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

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17 CFR Part 1

Securities and Exchange Commission

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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]]

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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.

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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.
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\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.
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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\
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\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.
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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.
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\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.
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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\
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\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).
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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).
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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\
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\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).
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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.
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\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).
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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\
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\19\ See CFTC Regulation Sec. 1.3(ggg); Exchange Act rule 3a71-
1(a), (b).
\20\ Proposing Release, 75 FR at 80176.
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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\
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\21\ Id.
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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\
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\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.
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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\
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\24\ See id. at 80176-77.
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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\
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\25\ See id. at 80177.
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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\
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\26\ See id.
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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\
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\27\ See id. at 80183-84.
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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\
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\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).
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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.
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\29\ 16 U.S.C. 824(f).
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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\
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\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.
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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\
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\33\ See id. at 80178.
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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\
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\34\ See id.
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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\
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\35\ See id.
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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\
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\36\ See id. at 80178-79.
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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\
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\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.
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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.
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\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.
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\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\
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\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.

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[[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.
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\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\
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\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\
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\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\
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\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.
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\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\
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\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.
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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.
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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\
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\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.
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\241\ See part II.B.2.d.iii, supra.
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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\
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\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\
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\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.
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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\
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\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.
---------------------------------------------------------------------------

[[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\
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\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)).

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[[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\
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\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.
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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.
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\453\ CFTC Regulation Sec. 1.3(ggg)(4)(i).
\454\ See letters from AFR and Better Markets I.
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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.
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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.
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\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.
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\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.
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\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\
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\463\ See CFTC Regulation Sec. 1.3(ggg)(4)(vi).
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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.
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\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\
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\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.
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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\
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\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.
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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\
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\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\
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\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\
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\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.

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[[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\
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\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.
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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\
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\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.
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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.
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\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\
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\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\
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\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\
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\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.

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[[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.
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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\
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\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.
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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\
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\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\
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\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\
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\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.
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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\
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\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.
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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\
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\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\
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\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.

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[[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\
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\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\
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\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.
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\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.
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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\
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\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\
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\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.
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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\
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\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).
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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\
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\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).
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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\
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\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.
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\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\
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\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.
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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\
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\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.

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[[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\
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\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\
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\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.

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[[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.
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\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\
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\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.
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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.
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\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\
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\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.
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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\
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\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.

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[[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\
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\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.
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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\
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\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\
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\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\
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\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.

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[[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.
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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\
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\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\
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\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.
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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).
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Commenters also suggested a variety of methods and adjustments for
calculating leverage ratios.\1083\
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\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).
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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\
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\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).
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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\
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\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.
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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.
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\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).
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The Commissions are aware, however, that the major participant
definitions differ from the mandatory clearing requireme