from the CPO definition,

registered as a CPO or properly exempt from CPO registration

appropriately reflects Congressional intent.

---------------------------------------------------------------------------

\679\ For these purposes, the Commissions would take the same

approach to insignificant deviations from exemptive filings as the

CFTC does in CFTC Regulation Sec. 4.7(e).

\680\ If the Commissions interpreted the ``subject to regulation

under this Act'' language in CEA section 1a(18)(A)(iv)(II) to mean

that the commodity pool operator must be registered as a CPO and

limited CPOs to claiming ECP status solely under clause (iv) of the

ECP definition, then the operators of all commodity pools trading

swaps would have to register as CPOs to be ECPs. While more CPOs

will be registering with the CFTC because the CFTC has withdrawn

CFTC Regulation Sec. 4.13(a)(4), see CPO/CTA Compliance Release,

and the Dodd-Frank Act has expanded the scope of the transactions

within the CFTC's jurisdiction, thus reducing the number of CPOs who

can rely on the 5 percent threshold in CFTC Regulation Sec.

4.13(a)(3) and thus claim the CPO registration exemption, the CFTC

did not withdraw 4.13(a)(3), so some CPOs will be able to continue

to rely on it. Also, not all persons operating commodity pools will

be CPOs. See CFTC Regulation Sec. 4.5 (exclusion from the

definition of the term ``commodity pool operator''). The Commissions

do not believe Congress intended commodity pool ECP status to

require CPO registration by the commodity pools' operators in all

cases.

\681\ If the mere act of forming or operating a commodity pool

means that a person is ``subject to regulation'' under the CEA, then

the ``subject to regulation'' language would not be needed.

---------------------------------------------------------------------------

D. Dealers and Major Participants as ECPs

1. Proposed Approach

The Commissions proposed to add swap dealers, security-based swap

dealers, major swap participants and major security-based swap

participants to the ECP definition on the basis that such persons ``are

likely to be among the most active and largest users of swaps and

security-based swaps.'' \682\

---------------------------------------------------------------------------

\682\ Proposing Release, 75 FR at 80184.

---------------------------------------------------------------------------

2. Commenters' Views

Several commenters supported the proposed addition of swap dealers,

security-based swap dealers, major swap participants, and major

security-based swap participants to the ECP definition.\683\ No

commenter opposed this aspect of the proposal.

---------------------------------------------------------------------------

\683\ One representative commenter stated that ``the proposed

definition in CFTC Proposed CFTC Regulation Sec. 1.3(m)(1)-(4)

fills important gaps left by Congress by ensuring that major swap

participants, major security-based swap participants, swap dealers

and security-based swap dealers are treated as ECPs.'' See letter

from Sidley.

---------------------------------------------------------------------------

3. Final Rule

The Commissions are adopting the new ECP categories as proposed.

The rules as adopted clarify that the terms ``swap dealer,''

``security-based swap dealer,'' ``major swap participant,'' and ``major

security-based swap participant'' have their respective meanings as

defined in the CEA and the Exchange Act and as otherwise further

defined by the Commissions.\684\

---------------------------------------------------------------------------

\684\ These new ECP categories are set forth in new CFTC

Regulation Sec. 1.3(m)(1)-(4).

---------------------------------------------------------------------------

E. Government Entities: Incorrect Cross-Reference

1. Description of the Issue

Clause (A)(vii) of the ECP definition conditions the ECP status of

governmental entities, and their political subdivisions, agencies,

instrumentalities and departments (collectively, ``government

entities''), in part, on the identity of their counterparties.

Specifically, a government entity may qualify as an ECP under the

provision in clause (A)(vii) that requires the entity's counterparty to

be ``listed in any of subclauses (I) through (VI) of section

2(c)(2)(B)(ii)'' of the CEA.\685\ However, subclauses (I) through (III)

of CEA section 2(c)(2)(B)(ii) \686\ are unrelated to counterparty types

(rather, they describe the dollar amounts that apply for purposes of

retail forex transactions under CEA section 2(c)(2)(B)), and subclauses

(IV) through (VI) of CEA section 2(c)(2)(B)(ii) no longer exist in the

statute. Read literally, then, this provision of the ECP definition is

inherently a nullity and, thus, cannot enable government entities to

qualify as ECPs.\687\

---------------------------------------------------------------------------

\685\ CEA section 1a(18)(A)(vii)(cc), 7 U.S.C.

1a(18)(A)(vii)(cc).

\686\ 7 U.S.C. 2(c)(2)(B)(ii)(I)-(III).

\687\ A government entity, though, can still qualify as an ECP

under the other provisions of clause (A)(vii) if it is a certain

type of ``eligible commercial entity'' as defined in CEA section

1a(17), 7 U.S.C. 1a(17), or owns and invests on a discretionary

basis $50 million or more in investments.

---------------------------------------------------------------------------

2. Commenters' Views

One commenter traced the history of the relevant provisions and

concluded that the reference to subclauses (I) through (VII) of CEA

section 2(c)(2)(B)(ii) in clause (A)(vii) of the ECP definition is

erroneous.\688\ This commenter pointed instead to CEA section

2(c)(2)(B)(i)(II) \689\ as the reference that should be included in

clause (A)(vii) of the ECP definition because it lists the entities

that are eligible to serve as counterparties in retail forex

transactions.

---------------------------------------------------------------------------

\688\ See letter from Wells Fargo dated June 3, 2011 (``Wells

Fargo I'').

\689\ 7 U.S.C. 2(c)(2)(B)(i)(II).

---------------------------------------------------------------------------

This commenter noted that the cross-reference in clause (A)(vii) of

the ECP definition was correct when it was added to the CEA as part of

the CFMA, but that it became incorrect in 2008 when an unrelated

amendment to the CEA was enacted \690\ that changed the numbering of

the CEA's provisions governing retail forex transactions but that

failed to make a conforming amendment to clause (A)(vii) of the ECP

definition. As a result of this 2008 amendment to the CEA, the list of

entities that formerly appeared in subclauses (I) through (VI) of CEA

sections 2(c)(2)(B)(ii) now appear in items (aa) through (ff) of CEA

section

[[Page 30656]]

2(c)(2)(B)(i)(II) instead.\691\ This commenter requested that ``the

Commissions correct this clearly erroneous reference in the definition

of ECP through interpretive guidance, rulemaking or Commission order.''

\692\

---------------------------------------------------------------------------

\690\ See section 13101 of the CRA.

\691\ 7 U.S.C. 2(c)(2)(B)(i)(II)(aa)-(ff).

\692\ See letter from Wells Fargo I.

---------------------------------------------------------------------------

3. Interpretive Guidance

Clause (A)(vii) of the ECP definition contains an erroneous cross-

reference to subclauses (I) through (VI) of CEA section 2(c)(2)(B)(ii).

Accordingly, the Commissions are issuing interpretive guidance by

identifying the counterparties with which a governmental entity can

enter into swaps to attain ECP status under the provision in clause

(A)(vii) that requires the entity's counterparty to be ``listed in any

of subclauses (I) through (VI) of section 2(c)(2)(B)(ii)'' of the CEA.

The Commissions consider a government entity covered by the

counterparty limitation in clause (A)(vii) to be an ECP with respect to

an agreement, contract, or transaction that is offered by, and entered

into with, a person that is listed in items (aa) through (ff) of

section 2(c)(2)(B)(i)(II) of the CEA. The limitation of ECP status

``with respect to'' a particular transaction is consistent with

Congress' determination that, for purposes of this provision of clause

(A)(vii), governmental entities may derive their ECP status from the

status of their counterparty.

F. Qualification as an ECP With Respect to Swaps Used To Hedge or

Mitigate Commercial Risk in Connection With the Conduct of an Entity's

Business

1. Proposing Release

In the Proposing Release, the Commissions requested comment on

whether any additional categories should be added to the definition of

ECP, ``such as the following categories suggested by commenters [on the

ANPRM]: Commercial real estate developers; energy or agricultural

cooperatives or their members; or firms using swaps as hedges pursuant

to the terms of the CFTC's Swap Policy Statement.'' \693\ As noted

above, the ECP definition is important because the Dodd-Frank Act

amended the CEA to prohibit a person that is not an ECP from entering

into swaps other than on or subject to the rules of a DCM.\694\

---------------------------------------------------------------------------

\693\ See Proposing Release, 75 FR at 80185. The reference to

the ``Swap Policy Statement'' is to the CFTC's Policy Statement

Concerning Swap Transactions, 54 FR 30694 (July 21, 1989). The Swap

Policy Statement ``identifie[d] those swap transactions which [were]

not * * * regulated as futures or commodity option transactions

under the [CEA] or the related regulations.'' 54 FR at 30694. One

element of the Swap Policy Statement required that the swap be

entered into in connection with each swap counterparty's line of

business. Id. at 30697. The Swap Policy Statement was applicable to

cash-settled swaps only, with foreign exchange considered to be cash

for this purpose. Id. at 30696. The Swap Policy Statement required

that the terms of the relevant swap be individually tailored,

meaning that the material terms of the swap had to be negotiated,

the parties had to make individualized credit determinations, and

the swap documentation could not be fully standardized. Id. at

30696-97. The Swap Policy Statement did not apply to swaps subject

to exchange-style offset, swaps that were cleared or subject to a

margin system, or swaps marketed to the public. Id. As noted in the

Product Definitions Proposal, the Dodd-Frank Act supersedes the Swap

Policy Statement. 76 FR at 29829, n. 74.

\694\ The discussion in this section relates only to swaps and

has no effect on the laws or regulations applicable to security-

based swaps, security-based swap agreements or mixed swaps.

As noted above, the Dodd-Frank Act also amended the Exchange Act

and the Securities Act to make it unlawful for a person to effect a

transaction in a security-based swap with or for a person that is

not an ECP unless the transaction is effected on a national

securities exchange registered with the SEC, and to make it unlawful

for a person to offer to sell, offer to buy or purchase, or sell a

security-based swap to a person that is not an ECP unless a

registration statement under the Securities Act is in effect with

respect to that security-based swap.

---------------------------------------------------------------------------

2. Commenters' Views

Several commenters supported the addition of categories to the

definition of ECP because, these commenters said, not all current swap

market participants are ECPs. Many of these commenters said that non-

ECPs have entered into swaps in reliance on the Swap Policy

Statement.\695\ Commenters highlighted, among other things, the

importance of the Swap Policy Statement to pass-through entities used

by farmers,\696\ operating companies \697\ and commercial property

developers,\698\ noting that such entities may not meet the ECP

criteria. According to these commenters, these pass-through entities

often are small and medium-sized businesses that enter into interest

rate swaps with lending financial institutions in reliance on the Swap

Policy Statement.\699\ The commenters explained that the loans usually

are guaranteed by the principals of the entity entering into the swap,

and that the borrower would qualify as an ECP if structured as a

single-level corporate entity or sole proprietorship.\700\ Commenters

said that if these non-ECP entities were limited to swaps that are

available on or subject to the rules of a DCM, many regional bank

borrowers would lose the ability to use swaps, real estate companies

would have less flexibility in risk management, and smaller lenders

would be at a competitive disadvantage.\701\ Another commenter said

that Dodd-Frank Act provisions such as the end-user clearing exception

indicate that Congress intended to preserve the availability of swaps

used for business reasons rather than for investment or

speculation.\702\

---------------------------------------------------------------------------

\695\ See letter from CDEU. One commenter estimated that swap

transactions completed by regional and community banks in reliance

on the Swap Policy Statement constituted 30-40% of all of such

banks' swaps, representing approximately 7,000 to 10,000 swaps per

year and $15 to $20 billion in related loan principal. See letter

from B&F I. Another commenter advised that it has entered 11 swaps,

with a total notional of $26 million, since its formation in 2007,

almost all of the counterparties to which ``qualified for the swap

under the [Swap Policy Statement] business purpose exemption.'' See

letter from Capstar. The CFTC stated when issuing the Swap Policy

Statement that it ``reflects the [CFTC]'s view that at this time

most swap transactions, although possessing elements of futures or

options contracts, are not appropriately regulated as such under the

[CEA] and [CFTC] regulations.'' Swap Policy Statement at 30694.

\696\ See, e.g., letter from Rabobank, N.A., Rabo AgriFinance,

Inc. and Co[ouml]peratieve Centrale Raiffeisen-Boerenleenbank B.A.

(``Rabobank, New York Branch'') (relating that ``[f]or a variety of

estate planning and regulatory purposes, farmers commonly hold their

ownership interests in land, buildings and farm equipment

indirectly, through a network of legal entities'').

\697\ See, e.g., letter from Fifth Third Bank and Union Bank,

N.A. (advising that ``[i]t is common for an operating business to

organize a separate limited liability company (for tax and legal

reasons) to acquire * * * assets * * * and to lease these assets to

the operating company[, which] becomes the borrow[er] * * * for the

loan used to acquire those assets'' and that ``[t]he limited

liability company often does not maintain sufficient capital to

qualify as an ECP'').

\698\ See, e.g., letters from Capstar, Frost National Bank, FTN

Financial Capital Markets, Midsize Banks and NAREIT.

\699\ See letters from BB&T I and B&F I. Commenters said that

these businesses may intentionally maintain less than $1 million in

equity primarily for tax and legal reasons. See letters from Capital

One and Columbia State Bank (stating that over 65% of its borrowers

are structured as limited liability companies or S corporations and

intentionally maintain less than $1 million in equity at the entity

entering into the swap).

\700\ See letter from Columbia State Bank. See also letter from

BB&T I.

\701\ See letters from BB&T I, Capital One, Capstar, Columbia

State Bank, Midsize Banks, NAREIT and Wells Fargo II.

\702\ See letter from FSR I.

---------------------------------------------------------------------------

To mitigate the impact of restricting non-ECPs to swaps that are

available on or subject to the rules of DCMs, some commenters said that

an entity should be able to qualify as an ECP based on the financial

qualifications of related entities, so long as various conditions

proposed by the commenters are satisfied. Some commenters said that an

entity should be eligible to be an ECP if its swap obligations are

guaranteed by an ECP,\703\ or if its controlling entity qualifies as an

ECP under clause (A)(v) of the statutory definition.\704\ Another

commenter suggested revisions to the

[[Page 30657]]

ECP definition that included looking to the ECP status or

sophistication of the majority owner of an entity in determining if the

entity itself is an ECP.\705\ Other commenters suggested other

provisions to allow non-ECPs to enter into swaps other than on or

subject to the rules of a DCM, so long as the non-ECP meets various

conditions indicating that the swap is used in connection with its line

of business.\706\

---------------------------------------------------------------------------

\703\ See letters from BB&T I, Midsize Banks and Wells Fargo II.

\704\ See letters from CDEU and Regional Banks.

\705\ See letter from NAREIT.

\706\ See letters from the American Public Gas Association

(``APGA''), Capital One and Gavilon dated December 23, 2010

(``Gavilon I'').

---------------------------------------------------------------------------

Other commenters argued for per se ECP qualification based on their

status as certain types of persons, such as farmers\707\ or for ECP

status based solely on a combination of a person's status and the swap

being related to a person's line of business with no additional

conditions.\708\

---------------------------------------------------------------------------

\707\ See meeting with Ron Eliason on December 16, 2010 (in

which Mr. Eliason contended that farmers should be able to enter

into swaps, even if they do not meet the income or asset tests in

the current ECP definition and, therefore, would not be permitted to

enter into swaps other than on or subject to the rules of a DCM).

\708\ See letter from APGA (requesting that ``the [CFTC]

exercise its authority under section la(18)(C) of the Act and

determine that public natural gas distribution companies, including

member-owned co-operatives, that enter into swaps in connection with

their business of supplying customers with natural gas are ECPs

within the meaning of section la(18) of the Act'').

---------------------------------------------------------------------------

3. Final Rules and Interpretation

In response to the commenters' concerns, the CFTC is adopting CFTC

Regulation Sec. 1.3(m)(7) to permit an entity, in determining its net

worth for purposes of subclause (A)(v)(III) of the ECP definition,\709\

to include the net worth of its owners, solely for purposes of

determining its ECP status for swaps used to hedge or mitigate

commercial risk, provided that all of its owners are themselves ECPs

(disregarding shell companies). Under CFTC Regulation Sec. 1.3(m)(7)

as adopted, an entity seeking to qualify under subclause (A)(v)(III) of

the ECP definition in order to enter into a swap used to hedge or

mitigate commercial risk is permitted to count the net worth of its

owners in determining its own net worth, so long as all its owners are

ECPs. This regulation applies only to entities that are otherwise

eligible to rely on subclause (A)(v)(III) to determine ECP status; it

does not expand or change the scope of application of that

paragraph.\710\

---------------------------------------------------------------------------

\709\ CEA section 1a(18)(A)(v)(III) provides that the term

``eligible contract participant'' includes ``a corporation,

partnership, proprietorship, organization, trust, or other entity *

* * that (aa) has a net worth exceeding $1,000,000; and (bb) enters

into an agreement, contract, or transaction in connection with the

conduct of the entity's business or to manage the risk associated

with an asset or liability owned or incurred or reasonably likely to

be owned or incurred by the entity in the conduct of the entity's

business.'' 7 U.S.C. 1a(18)(A)(v)(III).

\710\ For example, if a commodity pool were precluded by CFTC

Regulation Sec. 1.3(m)(6) from relying on clause (A)(v) of the

statutory definition to qualify as an ECP, such pool would not be

able to rely on CFTC Regulation Sec. 1.3(m)(7) to qualify as an

ECP.

---------------------------------------------------------------------------

CFTC Regulation Sec. 1.3(m)(7) as adopted applies only when

determining ECP status for swaps used to hedge or mitigate commercial

risk. This new regulation does not apply when determining ECP status

for other swaps or for security-based swaps, security-based swap

agreements, mixed swaps, or agreements, contracts or transactions that

are not swaps (regardless of the purpose for which they are used).

The Commissions have considered the comments indicating that, as

currently structured, many businesses are owned by multiple legal

entities and/or individuals, and the net worth of all the owners in the

aggregate in some cases would satisfy the $1 million net worth

requirement in subclause (A)(v)(III), even though the particular legal

entity that enters into a swap does not have a net worth exceeding $1

million.\711\ While the Commissions recognize that the requirement, in

subclause (A)(v)(III)(aa) of the ECP definition, that the entity

relying on that paragraph have a net worth exceeding $1 million

evidences Congress' intent that only entities with this level of

financial resources should be eligible for ECP status under this

paragraph of the definition, the Commissions agree with commenters that

application of this requirement in these circumstances would

inappropriately limit the ability of business entities to use swaps to

hedge or mitigate commercial risk. As a result, the Commissions are

persuaded that in this limited situation, the entity should qualify as

an ECP and be eligible to enter into swaps other than on or subject to

the rules of a DCM, so long as the entity is using the swap to hedge or

mitigate commercial risk and all of the owners of the entity are ECPs

(other than shell companies).

---------------------------------------------------------------------------

\711\ See, e.g., letters from B&F I (stating that ``[i]f the

customer does not * * * [itself] meet the ECP definition, then the

transaction would have to be guaranteed by any entity or individual

who is an owner * * * [who] meets the $10,000,000 total asset test

of section 1(a)(18)(A)(v)(I) of the Act or the $1,000,000 net worth

test of section 1(a)(18)(A)(v)(III) of the Act.''), NAREIT (urging

that the Commissions impute ECP status to non-ECP entities involved

in specified real estate businesses to such entities whose

``majority owner or controlling entity'' is an ECP) and Midsize

Banks (recommending that the ECP determination be made with respect

to a non-ECP entity's owners based on criteria including qualifying

natural persons as ECPs based on a $1,000,000 net worth).

---------------------------------------------------------------------------

In response to those commenters requesting per se ECP status or the

ability to qualify as an ECP based on a combination of status and

engaging in swaps related to a line of business, without further

restriction, the Commissions do not believe it is necessary or

appropriate to further define the term ECP to such an extent in order

to address most commenters' concerns. The Commissions note that such

approaches would undermine the prohibition in CEA section 2(e) \712\ on

non-ECPs executing swaps other than on or subject to the rules of a

DCM. The Commissions also note that focusing solely on a link between a

swap and a line of business would undermine the application of the ECP

definition to swaps in that the various prongs of the ECP generally are

linked to dollar thresholds, regulated status, or a combination of the

two.

---------------------------------------------------------------------------

\712\ 7 U.S.C. 2(e).

---------------------------------------------------------------------------

The Commissions also note that it currently is considering a draft

petition for relief pursuant to CEA section 4(c)(6)(C) \713\ for

certain entities described in Federal Power Act section 201(f),\714\

which may address the concerns of some commenters. Additionally, the

Commissions are developing joint rules to further define the term

``swap,'' including the forward exclusion from the swap definition

which, in turn, may result in certain transactions not being considered

swaps. Further, the CFTC also is considering today a form of trade

option exemption, which may further address commenters' concerns.

---------------------------------------------------------------------------

\713\ 7 U.S.C. 6(c)(6)(C).

\714\ 16 U.S.C. 824(f).

---------------------------------------------------------------------------

With respect to farmers, in response to the CFTC's Commodity

Options and Agricultural Swaps rulemaking proposal,\715\ commenters

generally were of the view that the ECP definition is appropriate in

its current form.\716\ While

[[Page 30658]]

the Commissions may consider providing further relief should experience

show, after the ECP definition becomes effective, that further relief

is warranted, neither the ECP definition nor the various actions cited

in the foregoing paragraph are final, so providing further relief is

premature. The Commissions' measured approach, which builds on the

existing net worth requirement in the general entity ECP category,

provides broad relief to many of the commenters (e.g., borrowers

generally) while otherwise adhering to the existing ECP categories.

---------------------------------------------------------------------------

\715\ 76 FR 6095 (Feb. 3, 2011).

\716\ See, e.g., letters from NCFC dated April 4, 2011 (``NCFC

II'') (stating ``[o]n behalf of the more than two million farmers

and ranchers who belong to one or more farmer cooperative(s), the

[NCFC] * * * [believes] the limitation on participation [in

agricultural swaps] to [ECPs] outside of a DCM * * * should limit

[agricultural swap] participation to appropriate persons'' and that

``[t]he ECP requirement with a threshold of $1 million in net worth

to be allowed to use swaps and options, other than on a DCM, is

appropriate for the products cooperatives offer their members''), ;

letter from NGFA dated April 4, 2011 (``NGFA II'') (stating that

``[t]he use of agricultural swaps has been constrained relative to

other swaps by virtue of being subject to CFTC regulatory

requirements, while other swaps have been exempted from CFTC

oversight,'' ``the Dodd-Frank Act * * * institutes a number of

safeguards, including the limitation that only [ECPs] may engage in

swaps unless entered into on a designated contract market,'' and

``[t]he NGFA believes that these safeguards provide more-than-ample

protection in the swaps marketplace for both agricultural and non-

agricultural swaps and that there is no compelling reason to place

additional burdens on agricultural swaps.'').

---------------------------------------------------------------------------

The Commissions note that commenters said that, because of the way

some businesses are structured for tax, estate planning or other

purposes, they enter into swaps through a legal entity that does not,

by itself, qualify as an ECP even though the net worth of the business

and its owners, taken in the aggregate, would qualify as an ECP

pursuant to subclause (A)(v)(III) of the ECP definition. The

Commissions believe that the best way to address this concern is to

allow such a business to consider the net worth of all its owners in

determining whether the net worth requirement in subclause (A)(v)(III)

is satisfied.\717\

---------------------------------------------------------------------------

\717\ The Commissions note that this regulation provides an

alternative means for certain business entities to qualify as ECPs.

It neither diminishes nor qualifies in any way the requirement in

CEA section 2(e) that persons that are not ECPs enter into swaps

only on or subject to the rules of a DCM.

---------------------------------------------------------------------------

CFTC Regulation Sec. 1.3(m)(7) is available only to an entity that

seeks to qualify as an ECP under subclause (A)(v)(III) of the statutory

definition in order to enter into a swap that will be used to hedge or

mitigate commercial risk. The Commissions limited CFTC Regulation Sec.

1.3(m)(7) to subclause (A)(v)(III) because this provision of the ECP

definition is available to a business entity that uses swaps in

connection with the conduct of its business or to manage risks

associated with assets or liabilities related to the conduct of its

business.\718\

---------------------------------------------------------------------------

\718\ CEA section 1a(18)(A)(v)(III)(bb), 7 U.S.C.

1a(18)(A)(v)(III)(bb). The Commissions note that an entity that

would qualify as an ECP under subclause (A)(v)(III) without

application of CFTC Regulation Sec. 1.3(m)(7) is not required to

meet the conditions stated in, this regulation.

---------------------------------------------------------------------------

The purpose of CFTC Regulation Sec. 1.3(m)(7) is to maintain the

ability of business entities to enter into swaps other than on or

subject to the rules of a DCM for limited purposes. This regulation

therefore is available only with respect to a swap that is used to

hedge or mitigate commercial risk within the meaning of CFTC Regulation

Sec. 1.3(kkk).\719\ CFTC Regulation Sec. 1.3(m)(7) applies only if

all of an entity's owners qualify as ECPs under the provision of the

ECP definition applicable to such owner. Although some commenters

suggested that an entity should be able to qualify as an ECP based on

the status of its majority or controlling owners,\720\ the Commissions

believe that CFTC Regulation Sec. 1.3(m)(7) should be available only

when all of an entity's owners qualify as ECPs. The Commissions do not

believe it would be appropriate to impair the protection of non-ECPs

that flows from the requirement that non-ECPs enter into swaps only on

or subject to the rules of a DCM.\721\ In order to maintain these

protections and prevent evasion, CFTC Regulation Sec. 1.3(m)(7)

provides that any shell company will be disregarded, and in order to

determine if the underlying entity may use CFTC Regulation Sec.

1.3(m)(7), each owner of such shell company must be an ECP.\722\

---------------------------------------------------------------------------

\719\ See part IV.C. The use of the phrase ``hedge or mitigate

commercial risk'' in CFTC Regulations Sec. Sec. 1.3(m)(7) and

1.3(kkk) is similar to the use of the same phrase in the exception

to the mandatory clearing requirement in CEA section 2(h)(7), 7

U.S.C. 2(h)(7).

\720\ See, e.g., letter from NAREIT.

\721\ See CEA section 2(e), 7 U.S.C. 2(e).

\722\ See CFTC Regulation Sec. 1.3(m)(7)(ii).

The term ``shell company'' means any entity that limits its

holdings to direct or indirect interests in entities that are ECPs

through reliance on CFTC Regulation Sec. 1.3(m)(7). Any entity that

holds at least one direct or indirect interest in an entity not

relying on CFTC Regulation Sec. 1.3(m)(7) would not be a shell

company. The ECP status of owners of entities that are not shell

companies is not relevant for purposes of CFTC Regulation Sec.

1.3(m)(7), which should permit wider financing of small businesses

using swaps to hedge or mitigate commercial risk.

To be clear, an individual will never be considered to be a

shell company for purposes of CFTC Regulation Sec. 1.3(m)(7).

---------------------------------------------------------------------------

Correspondingly, in aggregating net worth for purposes of

determining the ECP status of an entity pursuant to CFTC Regulation

Sec. 1.3(m)(7), if the entity is owned by a shell company, then it is

the net worth of the owners of that shell company that is relevant, not

the net worth of the shell company.\723\

---------------------------------------------------------------------------

\723\ This provision may apply repeatedly in a ``chain.'' For

example, if in determining whether an entity may rely on CFTC

Regulation Sec. 1.3(m)(7), an owner of that entity that is a shell

company is disregarded, then if the owner of that shell company is

also a shell company, that second shell company also is disregarded,

and so on.

---------------------------------------------------------------------------

Last, also in order to prevent evasion, CFTC Regulation Sec.

1.3(m)(7)(ii)(C) specifies that an individual may rely on the

proprietorship provision of clause (A)(v) of the statutory definition

for purposes of determining its status as an ECP owner of an entity

only if the proprietorship \724\ status arises independent of the

business conducted by such entity \725\ and the individual proprietor

acquires his/her interest in such entity (i) in connection with the

conduct of the individual's proprietorship or (ii) to manage the risk

associated with an asset or liability owned or incurred or reasonably

likely to be owned or incurred by the proprietorship.\726\ The

Commissions are adopting CFTC Regulation Sec. 1.3(m)(7)(ii)(C) because

they believe that the only circumstance in which a proprietorship

should be considered an ECP for purposes of CFTC Regulation Sec.

1.3(m)(7)(i) is if it is making an investment related to the

proprietorship.\727\ The ECP status of an individual acting other than

with respect to its proprietorship is determined based on the ECP

clause applicable to individuals. The Commissions note that they have

authority to take action to prevent evasion of the provisions regarding

shell companies and proprietorships by entities relying on CFTC

Regulation Sec. 1.3(m)(7) to establish ECP status.

---------------------------------------------------------------------------

\724\ A proprietorship generally is a business that a person

operates in a personal capacity and with respect to which that

person directly owns all the assets and directly is responsible for

all of the liabilities, rather than through a corporation,

partnership or other structure conveying limited liability. See

letters from Midmarket Banks and Wells Fargo II (stating that

``proprietors . . . typically are not separate legal entities'');

see also State of California Franchise Tax Board Web site (advising

that ``[t]he business and the owner are one. There is no separate

legal entity and thus no separate legal person''), at https://www.ftb.ca.gov/businesses/bus_structures/soleprop.shtml. A

proprietorship is not a separate taxable entity but reports the

income or loss of the business, which is taxed along with a sole

proprietor's other income, on a separate schedule attached to his or

her individual federal income tax return. See letter from Midmarket

Banks. See also 2011 Form1040 Schedule C: Profit or Loss from

Business (Sole Proprietorship), available at http://www.irs.gov/pub/irs-pdf/f1040sc.pdf; 2011 Instructions for Schedule C, available at

http://www.irs.gov/pub/irs-pdf/i1040sc.pdf.

\725\ CFTC Regulation Sec. 1.3(m)(7)(ii)(C)(I) is designed to

ensure that the individual qualifies as a proprietorship, if at all,

other than due to its interest in either an entity seeking to

qualify as an ECP under CFTC Regulation Sec. 1.3(m)(7)(i) or in any

other entity.

\726\ See CFTC Regulation Sec. 1.3(m)(7)(ii)(C)(IV). This

language is modeled on the language in 7 U.S.C.

1a(18)(A)(v)(III)(bb).

\727\ The Commissions note that this guidance regarding

proprietorships applies only when an entity is relying on CFTC

Regulation Sec. 1.3(m)(7). The Commissions do not intend that this

guidance would expand or limit the circumstances when a

proprietorship may otherwise rely on clause (A)(v) of the statutory

definition in establishing its ECP status.

---------------------------------------------------------------------------

[[Page 30659]]

G. ECP Status for Forex Pools Operated by Registered CPOs or CPOs

Exempt From Registration Under Certain Conditions

1. Description of the Issue and Commenters' Views

Notwithstanding the modifications to the look-through provisions

for Forex Pools discussed above in section III.B., the Commissions

acknowledge commenters' concerns about the potential for unintended

consequences arising from the look-through provisions of the Dodd-Frank

Act. Several commenters asserted that many Forex Pools are operated by

sophisticated, professional managers that do not need the protections

of a retail forex regime designed to protect non-ECPs that are engaging

in retail forex transactions.\728\ More specifically, some commenters,

based on CFTC enforcement actions involving Forex Pools, suggested that

commodity pools of a sufficient size, and/or operated by a registered

or exempt CPO, do not pose the risks of fraud and abuse of non-ECP

customers that the statutory look-through provision is intended to

address.\729\

---------------------------------------------------------------------------

\728\ See, e.g., letters from Millburn (characterizing the

proposed rules as ``greatly limit[ing] the ability of entities

managed by sophisticated money managers that are subject to

registration and examination by regulators to qualify as ECPs'') and

Sidley (describing ``[a] commodity pool, like a registered

investment company or an employee benefit plan, [a]s a pool of

assets from investors of varying (and, in some cases, undetermined)

levels of sophistication that are advised by a sophisticated

adviser'').

\729\ See joint letter from the Global Foreign Exchange Division

(``GXFD'') and MFA dated January 19, 2011 (``GFXD II'') (describing

35 CFTC Forex Pool enforcement cases from 2010 and 2011 and noting

that in 80% of these cases, the amount at issue in the misconduct

was less than $10 million, and that only one case involved a

registered CPO where the amount at issue in the misconduct was more

than $10 million; two additional cases involved misconduct involving

CPOs exempt from registration as such under CFTC Regulation Sec.

4.13(a). While the commenter did not characterize these amounts as

``total assets'' (instead, the commenter used terms such as

``fraudulently obtained'' or ``sustained losses of'' to modify the

cited dollar amounts) in most cases, it is clear that these amounts

are equivalent to, or subsets of, total assets. For instance, for a

CPO to have fraudulently obtained $10 million from commodity pool

participants, the CPO must have taken in $10 million from them,

resulting in the commodity pool at one time having $10 million in

total assets. See also letter from Sidley (providing 26 examples of

CFTC Forex Pool-related enforcement cases, all but one of which

involved Forex Pools with less than $50 million in total assets). A

number of the cases cited by GXFD and Sidley overlap; in the

aggregate, these commenters appear to have presented data on 45

different cases rather than 61.

---------------------------------------------------------------------------

As a result, commenters suggested that the look-through provision

should not apply in determining ECP status of commodity pools that meet

certain conditions. For example, commenters suggested that the look-

through not be applied to a commodity pool with $10 million in total

assets paired with another or other factors, such as not being

structured to evade,\730\ being subject to regulation under the

CEA\731\ or the CPO being registered as such.\732\ Another commenter

suggested requiring the total assets or minimum initial investment of a

Forex Pool to be sufficiently large that, in general, only legitimate

pools would exceed such thresholds.\733\ This commenter suggested a

total asset threshold of $50 million.\734\

---------------------------------------------------------------------------

\730\ See letter from GFXD II.

\731\ See letters from GXFD II and Skadden.

\732\ See meeting with SIFMA on January 20, 2012 (in which

representatives of SIFMA proposed a new non-exclusive set of

criteria for a Forex Pool to qualify as an ECP, which included, as

one of several alternatives in one element of the proposed criteria,

that a Forex Pool be operated by a registered CPO). See also letter

from Willkie Farr (observing that ``[i]t may be time to regulate

certain previously unregulated transactions and traders, so that

more CPOs are registered'' and that ``many commodity pools are

operated and advised by registered professionals'').

\733\ See letter from Sidley.

\734\ See id.

---------------------------------------------------------------------------

Separately, one commenter also claimed that the statutory look-

through, if strictly implemented, might inappropriately preclude Forex

Pools and their CPOs, many of whom are registered, from engaging in

retail forex transactions with swap dealers because swap dealers are

not Enumerated Counterparties (and some swap dealers also may not be

Enumerated Counterparties in a different capacity, such as being a U.S.

financial institution).\735\ This commenter stated that such a result

could reduce close out netting opportunities in the event of the

insolvency of a counterparty.

---------------------------------------------------------------------------

\735\ See joint letter from the GFXD and MFA dated January 10,

2012 (``GFXD I''). These commenters indicated that, while

[s]ome swap dealers may be dually licensed as a bank or a

broker-dealer [and therefore] eligible to transact in OTC foreign

exchange with retail investors as well as swaps with institutional

investors * * * as an operational matter, it is not clear that firms

will be able to and find it efficient to structure their business so

that the retail foreign exchange platform is conducted from the same

entity as the institutional swaps business.

---------------------------------------------------------------------------

2. Final Rule

In response to commenters, the CFTC is adopting CFTC Regulation

Sec. 1.3(m)(8), pursuant to which certain Forex Pools may qualify as

ECPs notwithstanding the look-through requirement. As adopted, CFTC

Regulation Sec. 1.3(m)(8) enables a Forex Pool that enters into a

retail forex transaction to qualify as an ECP with respect thereto,

irrespective of whether each participant in the Forex Pool is an ECP,

if the Forex Pool satisfies the following conditions:

It is not formed for the purpose of evading CFTC

regulation under Section 2(c)(2)(B) or Section 2(c)(2)(C) of the CEA or

related CFTC rules, regulations or orders governing Retail Forex Pools

and retail forex transactions);

It has total assets exceeding $10 million; and

It is formed and operated by a registered CPO or by a CPO

who is exempt from registration as such pursuant to CFTC Regulation

Sec. 4.13(a)(3).

CFTC Regulation Sec. 1.3(m)(8) as adopted requires that the Forex

Pool not be formed for the purpose of evading CFTC regulation of Retail

Forex Pools and retail forex transactions under CEA Section 2(c)(2)(B)

or (C). A Forex Pool that is formed for that purpose would not be an

ECP under new CFTC Regulation Sec. 1.3(m)(8).

CFTC Regulation Sec. 1.3(m)(8) as adopted also requires that the

Forex Pool have total assets exceeding $10 million to qualify as an

ECP. The $10 million threshold is twice the current total asset

threshold for a commodity pool to qualify as an ECP under CEA section

1a(18)(A)(iv). The Commissions believe the $10,000,000 threshold is

appropriate in light of the potential regulatory burdens a higher

threshold might impose on smaller commodity pools. The Commissions

believe that such a threshold, coupled with the other conditions of the

rule, is sufficiently high to assure that the protections provided to

retail forex transactions are not needed for these types of commodity

pools. The Commissions will vigilantly monitor developments with

respect to Forex Pools, including enforcement activity, and revisit

this total asset threshold if warranted by subsequent events.

Finally, CFTC Regulation Sec. 1.3(m)(8) as adopted requires that

Forex Pool be formed \736\ and operated by a CPO registered as such

with the CFTC or by a CPO who is exempt from registration as such

pursuant to CFTC Regulation Sec. 4.13(a)(3). The Commissions believe

that the registered CPO aspect of this condition is appropriate for

several reasons, including that it will ensure

[[Page 30660]]

that the NFA oversees compliance by those registered CPOs relying on

this new regulation.\737\ CPO registration also provides a clear means

of addressing wrongful conduct.\738\ Although some commenters suggested

that a CPO need only be ``subject to regulation under the CEA'' in

order for a Forex Pool operated by that CPO to qualify as an ECP

notwithstanding the look-through requirements, CFTC Regulation Sec.

1.3(m)(8) instead requires that the CPO of a Forex Pool be registered

as a CPO or be a CPO who is exempt from registration as such pursuant

to CFTC Regulation Sec. 4.13(a)(3), alternative conditions supported

by other commenters. The Commissions are requiring operation by a

registered CPO, or by a CPO who is exempt from registration as such

pursuant to CFTC Regulation Sec. 4.13(a)(3), as a condition for a

Forex Pool to qualify for ECP status under CFTC Regulation Sec.

1.3(m)(8) because, based on the data presented by commenters, CFTC

enforcement actions involving Forex Pools rarely involve registered

CPOs or CPOs exempt from registration as such.\739\

---------------------------------------------------------------------------

\736\ Given that (i) many CPOs will be registering as such for

the first time due to the CFTC's recent rescission of the exemption

from CPO registration set forth in CFTC Regulation Sec. 4.13(a)(4)

or its modification of the criteria for claiming the exclusion from

the CPO definition in CFTC Regulation Sec. 4.5 and (ii) such pools

were formed prior to their CPOs' registration as such, commodity

pools formed prior to December 31, 2012 need not have been

``formed'' by a registered CPO or by a CPO exempt from registration

as such pursuant to CFTC Regulation Sec. 4.13(a)(3) in order to be

qualified as ECPs under the new prong, so long as they are operated

by a registered CPO on or before such date.

\737\ See CPO/CTA Compliance Release at 11254 (noting that

``registration allows the Commission to ensure that all entities

operating collective investment vehicles participating in the

derivatives markets meet minimum standards of fitness and

competency''). See http://www.nfa.futures.org/NFA-registration/cpo/index.html for an overview of registration and related requirements

for CPOs, their principals and their associated persons and http://www.nfa.futures.org/NFA-compliance/NFA-commodity-pool-operators/index.html for an overview of the compliance regime for registered

CPOs overseen by the NFA. The CFTC anticipates that more CPOs will

register in the coming months now that it has withdrawn the CFTC

Regulation Sec. 4.13(a)(4) exemption from CPO registration,

increasing the number of registered CPOs, in turn increasing the

number of CPOs who can satisfy the registered CPO alternative under

CFTC Regulation Sec. 1.3(m)(8)(iii).

\738\ See CPO/CTA Compliance Release at 11254 (stating that

``the [CFTC] has clear authority to take punitive and/or remedial

action against registered entities for violations of the CEA or of

the [CFTC''s regulations * * * [and] to deny or revoke registration,

thereby expelling an individual or entity from serving as an

intermediary in the industry'' and that the CFTC's reparations

program and the NFA's arbitration program also are available avenues

``to seek redress for wrongful conduct by a [CFTC] registrant'').

\739\ As discussed above in note 729, only one of the 45 unique

cases presented by commenters involved a pool with more than $10

million in total assets and a registered CPO. Only two of those

cases involved a pool operated by CPOs exempt from registration: in

both of those cases, however, the CPO raised less than $10 million.

In addition, one of those CPOs relied on the CFTC Regulation Sec.

4.13(a)(4) CPO registration exemption. As discussed above, the CFTC

has withdrawn that exemption.

---------------------------------------------------------------------------

While NFA oversight of CPOs operating Retail Forex Pools is a

useful criterion to determine whether an exclusion from the look-

through provisions of CEA section 1a(8)(A)(iv) and CFTC Regulation

Sec. 1.3(m)(5) is warranted, the Commissions believe that Retail Forex

Pools operated by CPOs exempt from registration as such pursuant to

CFTC Regulation Sec. 4.13(a)(3) also merit relief from those look-

through provisions. On September 10, 2010, the CFTC published in the

Federal Register a final rule revising the CPO registration exemption

in CFTC Regulation Sec. 4.13(a)(3) to incorporate retail forex

transactions into the transactions subject to the alternative caps on

the use of commodity interests \740\ by CPOs claiming the

exemption.\741\ The CFTC explained in the related Federal Register

proposing release that the proposed change to CFTC Regulation Sec.

4.13(a)(3) was part of a proposal to adopt a comprehensive regulatory

scheme to implement the CRA with respect to retail forex transactions

(``CRA-Related Forex Proposal'').\742\ The CFTC also explained that

``the NFA-specified minimum security deposit for off-exchange retail

forex transactions would be included among the amounts that cannot

exceed 5 percent of the liquidation value of the pool's portfolio in

order for the operator to claim the exemption from registration under

Regulation 4.13(a)(3)''\743\ and that ``such amounts are roughly

equivalent to initial margin and option premiums).'' \744\ The CFTC

also described the CRA-Related Forex Proposal as ``amend[ing] existing

regulations as needed to clarify their application to, and inclusion

in, the new regulatory scheme for retail forex.'' \745\ More recently,

notwithstanding the Dodd-Frank Act's addition of the look-through

provision in CEA section 1a(8)(A)(iv), the CFTC determined to retain

the exemption from CPO registration under Regulation 4.13(a)(3),

reasoning that ``overseeing entities with less than five percent

exposure to commodity interests is not the best use of the Commission's

resources.'' \746\

---------------------------------------------------------------------------

\740\ The term ``commodity interest'' is defined in CFTC

Regulation Sec. 1.3(yy), and includes ``[a]ny contract, agreement

or transaction subject to [CFTC] jurisdiction under section 2(c)(2)

of the [CEA].'' CFTC Regulation Sec. 1.3(yy)(3).

\741\ See CFTC, Regulation of Off-Exchange Retail Foreign

Exchange Transactions and Intermediaries; Final Rules, 75 FR 55410

(Sept. 10, 2010).

\742\ CFTC, Regulation of Off-Exchange Retail Foreign Exchange

Transactions and Intermediaries; Proposed Rules, 75 FR 3282 (Jan.

10, 2010).

\743\ Section 12 of the NFA's Financial Requirements impose the

following minimum security deposit requirements for retail forex

transactions: (i) 2% of the notional value of transactions in the

British pound, the Swiss franc, the Canadian dollar, the Japanese

yen, the Euro, the Australian dollar, the New Zealand dollar, the

Swedish krona, the Norwegian krone, and the Danish krone; (ii) 5% of

the notional value of other transactions; (iii) for short options,

the above amount plus the premium received; and (iv) for long

options, the entire premium. See NFA Manual, available at http://www.nfa.futures.org/nfamanual/NFAManual.aspx?RuleID=SECTION%2012&Section=7.

\744\ CFTC, Regulation of Off-Exchange Retail Foreign Exchange

Transactions and Intermediaries; Proposed Rules, 75 FR 3282, 3287

(Jan. 10, 2010).

\745\ Id. at 3282.

\746\ CPO/CTA Compliance Release at 11261. The CFTC also stated

that:

[t]he Commission believes that trading exceeding five percent of

the liquidation value of a portfolio, or a net notional value of

commodity interest positions exceeding 100 percent of the

liquidation value of a portfolio, evidences a significant exposure

to the derivatives markets, and that such exposure should subject an

entity to the Commission's oversight.

Id. at 11263.

---------------------------------------------------------------------------

Given that, shortly before the adoption of the Dodd-Frank Act, the

CFTC proposed to add retail forex transactions to those that can be

entered into by CPOs claiming relief from registration as such under

CFTC Regulation Sec. 4.13(a)(3), that it finalized that action shortly

after the Dodd-Frank Act was adopted and that it recently left CFTC

Regulation Sec. 4.13(a)(3) in place despite having proposed to

withdraw that CPO registration exemption, and for the reasons described

above, the Commissions believe CPOs exempt from registration as such

pursuant to CFTC Regulation 4.13(a)(3) and operating Retail Forex Pools

should be able to continue to do so outside the retail forex regime.

Section 712(d)(2)(A) of the Dodd-Frank Act grants the Commissions

the authority to adopt such rules related to the ECP definition as the

Commissions determine are necessary and appropriate, in the public

interest, and for the protection of investors. Based on commenters'

views, the Commissions have determined that CFTC Regulation Sec.

1.3(m)(8) as adopted is necessary and appropriate because the statutory

look-through provision, if strictly implemented, would subject Forex

Pools operated by CPOs that are sophisticated, professional asset

managers to an array of additional compliance costs and deprive them of

access to swap dealers as counterparties when engaging in retail forex

transactions.\747\ The Commissions also have determined that it is

appropriate to limit the availability of ECP status under CFTC

Regulation Sec. 1.3(m)(8) to Forex

[[Page 30661]]

Pools operated by registered CPOs or by CPOs exempt from registration

as such pursuant to CFTC Regulation Sec. 4.13(a)(3).\748\ The

conditions in CFTC Regulation Sec. 1.3(m)(8) also are appropriate in

that they require Forex Pools seeking ECP status thereunder to have

total assets exceeding $10 million. Historically, CFTC enforcement

actions have involved fewer instances of misconduct by CPOs of Forex

Pools with total assets above this threshold.\749\

---------------------------------------------------------------------------

\747\ The nature of a swap dealer's business activities and

assets may detract from what is considered regulatory capital for an

FCM or RFED engaging in retail forex transactions, thereby making it

difficult for some swap dealers to dually register both as such and

as an FCM or RFED in order to do retail forex business. As an ECP, a

Forex Pool's choice of retail forex transaction counterparties will

not be limited to Enumerated Counterparties, and thus may include

swap dealers.

\748\ The Commissions note that the statistics presented by

commenters indicate that Forex Pool misconduct by registered CPOs

and those exempt from CPO registration is significantly rarer than

Forex Pool misconduct by otherwise unregistered CPOs. See letter

from the GFXD II.

\749\ See letter from Sidley (showing that 6 of the 27 cases

presented involved more than $10 million).

---------------------------------------------------------------------------

The Commissions have determined that CFTC Regulation Sec.

1.3(m)(8) is in the public interest in that it will make available a

category of counterparty (i.e., swap dealers) that likely would not

otherwise be available, and help to assure that sophisticated,

professional managers operating qualifying Forex Pools can continue to

engage in retail forex transactions. The Commissions have determined

that the conditions of CFTC Regulation Sec. 1.3(m)(8) are sufficient

for the protection of investors for the reasons discussed above, such

as a significant reduction in the incidence of Forex Pool misconduct

among CPOs, whether registered as such or exempt therefrom, operating

Forex Pools with more than $10 million in total assets. The Commissions

intend to monitor developments in the Forex Pool area and will revisit

the conditions of this regulation as warranted by subsequent events.

IV. Definitions of ``Major Swap Participant'' and ``Major Security-

Based Swap Participant''

The statutory definitions of ``major swap participant''\750\ and

``major security-based swap participant''\751\ (collectively, ``major

participant'') encompass any person that is not a swap dealer or

security-based swap dealer \752\ and that satisfy any one of three

alternative statutory tests that encompass a person: (i) That maintains

a ``substantial position'' in swaps or security-based swaps for any of

the major swap categories as determined by the Commissions; (ii) whose

outstanding swaps or security-based swaps create substantial

counterparty exposure that could have serious adverse effects on the

financial stability of the U.S. banking system or financial

markets;\753\ or (iii) that is a ``financial entity'' that is ``highly

leveraged'' relative to the amount of capital it holds (and that is not

subject to capital requirements established by an appropriate Federal

banking agency) and maintains a ``substantial position'' in outstanding

swaps or security-based swaps in any major category as determined by

the Commissions.\754\ The first--and only the first--of those three

statutory tests explicitly excludes: (i) Positions held for ``hedging

or mitigating commercial risk,'' and (ii) positions maintained by any

employee benefit plan as defined in sections 3(3) and (32) of ERISA for

the ``primary purpose of hedging or mitigating any risk directly

associated with the operation of the plan.''\755\

---------------------------------------------------------------------------

\750\ CEA section 1a(33).

\751\ Exchange Act section 3(a)(67).

\752\ As discussed above, a person may be designated as a dealer

for particular activities involving swaps or security-based swaps,

or particular swap or security-based swap activities, without being

deemed to be a dealer with regard to other categories or activities.

See part II.E, supra. To the extent that a person is subject to that

type of limited designation as a swap dealer or security-based swap

dealer, the person may be subject to being a major swap participant

or a major security-based swap participant in connection with

positions that fall outside of that limited dealer designation.

\753\ See CEA section 1a(33)(A)(ii); Exchange Act section

3(a)(67)(A)(ii)(II).

\754\ See CEA section 1a(33)(A)(iii); Exchange Act section

3(a)(67)(A)(ii)(III).

\755\ See CEA section 1a(33)(A)(i); Exchange Act section

3(a)(67)(A)(ii)(I).

---------------------------------------------------------------------------

The statutory definitions require the Commissions to define the

term ``substantial position'' at the threshold determined to be prudent

for the effective monitoring, management, and oversight of entities

that are systematically important or can significantly impact the

financial system of the U.S. In setting these thresholds, the

Commissions are required to consider the person's relative position in

uncleared as opposed to cleared swaps and may take into consideration

the value and quality of collateral held against counterparty

exposures.\756\

---------------------------------------------------------------------------

\756\ See CEA section 1a(33)(B) and Exchange Act section

3(a)(67)(B).

---------------------------------------------------------------------------

The statutory definitions further permit the Commissions to limit

the scope of the major participant designations so that a person may be

designated as a major participant in certain categories of swaps or

security-based swaps, but not all categories.\757\

---------------------------------------------------------------------------

\757\ See CEA section 1a(33)(C); Exchange Act section

3(a)(67)(C).

---------------------------------------------------------------------------

In addition, the ``major swap participant'' definition excludes

certain entities whose primary business is providing financing and that

use derivatives for the purpose of hedging underlying commercial risks

related to interest rate and foreign currency exposures, 90 percent or

more of which arise from financing that facilitates the purchase or

lease of products, 90 percent or more of which are manufactured by the

parent company or another subsidiary of the parent company.\758\ The

``major security-based swap participant'' definition does not contain

this type of exclusion.

---------------------------------------------------------------------------

\758\ See CEA section 1a(33)(D).

---------------------------------------------------------------------------

As detailed in the Proposing Release, the major participant

definitions focus on the market impacts and risks associated with a

person's swap and security-based swap positions.\759\ This is in

contrast to the definitions of ``swap dealer'' and ``security-based

swap dealer,'' which focus on a person's activities and account for the

amount or significance of those activities only in the context of the

de minimis exception. However, persons that meet the major participant

definitions in large part must follow the same statutory requirements

that will apply to swap dealers and security-based swap dealers.\760\

In this way, the statute applies comprehensive regulation to entities

whose swap or security-based swap activities do not cause them to be

dealers, but nonetheless could pose a high degree of risk to the U.S.

financial system generally.\761\

---------------------------------------------------------------------------

\759\ See Proposing Release, 75 FR at 80185.

\760\ In particular, under CEA section 4s and Exchange Act

section 15F, dealers and major participants in swaps or security-

based swaps generally are subject to the same types of margin,

capital, business conduct and certain other requirements, unless an

exclusion applies. See CEA section 4s(h)(4), (5); Exchange Act

section 15F(h)(4), (5). See also CFTC, Business Conduct Standards

for Swap Dealers and Major Swap Participants with Counterparties;

Final Rule, 77 FR 9733 (Feb. 17, 2012); Notice of Proposed

Rulemaking: Capital requirements of swap dealers and major swap

participants, 76 FR 27802 (May 12, 2011); and SEC, Notice of

Proposed Rulemaking: Business Conduct Standards for Security-Based

Swap Dealers and Major Security-Based Swap Participants, Securities

Exchange Act Release No. 64766, 76 FR 42396 (July 18, 2011).

\761\ As discussed below, the tests of the major participant

definitions use terms--particularly ``systemically important,''

``significantly impact the financial system'' or ``create

substantial counterparty exposure''--that denote a focus on entities

that pose a high degree of risk through their swap and security-

based swap activities. In addition, the link between the major

participant definitions and risk was highlighted during the

Congressional debate on the statute. See 156 Cong. Rec. S5907 (daily

ed. July 15, 2010) (colloquy between Senators Hagen and Lincoln,

discussing how the goal of the major participant definitions was to

``focus on risk factors that contributed to the recent financial

crisis, such as excessive leverage, under-collateralization of swap

positions, and a lack of information about the aggregate size of

positions'').

---------------------------------------------------------------------------

Although the two major participant definitions are similar, they

address instruments that reflect different types of risks and that can

be used by end-users and other market participants for

[[Page 30662]]

different purposes. Interpretation of the definitions must account for

those differences as appropriate.

The Commissions in the Proposing Release proposed to further define

the ``major swap participant'' and ``major security-based swap

participant'' definitions, by specifically addressing: (i) The

``major'' categories of swaps or security-based swaps; (ii) the meaning

of ``substantial position''; (iii) the meaning of ``hedging or

mitigating commercial risk''; (iv) the meaning of ``substantial

counterparty exposure that could have serious adverse effects on the

financial stability of the United States banking system or financial

markets''; and (v) the meanings of ``financial entity'' and ``highly

leveraged.'' The proposal also addressed the period of time that a

major participant would have to register (as well as the minimum length

of time for being a major participant), the limited purpose

designations of major participants, the exclusion for ERISA plan

hedging positions, and certain additional interpretive issues.

After considering commenters' views, the Commissions are adopting

final rules further defining the meaning of major participant.

As discussed below, the Commissions also are directing their

respective staffs to report separately as to whether changes are

warranted to any of the rules implementing the major participant

definitions. These staff reports will help the Commissions evaluate the

``major swap participant and ``major security-based swap participant''

definitions, including whether new or revised tests or approaches would

be appropriate for identifying major participants.\762\

---------------------------------------------------------------------------

\762\ See part V, infra.

---------------------------------------------------------------------------

A. ``Major'' Categories of Swaps and Security-Based Swaps

1. Proposed Approach

The first and third tests of the statutory major participant

definitions encompass entities that maintain a substantial position in

a ``major'' category of swaps or security-based swaps.\763\

---------------------------------------------------------------------------

\763\ See CEA section 1a(33)(A)(i), (iii); Exchange Act section

3(a)(67)(a)(2)(i), (iii).

---------------------------------------------------------------------------

In the Proposing Release, the Commissions proposed to designate

four ``major'' categories of swaps and two ``major'' categories of

security-based swaps. These categories sought to reflect the risk

profiles of the various types of swaps and security-based swaps, and

the different purposes for which end-users use those instruments. The

Proposing Release also noted the importance of not parsing the

``major'' categories so finely as to base the ``substantial position''

thresholds on unduly narrow risks and reduce those thresholds'

effectiveness as risk measures.\764\

---------------------------------------------------------------------------

\764\ See Proposing Release, 75 FR at 80186-87.

---------------------------------------------------------------------------

The proposed four ``major'' categories of swaps were rate swaps,

credit swaps, equity swaps and other commodity swaps.\765\ Rate swaps

would encompass any swap which is primarily based on one or more

reference rates, such as swaps of payments determined by fixed and

floating interest rates, currency exchange rates, or other monetary

rates. Credit swaps would encompass any swap that is primarily based on

default, bankruptcy and other credit-related risks related to, or the

total returns on, instruments of indebtedness (including loans),

including but not limited to any swap primarily based on one or more

broad-based indices related to debt instruments, and any swap that is a

broad-based index credit default swap or total return swap. Equity

swaps would encompass any swap that is primarily based on equity

securities, such as any swap primarily based on one or more broad-based

indices of equity securities, including any total return swap on one or

more broad-based equity indices. Other commodity swaps would encompass

any swap not included in any of the first three categories, and would

generally include, for example and not by way of limitation, any swap

for which the primary underlying item is a physical commodity or the

price or any other aspect of a physical commodity. The four categories

were intended to cover all swaps, and each swap would be in the

category that most closely describes the primary item underlying the

swap.\766\

---------------------------------------------------------------------------

\765\ See proposed CFTC Regulation Sec. 1.3(iii).

\766\ The statutory definition of ``swap'' lists 22 different

types of swaps.

---------------------------------------------------------------------------

The Commissions proposed to designate two ``major'' categories of

security-based swaps.\767\ The first category would encompass any

security-based swap that is based, in whole or in part, on one or more

instruments of indebtedness (including loans), or a credit event

relating to one or more issuers or securities, including but not

limited to any security-based swap that is a credit default swap, total

return swap on one or more debt instruments, debt swaps, or debt index

swaps. The second category would encompass any other security-based

swaps not included in the first category, including for example, swaps

on equity securities or narrow-based security indices comprised of

equity securities.\768\ These proposed categories were based on the

different uses of these types of security-based swaps, and were

consistent with market statistics and infrastructures that distinguish

between those types of security-based swaps.\769\

---------------------------------------------------------------------------

\767\ See proposed Exchange Act rule 3a67-2.

\768\ The second category also encompasses all security-based

swaps on narrow based indices that are comprised of both debt and

equity components.

\769\ See Proposing Release, 75 FR at 80187.

---------------------------------------------------------------------------

2. Commenters' Views

Certain commenters requested clarification regarding how the major

categories would be applied. One commenter particularly requested

additional clarity as to how the proposed categories will apply to

mixed swaps and to swaps that are based on debt that is convertible to

equity,\770\ while another commenter requested additional clarity as to

the status of certain mortgage-related transactions.\771\

---------------------------------------------------------------------------

\770\ See letter from ISDA I.

\771\ See letter from Freddie Mac.

---------------------------------------------------------------------------

One commenter suggested that the final rules should include a

catch-all provision to allow the Commissions to review large positions

that appear to be structured to evade proper categorization, and that

market participants should suggest the protocols for categorization of

swaps or security-based swaps.\772\

---------------------------------------------------------------------------

\772\ See meeting with Professor Darrell Duffie, Stanford

University Graduate School of Business (``Duffie'') on February 2,

2011.

---------------------------------------------------------------------------

One commenter suggested that the rate swap category should be

divided between interest rates and currencies, and that energy,

agriculture and metals swaps should be separate categories.\773\

Another commenter expressed the view that creation of a separate

category for cross currency swaps could lead to confusion among market

participants who may feel obligated to bifurcate cross currency swaps

between two categories.\774\ Some commenters expressed general support

for the major categories as proposed.\775\

---------------------------------------------------------------------------

\773\ See letter from Better Markets I.

\774\ See letter from ACLI.

\775\ See letters from Barnard, ISDA I and MetLife; see also

letter from American Insurance Association (``AIA'') (agreeing that

the defined major categories would cover substantially all

significant swaps and security-based swaps).

---------------------------------------------------------------------------

3. Final Rules

After considering the issue in light of comments received, the

Commissions are adopting final rules designating ``major'' categories

of swaps and security-based swaps consistent with the proposal.

Accordingly, the final rules provide that the four ``major'' categories

of swaps are rate swaps,

[[Page 30663]]

credit swaps, equity swaps and other commodity swaps.\776\ The two

``major'' categories of security-based swaps are debt security-based

swaps \777\ and other security-based swaps.\778\

---------------------------------------------------------------------------

\776\ See CFTC Regulation Sec. 1.3(iii). The four major

categories of swaps are the same as the asset classes used in the

CFTC Regulations relating to SDRs and reporting, except that the

asset classes for interest rate swaps and foreign exchange

transactions are combined into the single rate swap major category

of swaps. See CFTC, Swap Data Repositories: Registration Standards,

Duties and Core Principles; Final Rule, 76 FR 54538 (Sept. 1, 2011)

and Swap Data Recordkeeping and Reporting Requirements; Final Rule,

77 FR 2136 (Jan. 13, 2012).

\777\ The name of the first major category of security-based

swaps has been changed to ``debt security-based swaps'' in this

Adopting Release from ``security-based credit derivatives'' in the

Proposing Release. This change more accurately reflects the products

encompassed by this category, particularly total return swaps on

debt instruments. See Exchange Act rule 3a67-2(a).

In addition, the final rules defining the major categories for

purposes of the major participant definitions remove a cross-

reference to the corresponding dealer definitions under the CEA or

the Exchange Act to clarify that the rules apply only in the context

of the major participant definitions, and not the dealer

definitions. See CFTC Regulation Sec. 1.3(iii); Exchange Act rule

3a67-2.

\778\ See Exchange Act rule 3a67-2(b).

---------------------------------------------------------------------------

The Commissions believe that it is not necessary to further divide

the proposed categories or add new categories for swaps and security-

based swaps for purposes of the major participant definitions. We

believe that maintaining a large number of narrow categories of swaps

and security-based swaps would increase the possibility of confusion by

market participants with regard to categorizing the swaps and security-

based swaps in which they transact. The Commissions also continue to

believe that it is important not to parse the ``major'' categories so

finely as to base the ``substantial position'' thresholds on unduly

narrow groupings that would reduce those thresholds' effectiveness as

risk measures. Categories that are broad and clearly delineated further

should help prevent action to evade designation as a major participant

in a particular ``major'' category.

While we believe that these rules in general are sufficiently clear

to allow each swap and security-based swap to be placed in the

appropriate category, we are mindful of the commenters' request for

guidance with regard to certain circumstances. In the case of mixed

swaps, we would expect that the instrument would be placed in the

``swap'' and ``security-based swap'' categories that are consistent

with the underlying attributes that cause such instrument to be a mixed

swap.\779\ Also, swaps or security-based swaps that are based on more

than one item, instrument or risk, should be placed in the category

that most closely describes the primary item, instrument or risk

underlying the swap or security-based swap.\780\

---------------------------------------------------------------------------

\779\ The Commissions have proposed rules regarding the

regulation of mixed swaps. See Product Definitions Proposal, note 3,

supra.

\780\ In the case of instruments on debt securities that are

convertible into equity, in general we would expect the instrument

to be categorized based on its status (as debt or equity) at the

time of evaluation.

---------------------------------------------------------------------------

B. ``Substantial Position''

1. Proposed Approach

The major participant definitions require that the Commissions

define a ``substantial position'' in swaps or security-based swaps at a

threshold that we determine to be ``prudent for the effective

monitoring, management, and oversight'' of entities that are

systemically important or can significantly impact the U.S. financial

system. The definitions further require that we consider a person's

relative position in uncleared and cleared swaps or security-based

swaps, and permit us to consider the value and quality of collateral

held against counterparty exposure.\781\

---------------------------------------------------------------------------

\781\ See CEA section 1a(33)(B); Exchange Act section

3(a)(67)(B).

---------------------------------------------------------------------------

The proposed rules provided that a person would have a

``substantial position'' in swaps or security-based swaps if the daily

average current uncollateralized exposure associated with its swap or

security-based swap positions in a major category in a calendar quarter

amounted to $1 billion or more (or $3 billion in the case of rate

swaps).\782\ A person also would have a ``substantial position'' if the

daily average of the sum of the current uncollateralized exposure plus

the potential future exposure associated with its positions in a major

category in a calendar quarter amounted to $2 billion or more (or $6

billion for the rate swap category).\783\

---------------------------------------------------------------------------

\782\ See proposed CFTC Regulation Sec. 1.3(jjj)(1); proposed

Exchange Act rule 3a67-3(a)(1), (d).

\783\ See proposed CFTC Regulation Sec. 1.3(jjj)(1); proposed

Exchange Act rule 3a67-3(a)(2), (d).

---------------------------------------------------------------------------

The proposed rules did not prescribe any particular methodology for

measuring current exposure or valuing collateral posted, and instead

provided that the method used should be consistent with counterparty

practices and industry practices generally.\784\ The proposed rules

also provided that an entity could calculate its current

uncollateralized exposure by accounting for netting agreements on a

counterparty-by-counterparty basis,\785\ and the Proposing Release set

forth a method for allocating any residual uncollateralized exposure to

a counterparty that remains following netting.\786\

---------------------------------------------------------------------------

\784\ See proposed CFTC Regulation Sec. 1.3(jjj)(2)(ii);

proposed Exchange Act rule 3a67-3(a)(2)(i).

\785\ See proposed CFTC Regulation Sec. 1.3(jjj)(2)(iii);

proposed Exchange Act rule 3a67-3(b)(3).

\786\ See Proposing Release, 75 FR at 80190.

---------------------------------------------------------------------------

The proposed potential future exposure test was based on the risk-

adjusted notional amount of the entity's swap and security-based swap

positions, consistent with a test used by bank regulators for purposes

of setting capital standards.\787\ The test also excluded or lowered

the potential exposure associated with certain lower-risk

positions.\788\ In addition, the measures of potential future exposure

would be discounted by up to 60 percent to reflect the risk mitigation

provided by netting agreements,\789\ and would further be decreased by

80 percent for positions subject to central clearing or daily mark-to-

market margining.\790\

---------------------------------------------------------------------------

\787\ See id. at 80191-92.

\788\ See proposed CFTC Regulation Sec. 1.3(jjj)(3)(iii);

proposed Exchange Act rule 3a67-3(c)(2)(i)(C), (D).

\789\ See proposed CFTC Regulation Sec. 1.3(jjj)(3)(ii)(B);

proposed Exchange Act rule 3a67-3(c)(2)(ii).

\790\ See proposed CFTC Regulation Sec. 1.3 (jjj)(3)(iii)(A);

proposed Exchange Act rule 3a67-3(c)(3)(i). This discount for daily

margining would be available even in the presence of a threshold or

a minimum transfer amount, so long as the threshold and the minimum

transfer amount (if the latter exceeds $1 million) are separately

added to the entity's current exposure for purposes of the current

exposure plus potential future exposure test. See proposed CFTC

Regulation Sec. 1.3(jjj)(3)(iii)(B); proposed Exchange Act rule

3a67-3(c)(3)(ii).

---------------------------------------------------------------------------

2. Commenters' Views

a. Basis for Regulating Major Participants and Alternative Approaches

for Identifying ``Substantial Positions''

Several commenters expressed the view that the major participant

definition is intended to address entities whose swap or security-based

swap positions pose systemic risk,\791\ while one commenter took the

contrary view that the definition also is intended to address the

significance of an entity's swap or security-based swap positions (as

well as the risk those positions pose).\792\

---------------------------------------------------------------------------

\791\ E.g., letters from BlackRock I and MFA I.

\792\ See letter from Better Markets I.

---------------------------------------------------------------------------

One commenter stated that the proposal inappropriately sought to

account for the risk posed by the potential default of multiple

entities, rather than a single entity.\793\ Some commenters suggested

that the analysis should account for the concentration of the risk

posed by an entity's

[[Page 30664]]

positions,\794\ and one commenter suggested that the analysis should

not account for individual categories of swaps or security-based

swaps.\795\

---------------------------------------------------------------------------

\793\ See letter from BlackRock I.

\794\ See letters from Black Rock I (suggesting a two-step

process that accounts for the reduced risk associated with entities

whose positions are distributed among several counterparties); CCMR

I and APG Algemene Pensioen Groep NV (``APG'').

\795\ See letter from NYCBA Committee.

---------------------------------------------------------------------------

b. Levels of Proposed ``Substantial Position'' Thresholds

A number of commenters expressed the view that the proposed

thresholds are inappropriately low.\796\ Some commenters stated the

thresholds initially should be high, with later revisions based on

market data.\797\

---------------------------------------------------------------------------

\796\ See letters from ABC/CIEBA (indirectly referring to AIG

Financial Products, and noting that it had $400 billion in notional

positions and defaulted when it was required to post approximately

$100 billion in collateral); BG LNG I (alluding to lack of systemic

impact associated with Enron's failure, and suggesting that the

Commissions convene an advisory committee to develop thresholds);

NCGA/NGSA I (alluding to corporate financial losses involving

derivatives that have exceeded the proposed thresholds without

significantly impacting the U.S. financial system); ACLI (supporting

increase in proposed thresholds under the CEA to $4 billion current

uncollateralized exposure and $8 billion current uncollateralized

exposure plus potential future exposure); and Chesapeake Energy.

\797\ See letters from MFA dated February 25, 2011 (``MFA II'')

(stating that thresholds initially should be set higher, while later

survey-based thresholds should be based on potential systemic risk

impact and the cost of performing the calculations); CCMR I (stating

that the Commissions presently have insufficient data to determine

appropriate thresholds, and that thresholds initially should be

high); BlackRock I (stating that the Commissions should refrain from

establishing thresholds if sufficient information is not available);

and Freddie Mac. Two commenters particularly addressed the proposed

thresholds applicable to rate swaps. See letters from ACLI and

MetLife.

---------------------------------------------------------------------------

Some commenters did not oppose the proposed thresholds or expressed

support for the thresholds (though many of those commenters separately

raised issues about the underlying tests),\798\ while two commenters

supported lowering the proposed thresholds.\799\ Some commenters took

the position that the thresholds should be adjusted over time to

reflect factors such as inflation or market characteristics.\800\

---------------------------------------------------------------------------

\798\ See, e.g., letters from ACLI, Fidelity, SIFMA AMG dated

Feb. 22, 2011 (``SIFMA AMG II'') and Vanguard (supporting proposed

limits for credit swaps, equity swaps and other commodity swaps, but

not rate swaps).

\799\ See letters from AFR (supporting use of a $500 million

uncollateralized exposure threshold, or a $1 billion current

exposure plus potential future exposure threshold, with higher

thresholds for rate swaps) and Greenberger.

\800\ See, e.g., letters from MFA I (referring to inflation and

measures such as the amount of equity in the U.S. banking system)

and ISDA I (referring to evolution of the size and fundamental

characteristics of the markets, and changes to valuation

methodologies and economic conditions).

---------------------------------------------------------------------------

c. Current Uncollateralized Exposure Test

Measures of exposure and valuation of collateral--A number of

commenters supported the Proposing Release's position that the current

exposure analysis not prescribe any methodology for measuring exposure

or valuing collateral.\801\ On the other hand, some commenters

requested explicit approval of particular methodologies,\802\ a good

faith safe harbor,\803\ or regulator-prescribed measurement

standards.\804\ Some commenters emphasized the need to be able to post

non-cash collateral in connection with positions.\805\ Two commenters

requested codification of the proposal's position that operational

delays associated with the daily exchange of collateral would not lead

to current uncollateralized exposure for purposes of the analysis.\806\

---------------------------------------------------------------------------

\801\ See letters from Fidelity, ICI I, ISDA I and MFA I.

\802\ See letter from BlackRock I. Consistent with the proposal,

the final rules contemplate the use of industry standard practices

in the calculation of current exposure and potential future

exposure. As with other rules adopted by the Commissions, a market

participant may raise questions with the Commissions about the

participant's approach to addressing the final rules--including its

use of particular methodologies--for further guidance as may be

necessary or appropriate.

\803\ See letter from FSR I (particularly noting difficulty of

valuing illiquid or bespoke positions).

\804\ See letter from Better Markets I.

\805\ See, e.g., letters from ACLI, CDEU and MetLife.

\806\ See letters from SIFMA AMG II and Vanguard.

---------------------------------------------------------------------------

Netting issues--Some commenters stated that the proposed netting

provisions should be expanded to encompass additional products that may

be netted for bankruptcy purposes.\807\ One commenter took the view

that these provisions should be expanded across multiple netting

agreements to the extent that offsets are permitted.\808\ One commenter

asked for clarification as to the scope of the netting provisions,\809\

and one commenter expressed general support for the proposed netting

provisions.\810\

---------------------------------------------------------------------------

\807\ See letters from ISDA I (specifically addressing

securities contracts and forward contracts); NRG Energy

(specifically addressing forwards); and APG (specifically addressing

securities options and forwards).

\808\ See letter from FSR I.

\809\ See letter from Fidelity (seeking confirmation that

``master netting agreement'' can include an ISDA Master Agreement).

\810\ See letter from ACLI.

---------------------------------------------------------------------------

Allocation of uncollateralized exposure--Some commenters requested

that the final rules incorporate the principles, articulated in the

Proposing Release, for allocating any uncollateralized exposure that

remains following netting.\811\ Other commenters raised concerns that

those principles were based on an unwarranted assumption that

collateral is specifically earmarked to particular transactions.\812\

---------------------------------------------------------------------------

\811\ See letters from SIFMA AMG II and Vanguard.

\812\ See letters from FSR I and ISDA I; see also letter from

MetLife (suggesting pro rata allocation of uncollateralized current

exposure among each major category with current exposure).

---------------------------------------------------------------------------

d. Potential Future Exposure Test

General concerns and suggested alternative approaches--Some

commenters disagreed with the Proposing Release's statement that the

potential future exposure analysis would evaluate potential changes in

the value of a swap or security-based swap over the remaining life of

the contract; those commenters stated that the test instead should

focus on potential volatility during the time it would take for a non-

defaulting party to close out a defaulting party's positions.\813\

---------------------------------------------------------------------------

\813\ See letters from SIFMA AMG II and Vanguard.

---------------------------------------------------------------------------

Some commenters criticized the tables setting forth the risk

adjustments used to calculate potential future exposure.\814\

Commenters further suggested using, as alternatives, value-at-risk

measures or other models,\815\ or the ``standardized method'' under

Basel II.\816\ Commenters also argued that risk adjustments should

provide a greater discount to credit swaps on ``investment grade''

instruments than to other credit swaps, that index CDS should be

subject to a greater discount than single name CDS, and that there

should be a lower discount factor for CDS of shorter maturity.\817\ One

commenter generally supported the proposed conversion factors and

adjustments.\818\

---------------------------------------------------------------------------

\814\ See letters from Riverside Risk Advisors LLC (``Riverside

Risk Advisors'') (criticizing, among other aspects, discontinuities

in table, a failure to account for how far a swap is in or out of

the money, the use of a single discount factor for credit default

swaps, the fact that the risk factor for short-term equity swaps is

lower than the risk factor for credit swaps, and the fact that

equity swaps do not distinguish between high-volatility and low-

volatility stocks, as well as the failure to address portfolio

effects of diversification and correlation, and ``wrong-way'' risk

in the form of ``an adverse correlation between counterparty default

risk and the value of its derivatives contracts''); and ISDA I

(noting that the conversion factors were calibrated more than 15

years ago and were not designed for later instruments such as credit

products).

\815\ See letters from Riverside Risk Advisors (supporting

giving end-users the option to use a model-based approach); and

Better Markets I (supporting use of a value-at-risk calculation).

\816\ See letter from ISDA I.

\817\ See letters from AIMA I and MFA I.

\818\ See letter from MetLife.

---------------------------------------------------------------------------

Some commenters expressed the view that measures of potential

future exposure should be superseded by negotiated independent amounts

or regulator-required initial margin.\819\ Some commenters also argued

that

[[Page 30665]]

excess posted collateral or net in-the-money positions should be offset

against potential future exposure.\820\

---------------------------------------------------------------------------

\819\ See letters from SIFMA AMG II and Vanguard.

\820\ See, e.g., letters from AIMA I, Fidelity, MFA I, SIFMA AMG

II and Vanguard.

---------------------------------------------------------------------------

Potential future exposure measures for lower-risk positions--Some

commenters stated that the proposal to cap potential future exposure

when a person buys credit protection using a credit default swap should

be expanded to apply to any position with a fixed downside risk.\821\

Commenters also suggested that the potential future exposure associated

with purchases of credit protection be further discounted,\822\ while

one commenter took the position that purchases of credit default swaps

should be excluded from the potential future exposure test.\823\

Commenters also addressed the appropriate discount rate for calculating

the net present value of unpaid premiums.\824\

---------------------------------------------------------------------------

\821\ See letters from MFA I (citing fixed portions of interest

rate swaps), MetLife (citing purchased options as well as CDS), ACLI

and Ropes & Gray.

\822\ See letters from MFA I (arguing that the tightening of

credit spreads would imply a healthy credit environment) and AIMA;

see also meeting with MFA on February 14, 2011.

\823\ See letter from Vanguard.

\824\ See letter from MFA I (suggesting the possible use of the

LIBOR/Swap rate) and AIMA I.

---------------------------------------------------------------------------

Netting issues--One commenter stated that the proposal's netting

provisions did not adequately account for the risk mitigation

associated with hedged positions,\825\ while another commenter asked

that the proposed netting provisions be clarified and simplified.\826\

One commenter supported the proposed netting approach.\827\

---------------------------------------------------------------------------

\825\ See letter from ISDA I.

\826\ See letter from SIFMA AMG II.

\827\ See letters from ACLI.

---------------------------------------------------------------------------

Discount for cleared or margined positions--Several commenters took

the view that cleared positions should be excluded entirely from the

potential future exposure analysis, rather than only being subject to

an 80 percent discount,\828\ and some commenters also supported a

complete exclusion for positions subject to daily mark-to-market

margining.\829\ One commenter suggested a minimum 98 percent reduction

for positions subject to central clearing or mark-to-market

margining,\830\ while one commenter suggested that there be a higher

discount for positions subject to the posting of initial margin.\831\

---------------------------------------------------------------------------

\828\ See, e.g., letters from MFA I, SIFMA AMG II and Vanguard.

\829\ See letters from BG LNG I, Fidelity and ICI I.

\830\ See letter from ISDA I.

\831\ See letter from FHLB I (suggesting 90 percent discount for

cleared swaps and for uncleared swaps for which initial margin has

been posted; alternatively suggesting that posted initial margin be

subtracted from the calculated amount).

---------------------------------------------------------------------------

Some commenters also stated that there should be a partial discount

provided in connection with positions for which mark-to-market

margining is done less than daily,\832\ and that there should be a

discount for positions that are margined using security interests or

liens.\833\ On the other hand, one commenter stated that there is no

basis for providing any discount for marked-to-market positions.\834\

---------------------------------------------------------------------------

\832\ See letters from Fidelity and Canadian Master Asset

Vehicle I and Master Asset Vehicle II (``Canadian MAVs'').

\833\ See letter from FHLB I (giving as an example swaps

collateralized by security interests in real estate, oil or gas

interests, or by first liens on financial assets).

\834\ See letter from Better Markets I; see also letter from AFR

(generally opposing use of risk adjustments, but suggesting that any

such discounts should be larger for cleared positions).

---------------------------------------------------------------------------

One commenter requested that the rule language codify language in

the Proposing Release as to when a position is subject to daily mark-

to-market margining.\835\ A number of commenters addressed proposed

rule language that was intended to clarify that the discount for daily

mark-to-market margining would be available even in the presence of

thresholds and minimum transfer amounts.\836\

---------------------------------------------------------------------------

\835\ See letter from SIFMA AMG II.

\836\ See letter from CDEU (stating that the proposal could

overstate an entity's future exposure, and favoring use of the lower

of the calculated potential future exposure or the CSA threshold);

see also letters from SIFMA AMG II and Vanguard.

---------------------------------------------------------------------------

Two commenters supported the proposed approach in general.\837\ One

commenter specifically supported the proposed 80 percent reduction for

positions subject to daily mark-to-market margining,\838\ and one

commenter specifically supported a reduction for cleared

positions.\839\

---------------------------------------------------------------------------

\837\ See letters from ACLI and MetLife.

\838\ See letter from Vanguard.

\839\ See letter from Better Markets I.

---------------------------------------------------------------------------

Additional issues regarding the potential future exposure test--

Some commenters argued that the Commissions should clarify how the

categories in the proposed potential future exposure tables would be

applied, given how those differ from the proposed ``major'' categories

of swaps and security-based swaps.\840\

---------------------------------------------------------------------------

\840\ See letters from SIFMA AMG II and Vanguard.

---------------------------------------------------------------------------

Some commenters raised concerns that the proposed use of an

instrument's ``effective notional'' amount is ambiguous.\841\

Commenters also took the position that for purposes of the potential

future exposure calculation, notional amounts should be adjusted to

reflect delta weighting,\842\ that the measure of duration for options

on swaps should consider whether the underlying swap is cash-

settled,\843\ and that the adopting release should set forth examples

of potential future exposure calculations.\844\

---------------------------------------------------------------------------

\841\ See letters from FSR I, SIFMA AMG II and Vanguard.

\842\ See letters from MFA I and Ropes & Gray.

\843\ See letter from MFA I.

\844\ See id.

---------------------------------------------------------------------------

e. Cost Concerns

Some commenters emphasized the need to avoid an overbroad major

participant definition, \845\ and highlighted concerns about being

subject to unnecessary regulation.\846\

---------------------------------------------------------------------------

\845\ See joint letter from Representatives Bachus and Lucas.

\846\ See, e.g., letters from SIFMA AMG II (stating that the

commenter's suggested changes in connection with the substantial

position analysis would reduce burdens and costs to market

participants, and more closely align the tests with the objectives

they are meant to achieve) and ABC/CIEBA; see also letter from

NFPEEU (reserving the right to dispute the cost-benefit analysis

associated with the proposed dealer and major participant rules

until all relevant Dodd-Frank Act releases could be analyzed as a

whole).

---------------------------------------------------------------------------

f. Additional Issues

One commenter suggested there be an explicit presumption against

imposing major participant (or dealer) regulation on end-users.\847\

Some commenters requested that the current uncollateralized exposure

test explicitly exclude cleared positions, net in-the-money positions,

and fully collateralized out-of-the-money positions,\848\ and one

commenter also supported excluding those positions from the potential

future exposure analysis.\849\ That commenter also supported excluding

swaps on government securities from the substantial position

analysis.\850\

---------------------------------------------------------------------------

\847\ See letter from CDEU.

\848\ See letters from ICI I, SIFMA AMG II and Vanguard.

\849\ See letter from ICI I.

\850\ See letter from ICI I (noting size of government security

market and Federal Reserve control over supply and demand, and

stating that the proposed thresholds are ill-suited to address the

``vast'' government securities market).

---------------------------------------------------------------------------

One commenter requested confirmation that dealers and major

participants would not be required to compute, assist with, or verify

computations for counterparties that may be major participants, and

also that market participants can enlist third-party services to assist

in performing the calculations.\851\ One commenter requested

clarification that the proposed focus on uncollateralized exposure does

not mean that end-users themselves

[[Page 30666]]

should not demand collateral from dealers.\852\

---------------------------------------------------------------------------

\851\ See letter from ISDA I.

\852\ See letter from FHLB I.

---------------------------------------------------------------------------

3. Final Rules

a. Guiding Principles

The final rules defining ``substantial position'' focus on

identifying persons whose large swap and security-based swap positions

pose market risks that are significant enough that it would be

``prudent'' to regulate those persons. In developing these rules we

have been mindful of the costs associated with regulating major

participants, and have considered cost and benefit principles as part

of the analysis of what level of swap and security-based swap positions

reasonably form the lower bounds for identifying when it would be

``prudent'' that particular entities be subject to monitoring,

management and oversight of entities that may be systemically important

or may significantly impact the U.S. financial system.\853\

---------------------------------------------------------------------------

\853\ At the same time, as discussed above in the context of the

de minimis exception to the dealer definitions, we are mindful that

the benefits of financial regulation cannot be quantified. For

example, while the regulation of major participants will comprise

one component of Title VII's comprehensive regulatory framework that

should be expected to help lessen the amount and frequency of

financial crises, we cannot place a dollar figure on the

contribution of major participant regulation to those benefits. In

light of those factors, we believe that it would be ``prudent'' to

regulate, as major participants, those persons whose swap or

security-based swap positions are large enough to pose a material

potential of causing significant counterparty impacts, consistent

with the levels set forth in the final rules. The Commissions will

further address the comparative costs and benefits associated with

regulating major participants in the context of the substantive

rules applicable to major participants.

---------------------------------------------------------------------------

The final rules implementing the ``substantial position''

definition follow the basic approach that the Commissions proposed,

including the combined use of current exposure and potential future

exposure tests.\854\ While we have carefully considered the views of

commenters who suggested alternative approaches, we have concluded that

it is appropriate to adopt the basic approach that was proposed, as

described below.

---------------------------------------------------------------------------

\854\ As with the proposal, the final rules apply these tests to

swap and security-based swap positions in a ``major'' category. See

CFTC Regulation Sec. 1.3(jjj)(1); Exchange Act rule 3a67-3(a). The

final rules have been modified from the proposal, however, by

removing a reference to ``positions excluded from consideration.''

We have concluded that this reference is unnecessary because the

first statutory major participant test explicitly provides that

positions that are subject to the commercial risk hedging and the

ERISA hedging exclusions of the first major participant test need

not be considered for purposes of that test.

---------------------------------------------------------------------------

Focus on default-related credit risks. The final rules

implement tests that seek to reflect the credit risk that a person's

swap or security-based swap positions would pose in the event of

default. In arguing that the analysis should consider factors in

addition to default-related risks, commenters have noted that certain

regulations applicable to major participants address business conduct

issues that are distinct from systemic risk issues.\855\ We nonetheless

believe that the statutory definition of ``substantial position''

indicates that the analysis should focus on default-related credit

risks, because a default-related approach is more closely linked to the

statutory criteria that the definition focus on entities that are

``systemically important'' or can ``significantly impact'' the U.S.

financial system than would be an approach that focuses on the

potential for disruptive market movements.\856\

---------------------------------------------------------------------------

\855\ See, e.g., letter from Better Markets I.

\856\ We also believe that the statutory definition should focus

on all default-related credit risks associated with swap or

security-based swap positions. We do not see a basis for excluding

any class of risks (e.g., risks associated with swaps based on

government securities) from the analysis.

---------------------------------------------------------------------------

Failure of multiple entities close in time. The final

rules that implement the ``substantial position'' definition seek to

reflect the risks that would be posed by the default of multiple

entities close in time. Although one commenter took the view that the

purpose of major participant regulation is to prevent the credit

exposure of a single person from having a systemic impact,\857\ we do

not believe that the major participant definitions should be construed

so narrowly. The events of recent years demonstrate that market stress

may lead to the failure and near-failure of multiple entities with

large financial positions over a relatively short time period. We do

not believe that it would be prudent or well-reasoned to presume that

recent history cannot repeat itself, and to assume that future failures

of entities with large financial positions will be isolated events.

---------------------------------------------------------------------------

\857\ See letter from BlackRock I.

---------------------------------------------------------------------------

Aggregate risk. The final rules address the aggregate risk

posed by an entity's swap or security-based swap positions, rather than

seeking to focus on principles of concentration (such as by using a

threshold that addresses an entity's largest exposure to an individual

counterparty) or on converse principles of interconnection. The

statutory ``substantial position'' definition is specifically written

in terms of market risk concerns (i.e., ``systemically important'' and

``can significantly impact the financial system of the United

States''), and measures of aggregate risk appear to be best geared to

reflect this standard.\858\

---------------------------------------------------------------------------

\858\ Moreover, a test that focuses on the concentration of an

entity's swap or security-based swap exposure toward one or a few

individual parties potentially poses a tension with the view that

interconnections of exposure among multiple parties are important to

establishing systemic risk.

---------------------------------------------------------------------------

Use of objective, quantitative criteria. The final rules

provide for a ``substantial position'' analysis that is based on

objective, quantitative criteria that would permit a market participant

to determine which level of swap or security-based swap positions would

cause it to be a major participant. Although one commenter has

suggested the use of a two-step approach that uses thresholds as a safe

harbor and that would be accompanied by a second-level

determination,\859\ we do not believe that such an approach would be

consistent with the statutory language or with principles of regulatory

efficiency.\860\ Accordingly, a person whose swap or security-based

swap positions satisfy the applicable thresholds will be a major

participant, with no further layer of review provided.\861\

---------------------------------------------------------------------------

\859\ See letter from BlackRock I.

\860\ The major participant definitions specifically require

that the term ``substantial position'' be defined ``by rule or

regulation'' via a ``threshold.'' That language would not appear to

anticipate the use of a multi-tier approach that accounts for

subjective criteria.

In this respect, the major participant definitions may be

compared with section 113 of the Dodd-Frank Act, which authorizes

the Financial Stability Oversight Council (``FSOC'') to provide for

a non-bank financial company to be supervised by the Board if the

FSOC ``determines that material financial distress at the U.S.

nonbank financial company, or the nature, scope, size, scale,

concentration, interconnectedness, or mix of the activities of the

U.S. nonbank financial company, could pose a threat to the financial

stability of the United States.'' Section 113 further provides that

these designations will result from a vote of the FSOC based on a

variety of factors. The ``major participant'' definition does not

provide for this type of entity-specific determination, and we

believe that the ``major participant'' definition more appropriately

is implemented by objective factors that allow market participants

to determine whether they will fall within the definition.

\861\ In addition, the final rules provide that the

``substantial position'' analysis that implements the first (and

third) major participant test will be based on the ``major''

categories of swaps and security-based swaps. Notwithstanding

commenter concerns that this approach will require market

participants to analyze their swaps and security-based swaps in new

ways and will result in additional costs, this focus on ``major''

categories is dictated by the plain language of the statute.

---------------------------------------------------------------------------

b. Current Uncollateralized Exposure Test

Consistent with the proposal, the final rules implementing the

``substantial position'' definition include a test that accounts for

the current uncollateralized exposure posed by an entity's swap or

security-based swap positions in a major

[[Page 30667]]

category.\862\ This provides a measure of the amount of potential risk

that an entity would pose to its counterparties if the entity currently

were to default.\863\

---------------------------------------------------------------------------

\862\ CFTC Regulation Sec. 1.3(jjj)(1); Exchange Act rule 3a67-

3(b)(2). The final rules contain technical changes from the proposal

to clarify the steps entailed by this calculation.

\863\ See Proposing Release, 75 FR at 80188.

---------------------------------------------------------------------------

As with the proposal, a person would apply this test by examining

the positions it maintains with each of its counterparties in a

particular major category of swaps or security-based swaps. For each

counterparty, the person would determine the dollar value of the

aggregate current exposure arising from each of its swap or security-

based swap positions with negative value in that major category by

marking-to-market using industry standard practices, and deduct from

that amount the aggregate value of the collateral the entity has posted

with respect to the swap or security-based swap positions.\864\ The

``aggregate uncollateralized outward exposure'' would be the sum of

those uncollateralized amounts over all counterparties with which the

person has entered into swaps or security-based swaps in that major

category.\865\

---------------------------------------------------------------------------

\864\ As we noted in the Proposing Release, we recognize that

there may be operational delays between changes in exposure and the

resulting exchanges of collateral, and in general we would not

expect that operational delays associated with the daily exchange of

collateral would be considered to lead to uncollateralized exposure

for these purposes. See Proposing Release, 75 FR at 80189 n.92.

Although we are not codifying this principle within the final rules,

we will be mindful of the principle when enforcing those rules.

\865\ CFTC Regulation Sec. 1.3(jjj)(2); Exchange Act rule 3a67-

3(b)(2).

---------------------------------------------------------------------------

The final rules implementing this test largely are the same as the

rules the Commissions proposed, but with certain modifications to

address issues raised by commenters.

i. Measure of Exposure and Valuation of Collateral

Consistent with the proposal, the final rules do not prescribe any

particular methodology for measuring current exposure or for valuing

collateral posted, but instead require the use of industry standard

practices.\866\ In this regard we do not concur with commenter requests

that we approve or prescribe particular methodologies, or provide a

safe harbor for measures or valuations made in good faith.\867\

Instead, it is appropriate that the final rules provide market

participants with the flexibility to use the same methodologies that

they use in connection with their business activities. Accordingly, we

would expect entities to value current uncollateralized exposure based

on the amounts that would be payable if the transaction were

terminated.

---------------------------------------------------------------------------

\866\ CFTC Regulation Sec. 1.3(jjj)(2); Exchange Act rule 3a67-

3(b)(1). As we noted in the Proposing Release, collateral may be

posted to a third-party custodian, directly to the counterparty, or

in accordance with the rules of a derivatives clearing organization

or clearing agency. See Proposing Release, 75 FR at 80189 n.94.

\867\ See letters from BlackRock I, Better Markets I and FSR I.

---------------------------------------------------------------------------

To the extent the measure of exposure or the valuation of

collateral is subject to other rules or regulations, we also would

expect those measures and valuations for purposes of the major

participant calculations to be consistent with those other applicable

rules.\868\ In addition, the ``substantial position'' analysis may take

into account the posting of non-cash collateral to the extent that the

posting of such collateral, and the valuation of that collateral, is

consistent with industry standard practices or applicable

regulation.\869\

---------------------------------------------------------------------------

\868\ These principles should apply even in the case of valuing

illiquid or bespoke positions. Market participants have the

flexibility to use commercially reasonable approaches that are

consistent with their financial statements, tax calculations and

compliance with other regulations.

\869\ For non-cash collateral to be considered for purposes of

these calculations, the collateral must be available for the

counterparty's use if the entity posting the collateral were to

default. At a minimum, this would require that the counterparty

possess a perfected security interest in that collateral. As we

noted in the Proposing Release, while we expect that other

regulatory requirements applicable to the valuation of swap or

security-based swap positions and collateral would be relevant to

certain calculations relating to major participant status, these

rules would not necessarily be relevant for other purposes, such as

in the context of capital and margin requirements. See Proposing

Release, 75 FR at 80189 n.95.

---------------------------------------------------------------------------

ii. Netting

The final rules build upon the proposal with regard to the measure

of uncollateralized current exposure in the presence of netting

arrangements. In particular, to address commenter concerns these

provisions have been modified from the proposal to account for the fact

that two counterparties may have multiple netting agreements for which

offsets are permitted, and to extend the netting principles to any

financial instruments that may be netted for purposes of applicable

bankruptcy law (rather than limiting those instruments to swaps,

security-based swaps and securities financing transactions).

Accordingly, the final rules provide that an entity may calculate

its exposure on a net basis by applying the terms of one or more master

netting agreements with a counterparty. The entity may account for

offsetting positions entered into with that particular counterparty

involving swaps or security-based swaps as well as securities financing

transactions (consisting of securities lending and borrowing,

securities margin lending and repurchase and reverse repurchase

agreements), and other financial instruments and agreements that are

subject to netting offsets for purposes of applicable bankruptcy law,

to the extent consistent with the offsets provided by those master

netting agreements.\870\ These revisions should permit the current

uncollateralized exposure test to more accurately reflect the degree of

credit risk that an entity poses to its counterparty in the event of

default.

---------------------------------------------------------------------------

\870\ CFTC Regulation Sec. 1.3(jjj)(2)(iii); Exchange Act rule

3a67-3(b)(3)(i). This provision provides for netting under the

master netting agreement of any instruments, contracts or agreements

(including contracts on physical commodities), that would qualify

for netting under applicable bankruptcy law. As we noted in the

Proposing Release, the proposed rules regarding possible offsets of

various positions are for purposes of determining major participant

status only. Other rules proposed by the Commissions may address the

extent to which, if any, persons such as dealers and major

participants may offset positions for other purposes. See Proposing

Release, 75 FR at 80189 n.98. As proposed, Exchange Act rule 3a67-

3(b)(3)(i) referred to ``security-based swaps (in any swap

category)''; this reference has been revised in the final rule to

``security-based swaps (in any security-based category).''

---------------------------------------------------------------------------

As discussed in the proposal, these netting provisions apply only

to offsetting positions with a single counterparty.\871\ The provisions

do not extend to the market risk offsets associated with an entity's

positions with multiple counterparties, because such offsets would not

directly mitigate the risks that an individual counterparty would face

in the event of the entity's default.\872\

---------------------------------------------------------------------------

\871\ CFTC Regulation Sec. 1.3(jjj)(2)(iii); Exchange Act rule

3a67-3(b)(3)(ii).

\872\ The fact that positions with third parties do not offset

exposure to a particular counterparty was recently highlighted by a

decision finding that the Bankruptcy Code does not permit excess

collateral held by one creditor to offset amounts that the debtor

owed to the creditor's affiliates. See In re Lehman Brothers Inc.,

Case No. 08-01420 (JMP) (SIPA), slip op. (Bankr. S.D.N.Y Oct. 4,

2011).

---------------------------------------------------------------------------

iii. Allocation of Uncollateralized Exposure Following Netting

The final rules build upon the proposal by codifying the method,

discussed in the Proposing Release, related to the allocation of any

uncollateralized exposure that remains following netting and the

posting of collateral. This type of allocation can be necessary

because, with netting, it otherwise may not be possible to directly

attribute residual uncollateralized exposure to a particular major

category of swap or security-based

[[Page 30668]]

swap.\873\ Some commenters have requested that the final rules codify

this method to provide more certainty to market participants.\874\

---------------------------------------------------------------------------

\873\ Such allocation would not be necessary, of course, to the

extent that an entity has no current uncollateralized exposure to a

counterparty following netting and the posting of collateral.

\874\ See letters from SIFMA AMG II and Vanguard.

---------------------------------------------------------------------------

Accordingly, the final rules incorporate a formula which, for

purposes of the substantial position analysis, provides that the amount

of net uncollateralized exposure that is attributable to a particular

major category of swap or security-based swap would be allocated pro

rata in a manner that compares the amount of the entity's out-of-the-

money positions in that major category to its total out-of-the-money

positions in all categories that are subject to the netting

arrangements with that counterparty.\875\ This approach does not

require that any collateral be specifically earmarked to particular

swaps or security-based swaps, and can be followed so long as

collateral is posted based on the net exposure associated with all

instruments subject to the applicable netting agreements with that

particular counterparty.\876\

---------------------------------------------------------------------------

\875\ CFTC Regulation Sec. 1.3(jjj)(2)(iii)(A); Exchange Act

rule 3a67-3(b)(4). Under this formula, for example, if an entity's

exposure to a particular counterparty is $120 million after

accounting for netting and the posting of collateral, and, subject

to netting, the entity has $40 million in out-of-the-money positions

in security-based credit derivatives, $90 million in out-of-the-

money positions in other security-based swaps, and $120 million in

out-of-the money positions in swaps and other instruments subject to

the netting agreements, then $19.2 million in net uncollateralized

exposure would be attributed to the ``security-based credit

derivatives'' category (equal to $120 million [middot] ($40 million/

($40 million + $90 million + $120 million)), and $43.2 million in

net uncollateralized exposure would be attributed to the ``other

security-based swaps'' category (equal to $120 million [middot] ($90

million/($40 million + $90 million + $120 million)).

\876\ Although one commenter suggested that the analysis should

further consider whether there are collateral posting requirements

that are specific to a particular position, we believe that the test

we are adopting is flexible enough to address that possibility. To

the extent that the parties' collateral arrangements provide that

collateral be earmarked to particular swap or security-based swap

positions, an entity may calculate its potential future exposure

with respect to that counterparty with regard to the applicable

major category of swaps or security-based swaps, without accounting

for netting across categories or instruments.

---------------------------------------------------------------------------

iv. Application of Current Exposure Test to Cleared, Fully

Collateralized or Net In-the-Money Positions

Although certain commenters have requested that the current

uncollateralized exposure test explicitly exclude swap or security-

based swap positions that are cleared, fully collateralized or net in-

the-money,\877\ the final rules do not provide such exclusions. As we

recognized in the Proposing Release, centrally cleared swaps and

security-based swaps are subject to mark-to-market margining that would

largely eliminate the uncollateralized exposure associated with a

position, effectively resulting in the cleared position being excluded

from the analysis.\878\ Also, by definition, fully collateralized

positions are not associated with current uncollateralized exposure,

and thus would be excluded from the analysis. As such, we do not

believe that it would be necessary to explicitly exclude such positions

from the analysis.\879\

---------------------------------------------------------------------------

\877\ See letters from ICI I, SIFMA AMG II and Vanguard.

\878\ See Proposing Release, 75 FR at 80189 n.92.

\879\ Moreover, to the extent that such positions are associated

with uncollateralized amounts, such as those that arise from

thresholds or minimum transfer amounts pursuant to the applicable

credit support annex, then those amounts present counterparty risk

that should be considered as part of the major participant analysis.

---------------------------------------------------------------------------

Similarly, we do not believe that it is necessary for the rules to

explicitly exclude net in-the-money swap or security-based swap

positions. If an entity does not have any current uncollateralized

exposure to a particular counterparty--after accounting for the

entity's netting agreement with that counterparty and the posting of

collateral--then the entity may disregard its positions with that

counterparty for purposes of calculating current uncollateralized

exposure. Otherwise, it is appropriate to consider the contribution of

all swaps or security-based swaps to current uncollateralized exposure,

as determined by the allocation methodology discussed above.\880\

---------------------------------------------------------------------------

\880\ Under that allocation approach, if none of the entity's

swap or security-based swap positions in a major category with that

counterparty are out-of-the-money, then none of the current exposure

resulting from the netting agreement would be attributed to that

major category.

---------------------------------------------------------------------------

c. Potential Future Exposure Analysis

The ``substantial position'' analysis also will consider an

entity's ``aggregate potential outward exposure,'' which would reflect

the potential exposure of the entity's swap or security-based swap

positions in the applicable ``major'' category of swap or security-

based swaps, subject to certain adjustments.\881\ The final rules

implementing this test in general follow the proposed approach, but

have been revised to address commenter concerns.

---------------------------------------------------------------------------

\881\ CFTC Regulation Sec. 1.3(jjj)(3); Exchange Act rule 3a67-

3(c).

---------------------------------------------------------------------------

i. Purpose Underlying the Potential Future Exposure Test

As discussed in the proposal, a potential future exposure test

addresses the fact that a sole focus on current uncollateralized

exposure could fail to identify risky entities until some time after

they begin to pose the level of risk that should subject them to

regulation as major participants.\882\ A potential future exposure test

would allow the substantial position analysis to account for this risk

by addressing how the value of an entity's swap or security-based swap

positions may move against the entity over time.\883\

---------------------------------------------------------------------------

\882\ See Proposing Release, 75 FR at 80188.

\883\ See id. at 80191.

---------------------------------------------------------------------------

Accordingly, consistent with the proposal, the final rules

incorporate a potential future exposure test that seeks to estimate how

much the value of swaps or security-based swaps might change against an

entity over the remaining life of the contract. Although some

commenters took the view that this test should only address potential

volatility during the period of time it would take for a non-defaulting

party to close out positions and liquidate collateral,\884\ we believe

that it is more appropriate for the analysis to consider the risks that

swaps or security-based swap positions pose over the lives of those

positions. An exclusive focus on short-term risks would fail to account

for the possibility that an entity's large swap or security-based swap

positions can readily produce large losses in adverse market

circumstances, potentially leading either to large uncollateralized

exposure (if the posting of collateral is not required), or to large

collateral calls that may lead to the entity's default (or to calls for

extraordinary action) and that can threaten non-defaulting parties with

significant costs and challenges in connection with liquidating and

replacing those positions. The analysis should give appropriate weight

to those risks.

---------------------------------------------------------------------------

\884\ See letters from SIFMA AMG II and Vanguard.

---------------------------------------------------------------------------

ii. Risk Multipliers

Subject to modifications addressed below, the final rules

implementing the ``substantial position'' analysis incorporate a

potential future exposure test based on the proposal's general approach

of adjusting notional positions using risk multipliers.\885\ This

approach incorporates and builds upon tests used by bank regulators for

the purposes of setting prudential capital.\886\ Through

[[Page 30669]]

this methodology, the final rules implement an objective approach that

readily can be replicated by market participants.

---------------------------------------------------------------------------

\885\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(1); Exchange

Act rule 3a67-3(c)(2)(i).

\886\ See 12 CFR part 3, app. C, section 32 (Office of the

Comptroller of the Currency capital adequacy guidelines for banks);

12 CFR part 325, app. D, section 32 (Federal Deposit Insurance Corp.

capital adequacy guidelines for banks); 12 CFR part 208, app. F,

section 32 (Federal Reserve System capital adequacy guidelines for

banks); 12 CFR part 225, app. G, section 32 (Federal Reserve System

capital adequacy guidelines for bank holding companies).

---------------------------------------------------------------------------

Although some commenters have suggested the use of value-at-risk

measures or internal models to evaluate potential future exposure,\887\

we do not believe that such approaches would be well tailored to be

implemented by a range of market participants, or would lead to

comparable results across market participants with identical swap or

security-based swap portfolios.

---------------------------------------------------------------------------

\887\ See letters from Riverside Risk Advisors and Better

Markets I.

---------------------------------------------------------------------------

In adopting this approach, we are mindful of the significance of

commenter concerns about the adequacy of the tables that set forth the

risk multipliers that would be applied to notional positions. These

comments address, among other issues: discontinuities in the tables;

the failure to account for whether, and how much, a swap or security-

based swap is in-the-money or out-of-the money; the failure of the

multipliers applicable to interest rate swaps to distinguish between

counterparties who pay floating rates and counterparties who pay fixed

rates; the failure of the multipliers in the credit category to account

for the volatility of the underlying instrument or the duration of the

swap or security-based swap; the failure of the multipliers for equity

and commodity swaps to distinguish between high-volatility and low-

volatility stocks and commodities; the adequacy of how the test

addresses diversification and correlation; the fact that the approach

does not provide for delta weighting of options positions; and the fact

that the factors do not distinguish between index and single-name

credit default swaps.\888\ While we acknowledge that it may be possible

to develop revised risk multipliers that are more finely tuned to

reflect relevant risk factors, at this time we believe that it would be

most appropriate to implement the ``substantial position'' analysis by

building upon an existing regulatory approach that is comparatively

simpler to implement and leads to reproducible results, rather than

seeking to develop a brand new approach.\889\

---------------------------------------------------------------------------

\888\ See, e.g., letters from Riverside Risk Advisors and MFA I.

\889\ We also are not following a commenter suggestion to

incorporate the ``standardized method'' prescribed as part of the

``Basel II'' bank capital methodology. See letter from ISDA I. The

standardized method relies on counterparty credit ratings provided

by external credit rating agencies for purposes of calculating risk-

weighted capital measurements. See ``International Convergence of

Capital Measurement and Capital Standards, A Revised Framework,

Comprehensive Version,'' the Basel Committee on Banking Supervision,

June 2006. Incorporating this reliance on credit ratings provided by

external credit rating agencies into these final rules would be

inconsistent with Section 939A of the Dodd-Frank Act, which required

all Federal agencies to review and modify existing regulations ``to

remove any reference to or requirement of reliance on credit ratings

and to substitute in such regulations such standard of credit-

worthiness as each respective agency shall determine as appropriate

for such regulations.''

---------------------------------------------------------------------------

The final rules implementing the ``major security-based swap

participant'' definition, however, modify the proposed risk multipliers

in response to commenter concerns about how the ``major'' categories of

security-based swaps should be applied to the risk multiplier

categories. In particular, the final risk multiplier category for

security-based swaps in the ``equity and other'' category encompasses

all security-based swaps that are not credit derivatives, and the final

rules eliminate the proposed category for ``other'' types of security-

based swaps.\890\

---------------------------------------------------------------------------

\890\ See Exchange Act rule 3a67-3(c)(2)(i). Aside from making

the risk multipliers consistent with the ``major'' categories of

security-based swaps, this change also should allow total return

swaps on debt to be subject to the same risk multipliers as total

return swaps on equity, rather than causing the debt swaps to be

subject to higher multipliers (which may not accurately reflect the

comparative risks of those instruments).

---------------------------------------------------------------------------

iii. Potential Future Exposure Measures for Certain Lower-Risk

Positions

Consistent with the proposal, the potential future exposure

calculation will exclude purchases of options and other positions for

which a person has prepaid or otherwise satisfied its payment

obligations.\891\ Also, in response to commenter concerns, the final

rules expand on the proposal with regard to capping the potential

future exposure associated with certain lower-risk swap and security-

based swap positions. The final rules particularly cap--at the net

present value of the unpaid premiums--the potential future exposure

associated with positions by which a person buys credit protection

using a credit default swap, and positions by which a person purchases

an option for which the person retains additional payment obligations

under the position.\892\ This reflects the reduced risk associated with

such positions. The final rules do not prescribe a particular discount

rate for purposes of this analysis, and market participants instead

should use a commercially appropriate discount rate.

---------------------------------------------------------------------------

\891\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(3)(ii);

Exchange Act rule 3a67-3(c)(2)(i)(C).

\892\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(4); Exchange

Act rule 3a67-3(c)(2)(i)(D). The proposed rules would have applied

this net present value caps only to the purchase of credit

protection. The final rules expand this provision by also capping

the potential future exposure associated with the purchases of

options in which an entity retains payment obligations, to reflect

the reduced risk associated with those positions.

---------------------------------------------------------------------------

In addition, to better align the results of the potential future

exposure analysis with the risks that a person presents, the final

rules have been modified from the proposal to also exclude swap or

security-based swap positions for which, pursuant to regulatory

requirement, a person has placed in reserve an amount of cash or

Treasury securities that is sufficient to pay the person's maximum

possible liability under the position, when the person is prohibited

from using that cash or those securities without also liquidating the

swap or security-based swap position.\893\

---------------------------------------------------------------------------

\893\ CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(3)(iii); Exchange

Act rule 3a67-3(c)(2)(i)(C)(3). This exclusion of such positions

from the major participant analysis may apply, for example, to

certain swap or security-based swap positions of insurers where

applicable law requires an amount equal to the maximum possible

exposure of the insurer be segregated.

---------------------------------------------------------------------------

iv. Adjustments for Netting

Consistent with the proposal, and with the bank regulator standards

that form the basis for these potential future exposure measures, the

final rules provide that an entity may reduce the measure of its

potential future exposure in a major category by up to 60 percent to

reflect the risk mitigation effects of master netting agreements. We

believe that this approach appropriately reflects the risk mitigating

attributes of netting on potential future exposure. Moreover, in light

of commenter requests for clarification of how these netting provisions

would be applied,\894\ the final rules have been revised from the

proposal to provide that the risk reduction associated with netting

should be estimated using the same pro rata allocation methodology that

will be used to measure current exposure.\895\

---------------------------------------------------------------------------

\894\ See letter from SIFMA AMG II.

\895\ Consistent with the proposal, the effects of netting are

to be estimated using the formula: P Net = 0.4 x P Gross + 0.6 x NGR

x P Gross. Under that equation, P Net is the potential exposure

adjusted for bilateral netting; P Gross is that potential outward

exposure without adjustment for bilateral netting; and NGR is the

net to gross ratio. The final rule has been revised from the

proposal to clarify that the net to gross ratio equals the current

exposure associated with the major category as calculated using the

pro rata methodology discussed above, divided by what the measure of

current exposure in connection with those out-of-the-money positions

would be in the absence of that methodology.

Accordingly, for the example set forth in note 875, supra, the

NGR for ``security-based credit derivatives'' and ``other security-

based swaps'' both would equal 0.48 (equal to $19.2 million net

exposure divided by $40 million in out-of-the-money positions in the

case of ``security-based credit derivatives,'' or $43.2 million net

exposure divided by $90 million in out-of-the-money positions in the

case of ``other security-based swaps''). If an entity has no current

exposure to a counterparty following the application of netting

arrangements and collateralization, the NGR for those positions

would equal zero, and the potential exposure would equal 40 percent

of what it would equal otherwise.

---------------------------------------------------------------------------

[[Page 30670]]

v. Adjustments for Cleared and Margined Positions

The final rules also provide for the measure of potential future

exposure to be adjusted in the case of swap and security-based swap

positions that are centrally cleared or that are subject to daily mark-

to-market margining. This is consistent with the purpose of the

potential future exposure test, which is to account for the extent to

which the current outward exposure of positions (though possibly low or

even zero at the time of measurement) might grow to levels that can

lead to high counterparty risk to counterparties or to the markets

generally. The practice of the periodic exchange of mark-to-market

margin between counterparties helps to mitigate the potential for large

future increases in current exposure.

Consistent with the proposal, the final rules reflect this ability

to mitigate risk by providing that the potential future exposure

associated with positions that are subject to daily mark-to-market

margining will equal 0.2 times the amount that otherwise would be

calculated. However, in response to commenters' opinions about the

risk-mitigating effects of central clearing, and the additional level

of rigor that clearing agencies may have with regards to the process

and procedures for collecting daily margin, the final rules further

provide that the potential future exposure associated with positions

that are subject to central clearing will equal 0.1 (rather than the

proposed 0.2) times the potential future exposure that would otherwise

be calculated.\896\

---------------------------------------------------------------------------

\896\ See CFTC Regulation Sec. 1.3(jjj)(3)(iii)(A); Exchange

Act rule 3a67-3(c)(3)(i). The final rules further have been revised

to clarify that the 0.1 factor applies to positions cleared by a

registered clearing agency or by a clearing agency that has been

exempted from registration.

---------------------------------------------------------------------------

Although some commenters supported the complete exclusion of

cleared positions from the potential future exposure analysis,\897\ and

we are mindful of the risk mitigating attributes of central clearing,

we also recognize that central clearing cannot reasonably be expected

to entirely eliminate counterparty risk.\898\ We conclude, however,

that the use of a 0.1 factor (in lieu of the proposed 0.2) would be

appropriate for cleared positions, reflecting the strong risk

mitigation features associated with central clearing, particularly the

procedures regarding the collection of daily margin and the use of

counterparty risk limits, while recognizing the presence of some

remaining counterparty risk.

---------------------------------------------------------------------------

\897\ See, e.g., letters from MFA I and SIFMA AMG II.

\898\ Central clearing helps to mitigate counterparty credit

risk by improving risk management and, among other things,

mutualizing the risk of counterparty failure. If multiple members of

a central counterparty fail beyond the level to which such risk is

managed, however, the central counterparty would also be at risk of

failure. Cf. Basel Committee on Banking Supervision, Consultative

Document, ``Capitalisation of bank exposures to central

counterparties,'' Nov. 25, 2011 (available at: http://www.bis.org/publ/bcbs206.pdf) (proposing that the capital charge for trade

exposures to a qualifying central counterparty should carry a low

risk weight, reflecting the relatively low risk of default of the

qualifying central counterparty). In addition, as we discussed in

the Proposing Release, see 75 FR at 80192 n.115, for example,

central counterparties that clear credit default swaps do not

necessarily become the counterparties of their members' customers

(although even absent direct privity those central counterparties

benefit customers by providing for protection of collateral they

post as margin, and by providing procedures for the portability of

customer positions in the event of a member's default). As a result,

central clearing may not eliminate the counterparty risk that the

customer poses to the member, although required mark-to-market

margining should help control that risk, and central clearing would

be expected to reduce the likelihood that an entity's default would

lead to broader market impacts.

---------------------------------------------------------------------------

Moreover, although some commenters opposed any deduction from the

measure of potential future exposure for uncleared positions that are

margined on a daily basis,\899\ we believe that the risk-mitigating

attributes of daily margining warrant an adjustment given that the goal

of the potential future exposure test is to account for price movements

over the remaining life of the contract.\900\ The use of a 0.2 factor

also reflects our expectation that the risk mitigation associated with

uncleared but margined positions would be less than the risk mitigation

associated with cleared positions.

---------------------------------------------------------------------------

\899\ See letter from Better Markets I; see also letter from

AFR.

\900\ We do not believe that it is appropriate to have this type

of discount when mark-to-market margining is done less than daily,

however.

---------------------------------------------------------------------------

While higher or lower alternatives to the 0.1 and 0.2 factors may

also be reasonable for positions that are cleared or margined on a

daily basis, we believe that the factors of the final rules reasonably

reflects the risk mitigating (but not risk eliminating) features of

those practices. The final rules also retain and clarify provisions

addressing when daily mark-to-market margining occurs for purposes of

this discount.\901\

---------------------------------------------------------------------------

\901\ We recognize that at times, market participants whose

agreements provide for the daily exchange of variation margin in

connection with swaps or security-based swaps in practice may not

exchange collateral daily, if the amounts at issue are relatively

small (such as through the use of collateral thresholds and minimum

transfer amounts). We do not believe that such practices would be

inconsistent with providing a discount for daily margining

practices. The proposed rules sought to accommodate those practices

by providing that positions would be considered to be subject to

daily mark-to-market margining for purposes of the

``uncollateralized outward exposure'' plus ``potential outward

exposure'' analysis, so long as the total of such thresholds, and

the total of such minimum transfer amounts above $1 million are

deemed to be ``uncollateralized outward exposure'' for those

purposes.

In light of commenter concerns, which indicated that the

proposal was not fully clear about the mechanics and purpose of this

approach, the relevant rule language has been revised to clarify

that this attribution of thresholds and minimum transfer amounts is

solely for the purpose of determining whether certain positions are

subject to daily mark-to-market margining for purposes of the

analysis. In addition, the final rules have been revised from the

proposal to provide that the attribution of thresholds as

``uncollateralized outward exposure'' for these purposes will be

reduced by initial margin posted, up to the amount of the threshold.

See CFTC Regulation Sec. 1.3(jjj)(iii)(B); Exchange Act rule 3a67-

3(c)(3)(ii).

---------------------------------------------------------------------------

vi. Application of ``Effective Notional'' Amounts

Consistent with the proposal (as well as the rules implementing the

de minimis exception to the dealer definitions), the potential future

exposure test is based on the ``effective notional'' amount of the swap

or security-based swap when the stated notional is leveraged or

enhanced by the structure of the swap or security-based swap.\902\

---------------------------------------------------------------------------

\902\ As discussed above, this may occur, for example, if the

exchange of payments associated with an equity swap is based on a

multiple of the return associated with the underlying equity. As is

the case for measuring current exposure, the final rules do not

prescribe any particular methodology for calculating the notional

amount or effective notional amount used in the calculation of

potential future exposure, but instead contemplate the use of

industry standard practices.

---------------------------------------------------------------------------

Moreover, as discussed in the Proposing Release,\903\ in the case

of positions that represent the sale of an option on a swap or

security-based swap (other than the sale of an option permitting the

person exercising the option to purchase a credit default swap), we

would view the effective notional amount of the option as being equal

to the effective notional amount of the underlying swap or security-

based swap, and in general we would view the duration used for purposes

of the formula as being equal to the sum of the duration of the option

and the duration of the underlying swap or security-based swap.\904\

---------------------------------------------------------------------------

\903\ See Proposing Release, 75 FR 80192 n.110.

\904\ The effective notional amount of the underlying instrument

is used for these purposes because that amount fairly reflects the

basis for measuring the potential counterparty risk associated with

the instrument. The sum of the duration of the option and the

underlying instrument is used for these purposes because that sum

reflects the length of time of the potential counterparty risk

associated with the instrument.

At the same time, we agree with a commenter's view that if the

underlying swap or security-based swap is cash settled, the

calculation of duration will only include the duration of the

option, and not the duration of the swap, because counterparty

exposure would exist only until the option expiration date. See

letter from MFA I.

---------------------------------------------------------------------------

[[Page 30671]]

vii. Treatment of Initial Margin or Overcollateralization

The final rules retain the proposed approach of not modifying the

measure of potential future exposure to reflect collateral that a

person has posted to its counterparty in excess of current exposure.

Although we recognize that the posting of excess collateral may

mitigate the future credit risk that the potential future exposure

measure is intended to estimate, that mitigating effect is not certain,

and any such mitigation may not reflect the full value of the excess

collateral. Moreover, while we believe that the measure of potential

future exposure associated with swap or security-based swap positions

reasonably estimates the credit risk that may be posed by those

positions for purposes of the substantial position analysis, we also

recognize that particular positions may prove to pose a far higher

amount of credit risk.\905\ Given how the credit risk associated with a

swap or security-based swap position can far exceed the associated

measure of potential future exposure, we do not believe that it would

be appropriate to offset that measure to account for

overcollateralization.\906\

---------------------------------------------------------------------------

\905\ For example, if a person writes a CDS that provides $10

billion in protection on a reference entity, with the CDS being

subject to daily mark-to-market margining, then for purposes of the

substantial position analysis that CDS would be associated with a

potential future exposure measure of no more than $200 million

(reflecting the 0.1 conversion factor and the additional 0.2

multiplier for margined positions), even before accounting for

netting. Yet if the reference entity were to default, the writer of

the CDS could pose up to $10 billion in credit risk to its

counterparty.

\906\ However, as discussed above, see note 901, supra, initial

margin may be considered when determining if a collateral threshold

is to be attributed to current uncollateralized exposure for

purposes of determining whether certain positions are subject to

daily mark-to-market margining for purposes of the substantial

position analysis.

---------------------------------------------------------------------------

d. Thresholds

The final rules retain the proposed thresholds for the amount of

current uncollateralized exposure and potential future exposure that

will cause an entity to be deemed to be a major participant.

Accordingly, for a person to have a ``substantial position'' in a major

category of swaps, it would be necessary for that person to have a

daily average current uncollateralized exposure of at least $1 billion

(or $3 billion for the rate swap category), or a daily average current

uncollateralized exposure plus potential future exposure of $2 billion

(or $6 billion for the rate swap category).\907\ To have a

``substantial position'' in a major category of security-based swaps,

it would be necessary for the person to have a daily average current

uncollateralized exposure of at least $1 billion, or a daily average

current uncollateralized exposure plus potential future exposure of at

least $2 billion.\908\

---------------------------------------------------------------------------

\907\ CFTC Regulation Sec. 1.3(jjj)(1).

\908\ Exchange Act rule 3a67-3(a).

---------------------------------------------------------------------------

As the Proposing Release noted, the proposed thresholds sought to

reflect: (i) The financial system's ability to absorb losses of a

particular size; (ii) the recognition that it would not be appropriate

for the substantial position test to encompass entities only after they

pose significant risks to the market through their swap or security-

based swap activity; and (iii) the need to account for the possibility

that multiple market participants may fail close in time.\909\ While

some commenters took the position that the proposed thresholds were

inappropriately low, those commenters did not present empirical data or

analysis in support of that view. Moreover, the Commissions do not

concur with the suggestion \910\ that the major participant definitions

can reasonably be read to require that we defer this rulemaking until

we have gathered additional data. Instead, the definitions direct us to

set a standard that is ``prudent,'' which is what we have sought to do.

---------------------------------------------------------------------------

\909\ As discussed above, we do not believe it would be prudent

to presume that entity failures will be separated in time during

periods of financial stress.

\910\ See letters from BlackRock I and CCMR I.

---------------------------------------------------------------------------

Some commenters who supported an increase in the proposed

thresholds attempted to support their positions via analogy to past

events, with the most significant of these being an analogy to AIG

Financial Products (``AIG FP'').\911\ The analogy to AIG FP \912\

actually argues against an increase in these thresholds, however,

particularly given that the credit derivative portfolio that

significantly contributed to the liquidity problems that AIG FP faced

amounted to $72 billion in notional amount.\913\ Under the final rules,

in the presence of central clearing or daily marking to market it would

take a credit derivative portfolio in excess of that amount to trigger

the potential future exposure threshold under the ``substantial

position'' analysis.\914\ This indicates that the thresholds are not

inappropriately low, particularly given our view that the major

participant definition is intended to encompass entities before their

swap or security-based swap positions pose significant market

threats.\915\ Conversely, while

[[Page 30672]]

additional data and analysis may warrant a reduction of these

thresholds in the future, commenters who supported a reduction in those

thresholds have not persuaded us that the proposed thresholds should be

lowered.

---------------------------------------------------------------------------

\911\ See letter from ABC/CIEBA. One commenter's analogy to

Enron also is unpersuasive. See letter from BG LNG I. In particular,

the $18.7 billion in Enron derivatives exposure cited by that

commenter does not account for collateral posted in connection with

those positions. Also, the market impact of Enron's bankruptcy was

substantially mitigated by the sale of Enron's derivatives trading

arm to a third party.

Moreover, although one commenter generally alluded to corporate

financial losses in the derivatives markets that exceeded the

proposed $1 billion and $2 billion thresholds, see letter from NCGA/

NGSA II, the relevant question does not focus on losses that market

participants have incurred, but instead focuses on what degree of

credit risk to counterparties in the swap and security-based swap

markets presents such a potential to cause significant market impact

that it would be prudent to regulate persons who pose that degree of

credit risk in connection with their swap or security-based swap

positions.

\912\ Our discussion of how the major participant analysis may

apply to an entity that has a portfolio of a size equivalent to that

of AIG FP should not be read to imply that a person may engage in

swap and security-based swap activities akin to those of AIG FP

without registering as a swap dealer or security-based swap dealer.

\913\ See, e.g., Congressional Oversight Panel, The AIG Rescue,

Its Impact on Markets, and the Government's Exit Strategy 22-24

(2010) (discussing how the risk in AIG's CDS business largely was

the result of a ``multi-sector'' CDO book that amounted to $72

billion notional as of September 2008, and how the losses to AIG

were driven by 125 of the roughly 44,000 contracts entered into by

AIG FP).

\914\ For cleared security-based credit default swaps (in which

we assume daily margining requirements result in no current

uncollateralized exposure) achieving $2 billion of potential future

exposure would require writing $200 billion notional of credit

default swap protection (reflecting the 0.10 multiplier in the risk

adjustment tables, and the additional 0.10 multiplier for positions

that are cleared). Similarly, it would take a $100 billion notional

portfolio of uncleared but marked-to-market security-based credit

default swaps to meet that same threshold (reflecting the 0.20

multiplier for positions that are subject to daily mark-to-market

margining). The total might be even higher if such instruments were

subject to counterparty netting agreements.

Even in the absence of clearing or daily mark-to-market

margining, it would take a minimum $20 billion notional portfolio of

written protection on credit (reflecting the 0.10 multiplier in the

risk adjustment tables) to meet the $2 billion potential future

exposure threshold. Accounting for netting (which can reduce

potential future exposure measures by up to 60 percent) could

materially increase that required amount.

\915\ The case of Long-Term Capital Management (``LTCM'') also

is instructive in connection with the current exposure thresholds of

the major participant analysis. Had LTCM failed, its top 17

counterparties would have suffered estimated total losses of between

$3 and $5 billion. See President's Working Group on Financial

Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital

Management (April 1999) at 17 (http://www.treasury.gov/resource-center/fin-mkts/Documents/hedgfund.pdf). The government acted in

connection with LTCM because the rushed close-out of LTCM's

positions would have affected other market participants, and the

spread of losses would have led to market uncertainty, likely

causing a number of credit and interest rate markets to experience

extreme price moves and possibly not function for a period of time.

See Statement by William J. McDonough, President Federal Reserve

Bank of New York before the Committee on Banking and Financial

Services U.S. House of Representatives (October 1, 1998) (http://www.newyorkfed.org/newsevents/speeches_archive/1998/mcd981001.html).

---------------------------------------------------------------------------

e. Additional Issues

The final rules applying the ``substantial position'' analysis and

the major participant definitions generally apply to all types of swaps

or security-based swaps that a person maintains. Although one commenter

suggested that swaps on government securities should be excluded from

the analysis, the rules will not provide such an exclusion. To the

extent that a person presents credit risk as a result of swaps

referencing government securities, there is no basis for disregarding

that risk when determining whether the person is a major participant.

In addition, in light of one commenter's concern,\916\ the

Commissions believe that it is important to emphasize that these rules

should not be interpreted to deter end-users from requesting margin

from dealers or major participants who are their counterparties to

swaps or security-based swaps.

---------------------------------------------------------------------------

\916\ See letter from FHLB I.

---------------------------------------------------------------------------

Also, in light of a point raised by another commenter,\917\ the

Commissions note that these rules implementing the major participant

definitions do not place any independent calculation or other

obligations upon counterparties to potential major participants, and

that the rules do not preclude a potential major participant from

seeking the assistance of a third party to perform the relevant

calculation.

---------------------------------------------------------------------------

\917\ See letter from ISDA I.

---------------------------------------------------------------------------

C. ``Hedging or Mitigating Commercial Risk''

1. Proposed Approach

a. General Availability of the Proposed Exclusion

The first test of the major participant definitions excludes

positions held for ``hedging or mitigating commercial risk'' from the

substantial position analysis.\918\ In the Proposing Release, we

preliminarily concluded that positions that hedge or mitigate a

person's commercial risk may qualify for this exclusion regardless of

whether the entity is financial or non-financial in nature.\919\ That

conclusion in part was prompted by the fact that the statutory major

participant definitions do not explicitly make the exclusion

unavailable to financial entities; in contrast to the Title VII

exceptions from mandatory clearing requirements in connection with

hedging commercial risk,\920\ which explicitly are unavailable to

financial entities.\921\ The conclusion also was prompted by the

presence of the third major participant test--which specifically

applies the substantial position analysis to certain non-bank financial

entities but (unlike the first test) does not exclude commercial risk

hedging positions from the analysis.\922\

---------------------------------------------------------------------------

\918\ See CEA section 1a(33)(A)(i)(I); Exchange Act section

3(a)(67)(A)(i)(I).

\919\ See Proposing Release, 75 FR at 80194.

\920\ See CEA section 2(h)(7)(A); Exchange Act section

3C(g)(1)(B).

\921\ As we discussed in the Proposing Release, had the Dodd-

Frank Act intended the phrase ``hedge or mitigate commercial risk''

to apply only to activities of, or positions held by, non-financial

entities, it would not have been necessary for the mandatory

clearing exceptions to include additional provisions generally

restricting the availability of the exceptions to non-financial

entities. See Proposing Release, 75 FR at 80194.

\922\ As we discussed in the Proposing Release, the third

statutory major participant test would be redundant if the hedging

exclusion in the first major participant test were entirely

unavailable to financial entities. See Proposing Release, 75 FR at

80194 n.125.

---------------------------------------------------------------------------

In the Proposing Release, we also preliminarily concluded that the

question of whether an activity is commercial in nature should not be

determined solely by a person's organizational status as a for-profit,

non-profit or governmental entity, but instead should depend on whether

the underlying activity is commercial in nature.\923\

---------------------------------------------------------------------------

\923\ See Proposing Release, 75 FR at 80194.

---------------------------------------------------------------------------

The proposal did not preclude the exclusion from being available in

connection with hedges of a person's ``financial'' or ``balance sheet''

risks. In addition, the proposal solicited comment as to whether the

exclusion should extend to activities in which a person hedges an

affiliate's risk.

b. Proposed Definition Under the CEA Exception

The proposed interpretation of ``hedging or mitigating commercial

risk'' for purposes of the CEA's definition of ``major swap

participant'' premised the exclusion on the principle that swaps

necessary to the conduct or management of a person's commercial

activities should not be included in the calculation of the entity's

substantial position.\924\

---------------------------------------------------------------------------

\924\ The scope of the proposed exclusion is based on our

understanding that when a swap or security-based swap is used to

hedge a person's commercial activities, the gains or losses

associated with the swap or security-based swap itself will

generally be offset by losses or gains in the person's commercial

activities, and hence the risks posed by the swap or security-based

swap to counterparties or the industry will generally be mitigated.

---------------------------------------------------------------------------

The CFTC noted first that the phrase ``hedging or mitigating

commercial risk'' as used with respect to the major swap participant

definition is virtually identical to Dodd-Frank provisions granting an

exception from the mandatory clearing requirement to non-financial

entities that are using swaps to hedge or mitigate commercial

risk.\925\ Also noted was that although only non-financial entities

that use swaps or security-based swaps to hedge or mitigate commercial

risk generally may qualify for the clearing exemption, no such

statutory restriction applies with respect to the exclusion for hedging

positions in the first test of a major participant. We therefore

concluded that positions established to hedge or mitigate commercial

risk may qualify for the exclusion, regardless of the nature of the

entity--i.e., whether or not the entity is financial (including a bank)

or non-financial.\926\

---------------------------------------------------------------------------

\925\ See CEA section 2(h)(7)(A); Exchange Act section

3C(g)(1)(B) (exception from mandatory clearing requirements when one

or more counterparties are not ``financial entities'' and are using

swaps or security-based swaps to ``hedge or mitigate commercial

risk'').

\926\ The presence of the third major participant test suggests

that financial entities generally may not be precluded from taking

advantage of the hedging exclusion in the first test. The third

test, which does not account for hedging, specifically applies to

non-bank financial entities that are highly leveraged and have a

substantial position in a major category of swaps or security-based

swaps. That test would be redundant if the hedging exclusion in the

first major participant test were entirely unavailable to financial

entities.

---------------------------------------------------------------------------

The CFTC preliminarily believed that whether a position hedges or

mitigates commercial risk should be determined by the facts and

circumstances at the time the swap is entered into, and should take

into account the entity's overall hedging and risk mitigation

strategies. However, the swap could not be held for a purpose that is

in the nature of speculation, investing or trading. We anticipated that

a person's overall hedging and risk management strategies would help

inform whether or not a particular position is properly considered to

hedge or mitigate commercial risk. Further, the exclusion under the

Proposing Release included swaps hedging or mitigating any of a

person's business risks, regardless of the

[[Page 30673]]

swap's status under accounting guidelines or the bona fide hedging

exemption.

c. Proposed Definition Under the Exchange Act Exception

For purposes of the Exchange Act's ``major security-based swap

participant'' definition, the proposed rule defining ``hedging or

mitigating commercial risk'' would require that a security-based swap

position be ``economically appropriate'' to the reduction of risks in

the conduct and management of a commercial enterprise, where those

risks arise from the potential change in the value of assets,

liabilities and services connected with the ordinary course of business

of the enterprise.\927\ The Proposing Release stated that the SEC

preliminarily planned to interpret the concept of ``economically

appropriate'' based on whether a reasonably prudent person would

consider the security-based swap to be appropriate for managing the

identified commercial risk. It further stated that the SEC also

preliminarily believed that for a security-based swap to be deemed

``economically appropriate'' in this context, it should not introduce

any new material quantum of risks (i.e., it could not reflect over-

hedging that could reasonably have a speculative effect) and it should

not introduce any basis risk or other new types of risk (other than the

counterparty risk that is attendant to all security-based swaps) more

than reasonably necessary to manage the identified risk.\928\

---------------------------------------------------------------------------

\927\ See proposed Exchange Act rule 3a67-4(a).

\928\ See Proposing Release, 75 FR at 80195 n.129.

---------------------------------------------------------------------------

The proposed rules further provided that the security-based swap

position could not be held for a purpose that is in the nature of

speculation or trading--a limitation that would make the exclusion

unavailable to security-based swap positions that are held

intentionally for the short term and/or with the intent of benefiting

from actual or expected short-term price movements or to lock in

arbitrage profits, including security-based swap positions that hedge

other positions that themselves are held for the purpose of speculation

or trading.\929\ The proposal also provided that a security-based swap

position could not be held to hedge or mitigate the risk of another

security-based swap position or swap position unless that other

position itself is held for the purpose of hedging or mitigating

commercial risk.\930\ Finally, the proposal would have conditioned the

entity's ability to exclude these security-based swap positions on the

entity engaging in certain specified activities related to documenting

the underlying risks and assessing the effectiveness of the hedge in

connection with the security-based swap positions.\931\

---------------------------------------------------------------------------

\929\ See proposed Exchange Act rule 3a67-4(b)(1), and Proposing

Release, 75 FR at 80195 n.131.

\930\ See proposed Exchange Act rule 3a67-4(b)(2).

\931\ See proposed Exchange Act rule 3a67-4(c).

---------------------------------------------------------------------------

2. Commenters' Views

a. In General

Several commenters generally supported the broad concepts

underlying the proposed rules for identifying hedges of commercial

risk, and particularly supported the proposed use of an ``economically

appropriate'' standard instead of the ``highly effective'' standard

that is used to identify hedges for accounting purposes.\932\ On the

other hand, one commenter stated that the definition should incorporate

all manner of risks associated with commercial operations, including

interest rate and currency risks, risks from incidental activities to

commercial activities and risks from financial commodities.\933\ One

commenter further stated that the definition should encompass positions

that facilitate asset optimization and dynamic hedging.\934\

---------------------------------------------------------------------------

\932\ See letters from ACLI, Barnard, CDEU, COPE I, EEI/EPSA,

FSR I, ISDA I, Kraft, MetLife, NAIC, Philip Morris International

Inc. (``Philip Morris'') and Utility Group.

\933\ See letter from CDEU.

\934\ See letter from Peabody.

---------------------------------------------------------------------------

Commenters further stated that the exception should include any

position taken as part of a bona fide risk mitigation strategy,\935\

and that Congress included ``mitigation'' in the exception for the

purpose of covering risk reduction strategies that may not clearly be

hedges but mitigate risk.\936\ Some commenters also criticized the

Proposing Release's position equating the terms ``hedging'' and

``mitigating.'' \937\ One commenter also expressed concern that

entities would find it difficult to analyze their positions with

respect to the Proposing Release's statement, in the context of the

Exchange Act definition, that ``economically appropriate'' security-

based swaps would not add a new quantum of risk.\938\

---------------------------------------------------------------------------

\935\ See letter from ISDA I.

\936\ See letter from CDEU.

\937\ See letters from APG, CDEU and ISDA I.

\938\ See letter from SIFMA AMG II.

---------------------------------------------------------------------------

Conversely, some commenters suggested that the proposed

interpretation was too broad,\939\ and that a broad interpretation

could allow evasion,\940\ or permit corporate end users to accumulate

very large positions without becoming major swap participants.\941\ One

commenter stated that to include ``financial risks'' within the

exclusion's scope would be improper because a ``commercial risk'' is

one that is inherent in a person's commercial activities, while

interest rate and currency risks arise from choices about how a person

structures and finances its operations.\942\ Some commenters stated

that the rule should not include hedging of financial risks because

Congress deleted the reference in an earlier version of the Dodd-Frank

Act to hedging of ``balance sheet risk.'' \943\ One commenter urged

that we consider using accounting hedge treatment or the bona fide

hedging exemption as guideposts for determining the availability of the

exclusion.\944\ Commenters also raised concerns about differences

between the proposed approaches under the CEA and Exchange Act

definitions of the terms.\945\

---------------------------------------------------------------------------

\939\ See letters from AFR and AFSCME. The CFTC also received

submissions of a substantially identical letter from approximately

193 individuals and small businesses urging the CFTC to define

commercial risk narrowly to include only risks arising from physical

commodity price fluctuations, and not financial risks, and to

construe the exception for captive finance companies narrowly. See,

e.g., letter from Needham Oil & Air, LLC. In addition, the CFTC

received submissions from approximately 535 individuals of a

different letter, which also urged the CFTC to define commercial

risk narrowly. See, e.g., letter from Christie Hakim.

\940\ See letters from Sen. Carl Levin (``Senator Levin''),

Commodity Markets Oversight Coalition (``CMOC'') and Greenberger and

meeting with MFA on February 14, 2011.

\941\ See meeting with SIFMA AMG on February 4, 2011.

\942\ See meeting with AFR and Better Markets on March 17, 2011.

\943\ See letters from AFR and CMOC, and meeting with Duffie on

February 2, 2011.

\944\ See letter from Senator Levin.

\945\ See letters from Senator Levin, NAIC and SIFMA AMG II.

---------------------------------------------------------------------------

One commenter suggested that the definition should be expanded to

include as commercial risks the risks faced by government entities

because their need to manage risk is no different than the need of

commercial firms.\946\ Additional commenters suggested that commercial

risk be interpreted to include risks faced by non-profit firms.\947\

---------------------------------------------------------------------------

\946\ See letter from Milbank, Tweed, Hadley & McCloy LLP

(``Milbank'').

\947\ See letters from CDEU and NFPEEU.

---------------------------------------------------------------------------

Some commenters also supported modification of the rule text for

specific purposes such as including risks from ``transmitting'' to

cover activities of electricity companies,\948\ to encompass risks

``arising from'' an asset rather than just risks arising from changes

in value

[[Page 30674]]

of the asset,\949\ and to encompass the use of swaps by structured

finance special purpose vehicles to hedge interest rate risk in

structured financing.\950\

---------------------------------------------------------------------------

\948\ See letter from Edison Int'l.

\949\ See letter from Milbank.

\950\ See letter from American Securitization Forum (``ASR'').

---------------------------------------------------------------------------

b. Availability of Exclusion to Financial Entities

Several commenters supported making the exclusion available to

financial companies.\951\ Some commenters further stated that there

should be no special limits on financial entities with regard to the

exclusion,\952\ and that commercial risk should be defined broadly to

include all of the commercial activities of a person, whether or not

those activities relate to financial or non-financial commodities.\953\

Two commenters discussing the use of swaps by insurance companies

stated that making the exclusion available to financial companies is

consistent with CFTC practice in the futures markets, that there is no

fundamental difference in how an insurance company or a commercial

enterprise uses swaps to reduce its risk, and that commercial risk

encompasses financial risk.\954\ In addition, these commenters noted

that insurance regulators allow insurance companies to use swaps to

hedge risk.\955\

---------------------------------------------------------------------------

\951\ See letters from ACLI, American Express Company

(``Amex''), California State Teachers' Retirement System

(``CalSTRS'') dated Feb. 28, 2011 (``CalSTRS I''), ISDA I, MetLife,

NAIC and Peabody.

\952\ See letters from Amex, CalSTRS I and Peabody.

\953\ See letter from Amex.

\954\ See letters from ACLI and MetLife.

\955\ Id.

---------------------------------------------------------------------------

On the other hand, some commenters opposed allowing financial

entities to avail themselves of the exclusion, arguing that there is no

benefit from allowing a financial firm to avoid major participant

regulation through the hedging exclusion,\956\ that the exclusion would

allow financial companies to engage in risky trades,\957\ and that the

exclusion should be narrowly interpreted to cover hedging of only risks

related to products.\958\

---------------------------------------------------------------------------

\956\ See letter from Senator Levin (further highlighting the

need to add strict standards and controls to prevent evasion).

\957\ See letters cited in note 939, supra.

\958\ See letter from AFR.

---------------------------------------------------------------------------

c. Hedging Risks of Affiliates and Third Parties

Some commenters expressed support for allowing persons to take

advantage of the hedging exclusion when they use swaps to hedge the

commercial risks of affiliates or third parties. Some commenters

suggested that a person that aggregates and hedges risk within a

corporate group should be allowed to use the exclusion despite the fact

that it is the affiliates' risks that are hedged.\959\ One commenter

further stated that providers of risk management services should be

allowed to take advantage of the exclusion because they are hedging

commercial risk on behalf of their clients.\960\

---------------------------------------------------------------------------

\959\ See letters from CDEU, EDF Trading, Kraft, Metlife and

Philip Morris.

\960\ See letter from EDF Trading.

---------------------------------------------------------------------------

One commenter, on the other hand, stated that the exclusion should

be read narrowly for captive finance companies because the hedging

entity may have to liquidate positions rapidly without access to

affiliate's funds.\961\

---------------------------------------------------------------------------

\961\ See meeting with Duffie on February 2, 2011.

---------------------------------------------------------------------------

d. Hedge Effectiveness and Documentation

Many commenters suggested that the rule should not test hedge

effectiveness, explaining that requiring demonstration of hedge

effectiveness would impose a subjective standard and would not reduce

systemic risk.\962\ In this regard, some commenters that addressed the

proposed procedural requirements in the Exchange Act definition argued

that these procedures would place unnecessary regulatory burdens on

entities not regulated under the Dodd-Frank Act.\963\ Conversely, one

commenter that supported testing hedge effectiveness stated that the

subdivided parts of a hedge should line up exactly with the subdivided

parts of the risk.\964\

---------------------------------------------------------------------------

\962\ See letters from EEI/EPSA and EDF Trading; see also

letters from CDEU, Kraft Metlife, NRG Energy and Philip Morris (that

such a test would be overly prescriptive).

\963\ See letters from FSR I and SIFMA AMG I.

\964\ See letter from Better Markets I.

---------------------------------------------------------------------------

Some commenters agreed that the relationship between hedging and

risk should be documented. One commenter expressed the view that

documentation would facilitate audits.\965\ Others took the view that a

person should be required to demonstrate that the hedge does not create

additional risk, that the risk may be hedged by swaps, and that there

is a link between the swap and the risk.\966\

---------------------------------------------------------------------------

\965\ See letter from Metlife (but opposing ongoing evaluation

of hedge effectiveness).

\966\ See letters from AFR and Senator Levin.

---------------------------------------------------------------------------

Several commenters suggested that once initiated, a hedge should

not be retested over time, regardless of whether the position continues

to serve a hedging purpose.\967\ Other commenters disagreed, stating

that a position that is no longer a hedge should not be covered by the

exclusion.\968\

---------------------------------------------------------------------------

\967\ See letters from CDEU, EDF Trading, EEI/EPSA, Kraft,

Metlife, NRG Energy and Philip Morris.

\968\ See letters from Better Markets I and Senator Levin.

---------------------------------------------------------------------------

e. Swaps That Hedge Positions Held for Speculative, Investment or

Trading Purposes

Many commenters took the view that swaps or security-based swaps

used to hedge positions held for speculative, investment or trading

purposes should qualify as hedges of commercial risk.\969\ A few

commenters stated that speculation, investment and trading are

fundamental to commercial activity, and thus cannot be differentiated

from other types of commercial activity.\970\ Other commenters

suggested the exclusion should cover swap positions that hedge other

swap or security-based swap positions that are not themselves hedging

positions.\971\ Some commenters asserted that trading is different from

speculating (taking an outright view on market direction) and investing

(entering into a swap for appreciation in value of the swap position),

and that swaps held for ``trading'' should be able to qualify for the

exclusion.\972\

---------------------------------------------------------------------------

\969\ See letters from BG LNG II, COPE I, EPSA, FSR I, Metlife,

Peabody, Vitol and WGCEF dated February 22, 2011 regarding the major

swap participant definition (``WGECF II''), and meeting with Bunge;

see also letter from ISDA I (taking the view that swaps and

security-based swaps used to hedge speculative positions should

qualify as hedges and stating that failure to treat them as hedges

would ``invariably result in there being more unhedged speculative

risk in the market'').

\970\ See letters from Vitol and WGCEF II and meeting with

Bunge.

\971\ See letters from BG LNG II, FSR I, ISDA I and Metlife.

\972\ See letters from COPE I, EPSA and Peabody.

---------------------------------------------------------------------------

Some commenters requested that the definition under the CEA clarify

how swaps that qualify as bona fide hedges are treated for the major

swap participant definition if the underlying position had a

speculative, investment or trading purpose,\973\ and clarify that while

the hedging exclusion would not apply to swap positions that hedge

other swap positions that are held for speculation or trading, the

hedging provision would apply to swap positions that hedge other non-

swap positions held for speculation or trading.\974\ Commenters also

requested that the final rules provide that the hedging exclusion be

available for physical positions in exempt or agricultural commodities

and arbitrage positions relating to price differences between physical

commodities at

[[Page 30675]]

different locations.\975\ One commenter, on the other hand, suggested

that even swap positions that hedge other swap positions which are not

hedging positions should be treated as hedging commercial risk because

they are risk reducing.\976\

---------------------------------------------------------------------------

\973\ See letters from Vitol and WGCEF dated June 3, 2011

regarding the major swap participant definition (``WGECF VI'').

\974\ See letter from BG LNG II.

\975\ See letters from BGLNG II and WGCEF VI.

\976\ See letters from MetLife.

---------------------------------------------------------------------------

Four commenters took the position that swaps held for a purpose

that is in the nature of speculation, investing or trading should not

qualify as hedges of commercial risk.\977\ One commenter pointed out

that experience has shown that market participants sometimes

inaccurately characterize positions as hedges (e.g., the inaccurate

characterization occurs because the nature of positions change over

time), and that excluding swap positions that hedge speculative,

investment or trading positions would be especially inappropriate for

financial firms that frequently use swaps to speculate, invest or

trade.\978\ One commenter stated that any swap position hedging another

swap position could never be considered to be hedging commercial risk

because the second swap is only adjusting the first swap position,

meaning that neither swap would be congruent with risk reduction.\979\

Another commenter stated that the hedging exclusion should not cover

any swap hedging a speculative position.\980\

---------------------------------------------------------------------------

\977\ See letters from AFR, Better Markets I and Senator Levin

and meeting with Duffie on February 2, 2011.

\978\ See letter from Senator Levin.

\979\ See letter from Better Markets I.

\980\ See meeting with Duffie on February 2, 2011.

---------------------------------------------------------------------------

3. Final Rules--General Availability of the Exclusions

As with the proposed rules, the final CEA and Exchange Act rules

implementing this exclusion are different in certain regards to reflect

the different ways that swaps and security-based swaps may be expected

to be used to hedge commercial risk, as well as differences in existing

regulations under the CEA and the Exchange Act. Notwithstanding these

differences, the two rules follow parallel approaches and address

certain key issues in similar ways.

a. Availability to Financial Entities

Consistent with the position we took in the Proposing Release, the

final rules with regard to both major participant definitions do not

foreclose financial entities from being able to take advantage of the

commercial risk hedging exclusion in the first major participant test.

This conclusion in part is guided by the fact that the statutory text

implementing this hedging exclusion does not explicitly foreclose

financial entities from taking advantage of the exclusion--in contrast

to Title VII's exceptions from mandatory clearing requirements for

commercial risk hedging activities. The conclusion also results from

the need to avoid an interpretation that would cause the third major

participant test to be redundant.\981\

---------------------------------------------------------------------------

\981\ While we recognize that commenters have identified policy

reasons as to why financial entities should be entirely excluded

from being able to take advantage of the hedging exclusion, we

continue to believe the language of the major participant

definitions dictates a contrary approach.

---------------------------------------------------------------------------

In reaching this conclusion, we recognize that some commenters

stated that there would be no benefit from allowing financial firms to

avoid regulation as a major swap participant through the hedging

exclusion, and that the exclusion should cover only risks related to

non-financial commercial activities, or else the exclusion would allow

financial companies to engage in risky transactions.\982\ We believe

that not allowing the exclusion to cover swaps or security-based swaps

used for speculation or trading (or investments, in the case of swaps)

will be sufficient to limit financial entities' ability to engage in

risky transactions. We also are not persuaded that ``commercial risk''

should be limited to only risks related to non-financial activities.

---------------------------------------------------------------------------

\982\ See letters from AFR and Senator Levin.

---------------------------------------------------------------------------

We nonetheless recognize the significance of concerns that

financial entities may seek to depict speculative positions as hedges

to take advantage of the exclusion. We also are mindful of the need to

give appropriate meaning to the term ``commercial risk'' within the

exclusion. We believe that the standard set forth in the final rules,

including the provisions that make the exclusions unavailable to swap

or security-based swap positions of a speculative or trading nature (or

investment purposes, in the case of swaps), apply the statutory test in

a manner that appropriately addresses those other concerns. As

discussed below, those standards limit the ability of financial

entities to take advantage of the exclusion.\983\

---------------------------------------------------------------------------

\983\ We also do not believe that the size of an entity or an

entity's position is determinative of whether a position hedges

commercial risk. Moreover, given that the major participant

definitions implicitly require large swap or security-based swap

positions as triggers, a rule that made the hedging exclusion

unavailable to entities with large positions could negate the

statutory hedging exclusion.

---------------------------------------------------------------------------

b. Availability to Non-Profit and Governmental Entities

Under the final rules, a person's organizational status will not

determine the availability of this hedging exclusion. The exclusion

thus may be available to non-profit or governmental entities, as well

as to for-profit entities, if the underlying activity to which the swap

or security-based swap relates is commercial in nature.

c. Hedges of ``Financial'' or ``Balance Sheet'' Risks

Under the final rules, the exclusion is available to positions that

hedge ``financial'' or ``balance sheet'' risks. While we recognize that

some commenters oppose the exclusion of those positions,\984\ we

nonetheless believe that the exclusion would be impermissibly narrow if

it failed to extend to the ``financial'' or ``balance sheet'' risks

that entities may face as part of their commercial operations, given

that those types of risks (e.g., interest rate and foreign exchange

risks) may be expected to arise from the commercial operations of non-

financial end-users of swaps and security-based swaps. We do not

believe the exclusion was intended to address those risks differently

from other commercial risks, such as risks associated with the cost of

physical inputs or the price received for selling products.\985\

---------------------------------------------------------------------------

\984\ See notes 942 and 943, supra.

\985\ Moreover, it is questionable as to what types of security-

based swap positions--if any--would fall within the exclusion for

purposes of the ``major security-based swap participant'' definition

if the exclusion did not extend to hedges of ``financial'' or

``balance sheet'' risks. Security-based swaps such as single-name

credit default swaps and equity swaps would not appear amenable to

hedging a commercial entity's non-financial risks, such as price

risks associated with non-financial inputs or sales. We do not

believe that it would be appropriate to interpret the exclusion in

such a way as to make it a nullity in the context of the ``major

security-based swap participant'' definition.

---------------------------------------------------------------------------

d. Hedging on Behalf of an Affiliate

The final rules further provide that the exclusion is not limited

to the hedging of a person's own risks, but also would extend to the

hedging of the risks of a person's majority-owned affiliate.\986\

[[Page 30676]]

This approach reflects the fact that a corporate group may use a single

entity to face the market to engage in hedging activities on behalf of

entities within the group. In our view, it would not be appropriate for

the swap or security-based swap positions of the market-facing entity

to be encompassed within the first major participant test if those same

positions could have been excluded from the analysis if entered into

directly by the affiliate.\987\ Of course, the exclusion will only be

available to the market-facing entity if the position would have been

subject to the exclusion--e.g., not for a speculative or trading

purpose--had the affiliate directly entered into the position.

---------------------------------------------------------------------------

\986\ See CFTC Regulation Sec. 1.3(kkk)(1)(i); Exchange Act

rule 3a67-4(a)(1). For these purposes--consistent with the standards

regarding the application of the dealer and major participant

definitions to inter-affiliate swaps and security based swaps, see

parts II.C and IV.G--we would view the counterparties to be

majority-owned affiliates if one party directly or indirectly holds

a majority ownership interest in the other, or if a third party

directly or indirectly holds a majority interest in both, based on

holding a majority of the equity securities of an entity, or the

right to receive upon dissolution or the contribution of a majority

of the capital of a partnership. See note 348, supra.

\987\ The exclusion, however, would not be available to the

extent that a person enters into swaps or security-based swaps in

connection with the hedging activities of an unaffiliated third

party. Such activities, moreover, may indicate that the person is

acting as a swap dealer or security-based swap dealer.

---------------------------------------------------------------------------

4. Final Rules--``Major Swap Participant'' Definition Under the CEA

a. In General

The general scope of the rule regarding ``hedging or mitigating

risk'' will be adopted substantially as proposed.\988\ The CFTC,

however, is adopting CFTC Regulation Sec. 1.3(kkk) with a modification

to paragraph (1)(iii) to include a reference to qualified hedging

treatment for positions meeting Government Accounting Standards Board

(``GASB'') Statement 53, Accounting and Financial Reporting for

Derivative Instruments. The CFTC believes that this minor modification

to CFTC Regulation Sec. 1.3(kkk) is necessary in order to include

swaps that qualify for hedging treatment issued by GASB.\989\

---------------------------------------------------------------------------

\988\ The final rule text of CFTC Regulation Sec. 1.3(kkk)(2)

has been revised to include the conjunction ``and'' between clauses

(i) and (ii). In the proposed text of this rule, there was no

conjunction between these two clauses, while the conjunction ``and''

was used in the parallel rule, Sec. 240.3a67-4(b), under the

Exchange Act. Thus, the revision of the final rule text conforms the

CEA rule to the Exchange Act rule.

Also, the final rule text of CFTC Regulation Sec.

1.3(kkk)(1)(E) has been revised to include interest and currency

rates to be consistent with Sec. 1.3(kkk)(1)(F). Both provisions

address similar financial risks arising from rate ``movements'' and

``exposures,'' respectively.

\989\ Local government entities that use GASB accounting

standards may not be able to use comparable FASB hedge accounting as

a demonstration that a swap is a hedge. Although the two standards

are not the same, they are similar in effect and degree in respect

of determining whether a swap hedges a risk.

---------------------------------------------------------------------------

As noted above, the CFTC will not prohibit financial companies from

using the hedging exclusion because the exclusion for positions held

for hedging or mitigating commercial risk set forth in CEA section

1a(33)(A)(i)(1) does not limit its application based on the

characterization or status of the person or entity. Unlike the end-user

clearing exemption of section 2(h)(7), the major swap participant

hedging exclusion is not foreclosed to financial entities.\990\ In

addition, the hedging exclusion will extend to entities hedging the

risks of affiliates in a corporate group, but not to third parties

outside of a corporate group.

---------------------------------------------------------------------------

\990\ Although CEA section 1a(33)(A)(iii), 7 U.S.C.

1a(33)(A)(iii) provides that financial entities that are highly

leveraged and not subject to capital requirements established by a

Federal banking agency are effectively precluded from applying the

hedging exclusion, other financial entities are not so precluded.

Thus, availability of the hedging exclusion to some financial

entities for purposes of the major swap participant definition is

contemplated in the statutory text.

---------------------------------------------------------------------------

Like the proposed rule, the final rule under the CEA does not

require a demonstration of hedge effectiveness, periodic retesting or

specific documentation in order to apply the hedging exclusion from the

definition of major swap participant.

b. Swaps That Hedge Positions Held for Speculation, Investment, or

Trading

Swaps that hedge positions held for speculation, investment or

trading will not qualify for the exclusion. In the Proposing Release,

the CFTC explained that swap positions held for the purpose of

speculation, investment or trading are those held primarily to take an

outright view on market direction, including positions held for short

term resale, or to obtain arbitrage profits.\991\ Additionally, the

Proposing Release stated that swap positions that hedge other positions

that themselves are held for the purpose of speculation, investment or

trading are also speculative, investment or trading positions.\992\

---------------------------------------------------------------------------

\991\ See 75 FR at 80195 n.128.

\992\ Id.

---------------------------------------------------------------------------

We note that some commenters suggested that swaps that hedge

speculative, investment or trading positions should qualify for the

exclusion because speculation, investment or trading are fundamental to

commercial activity and cannot be differentiated from other types of

commercial activity. Similarly, commenters that support allowing

speculative, investment or trading positions to qualify for the

exception stated that a swap hedging the risk of another swap

(regardless of that swap's nature) is risk reducing and therefore

hedges commercial risk. We believe that these commenters'

interpretation of ``commercial'' is not consistent with congressional

intent or the meaning of ``commercial'' in the Dodd-Frank Act with

respect to the first test of the major participant definition or the

end-user exception to the clearing mandate. We are unconvinced that

allowing swap positions to qualify for the exception would be

appropriate when used to hedge speculative, investment or trading

positions because the swap would not hedge or mitigate the risks

associated with the underlying position, or at least not in the manner

intended by Congress. In addition, we believe that doing so would

undermine the effectiveness of the major participant definition in that

entities would be able to characterize positions for speculative,

investment or trading purposes as hedges and therefore evade regulation

as major participants.

Under CFTC Regulation Sec. 1.3(kkk)(2)(i), swap positions executed

for the purpose of speculating, investing, or trading are those

positions executed primarily to take an outright view on market

direction or to obtain an appreciation in value of the swap position

itself, and not primarily for hedging or mitigating underlying

commercial risks.\993\ For example, swaps positions held primarily for

the purpose of generating profits directly upon closeout of the swap,

and not to hedge or mitigate underlying commercial risk, are

speculative or serve as investments. Further, as an alternative

example, swaps executed for the purpose of offsetting potential future

increases in the price of inputs that the entity reasonably expects to

purchase for its commercial activities serve to hedge a commercial

risk.

---------------------------------------------------------------------------

\993\ The Commissions note that the SEC interprets the

availability of the hedging exclusion differently in the context of

the ``major security-based swap participant'' definition, and that

the SEC's guidance in this area controls for purposes of that

definition.

---------------------------------------------------------------------------

The CFTC notes that the use of ``trading'' in this context is not

used to mean simply buying and selling. Rather, a party is using a swap

for the purpose of trading under the rule when the party is entering

and exiting swap positions for purposes that have little or no

connection to hedging or mitigating commercial risks incurred in the

ordinary course of business. ``Trading,'' as used in CFTC Regulation

Sec. 1.3(kkk)(2)(i), therefore would not include simply the act of

entering into or exiting swaps if the swaps are used for the purpose of

hedging or mitigating commercial risks incurred in the ordinary course

of business.\994\

---------------------------------------------------------------------------

\994\ The CFTC further clarifies that merchandising activity in

the physical marketing channel qualifies as commercial activity,

consistent with the Commission's longstanding bona fide hedging

exemption to speculative position limits. See Sec. 1.3(kkk)(1)(ii).

---------------------------------------------------------------------------

[[Page 30677]]

The CFTC acknowledges that some swaps that may be characterized as

``arbitrage'' transactions in certain contexts may also reduce

commercial risks enumerated in CFTC Regulation Sec. 1.3(kkk)(1). The

discussion in footnote 128 of the Proposing Release was intended to

focus on clarifying that swaps are speculative for purposes of the rule

if entered into principally and directly for profit and not principally

to hedge or mitigate commercial risk. The reference to ``arbitrage

profits'' in footnote 128 was intended to provide an example of what is

commonly a speculative swap, not to characterize all arbitrage swaps as

speculative.

c. ``Economically Appropriate'' Standard

The CFTC has determined to adopt the ``economically appropriate''

standard as proposed. We believe that this standard will help the CFTC

and market participants distinguish which swaps are, or are not,

commercial hedges thereby reducing regulatory uncertainty and helping

prevent abuse of the hedging exclusion. CFTC Regulation 1.3(kkk)(1)(i)

of the final rules enumerates specific risk shifting practices that are

deemed to qualify for purposes of the hedging exclusion.\995\ Whether a

swap is economically appropriate to the reduction of risks will be

determined by the facts and circumstances applicable to the swap at the

time a swap is entered into. While we acknowledge that this standard

leaves room for judgment in its application, we believe this

flexibility is needed given the wide variety of swaps and hedging

strategies the rule applies to. We believe the economically appropriate

standard together with the identification of the six different

categories of permissible commercial risks listed in final CFTC

Regulation Sec. 1.3(kkk)(1)(i) is specific enough, when reasonably

applied, to distinguish whether a swap is being used to hedge or

mitigate commercial risk.

---------------------------------------------------------------------------

\995\ In the alternative to meeting the requirements of CFTC

Regulation Sec. 1.3(kkk)(1)(i), a swap may also be eligible for the

hedging exclusion if the swap qualifies as a bona fide hedge for

purposes of an exception from position limits under the CEA as

provided in CFTC Regulation Sec. 1.3(kkk)(1)(ii), or if it

qualifies for hedging treatment under FASB Accounting Standards

Codification Topic 815 or under GASB Statement 53 as provided in

CFTC Regulation Sec. 1.3(kkk)(1) (iii). Consequently, the universe

of swaps that can qualify for the hedging exclusion is broader than

the universe of swaps that qualify as bona fide hedges for purposes

of an exception from position limits under the CEA as provided in

CFTC Regulation Sec. 1.3(kkk)(1)(ii).

---------------------------------------------------------------------------

The Commission has determined not to adopt a ``congruence''

standard because that standard may be too restrictive and difficult to

use given the range of potential types of swaps and hedging strategies

available.

5. Final Rules--``Major Security-Based Swap Participant'' Definition

Under the Exchange Act

a. ``Economically Appropriate'' Standard

The final rules retain the proposed ``economically appropriate''

standard, by which a security-based swap position that is used for

hedging purposes \996\ would be eligible for exclusion from the first

major participant analysis if the position is economically appropriate

to the reduction of risks in the conduct and management of a commercial

enterprise, when those risks arise from the potential change in the

value of assets, liabilities and services in connection with the

ordinary course of business of the enterprise.\997\

---------------------------------------------------------------------------

\996\ In the Proposing Release we stated that we did not believe

the use of the term ``mitigating'' in the exclusion to mean

something significantly more than ``hedging.'' See Proposing

Release, 75 FR 80194 n.127. As noted above, some commenters

disagreed, and argued that ``mitigating'' should be interpreted more

broadly to encompass general risk mitigation strategies. See, e.g.,

letters from ISDA and CDEU. In our view, the final rules we are

adopting--including the use of ``economically appropriate''

standards and the exclusions for certain positions--encompass

positions that may reasonably be described as ``hedging'' or

``mitigating'' commercial risk.

\997\ Exchange Act rule 3a67-4(a)(1). Under this standard, the

first major participant analysis need not account for security-based

swap positions that pose limited risk to the market and to

counterparties because the positions are substantially related to

offsetting risks from a person's commercial operations. These

hedging positions would include activities, such as the management

of receivables, that arise out of the ordinary course of a person's

commercial operations, including activities that are incidental to

those operations. See Proposing Release, 75 FR at 80195.

In addition, the security-based swap positions included within

the rule would not be limited to those recognized as hedges for

accounting purposes. See id.

---------------------------------------------------------------------------

Consistent with the Proposing Release, we interpret the concept of

``economically appropriate'' to mean that the security-based swap

position cannot materially over-hedge the underlying risk such that it

could reasonably have a speculative effect,\998\ and that the position

cannot introduce any new basis risk or other type of risk (other than

counterparty risk that is attendant to all security-based swaps) more

than reasonably is necessary to manage the identified risks.

---------------------------------------------------------------------------

\998\ In the Proposing Release, we described the ``economically

appropriate'' standard as excluding positions that introduce ``any

new material quantum of risks.'' See Proposing Release, 75 FR 80194

n. 129. The interpretation in this release is consistent with that

approach, but does not make use of the same ``quantum of risks''

terminology.

---------------------------------------------------------------------------

For example, a manufacturer that wishes to hedge the risk

associated with a customer's long-term lease of a product may purchase

credit protection using a single-name credit default swap on which the

customer is the reference entity. The credit default swap may be

excluded from the first major participant analysis even if it is for a

shorter term than the anticipated duration of the lease so long as the

use of such a shorter-term instrument is reasonable as a hedge, such as

due to cost or liquidity reasons.\999\ Also, the credit default swap

may be excluded from the first major participant test if it hedges an

amount of risk that is lower than the total amount of risk associated

with the long-term contract.\1000\

---------------------------------------------------------------------------

\999\ In other words, the entity may determine that the use of a

credit default swap for a term that is shorter than the lease is

justified if that shorter-term instrument costs less or is more

liquid than a bespoke instrument that matches the duration of the

contract. While the shorter-term credit default swap does not

eliminate the underlying commercial risk, the instrument's use may

be commercially reasonable for hedging purposes, and hence

appropriately excluded from the first major participant test.

\1000\ The use of a credit default swap for an amount that is

smaller than the underlying risk may be justified as part of an

entity's risk management strategy. For example, an entity may choose

to engage in a partial hedge because a credit default swap for a

smaller amount than the underlying risk may cost less or be more

liquid than a bespoke instrument that more closely matches the

amount of the risk.

---------------------------------------------------------------------------

In adopting this rule, we have considered commenter views that we

should consider limiting the exclusion to positions that are recognized

as hedges for accounting purposes.\1001\ We nonetheless do not believe

that the requirements that are appropriate to identifying hedging for

accounting purposes are needed to limit the availability of the hedging

exclusion. Moreover, linking the availability of the exclusion to

accounting standards--which themselves may evolve over time--may lead

the availability of the exclusion to evolve over time in unforeseen

ways. We accordingly believe that the exclusion should be available if

a security-based swap position is economically appropriate for hedging

purposes (and not otherwise precluded from taking advantage of the

exclusion).

---------------------------------------------------------------------------

\1001\ See letter from Senator Levin.

---------------------------------------------------------------------------

We also have considered commenter concerns that the ``economically

appropriate'' standard is too broad,\1002\ and the additional

suggestion that the exclusion instead should be limited to

circumstances in which the hedge is ``congruent'' to the underlying

risk.\1003\

---------------------------------------------------------------------------

\1002\ See letters from AFR and AFSCME.

\1003\ See letter from Better Markets I. We nonetheless do not

believe that such a requirement would be consistent with the

exclusion's ``commercial risk'' terminology or underlying intent. A

congruence standard particularly would not appear to adequately

reflect the fact that commercially reasonable hedging activities can

leave residual basis risk.

---------------------------------------------------------------------------

[[Page 30678]]

We recognize the significance of commenters' concerns as to the

practical application of the ``economically appropriate'' standard,

particularly with regard to hedges that are not perfectly correlated

with the underlying risk.\1004\ The standard embeds principles of

commercial reasonableness that should assuage those implementation

concerns, however. These principles necessarily account for the fact

that the reasonable use of security-based swaps to hedge a person's

commercial risk may result in residual basis risk, and that the mere

presence of this basis risk should not preclude the availability of the

exclusion. Moreover, the mere presence of residual basis risk need not

run afoul of the restriction against materially over-hedging the

underlying risk, which is instead intended to prevent the hedging

exclusion from applying to positions that are entered into for

speculative purposes or that have speculative effect (such as by being

based on a notional amount that is disproportionate to the underlying

risk).\1005\

---------------------------------------------------------------------------

\1004\ See letter from SIFMA AMG II.

\1005\ For example, non-material basis risk or a non-material

over-hedge may occur due to the use of a standardized instrument. A

commercial entity may reasonably determine that it is cost effective

to use a standardized security-based swap to hedge the underlying

risk, even if use of the standardized instrument introduces non-

material basis risk or reflects a non-material amount of over-

hedging compared to what would be the result of using a bespoke

security-based swap to hedge that risk.

---------------------------------------------------------------------------

We also acknowledge that an ``economically appropriate'' standard

does not provide the compliance assurance that would accompany

quantitative tests or safe harbors. Nonetheless, grounding the hedging

exclusion in principles of commercial reasonableness permits the

standard to be sufficiently flexible to appropriately address an end-

user's particular circumstances and hedging needs. Use of an

``economically appropriate'' standard also is consistent with the fact

that entities should be expected to use their reasonable business

judgment when hedging their commercial risks.

To provide additional guidance to entities hedging commercial risk,

moreover, the final rule incorporates examples of security-based swap

positions that, depending on the applicable facts and circumstances,

may satisfy the ``economically appropriate'' standard.\1006\ These are:

---------------------------------------------------------------------------

\1006\ Exchange Act rule 3a67-4(a)(2). We previously noted that

the proposed definition would facilitate those types of security-

based swap positions. See Proposing Release, 75 FR at 80196.

---------------------------------------------------------------------------

Positions established to manage the risk posed by a

customer's, supplier's or counterparty's potential default in

connection with: financing provided to a customer in connection with

the sale of real property or a good, product or service; a customer's

lease of real property or a good, product or service; a customer's

agreement to purchase real property or a good, product or service in

the future; or a supplier's commitment to provide or sell a good,

product or service in the future.\1007\

---------------------------------------------------------------------------

\1007\ As discussed in the Proposing Release, see 75 FR at 80196

n.135, the references here to customers and counterparties do not

include swap or security-based swap counterparties.

---------------------------------------------------------------------------

Positions established to manage the default risk posed by

a financial counterparty (different from the counterparty to the

hedging position at issue) in connection with a separate transaction

(including a position involving a credit derivative, equity swap, other

security-based swap, interest rate swap, commodity swap, foreign

exchange swap or other swap, option, or future that itself is for the

purpose of hedging or mitigating commercial risk pursuant to the rule

or the counterpart rule under the Commodity Exchange Act);

Positions established to manage equity or market risk

associated with certain employee compensation plans, including the risk

associated with market price variations in connection with stock-based

compensation plans, such as deferred compensation plans and stock

appreciation rights;

Positions established to manage equity market price risks

connected with certain business combinations, such as a corporate

merger or consolidation or similar plan or acquisition in which

securities of a person are exchanged for securities of any other person

(unless the sole purpose of the transaction is to change an issuer's

domicile solely within the United States), or a transfer of assets of a

person to another person in consideration of the issuance of securities

of such other person or any of its affiliates;

Positions established by a bank to manage counterparty

risks in connection with loans the bank has made; and

Positions to close out or reduce any of the positions

addressed above.

b. Treatment of Speculative or Trading Positions

The final rule, consistent with the proposal, provides that this

hedging exclusion does not extend to security-based swap positions that

are in the nature of speculation or trading.\1008\ The exclusion thus

does not extend to security-based swap positions that are held for

short-term resale and/or with the intent of benefiting from actual or

expected short-term price movements or to lock in arbitrage profits, or

to security-based swap positions that hedge other positions that

themselves are held for the purpose of speculation or trading.\1009\

---------------------------------------------------------------------------

\1008\ Exchange Act rule 3a67-4(b)(1). The commercial risk

hedging exclusion for the purposes of the ``major security-based

swap participant'' definition (in contrast to the commercial risk

hedging exclusion in connection with the ``security-based swap

dealer'' definition) does not turn upon whether a position is

``primarily'' for speculative or trading purposes. For the ``major

security-based swap participant'' definition, a security-based swap

position with any speculative or trading purpose cannot take

advantage of the commercial risk hedging exclusion regardless of

whether speculation or trading constitutes the ``primary'' purpose

of the position.

\1009\ See generally Basel Committee on Banking Supervision,

``International Convergence of Capital Measurement and Capital

Standards, A Revised Framework, Comprehensive Version'' (June 2006)

at ]] 685-689(iii) (defining the term ``trading book'' for purposes

of international bank capital standards, and stating that positions

that are held for short-term resale and/or with the intent of

benefiting from actual or expected short-term price movements or to

lock in arbitrage profits are typically considered part of an

entity's trading book).

In contrast to the CEA rule implementing the commercial risk

hedging definition in the context of the ``major swap participant''

definition, the Exchange Act rule does not explicitly exclude

security-based swaps held for the purpose of investing. We note,

however, that security-based swaps held for the purpose of investing

(i.e., held primarily to obtain an appreciation in value of the

security-based swap position) would not meet the ``economically

appropriate'' standard set forth above, and hence would not be

eligible for the exclusion.

---------------------------------------------------------------------------

The Commissions recognize that some commenters take the position

that the exclusion should extend to security-based swap positions that

hedge speculative or trading positions.\1010\ In support, these

commenters have stated that the proposed approach would lead to more

unhedged risk in the market, and that the proposed approach could lead

entities that use security-based swaps to hedge speculative positions

to be major participants, in contrast to unhedged (and presumably

riskier) entities. Commenters further requested clarification regarding

how entities may distinguish speculative or trading positions from

other security-based swap positions.\1011\

---------------------------------------------------------------------------

\1010\ See, e.g., letters from FSR I and ISDA I.

\1011\ See, e.g., letter from CDEU.

---------------------------------------------------------------------------

The Commissions nonetheless do not believe that it would be

appropriate to extend the hedging exclusion to speculative or trading

positions, including security-based swap positions that themselves

hedge other positions that are for speculative or trading

[[Page 30679]]

purposes. Those limitations are appropriate to help give meaning to the

concept of ``commercial'' risk, and to reflect the legislative intent

to limit the impact of Title VII on commercial end-users of security-

based swaps.\1012\ Indeed, the use of security-based swap positions in

connection with speculative and trading activity often may be expected

either to have the purpose of locking-in arbitrage profits associated

with those activities or producing an adjusted risk profile in

connection with perceptions of future market behavior--neither of which

would eliminate the speculative or trading purpose of the

activity.\1013\ We do not believe that it would be appropriate, or

consistent with the Dodd-Frank Act, to interpret the term ``commercial

risk'' to accord the same regulatory treatment to security-based swap

positions for speculative or trading purposes as is accorded to the use

of security-based swap positions in connection with commercial

activities such as producing goods or providing services to

customers.\1014\

---------------------------------------------------------------------------

\1012\ In addition, this limitation is consistent with the

exclusion from the first major participant test in connection with

ERISA plans. That exclusion particularly addresses security-based

swap positions with the primary purpose of ``hedging or mitigating

any risk directly associated with the operation of the plan.'' It is

not clear why that scope of the ERISA exclusion would need to be

incorporated into the first major participant test if the

``commercial risk'' exclusion already were broad enough to encompass

hedges of trading or speculative positions.

\1013\ As an example, one speculative/trading strategy involving

security-based swaps can be to purchase short-dated credit

protection in conjunction with a long-dated bond, to reflect a view

that a particular company is likely to fail in the current credit

environment. Combined, those positions can produce losses if the

current credit environment did not change or if spreads were to

widen, but could produce profits either if the company were to

default or if spreads were to narrow and funding costs were to

decrease. See Morgan Stanley, Credit Derivatives Insights 156-58

(4th ed., 2008). In other words, under that strategy the purchase of

the credit protection would offset a portion of the risks associated

with the ownership of the bond, but for the purpose of taking a

directional view of the market with the hope for profit if the

purchaser's view of future market dynamics is correct (and the

reality of losses if the purchaser's view of the market is wrong).

It would require an extraordinarily liberal construction of

``commercial risk'' to subsume this type of speculative security-

based swap activity.

At the same time, we recognize that an entity hedging a

commercial risk (in contrast to a risk arising from a speculative or

trading strategy) reasonably may choose to use a security-based swap

that is shorter-dated than the underlying risk, with the security-

based swap appropriately excluded from the first major participant

definition.

\1014\ This approach does not reflect any value judgment about

the role of speculation in the market for security-based swaps, or

about the relative market benefits or risks associated with

speculation. This position simply represents an attempt to give

meaning to the statutory use of the term ``commercial risk'' in a

way that reflects Title VII's special treatment of commercial end-

users, and (as discussed below) avoid an interpretation that

effectively undermines the first major participant test.

---------------------------------------------------------------------------

Moreover, the Commissions believe that it would undermine the major

participant definition to attribute a non-speculative or non-trading

purpose to security-based swap positions that hedge speculative or

trading positions. When a person uses a security-based swap position to

help lock in profits or otherwise control the volatility associated

with speculative or trading activity, or to cause that speculative or

trading activity to reflect a particular market outlook or risk

profile, the security-based swap position serves as an integral part of

that speculative or trading activity. It thus would not appear

appropriate or consistent with economic reality to seek to distinguish

the security-based swap component from the other speculative or trading

aspects of that activity. In fact, if ``hedges'' of speculative or

trading positions were excluded from the first major participant test,

entities could readily label a wide range of security-based swap

positions entered into for speculative or trading purposes as being

excluded hedges.\1015\ Taken to its natural conclusion, such an

approach largely may exclude security-based swap positions from the

first major participant test, effectively writing that test out of the

statutory definition.

---------------------------------------------------------------------------

\1015\ As noted by one participant to the roundtable on these

definitions: ``[B]eing a hedge fund manager, there's nothing in my

portfolio I can't claim to be hedging a risk. There's nothing.

There's not a trade I do ever that I can't claim it to be a hedge

against interest rates, or inflation, or against equity. You know,

the fact of the matter is, if you're a capital market participant,

your business is taking risks.'' Roundtable Transcript at 325

(remarks of Michael Masters, Better Markets).

---------------------------------------------------------------------------

We are aware of commenters' views that regulation of major

participants has the potential to create a disincentive against certain

entities' use of security-based swaps to manage risk in connection with

their speculative or trading activities.\1016\ Under this view,

regulation potentially could result in those entities electing not to

reduce the risks that they otherwise would seek to hedge, to avoid

being regulated as major participants.\1017\ That potential result,

however, is an unavoidable consequence of the legislative decision to

regulate persons whose security-based swap positions cause them to be

major participants. It would not be appropriate to use the hedging

exclusion to negate part of the underlying statutory definition simply

to avoid disincentives that are an unavoidable consequence of the

legislative decision to regulate major participants.

---------------------------------------------------------------------------

\1016\ See letter from ISDA I.

\1017\ Of course, this would only be the case where the entity's

hedging and speculative activities combined were at a level in

excess of the major participant thresholds.

---------------------------------------------------------------------------

At the same time, we are mindful that market participants have

requested further guidance as to how to distinguish between hedging

positions that are subject to this exclusion, and speculative or

trading positions that fall outside the exclusion. In our view,

analysis of this issue is simplified by the nature of security-based

swaps, and by the limited circumstances in which a person may be

expected to have a commercial risk such that the use of a security-

based swap may be economically appropriate for managing that commercial

risk (rather than being for speculation or trading purposes).

In the case of security-based swaps that are credit derivatives,

the final rule provides examples of the use of credit default swaps to

purchase credit protection that, depending on the applicable facts and

circumstances, may appropriately be excluded from the first major

participant test (e.g., the use of a credit default swap to purchase

credit protection in connection with the potential default of a

customer, supplier or counterparty, or in connection with loans made by

a bank). Certain other purchases of credit protection using credit

default swaps--such as the purchase of credit protection to manage the

risks associated with securities that a non-financial company holds in

a corporate treasury and that are not held for speculative or trading

purposes--may also meet the standard under these rules.\1018\ The sale

of offsetting credit protection may also reasonably be expected to fall

within the exclusion to the extent that this sale is reasonably

necessary to address changes (particularly reductions) in the amount of

underlying commercial risk hedged by the initial security-based swap

position.\1019\

---------------------------------------------------------------------------

\1018\ This is not to say that the purchase of credit protection

on a security that a person owns would necessarily be entitled to

the hedging exclusion. If the underlying security itself is held for

speculative or trading purposes, the credit protection would not be

excluded from the first major participant analysis, and in any event

would not reasonably be construed as hedging ``commercial risk.''

\1019\ Apart from that example, it is more difficult to foresee

circumstances in which the sale of credit protection using a credit

default swap would be expected to fall within the exclusion. We

recognize, for example, that a person that has a short position in a

security of a reference entity may have an incentive to sell credit

protection on that reference entity to offset movements in the price

or value of that short position (and/or lock in arbitrage profits in

connection with that short position). While that sale of credit

protection may mitigate the risks associated with that short

position, or produce an arbitrage profit in connection with that

short position, that security-based swap position would not appear

to constitute the hedging of ``commercial risk'' for purposes of the

exclusion.

---------------------------------------------------------------------------

[[Page 30680]]

As for security-based swaps that are not credit derivatives--such

as equity swaps and total return swaps--the final rule provides

examples of how the use of those security-based swaps in connection

with certain business combinations may, depending on the applicable

facts and circumstances, appropriately be excluded from the first major

participant test. The use of equity swaps or total return swaps to

manage the risks associated with securities that are held in a

corporate treasury (and that are not held for speculative or trading

purposes) may also appropriately be subject to the exclusion. Other

uses of equity swaps or total return swaps to offset risks associated

with long or short positions in securities, however, may not

appropriately be excluded from the first major participant test,

because such positions would be expected to have an arbitrage purpose

or other speculative or trading purpose, and would be inconsistent with

the ``commercial risk'' limitation to the hedging exclusion.

c. Treatment of Positions That Hedge Other Swap or Security-Based Swap

Positions

The final rule, consistent with the proposal, provides that the

hedging exclusion does not extend to a security-based swap position

that hedges another swap or security-based swap position, unless that

other position itself is held for the purposing of hedging or

mitigating commercial risk.\1020\ This provision allows the first major

participant analysis to exclude a person's purchase of credit

protection to help address the risk of default by a counterparty in

connection with an interest rate swap, foreign exchange swap or other

swap or security-based swap that the person has entered into for the

purpose of hedging or mitigating commercial risk.

---------------------------------------------------------------------------

\1020\ Exchange Act rule 3a67-4(b)(2).

---------------------------------------------------------------------------

d. Procedural Conditions

In contrast to the proposal, the final rule does not incorporate

procedural requirements in connection with the hedging exclusion from

the first test of the major security-based swap participant

definition.\1021\ In making this change, we have been mindful of

concerns that have been expressed that such procedural requirements

would lead to undue costs in connection with hedging activity.\1022\

---------------------------------------------------------------------------

\1021\ Those proposed provisions would have conditioned the

exclusion on the person identifying and documenting the underlying

risks, establishing and documenting a method of assessing the hedge

effectiveness, and regularly assessing the effectiveness of the

security-based swap as a hedge. See proposed Exchange Act rule 3a67-

4(c).

\1022\ See, e.g., letter from FSR I.

---------------------------------------------------------------------------

We understand, however, that many entities engaging in legitimate

hedging of commercial risks do, as a matter of business practice,

identify and document those risks and evaluate the effectiveness of the

hedge from time to time. The presence of supporting documentation

consistent with such procedures would help support a person's assertion

that a security-based swap position should be excluded from the first

major participant analysis, should the legitimacy of the exclusion

become an issue.

Also, although we are not requiring the entity to monitor the

effectiveness of the hedge over time, that absence of this requirement

does not change the underlying need for a security-based swap position

to be economically appropriate for the commercial risks facing the

entity to be excluded from the first major participant definition.

Thus, for example, if a person's underlying commercial risk materially

diminishes or is eliminated over time, a security-based swap position

that may have been economically appropriate to the reduction of risk at

inception at a certain point in time may, depending on the facts and

circumstances, no longer be reasonably included within the

exclusion.\1023\ As part of the reports required in connection with

possible future changes to the major participant definitions,\1024\ the

staffs are directed to address whether the continued availability of

the hedging exclusion should be conditioned on assessment of hedging

effectiveness and related documentation.

---------------------------------------------------------------------------

\1023\ Factors that may be relevant to determining whether a

security-based swap position is economically appropriate to the

reduction of risk may include the costs associated with terminating

or reducing that position.

\1024\ See part V, infra.

---------------------------------------------------------------------------

D. Exclusion for Positions Held by Certain Plans Defined Under ERISA

1. Proposed Approach

The first statutory test of the major participant definitions

excludes swap and security-based swap positions that are ``maintained''

by any employee benefit plan as defined in sections 3(3) \1025\ and

3(32) \1026\ of ERISA ``for the primary purpose of hedging or

mitigating any risk directly associated with the operation of the

plan.'' \1027\

---------------------------------------------------------------------------

\1025\ Section 3(3) of Title I of ERISA defines the term

``employee benefit plan'' to include ``an employee welfare benefit

plan or an employee pension benefit plan or a plan which is both an

employee welfare benefit plan and an employee pension benefit

plan.'' See 29 U.S.C. 1002(3). The terms ``employee welfare benefit

plan'' and ``employee pension benefit plan'' are further defined in

Sections 3(1) and (2) of ERISA. See 29 U.S.C. 1002(1) and (2).

\1026\ Section 3(32) of Title I of ERISA defines the term

``governmental plan'' to mean a plan that the U.S. government, state

or political subdivision, or agencies and instrumentalities

establish or maintain for its employees, as well as plans governed

by the Railroad Retirement Acts of 1935 and 1937, plans of

international organizations that are exempt from taxation pursuant

to the International Organizations Immunities Act, and certain plans

established and maintained by tribal governments or their

subdivisions, agencies or instrumentalities. See 29 U.S.C. 1002(32).

\1027\ CEA section 1a(33)(A)(i)(I); Exchange Act section

3(a)(67)(A)(ii)(I).

---------------------------------------------------------------------------

The proposed rules incorporated that statutory exclusion without

additional interpretation or refinement.\1028\ In the Proposing

Release, moreover, the Commissions expressed the preliminary view that

we did not ``believe that it is necessary to propose a rule to further

define the scope of this exclusion.'' We further noted that the

exclusion for those plans identified in the statutory definition is not

strictly limited to ``commercial'' risk, and that this may be construed

to mean that hedging by those ERISA plans should be broadly excluded.

The Commissions also solicited comment as to whether this exclusion

should be made available to additional types of entities.\1029\

---------------------------------------------------------------------------

\1028\ See proposed CFTC Regulation Sec. 1.3(hhh)(1)(ii)(A);

proposed Exchange Act rule 3a67-1(a)(2)(i).

\1029\ See Proposing Release, 75 FR at 80201, supra.

---------------------------------------------------------------------------

2. Commenters' Views

Some commenters requested clarification that the ERISA hedging

exclusion is broader than the commercial risk hedging exclusion, and

that the ERISA hedging exclusion can encompass positions that are not

solely for hedging purposes.\1030\ One

[[Page 30681]]

commenter cautioned against interpreting the ERISA hedging exclusion

broadly.\1031\

---------------------------------------------------------------------------

\1030\ See letters from BlackRock I (noting that the ERISA

hedging exclusion applies to positions with the ``primary purpose''

of hedging, ``which suggests plans may exclude swap positions even

if they serve a purpose in addition to hedging or mitigating''), the

ERISA Industry Committee (``ERISA Industry Committee'') (stating

that if ERISA Title I plans are not excluded from the major

participant definition, the rules should clarify that the ERISA

hedging exclusion is broader than the commercial hedging exclusion

and encompasses a variety of risks associated with the value of a

plan's assets or the measures of its liabilities; also stating that

the ERISA exclusion should not omit positions in the nature of

investing, and particularly discussing the use of swaps to provide

diversification), ABC/CIEBA (expressing the view that the ERISA

hedging exclusion extends beyond ``traditional'' hedges, and stating

that the exclusion should encompass swaps with purposes in addition

to hedging, and that the exclusion should encompass positions for

the purpose of rebalancing, diversification and gaining asset class

exposure) and CalSTRS I (requesting that regulations provide for an

ERISA hedging exclusion that is broader than the commercial risk

hedging exclusion, and that encompasses positions for the purpose of

investing).

One commenter alluded to the incorporation of efficient

portfolio theory principles within the exception. See letter from

Russell Investments.

\1031\ See letter from AFSCME (stating that while the statutory

exclusion may encompass swaps to mitigate currency risk of cash

market investments, the exclusion should not encompass swaps used

for investment purposes such as to gain asset class exposure or

avoid transaction costs associated with a direct investment).

---------------------------------------------------------------------------

Commenters also requested that the Commissions clarify that the

ERISA hedging exclusion applies to positions maintained by trusts that

hold plan assets,\1032\ or by pooled funds.\1033\ One commenter, in

contrast, stated that the exclusion should not be available to trusts

holding plan assets.\1034\

---------------------------------------------------------------------------

\1032\ See letters from ERISA Industry Committee (stating that

the rules should provide that the exclusion applies to positions

maintained by any trust holding plan assets) and ABC/CIEBA (stating

that the rules should provide the relevant entity for purposes of

the exclusion is the counterparty to the swap, further stating that

if a trust enters into a swap as a counterparty, it is the trust

that should be tested as a possible major participant, even if the

trust also holds non-ERISA assets).

\1033\ See letters from BlackRock I (discussing how plan

fiduciaries may invest plan assets ``in pooled investment vehicles

such as registered investment companies, private funds and bank

maintained collective trust funds,'' and stating that not including

pooled funds within the exclusion would limit plans' ability to

avail themselves of the efficiencies associated with pooling), ERISA

Industry Committee (stating that there is ``no reason'' why the

exception should not also extend to position held by a pooled

investment trust on behalf of multiple employee benefit plans) and

ABC/CIEBA (stating that if a pool within a trust is the

counterparty, it is that pool that should be tested as a possible

major participant, and noting Department of Labor regulations

providing that a collective investment vehicle would be viewed as

holding plan assets if the vehicle is not a registered investment

company, and plans hold at least 25 percent of the interests in the

vehicle).

\1034\ See letter from AFSCME (stating that ``it is important to

limit the exemption to plans themselves, not to entities holding

`plan assets' '').

---------------------------------------------------------------------------

One commenter stated that the exception should be extended to all

public pension plans,\1035\ and one commenter particularly took the

view that the exclusion should be available to church plans.\1036\ Some

commenters stated that the exclusion should be available to non-U.S.

plans.\1037\

---------------------------------------------------------------------------

\1035\ See letter from Russell Investments.

\1036\ See letter from Church Alliance (stating that the

exclusion also should encompass church plans defined in paragraph

3(33) of ERISA, on the grounds that Congress would not have intended

to discriminate against church plans, and that church plans are

considered ``special entities'' that should be the beneficiaries of

extra protection).

\1037\ See letters from ABC/CIEBA, APG and BTPS.

The Commissions intend to issue separate releases that address

the application of the major participant definitions, and Title VII

generally, to non-U.S. entities.

---------------------------------------------------------------------------

3. Final Rules

Consistent with the position expressed in the Proposing Release,

the Commissions interpret the ERISA hedging exclusion in the first

statutory major participant test to be broader than that test's

commercial risk hedging exclusion. This reflects the facts that the

ERISA hedging exclusion is not limited to ``commercial'' risk, and that

the ERISA hedging exclusion addresses positions that have a ``primary''

hedging purpose (which suggests that those positions may have a

secondary non-hedging purpose).

a. Types of Excluded Hedging Activities

The Commissions are mindful of commenters' request for additional

clarity regarding the scope of the ERISA hedging exclusion. In that

regard, we note that we generally would expect swap or security-based

swap positions to have a primary purpose of hedging or mitigating risks

directly associated with the operation of the types of plans identified

in the statutory definition--and hence eligible for the exclusion--when

those positions are intended to reduce disruptions or costs in

connection with, among others, the anticipated inflows or outflows of

plan assets, interest rate risk, and changes in portfolio management or

strategies.

Conversely, we believe that certain other types of positions would

less likely have the primary purpose of hedging or mitigating risks

directly associated with the operation of the plan, as anticipated by

the statutory definition.\1038\

---------------------------------------------------------------------------

\1038\ For example, we do not foresee that the use of a swap or

security-based swap position to replicate exposure to a foreign

market or to a particular asset class to be for the primary purpose

of hedging risks directly associated with the operation of these

types of plans. While we recognize that an asset manager may

perceive benefits in using swaps or security-based swaps in that

manner, it also is necessary to give effect to the statutory

language limiting the exclusion to positions that have a ``primary

purpose'' of hedging risks ``directly associated'' with the

``operations'' of a plan. We recognize that lack of diversification

may be viewed as a risk, but it is not an ``operations'' risk.

---------------------------------------------------------------------------

b. Availability of Exclusion

The Commissions recognize the significance of comments that these

plans may use separate entities such as trusts or pooled vehicles to

hold plan assets, and that the exclusion should not be interpreted in a

way that deters the use of those vehicles. We believe that the same

principles that underpin the exclusion for hedging positions directly

entered into by the types of plans identified in the statutory

definition also warrant making the exclusion applicable to plan hedging

positions that are entered into by those other parties that hold assets

of those types of plans. Otherwise, the major participant analysis

would have the effect of deterring efficiencies in plan operations for

no apparent regulatory purpose.

Accordingly, the Commissions interpret the meaning of the term

``maintain''--in the context of the statutory provision that the swap

or security-based swap position be ``maintained by'' an employee

benefit plan--not only to include positions in which the plan is a

counterparty, but also to include positions in which the counterparty

is a trust or pooled vehicle that holds plan assets. Thus, for example,

the exclusion would be available to trusts or pooled vehicles that

solely hold assets of the types of plans identified in the statutory

definition.\1039\ The exclusion further may be available to entities

that hold such plan assets in conjunction with other assets, but only

to the extent that the entity enters into swap or security-based swap

positions for the purpose of hedging risks associated with the plan

assets. The exclusion does not extend to positions that hedge risks of

other assets, even if those are managed in conjunction with plan

assets.\1040\

---------------------------------------------------------------------------

\1039\ This interpretive guidance is intended solely in the

context of the interpretation of the first test of the statutory

major participant definitions. The guidance is not based on or

relevant to the interpretation of other regulations relating to

ERISA.

\1040\ As appropriate, for purposes of the first major

participant analysis an entity may need to allocate the exposure

associated with swap or security-based swap positions between the

amount that is attributable to plan assets (and hence eligible for

exclusion) and the amount that is attributable to other assets.

---------------------------------------------------------------------------

The Commissions also are mindful of commenter concerns that the

exclusion should explicitly be made available to other plans, such as

church plans and non-U.S. plans.\1041\ In this regard, the Commissions

believe that the boundaries of the exclusion are set by the explicit

statutory language, which states that it applies to any employee

benefit plan as defined in paragraphs (3) and (32) of section 3 of

ERISA. This reference is disjunctive--that is, a plan is eligible for

the exclusion if it is within the scope of paragraph (3) (which refers

to employee benefit plans)

[[Page 30682]]

or of paragraph (32) (which applies to government plans). Accordingly,

the scope of the cited definitions in paragraphs (3) and (32) should be

determined in accordance with all law that applies in the

interpretation of ERISA.\1042\

---------------------------------------------------------------------------

\1041\ As previously noted, the Commissions intend to issue

separate releases that address the application of the major

participant definitions, and Title VII generally, to non-U.S.

entities.

\1042\ We are not taking a view as to whether church plans or

non-U.S. plans constitute employee benefit plans as defined by

section 3(3) of ERISA.

---------------------------------------------------------------------------

E. ``Substantial Counterparty Exposure''

1. Proposed Approach

The major participant definitions' second statutory test

encompasses persons whose outstanding swaps or security-based swaps

``create substantial counterparty exposure that could have serious

adverse effects on the financial stability of the U.S. banking system

or financial markets.'' \1043\ In contrast to those definitions' first

statutory test, which relates to persons with a ``substantial

position'' in swaps or security-based swaps in a ``major''

category,\1044\ this second test is not limited to positions in a

single category. Also, unlike the first test, the second statutory test

does not explicitly exclude certain commercial risk hedging positions

or ERISA hedging positions.

---------------------------------------------------------------------------

\1043\ CEA section 1a(33)(A)(ii); Exchange Act section

3(a)(67)(A)(ii)(II).

\1044\ CEA section 1a(33)(A)(i); Exchange Act section

3(a)(67)(A)(ii)(I).

---------------------------------------------------------------------------

For the ``major swap participant'' definition, the Proposing

Release provided that a person's swap positions pose ``substantial

counterparty exposure'' if those positions present a daily average

current uncollateralized exposure of $5 billion or more, or present

daily average current uncollateralized exposure plus potential future

exposure of $8 billion or more.\1045\ For the ``major security-based

swap'' definition, the proposal provided that a person's security-based

swap positions pose ``substantial counterparty exposure'' if those

positions present daily average current uncollateralized exposure of $2

billion or more, or present daily average current uncollateralized

exposure plus potential future exposure of $4 billion or more.\1046\

---------------------------------------------------------------------------

\1045\ See proposed CFTC Regulation Sec. 1.3(lll).

\1046\ See proposed Exchange Act rule 3a67-5.

---------------------------------------------------------------------------

Under the proposal, those measures would be calculated in the same

manner as would be used for the first major participant test, except

that the ``substantial counterparty exposure'' analysis would consider

all of a person's swap or security-based swap positions rather than

solely considering positions in a particular ``major'' category, and

that the ``substantial counterparty exposure'' analysis would not

exclude positions to hedge commercial risks or ERISA plan risks.

The proposed ``substantial counterparty exposure'' thresholds were

set higher than the proposed ``substantial position'' thresholds in

part to reflect the fact that the former test accounts for a person's

positions across four major swap categories or two major security-based

swap categories.\1047\ The proposed ``substantial counterparty

exposure'' thresholds also reflected the fact that this second test

(unlike the first major participant test) encompasses certain hedging

positions that, in general, we would expect to pose a lesser degree of

risk to counterparties and the markets.

---------------------------------------------------------------------------

\1047\ Thus, these proposed thresholds in part would account for

a person that has large positions in more than one major category of

swaps or security-based swaps, but that does not meet the

substantial position threshold for any single category of swaps or

security-based swaps.

---------------------------------------------------------------------------

2. Commenters' Views

a. General Comments

In light of the similarity between the proposed tests, a number of

the concerns that commenters expressed with regard to the proposed

``substantial position'' definition also apply to the proposed

``substantial counterparty exposure'' definition. In addition, some

commenters took the view that the proposed ``substantial counterparty

exposure'' thresholds were too low,\1048\ with several of those

commenters stating that the thresholds should be raised to a level that

reflects systemic risk.\1049\ A few commenters took the view that the

proposed thresholds were too high.\1050\ Some commenters generally

supported the approach to the definition of ``substantial counterparty

exposure'' proposed by the Commissions.\1051\

---------------------------------------------------------------------------

\1048\ See, e.g., letters from ATAA (supporting higher

thresholds to measure substantial counterparty exposure), CCMR I

(suggesting that the thresholds be set high initially, capturing

only a few entities until the Commissions are able to collect and

analyze data that supports lowering the thresholds), BG LNG I

(stating that proposed threshold should be increased substantially),

WGCEF II (stating that the Commissions should adopt substantial

position and substantial counterparty exposure tests that account

for current conditions in swap markets), ABC/CIEBA (requesting that

the Commissions raise the thresholds to better target persons

creating or causing systemic risk as set forth in the a major swap

participant and major security-based swap participant definitions),

BlackRock I (stating that proposed thresholds for the substantial

counterparty exposure test are too low so that they could encompass

market participants that do not have systemically important swap

positions) and ACLI (supporting increasing the thresholds under the

CEA definition to $7 billion in daily average aggregate

uncollateralized outward exposure or $14 billion in daily average

aggregate uncollateralized outward exposure plus daily average

aggregate potential outward exposure), and meeting with MFA on

February 14, 2011 (requesting that the Commissions raise the

thresholds for measuring substantial counterparty exposure until the

Commissions conduct a market survey to determine how many entities

would need to perform the calculations regularly and whether those

entities have characteristics capable of causing systemic risk).

\1049\ See letters from ABC/CIEBA, BlackRock I, ISDA I, WGCEF

II, and meeting with MFA on February 14, 2011.

\1050\ See letters from Greenberger (in connection with

thresholds relating to substantial position) and AFR (Commissions

should define a major swap participant or major security-based swap

participant as any person that maintains $500 million in daily

average, uncollateralized exposure for any category of swaps other

than rate swaps, for which the daily average could be up to $1.5

billion).

\1051\ See, e.g., letters from ATAA (supporting the proposed

definitions of ``substantial position'' and ``substantial

counterparty exposure,'' with the caveat that higher thresholds be

used to measure ``substantial counterparty exposure''), Dominion

Resources (supporting the Commissions proposed definitions of

``substantial position'' and ``substantial counterparty exposure''),

Fidelity (threshold levels set at appropriate levels but should be

periodically reviewed for adjustment), and Kraft (thresholds as

proposed are appropriate).

---------------------------------------------------------------------------

Some commenters took the view that the ``substantial counterparty

exposure'' test should focus on the size of an entity's exposure to

specific counterparties.\1052\ Several commenters suggested that the

thresholds should be adjusted over time for inflation and changes in

the swap and security-based swap markets.\1053\ One commenter urged

that the analysis consider the interconnectedness of the entity.\1054\

---------------------------------------------------------------------------

\1052\ See letters from MFA (stating that the calculation of

substantial counterparty exposure should measure the exposure that a

person has to each individual counterparty that is a systemically

important financial institution excluding cleared swap transactions)

and CCMR I (stating that the ``substantial counterparty exposure''

and ``substantial position'' thresholds should apply to the largest

exposure that a person has to another market participant, with any

aggregate test being set at a higher level).

\1053\ See letters from CDEU, COPE I, Fidelity, ISDA I, and MFA

I.

\1054\ See letter from CDEU.

---------------------------------------------------------------------------

One commenter addressed the application of the second major

participant test to insurance companies, arguing that substantial

counterparty exposure should be decided by the FSOC in consultation

with the relevant state insurance commissioner, and that hedges should

be excluded from the calculation for insurers.\1055\

---------------------------------------------------------------------------

\1055\ See letter from NAIC (stating that the Commissions should

defer to FSOC when considering the designation of insurers under the

second test, and should exclude from the analysis swaps and

security-based swap positions used for hedging provided that such

positions are subject to state investment laws and ongoing

monitoring by a state insurance regulatory authority).

---------------------------------------------------------------------------

b. Lack of Exclusion for Hedging Positions

A number of commenters took the view that the second major

participant

[[Page 30683]]

test should exclude commercial risk hedging positions from the

analysis.\1056\ Some commenters also supported excluding ERISA hedging

positions from the analysis.\1057\ One commenter opposed any such

exclusions for hedging positions.\1058\

---------------------------------------------------------------------------

\1056\ See letters from SIFMA AMG II (noting that the

Commissions have suggested that hedging positions may not raise the

same degree of risk as other swap positions), NAIC (supporting

exclusion of commercial risk hedging positions subject to state

investment laws and ongoing monitoring by state insurance

regulators), AIA (supporting hedging exclusion to avoid capturing

entities such as property-casualty insurers), CDEU (suggesting that

inclusion of hedging positions is inconsistent with goal of

mitigating systemic risk), APG (supporting exclusion of positions

held by regulated foreign pension plans), and NRG Energy (suggesting

that a lack of an exclusion would cause end-users to curtail hedging

activities and increase systemic risk); see also letter from AIMA I

(supporting an exemption or discount if the swap transaction is

cleared, an off-set for the value and quality of any collateral, and

consideration of the directional moves of particular swap

contracts).

\1057\ See letters from ABC/CIEBA and SIFMA AMG II. One

commenter further requested that ERISA Title I plans be explicitly

excluded from the second test. See letter from ERISA Industry

Committee. Another commenter requested an exclusion for ERISA plans

generally. See letter from CalSTRS I.

\1058\ See letter from Better Markets I (stating that excluding

hedging positions would be inappropriate because the Dodd-Frank Act

did not provide for any such exclusion in the second test, hedge

positions may still contribute to counterparty exposure, and the

thresholds already reflect the lower level of risk posed by hedge

positions).

---------------------------------------------------------------------------

3. Final Rules

Consistent with the Proposing Release, the final rules defining the

term ``substantial counterparty exposure'' generally are based on the

same current uncollateralized exposure and potential future exposure

tests that are used to identify a ``substantial position.'' \1059\ As

with the Proposing Release, moreover, the ``substantial counterparty

exposure'' analysis addresses all of a person's swap or security-based

swap positions (rather than being limited to positions in a ``major''

category), and does not exclude hedging positions.\1060\ The final

rules also incorporate the quantitative thresholds that were proposed

for those tests.\1061\

---------------------------------------------------------------------------

\1059\ Accordingly, changes that the final rules made to the

proposal with regard to the ``substantial position'' definition, see

part IV.B.3, supra, also are carried over to the definition of

``substantial counterparty exposure.''

\1060\ See CFTC Regulation Sec. 1.3(lll); Exchange Act rule

3a67-5.

\1061\ Accordingly, consistent with the proposal, the threshold

for the ``major swap participant'' definition is $5 billion or more

in daily average current uncollateralized exposure, or $8 billion or

more in daily average uncollateralized exposure plus potential

future exposure. The threshold for the ``major security-based swap

participant'' is $2 billion or more in daily average current

uncollateralized exposure, or $4 billion or more in daily average

uncollateralized exposure plus potential future exposure.

---------------------------------------------------------------------------

In adopting these final rules we have considered commenter views

that the ``substantial counterparty exposure'' analysis should exclude

certain commercial risk and ERISA hedging positions. We nonetheless

believe that the structure of the major participant definitions--

particularly the fact that those definitions specifically exclude

hedging positions from the first statutory test but not from the second

test--necessitates the conclusion that the second test not exclude

those hedging positions.

We also have considered commenter views that the ``substantial

counterparty exposure'' analysis should account for the maximum

exposure that a person poses to any single counterparty. We nonetheless

believe that the statutory test--particularly its focus on serious

adverse effects on financial stability or financial markets--more

appropriately is addressed by measures of the aggregate counterparty

risk that an entity poses through its swap or security-based swap

positions. Also, consistent with our views regarding the ``substantial

position'' definition, we believe that the ``substantial counterparty

exposure'' analysis appropriately is addressed via objective and

quantitative criteria (rather than a multi-tier approach), and

appropriately takes into account current uncollateralized exposure and

potential future exposure.

Consistent with the Proposing Release, the thresholds to implement

the second major participant test are higher than the corresponding

thresholds for the first major participant test. These differences

reflect the fact that the second test encompasses four ``major''

categories of swaps or two ``major'' categories of security-based

swaps, as well as the fact that this second test does not exclude

hedging positions that would appear to pose a lesser degree of

counterparty risk than non-hedging positions.

While we are mindful of commenter views that the proposed

``substantial counterparty exposure'' thresholds were too low,\1062\ we

believe that the same principles that support the proposed standards in

the context of the ``substantial position'' definition also support the

proposed standards for this second test. As with the ``substantial

position'' analysis, the ``substantial counterparty exposure'' analysis

seeks to reflect a standard that encompasses large market participants

before the counterparty risk posed by their swap and security-based

swap positions present too large a problem, as well as the financial

system's ability to absorb losses of a particular size, and the need to

account for the possibility that multiple market participants may fail

close in time.\1063\ Commenters have not presented empirical or

analytical evidence in support of a different standard. In the future,

the Commissions may review and potentially adjust these thresholds to

reflect evolving market structures and additional data.

---------------------------------------------------------------------------

\1062\ See notes 1051 and 1052, supra.

\1063\ As with the ``substantial position'' analysis, our

decision to adopt these thresholds is informed by events related to

AIG Financial Products and LTCM. See part IV.B.3.d, supra.

---------------------------------------------------------------------------

F. ``Highly Leveraged'' and ``Financial Entity''

1. Proposed Approach

The third statutory test of the major participant definitions

encompasses any non-dealer that: (i) Is a ``financial entity'' (other

than one that is ``subject to capital requirements established by an

appropriate Federal banking agency''), (ii) is ``highly leveraged

relative to the amount of capital it holds,'' and (iii) maintains a

``substantial position'' in any ``major'' category of swaps or

security-based swaps.\1064\ In contrast to the first statutory test--

which also encompasses persons with a ``substantial position'' in swaps

or security-based swaps in a ``major'' category--this third test does

not exclude positions that hedge commercial risk or ERISA risks.

---------------------------------------------------------------------------

\1064\ CEA section 1a(33); Exchange Act section 3(a)(67).

---------------------------------------------------------------------------

a. ``Financial Entity''

The Proposing Release defined the term ``financial entity'' for

purposes of the major participant definition in the same general manner

as Title VII defines that term for purposes of the end-user exemption

from mandatory clearing,\1065\ but with certain technical changes to

avoid circularity.\1066\

---------------------------------------------------------------------------

\1065\ CEA section 2(h)(7); Exchange Act section 3C(g)(3)(A).

\1066\ See proposed CFTC Regulation Sec. 1.3(mmm)(1); proposed

Exchange Act rule 3a67-6(a). For both sets of rules, the ``financial

entity'' definition would include any: commodity pool (as defined in

section 1a(10) of the CEA); private fund (as defined in section

202(a) of the Investment Advisers Act of 1940); employee benefit

plan as defined in paragraphs (3) and (32) of section 3 of ERISA;

and person predominantly engaged in activities that are in the

business of banking or financial in nature (as defined in section

4(k) of the Bank Holding Company Act of 1956).

To avoid circularity, the use of the term ``financial entity''

in the context of the ``major swap participant'' definition also

would encompass any ``security-based swap dealer'' and ``major

security-based swap participant,'' but would not include any ``swap

dealer'' or ``major swap participant'' (even though the latter terms

also are found in the ``financial entity'' definition used for

purposes of the end-user clearing exception). See proposed CFTC

Regulation Sec. 1.3(mmm)(1). In the context of the ``major

security-based swap participant'' definition, the term ``financial

entity'' also would encompass any ``swap dealer'' or ``major swap

participant,'' but would not include any ``security-based swap

dealer'' and ``major security-based swap participant.'' See proposed

Exchange Act rule 3a67-6(a).

---------------------------------------------------------------------------

[[Page 30684]]

b. ``Highly Leveraged''

The Proposing Release set forth two alternative approaches for

determining whether a particular entity would be deemed ``highly

leveraged.'' \1067\ Under one approach, an entity would be ``highly

leveraged'' if the ratio of its liabilities to equity exceeded 8 to 1;

this proposed alternative reflected the fact that the third statutory

major participant test excludes certain types of entities.\1068\ Under

the alternative approach, an entity would be ``highly leveraged'' if

the ratio of its liabilities to equity exceeded 15 to 1; this proposed

alternative reflected standards for maximum leverage in certain

circumstances found in Title I of the Dodd-Frank Act.\1069\ The

proposal further provided that leverage would be measured at the close

of business on the last business day of the applicable fiscal quarter,

and that liabilities and equity would be determined in accordance with

U.S. generally accepted accounting principles (``GAAP'').\1070\

---------------------------------------------------------------------------

\1067\ See proposed CFTC Regulation Sec. 1.3(mmm)(2); proposed

Exchange Act rule 3a67-6(b).

\1068\ The Proposing Release particularly noted that the third

statutory major participant test excludes financial institutions

subject to capital requirements set by Federal banking agencies, and

recognized the possibility those entities were excluded based on the

presumption that they generally are highly leveraged. The Proposing

Release noted, based on analysis of financial statements, that it

appears that those institutions generally have a leverage ratio of

10 to 1, and that this suggested that the ``highly leveraged''

threshold would have to be lower for those institutions to

potentially be subject to the third test. See Proposing Release, 75

FR at 80199.

\1069\ The Proposing Release noted that Title I provides that

the Board must require a bank holding company with total

consolidated assets equal to or greater than $50 billion, or a

nonbank financial company supervised by the Board, to maintain a

debt to equity ratio of no more than 15 to 1 if the FSOC determines

``that such company poses a grave threat to the financial stability

of the United States and that the imposition of such requirement is

necessary to mitigate the risk that such company poses to the

financial stability of the United States.'' See Dodd-Frank Act

section 165(j)(1). The Proposing Release further noted that this 15

to 1 ratio may represent an upper limit to acceptable leverage and

that the major participant analysis should use a lower threshold,

or, alternatively, that the 15 to 1 ratio provides an appropriate

test of whether an entity poses the systemic risk concerns

implicated by the major participant definitions. See Proposing

Release, 75 FR at 80199.

\1070\ The Proposing Release also stated that entities that file

quarterly reports on Form 10-Q and annual reports on Form 10-K with

the SEC would determine their total liabilities and equity based on

the financial statements included with such filings while all other

entities would calculate the value of total liabilities and equity

consistent with the proper application of U.S. GAAP. See id.

---------------------------------------------------------------------------

In proposing these alternative standards for identifying ``highly

leveraged'' entities, the Commissions recognized that traditional

balance sheet measures of leverage are limited as tools for evaluating

an entity's ability to meet its obligations--in part because such

measures do not directly account for potential risks posed by specific

instruments held on the balance sheet, or for financial instruments

held off of the balance sheet. At the same time, the Commissions

preliminarily concluded that it was not necessary to use more complex

measures of risk-adjusted leverage for these purposes, in part because

the third test's ``substantial position'' analysis already accounts for

such risks. The Commissions also noted the costs that would be

associated with causing entities to engage in complex calculations of

risk-adjusted leverage.\1071\

---------------------------------------------------------------------------

\1071\ See id. at 80198-99.

---------------------------------------------------------------------------

The Proposing Release solicited comment on a variety of issues

related to the proposed leverage ratios, including the relative merits

of the alternative 8 to 1 and 15 to 1 standards, and potential

alternative standards.\1072\

---------------------------------------------------------------------------

\1072\ See id. at 80199-200.

---------------------------------------------------------------------------

2. Commenters' Views

a. ``Financial Entity''

Some commenters recommended that certain types of entities should

be excluded from the definition of ``financial entity,'' on the grounds

that those types of entities are more appropriately treated as non-

financial end users of swaps for purposes of the Dodd-Frank Act.\1073\

Commenters specifically suggested that the ``financial entity''

definition exclude: (i) Centralized hedging and treasury subsidiaries

in corporate groups; \1074\ (ii) employee benefit plans; \1075\ and

(iii) cooperative structures.\1076\ Commenters also requested

clarification as to which entities would not be ``subject to capital

requirements established by an appropriate Federal banking agency,''

and hence not subject to the third statutory test.\1077\ In addition,

commenters addressed the application of the ``financial entity''

definition to non-U.S. persons.\1078\

---------------------------------------------------------------------------

\1073\ See, e.g., letters from CalSTRS dated June 15, 2011

(``CalSTRS II''), Kraft, Newedge, NRU CFC I and Philip Morris.

\1074\ See letters from Kraft and Philip Morris.

\1075\ See letter from CalSTRS II (asserting that there is not a

basis to treat ERISA plans as ``financial entities'' for purposes of

the major participant definitions solely to maintain consistency

with an ``anomalous'' statutory provision).

\1076\ See letter from NRU CFC I.

\1077\ See letters from ACLI (requesting confirmation that the

exclusion from the third statutory test extends to entities subject

to bank or financial holding companies, entities deemed systemically

important under Title I of the Dodd-Frank Act, and any other persons

subject to capital regulation established by a Federal banking

regulator) and MetLife (requesting clarification that the exclusion

extends to persons subject to regulation and capital requirements on

a consolidated basis under federal banking law, and persons that are

individually or systemically important financial institutions under

Title I).

\1078\ One commenter took the view that non-U.S. governments and

their agencies should be excluded from the ``financial entity''

definition for purposes of the major participant definition and the

Title VII end-user exemption from mandatory clearing. See letter

from Milbank. On the other hand, one commenter favored the inclusion

of non-U.S. governments in the ``financial entity'' definition. See

meeting with Duffie on February 2, 2011 (suggesting that foreign

governments and other foreign jurisdictions, such as municipalities,

should be treated as ``financial entities'' for purposes of the

major swap participant definition and other requirements under the

Dodd-Frank Act on the grounds that such entities could become

sources of systemic risk).

The Commissions intend to issue separate releases addressing the

application of Title VII to non-U.S. persons.

---------------------------------------------------------------------------

b. ``Highly Leveraged''

A number of commenters supported the proposed 15 to 1 alternative

leverage ratio over the 8 to 1 alternative, with some commenters

further suggesting that the final rule should set a leverage ratio

higher than 15 to 1, or that the ratio should be reconsidered when more

information is available regarding leverage among swap users.\1079\ One

commenter supported the proposed 8 to 1 alternative,\1080\ and one

commenter

[[Page 30685]]

suggested that the final rule should set a leverage ratio lower than 8

to 1.\1081\ One commenter suggested a ratio of 12 to 1, consistent with

certain capital requirements.\1082\

---------------------------------------------------------------------------

\1079\ See letters from ISDA I (suggesting that the wide use of

leverage by financial institutions means that the definition should

capture only entities with the ``very highest'' leverage ratios, and

that the 15 to 1 ratio should be viewed as a floor for identifying

highly leveraged entities given that it is used in Title I to

address entities that have already been determined to pose a ``grave

threat'' to the stability of the U.S. financial system), MFA I

(stating that 15 to 1 is the more appropriate of the two choices,

and that the Commissions could subsequently adjust the ratio after

receiving market data on the use of leverage), AIMA I (encouraging

the Commissions to adopt the 15 to 1 leverage threshold until an

assessment of the impact of the major participant definitions can be

completed); Amex (supporting the use of the 15 to 1 ratio, noting

that it is consistent with the maximum leverage allowed to entities

designated as a grave threat to financial stability under Title I of

the Dodd-Frank Act) and CDEU (recommending use of the 15 to 1

standard, based on its consistency with the leverage limit in Title

I of the Dodd-Frank Act for entities posing a grave threat to the

United States financial system and that ``it would be unreasonable

to propose a stricter leverage threshold under the major participant

test for nonbank financial end-users,'' and expressing concern that

entities comfortably falling under the 8 to 1 ratio could

unexpectedly exceed this threshold during periods of market stress

and that sudden designation as a major participant ``could seriously

hinder a company from meeting its obligations'').

\1080\ See letter from Better Markets I (stating that the 8 to 1

threshold would better serve the purposes of the Dodd-Frank Act by

``ensuring that more, rather than fewer, financial entities are

covered by the risk mitigation and business conduct standards that

Congress established'' for major participants, and that use of the

15 to 1 leverage ratio from Title I of the Dodd-Frank Act is

inappropriate because the Title I ratio is used for the ``relatively

draconian'' purpose of imposing leverage limits, while this ratio

would be used for ``the more modest purpose of imposing registration

requirements'').

\1081\ See letter from Greenberger (suggesting that the leverage

test should be set at a ratio that is lower than either of the two

proposed levels).

\1082\ See meeting with MFA on February 14, 2011 (MFA

representatives making point that ``highly leveraged'' should be

defined in coordination with other regulations under the Dodd-Frank

Act, and for example, a requirement that banks hold 8% capital

implies a leverage ratio of approximately 12:1).

---------------------------------------------------------------------------

Commenters also suggested a variety of methods and adjustments for

calculating leverage ratios.\1083\

---------------------------------------------------------------------------

\1083\ The suggested adjustments were: to measure the ratio of

net current credit exposure to Tier I capital, in a manner similar

to that used by bank regulators (see letter from Greenberger); to

include as liabilities all unfunded exposures on swaps, both current

and potential (see letter from Better Markets I); and to account for

the different risk levels of various classes of assets and

liabilities and for other factors affecting a person's riskiness

(see letters from CCMR I and MFA I).

---------------------------------------------------------------------------

Some commenters further suggested that specific leverage tests be

applied to particular types of financial entities. For employee benefit

plans, commenters particularly stated that a plan's obligations to pay

benefits should not be considered a liability for purposes of the

analysis, and the value of the plan's assets should be used as the

denominator for the ratio in lieu of using the non-applicable term

``equity.'' \1084\ Another commenter--which obtains a substantial

amount of funding by issuing subordinated debt, rather than equity--

expressed the view that the leverage calculation should allow it to

treat subordinated debt as equity.\1085\

---------------------------------------------------------------------------

\1084\ See letters from CalSTRS I (also stating that for

purposes of determining leverage ratios, the value of the plan's

assets should be determined as of most recent annual valuation

rather than quarterly) and APG (stating that only investment-related

liabilities, rather than anticipated shortfalls in benefit

obligations, should be considered in the leverage calculation, and

the test should be adjusted to take into account legally binding

investment restrictions and other constraints that could be just as

effective, or more effective, at reducing insolvency risk as capital

requirements that would limit leverage).

\1085\ See letter from NRU CFC I (stating that this application

of the leverage test would be consistent with its financial

statements).

---------------------------------------------------------------------------

Several commenters addressed the application of the leverage ratio

to insurance companies in light of the applicable regulatory regimes

and their use of statutorily required accounting methods rather than

GAAP.\1086\ Those commenters took the view that an insurance company's

leverage should be tested based on its risk-based capital ratio or on

its statutory accounting statements, with certain adjustments to

account for different types of liabilities,\1087\ or based on whether

its insurance regulator believes that it is adequately

capitalized.\1088\ One commenter said that the leverage ratio test

should not apply to insurance companies,\1089\ and another said that

application of the leverage ratio test to insurance companies should be

coordinated with the FSOC.\1090\

---------------------------------------------------------------------------

\1086\ See letters from ACLI, FSR I, MetLife and NAIC.

\1087\ See letters from ACLI, FSR I and NAIC.

\1088\ See letter from MetLife.

\1089\ See letter from FSR I.

\1090\ See letter from NAIC.

---------------------------------------------------------------------------

3. Final Rules

a. ``Financial Entity''

Consistent with the Proposing Release, the final rules defining

``financial entity'' for purposes of the third major participant test

are based on the corresponding ``financial entity'' definition used in

the Title VII exception from mandatory clearing for end users, with

certain adjustments to avoid circularity.\1091\ In this regard, while

we are mindful of one commenter's views that the differences between

the major participant definitions and the end-user clearing exception

necessitate different ``financial entity'' definitions,\1092\ we do not

concur with the view that the term ``financial entity'' should be

interpreted independently in these two contexts. Both sets of

provisions distinguish between financial and non-financial entities in

a way that limits the impact of Title VII on the latter set of

entities, and we believe that the definitions should be consistent in

light of those parallel purposes.

---------------------------------------------------------------------------

\1091\ See CFTC Regulation Sec. 1.3(mmm)(1); Exchange Act rule

3a67-6(a). Accordingly, this general definition encompasses

commodity pools, private funds, ERISA plans, and persons

predominately engaged in activities that are in the business of

banking or financial in nature, as well as certain dealers or major

participants. See note 1066, supra.

\1092\ See letter from CalSTRS II (ERISA plans should not be

included in the definition of ``financial entity'' for purposes of

the major participant definitions).

---------------------------------------------------------------------------

The Commissions are aware, however, that the major participant

definitions differ from the mandatory clearing requirements in how they

address affiliates. The mandatory clearing requirements include a

provision that specifically addresses affiliates of persons that

qualify for the exception from mandatory clearing for end users,\1093\

while no such specific provision is included in the major participant

definitions. Given this absence, the Commissions believe it is

appropriate to modify the final rules defining ``financial entity'' for

purposes of the major participant definitions from the proposal to

exclude certain centralized hedging and treasury entities.\1094\ The

Commissions understand that a primary function of such centralized

hedging and treasury entities is to assist in hedging or mitigating the

commercial risks of other entities within their corporate groups.

Although those entities' activities could constitute being ``in the

business of banking or financial in nature,'' we do not believe that it

would be appropriate to treat a person as a ``financial entity'' for

the purposes of the major participant definitions if the person would

fall within that definition solely because it facilitates hedging

activities involving swaps or security-based swaps by majority-owned

affiliates that themselves are not ``financial entities.'' \1095\

Absent this change, the major participant analysis would exclude

hedging positions that do not use centralized hedging facilities, but

would not exclude identical hedging positions that make use of a

centralized hedging facility.\1096\ Such a result would inappropriately

discourage the use of centralized hedging and treasury entities.

---------------------------------------------------------------------------

\1093\ See CEA section 2(h)(7)(D); Exchange Act section

3C(g)(4).

\1094\ See CFTC Regulation Sec. 1.3(mmm)(2); Exchange Act rule

3a67-6(b).

\1095\ Consistent with the general inter-affiliate exceptions

from the dealer and major participant definitions, see parts II.C

and IV.G, for purposes of these rules, the counterparties are

majority-owned affiliates if one party directly or indirectly holds

a majority ownership interest in the other, or if a third party

directly or indirectly holds a majority interest in both, based on

holding a majority of the equity securities of an entity, or the

right to receive upon dissolution or the contribution of a majority

of the capital of a partnership. See CFTC Regulation Sec.

1.3(mmm)(1); Exchange Act rule 3a71-6(b)(2).

\1096\ We also note that this result is parallel to the Title

VII end-user exception from mandatory clearing, which extends to

hedging activities of financial entities on behalf of non-financial

affiliates. See CEA section 2(h)(7)(D); Exchange Act section

3C(g)(4).

---------------------------------------------------------------------------

While the Commissions also have considered the views of commenters

that the ``financial entity'' definition should exclude certain other

types of entities--such as employee benefit plans, and cooperatives--

the final rules do not provide any such exclusions. As a general

matter, the Commissions believe that the ``financial entity''

definition should be the same for purposes of the major participant

[[Page 30686]]

definition as it is for purposes of the end-user exception from

mandatory clearing.\1097\

---------------------------------------------------------------------------

\1097\ Similarly, the Commissions in general are not adopting

categorical requests for exclusions from the major participant

definitions. See part IV.J, infra.

---------------------------------------------------------------------------

We also have considered the views of some commenters that

subsidiaries of bank holding companies, financial holding companies or

systemically important financial institutions should be considered to

be ``subject to capital requirements established by an appropriate

Federal banking agency,'' and hence not subject to the third statutory

major participant test. We nonetheless interpret the term ``subject to

capital requirements established by an appropriate Federal banking

agency'' to specifically apply to persons for whom a Federal banking

agency directly sets capital requirements. We do not believe that the

term should be interpreted to apply to other persons by virtue of their

being part of a holding company that is subject to those capital

requirements, or otherwise being affiliated with persons subject to

those capital requirements, because we do not believe that the mere

fact of that relationship is sufficient to control or mitigate the

credit risk that those persons pose to their counterparties.

b. ``Highly Leveraged''

i. Leverage Ratio Level

After considering commenters' views, the Commissions are adopting

final rules that define ``highly leveraged'' to generally mean a ratio

of liabilities to equity in excess of 12 to 1.\1098\ Our adoption of

this 12 to 1 standard, rather than the proposed 8 to 1 or 15 to 1

alternatives, takes into account commenters' views on the alternatives,

as well as one commenter's support for a 12 to 1 ratio.\1099\

---------------------------------------------------------------------------

\1098\ See CFTC Regulation Sec. 1.3(mmm)(2); Exchange Act rule

3a67-7(a). The final rules defining ``highly leveraged'' have been

renumbered from the proposal for the sake of clarity.

\1099\ See note 1082, supra, and accompanying text.

---------------------------------------------------------------------------

In general, we believe that the structure of the third statutory

major participant test--which, unlike the first statutory test, does

not permit the exclusion of certain hedging positions--reasonably may

be interpreted as reflecting the determination that: (a) higher

leverage indicates that an entity poses a heightened risk of being

unable to meet its obligations; and (b) such entities should not be

permitted to exclude hedging positions from the ``substantial

position'' analysis in light of the counterparty risks those positions

pose (even recognizing that these may be lower than counterparty risks

posed by comparable non-hedging positions).

Commenters who addressed the proposed leverage ratio raised diverse

points of view in support of the 8 to 1 and 15 to 1 alternatives, or

other standards. A number of those commenters, however, appeared to

focus on the outcome of particular leverage ratios--i.e., that a lower

leverage ratio likely would lead to more major participants, and that a

higher leverage ratio likely would lead to fewer major participants--

and to base their conclusions on their views of that outcome. In

general, the comments did not reflect an attempt to identify typical

leverage ratios for financial entities, or to address the link between

leverage and risk.

Some commenters specifically supported the use of a 15 to 1

leverage ratio in light of Title I's use of that ratio.\1100\ While

considering this perspective, we believe it also is appropriate to

consider the different purposes for which leverage is addressed in the

Title I and major participant contexts. The 15 to 1 leverage provision

in Title I reflects a maximum allowable threshold of leverage for

certain bank holding companies and nonbank financial companies when a

determination has been made that such entities pose a ``grave threat to

the financial stability of the United States'' and that the imposition

of this limitation is necessary to mitigate the risks posed by such

entities--in essence serving as a hard leverage cap for certain

entities that have been deemed risky to the U.S. financial

system.\1101\ In contrast, leverage serves a type of gatekeeper

function in the major participant definitions by identifying the amount

of leverage that will require a non-bank financial entity to engage in

the ``substantial position'' analysis without excluding hedging

positions, rather than seeking to limit the maximum leverage available

to those entities. Just as concepts of ``maximum leverage'' are

distinct from concepts of ``high leverage,'' the use of a 15 to 1

maximum leverage ratio in Title I does not mandate the conclusion that

the same 15 to 1 ratio must be used for interpreting the meaning of

``highly leveraged'' in the major participant definitions.\1102\

---------------------------------------------------------------------------

\1100\ See, e.g., letters from Amex and CDEU.

\1101\ See Dodd-Frank Act section 165(j)(1).

\1102\ We also note that the use of the 15 to 1 ratio of Title I

in this context could lead to potentially incongruous results. In

particular, if the Commissions were to use the 15 to 1 leverage

ratio for the ``highly leveraged'' definition, then an entity that

is deemed to be such a threat to the United States financial system

that its leverage has been capped pursuant to Title I also would

effectively be excepted from the third statutory test of the major

participant definitions due to that cap. The 12 to 1 leverage ratio

that we are adopting today does not give rise to the same result and

therefore does not present the same question of interpretation as to

whether this result would be appropriate.

---------------------------------------------------------------------------

In considering the definition of the term ``highly leveraged''

based on the reasoning outlined above, we also are mindful that, as the

Proposing Release noted,\1103\ broker-dealer capital regulations

include special provisions that apply when a broker-dealer's leverage

exceeds 12 to 1.\1104\ While we recognize that these capital

regulations have limitations as tools for defining ``highly leveraged''

for purposes of the major participant definitions due to differences in

how leverage would be calculated,\1105\ we also believe that these

regulations are informative regarding the use of leverage in the major

participant context given that they highlight an existing link between

increased regulatory oversight and the amount of leverage an entity

maintains.

---------------------------------------------------------------------------

\1103\ See Proposing Release, 75 FR at 80199 n.152.

\1104\ Exchange Act rule 15c3-1 provides that a broker-dealer

may determine its required minimum net capital, among other ways, by

applying a financial ratio that provides that its aggregate

indebtedness shall not exceed 1500 percent of its net capital (i.e.,

a 15 to 1 aggregate indebtedness to net capital ratio). In addition,

Exchange Act rule 17a-11 further requires that broker-dealers that

use such method to establish their required minimum net capital must

provide notice to regulators if their aggregate indebtedness exceeds

1200 percent of their net capital (i.e., a 12 to 1 aggregate

indebtedness to net capital ratio).

\1105\ The measure of aggregate indebtedness in rule 15c3-1

excludes certain secured liabilities, and the measure of net capital

excludes certain illiquid assets but includes certain subordinated

debt. As a result, the ratios discussed above would not necessarily

be equivalent to 15:1 or 12:1 ratios when converted to a balance

sheet ratio of liabilities to equity.

---------------------------------------------------------------------------

In light of the reasons noted above for using a leverage ratio

below 15 to 1, commenter concerns that a ratio of 8 to 1 would be too

low, one commenter's suggestion of a 12 to 1 leverage ratio, and

leverage tests found in broker-dealer capital regulations, the

Commissions have determined that a 12 to 1 leverage ratio reflects an

appropriate basis for identifying ``highly leveraged'' financial

entities. In making this determination we recognize that other

approaches also may be reasonable (e.g., lower thresholds based on the

analysis of the leverage of certain financial entities also may be

reasonable, as may higher thresholds based on Title I and on other

aspects of broker-dealer capital rules). We also recognize, however,

that the need to implement the major participant definitions requires

that we draw a line. In our view, a 12 to 1 ratio reflects a

[[Page 30687]]

reasonable location for this line that is appropriate for purposes of

the third major participant test, and that reasonably accounts for

commenter concerns and the other considerations discussed above.

ii. Leverage Ratio Calculation

Consistent with the proposal, the final rules defining ``highly

leveraged'' generally measure leverage as a ratio of a person's

liabilities to equity, as determined in accordance with GAAP.\1106\

Also, consistent with the proposal, these leverage ratios should be

calculated as of the close of business on the last business day of the

applicable fiscal quarter, as we do not believe there is any relevant

difference among financial entities that would require timing

variations.

---------------------------------------------------------------------------

\1106\ See CFTC Regulation Sec. 1.3(mmm)(2); Exchange Act rule

3a67-7(b). The accounting standard setters are currently working on

a number of projects that may impact how leverage would be

calculated using GAAP. The Commissions will review and potentially

adjust their rules in the future to reflect changes in GAAP.

---------------------------------------------------------------------------

In general, moreover, the Commissions believe that all types of

financial entities should be subject to the same methods of measuring

leverage, to facilitate the even application of the leverage test. At

the same time, we are mindful of the significance of commenter concerns

that calculating leverage as a ratio of liabilities to equity

consistent with GAAP would lead to inappropriate results for certain

types of financial instruments or financial entities.

We believe that these concerns are significant enough to warrant

one modification of the proposed approach to measuring leverage. In

particular, the final rules provide that certain employee benefit plans

may: (i) Exclude obligations to pay benefits to plan participants from

their measure of liabilities for purposes of the leverage calculation;

and (ii) substitute the total value of plan assets for equity for

purposes of the leverage calculation.\1107\ We believe that this change

will allow the measure of leverage to more appropriately reflect the

risk that those entities pose.

---------------------------------------------------------------------------

\1107\ See CFTC Regulation Sec. 1.3(mmm)(2)(ii); Exchange Act

rule 3a67-7(b). These provisions specifically apply to employee

benefit plans as defined by paragraph (3) and (32) of section 3 of

ERISA, consistent with the ERISA exclusion from the first statutory

major participant test.

---------------------------------------------------------------------------

Otherwise, we do not believe that it would be appropriate to depart

from GAAP measures of equity and liabilities for purposes of

identifying highly leveraged entities.\1108\

---------------------------------------------------------------------------

\1108\ Although commenters raised issues with regard to the

application of leverage ratios to insurers, see, e.g., letter from

FSR I, we do not believe that it would be appropriate to create a

special leverage test for insurers. We note that insurers that are

publicly traded companies already file financial statements

consistent with GAAP. Also, smaller insurers that do not file GAAP-

based financial statements would be able to take advantage of the

safe harbor from the major participant calculations. See part IV.M,

infra.

---------------------------------------------------------------------------

G. Application to Inter-Affiliate Swaps and Security-Based Swaps

1. Proposed Approach and Commenters' Views

In the Proposing Release, we stated that the major participant

analysis should consider the economic reality of swaps and security-

based swaps between affiliates, and preliminarily concluded that swaps

or security-based swaps among wholly owned affiliates ``may not pose

the exceptional risks to the U.S. financial system that are the basis

for the major participant definitions.''\1109\

---------------------------------------------------------------------------

\1109\ See Proposing Release, 75 FR at 80202.

---------------------------------------------------------------------------

A number of commenters concurred that swaps among affiliates should

be excluded from the major participant analysis.\1110\ At the same

time, no commenters expressed support for the Proposing Release's

suggestion that this interpretation be limited to transactions among

wholly owned subsidiaries. Instead, several commenters expressed the

view that the swaps or security-based swaps should not be counted for

purposes of the major participant analysis when the counterparties are

under common control,\1111\ or otherwise are affiliates.\1112\ One

commenter suggested that the analysis exclude swaps or security-based

swaps between entities that are under common control and whose

financial statements are consolidated.\1113\

---------------------------------------------------------------------------

\1110\ See, e.g., letters from COPE I, FSR I and Encana

Marketing (USA) Inc. dated February 22, 2011 (``Encana I'').

Some commenters explained the widespread use of central hedging

desks to allocate risk within affiliate groups or to gather risk

from within a group and lay off that risk on the market. See, e.g.,

letters from CDEU, EEI/EPSA, Encana I and FSR I. Also, some

commenters noted that including these inter-affiliate transactions

within the major participant analysis would result in many cases in

double-counting of an entity's swap or security-based swap activity.

See letters from CDEU and FSR I.

\1111\ See letter from Amex and CDEU. One commenter specifically

suggested that we adopt the definition of ``control'' found in the

Bank Holding Company Act. See joint letter from The Bank of Tokyo-

Mitsubishi UFJ, Ltd., Mizuho Corporate Bank, Ltd. and Sumitomo

Mitsui Banking Corporation.

\1112\ See, e.g., letters from COPE I, EEI/EPSA, FSR I, Encana I

and Utility Group.

\1113\ See joint letter from ABA Securities Association, ACLI,

FSR, FIA, Institute of International Bankers, ISDA and SIFMA.

---------------------------------------------------------------------------

2. Final Rule

After considering commenters' views, we have concluded that the

major participant definitions should not encompass a person's swaps or

security-based swaps for which the counterparty is a majority-owned

affiliate. As noted in our discussion of inter-affiliate activities in

the context of the dealer definitions, market participants may enter

into such inter-affiliate swaps or security-based swaps for a variety

of purposes. When swaps and security-based swaps are entered into to

allocate risk within a corporate group and do not pose a high

likelihood of risk to the broader market--as we believe would be the

case with majority ownership--we do not believe that their swaps and

security-based swaps raise the systemic risk and other concerns that

major participant regulation is intended to address. For this reason,

we do not believe that this interpretation needs to be limited to swaps

or security-based swaps among wholly owned affiliates, as the Proposing

Release had indicated.

Accordingly, the final rules provide that a person may exclude

particular swaps or security-based swaps from the analysis of whether

the person is a major participant, so long as the counterparties to

those swaps or security-based swaps are majority-owned

affiliates.\1114\

---------------------------------------------------------------------------

\1114\ See CFTC Regulation Sec. 1.3(hhh)(4); Exchange Act rule

3a67-3(e). A person's market-facing swap or security-based swap

positions, including those taken to lay off risk assumed from a

majority-owned affiliate, must still be included in the person's

substantial position and counterparty exposure calculations.

For the purposes of this rule, and consistent with the general

inter-affiliate exception from the dealer definitions, see part

II.C, supra, counterparties are majority-owned affiliates if one

party directly or indirectly owns a majority interest in the other,

or if a third party directly or indirectly owns a majority interest

in both, based on 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.

---------------------------------------------------------------------------

In taking this approach, we have also considered alternatives

suggested by commenters. For example, while one commenter suggested

that we allow the exclusion of all swaps or security-based swaps

between entities under common control, we believe that such an approach

would be overly inclusive for the purpose of identifying transactions

that should be excluded from the major participant analysis, given that

common control by itself does not ensure that two entities' economic

interests are sufficiently aligned.\1115\ Also, one commenter suggested

that the inter-affiliate exclusion should apply to swaps and security-

based swaps between affiliates whose financial statements are

consolidated, but, as we

[[Page 30688]]

addressed in the context of the dealer definitions, we do not believe

that the scope of this exclusion should be exposed to the risk of

future changes in accounting standards.\1116\

---------------------------------------------------------------------------

\1115\ See part II.C.2, supra.

\1116\ See text accompanying note 350, supra.

---------------------------------------------------------------------------

H. Application to Positions of Affiliated Entities and to Guarantees

1. Proposed Approach

The Proposing Release expressed the preliminary view that when a

parent is the majority owner of a subsidiary entity, the subsidiary's

swap or security-based swap positions may be aggregated at the parent

for purposes of the major participant analysis, on the grounds that the

parent effectively is the beneficiary of the transaction. At the same

time, the Proposing Release acknowledged that there could remain

questions as to whether the requirements applicable to major

participants--such as capital, margin and business conduct

requirements--should be placed upon the parent or the subsidiary.\1117\

---------------------------------------------------------------------------

\1117\ The Proposing Release further recognized that it may be

appropriate at times to place the requirements upon the subsidiary

to the extent the subsidiary is acting on behalf of the parent. See

Proposing Release, 75 FR at 80202.

---------------------------------------------------------------------------

The Proposing Release solicited comment on a number of aspects of

these issues, including whether attribution would be appropriate when

there is less than majority ownership, or when a parent provides

guarantees on behalf of its subsidiaries. The Proposing Release also

solicited comment with regard to implementation issues.\1118\

---------------------------------------------------------------------------

\1118\ See id.

---------------------------------------------------------------------------

2. Commenters' Views

A number of commenters expressed the view that the Commissions

should not aggregate the positions of affiliates to the parent, arguing

that legal separation should be respected unless there is some evidence

that separate affiliates are being used to evade regulation.\1119\

Other commenters took the view that aggregation of affiliates'

positions may be appropriate in some circumstances, such as when

aggregation would accurately reflect the structure of a corporate group

or its participation in the derivatives market.\1120\ One commenter

recommended that if the Commissions choose to require the aggregation

of affiliate positions for purposes of the major participant test, the

Commissions also should provide a mechanism for entities to receive

``disaggregation'' relief upon a showing that the affiliates are acting

autonomously.\1121\

---------------------------------------------------------------------------

\1119\ See letters from FSR I, ISDA, MetLife and Newedge.

Certain of those commenters also warned of problems that could arise

if the positions of international affiliates were aggregated, due to

conflicting regulations potentially applicable to such entities. See

letters from ISDA I, MetLife and Newedge. The Commissions are

addressing issues related to the application of the major

participant definitions to non-U.S. persons in separate releases.

\1120\ See letters from CDEU (suggesting that control should be

interpreted narrowly for purposes of the major participant test such

that affiliated positions would only be aggregated if there is whole

ownership or consolidation for accounting purposes, and exercise of

actual control in terms of ownership and management) and ACLI

(suggesting flexibility such that an entity with independent credit

and no guarantee or credit support from a parent could be treated

separately, but a corporate group could consolidate its affiliates'

positions if that would accurately reflect its participation in the

derivatives market).

\1121\ See letter from Newedge.

---------------------------------------------------------------------------

Some commenters argued that positions should not be consolidated

for purposes of the major participant analysis even when a parent

guarantees the obligations of a subsidiary.\1122\ Other commenters,

however, expressed less opposition to aggregation in the presence of a

guarantee or credit support.\1123\

---------------------------------------------------------------------------

\1122\ See letters from APG (stating that the aggregation of

inter-affiliate guaranteed transactions would raise costs without

providing a corresponding benefit to the financial system, and that

principal obligors and guarantors pose separate credit risks, which

are already priced into the positions, and that guarantees are not

traditionally regulated as swaps), CDEU (objecting to attributing

the positions of an end-user affiliate that relies on a parent for

credit support, primarily out of concern that an end-user that might

otherwise avail itself of the end-user clearing exception might be

forced to clear its transactions if they were attributed to the

major participant parent), ISDA I and Twelve Firms (stating that the

statutory major participant definitions do not indicate that they

encompass contingent credit support arrangements, and that credit

exposures of subsidiaries already will be addressed through

regulation of the subsidiary).

\1123\ See letters from FSR I (suggesting that there may be some

situations in which the positions of different entities in a

corporate group should be aggregated, such as when ``a parent entity

guarantees the obligations of its subsidiaries that are engaging in

swaps'') and MetLife (stating that ``it is not appropriate to

require aggregation of subsidiaries' swaps at the parent level

unless the parent is providing a guarantee or credit support for the

subsidiaries' obligations''); see also letter from ACLI (stating

that the positions of entities that do not have a guarantee or

credit support from a parent are entitled to an individualized

determination of their status under the major participant test).

---------------------------------------------------------------------------

Commenters also addressed the application of these principles to

particular types of entities. Some commenters took the view that

positions guaranteed by financial guarantors should not be attributed

to those entities for purposes of the major participant analysis.\1124\

Other commenters stated that the positions of a special purpose vehicle

should not be aggregated with its sponsor where there is no recourse to

the sponsor for the vehicle's obligations.\1125\ One commenter

requested clarification that positions of joint ventures would not be

aggregated with those of another entity if the positions are not

consolidated on the other entity's balance sheet.\1126\ Commenters

further took the view that ERISA plans should not be aggregated with

those of plan sponsors for purposes of the major participant tests,

noting that plans and sponsors are separate legal entities, file

separate financial statements, are subject to separate regulatory

schemes, and that plan sponsors are prohibited from providing credit

support or guarantees to ERISA Title I plans.\1127\

---------------------------------------------------------------------------

\1124\ See letters from AFGI (arguing against attribution on the

grounds that the guarantors are typically not exposed to a

fluctuating termination value of interest rate swaps for these types

of transactions due to the fact that they do not guarantee that

amount, but rather only guarantee continued payments of these

policies, and also that they are subject to the standard

underwriting process and thus are subject to comprehensive

regulation) and joint letter from MBIA Inc., MBIA Insurance Corp.

and National Public Finance Guarantee Corp. (``MBIA'') (arguing

against attribution on the grounds that the economic exposure to the

financial guarantor is the equivalent of having underwritten a fixed

rate bond issued by the particular municipal entity, and such

exposures are subject to the normal underwriting process and

significant risk management and regulatory oversight).

\1125\ See letters from American Securitization Forum

(suggesting that aggregation is not appropriate when the risk is

contained within the special purpose vehicle, and noting that

special purpose vehicles often bear the entire economic risk of a

security-based swap transaction and are bankruptcy remote, so the

failure of a special purpose vehicle to meet its obligations would

not have a rippling effect onto its sponsor) and FSR I (stating that

the major participant determination should focus on a special

purpose entity itself, and not its sponsor or transferor, in

circumstances where securitization vehicles have been consolidated

with sponsors or transferors for financial accounting purposes but a

counterparty would have to conduct a separate credit analysis on the

special purpose e