Washington, D.C., Dec. 3, 2010 — The Securities and Exchange Commission today voted unanimously to propose joint rules with the Commodity Futures Trading Commission (CFTC) that would further define a series of terms related to the security-based swaps market, including “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant.”
The rules seek to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which among other things established a comprehensive framework for regulating the over-the counter swaps market.
SEC Chairman Mary L. Schapiro said, “Today’s proposals lay out objective criteria, but they are just a first step, as we seek public comment to help us appropriately address the market impacts and potential risks posed by these entities.”
The SEC is seeking public comment on the proposed rules for a period of 60 days following their publication in the Federal Register.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act established a comprehensive framework for regulating the over-the-counter swaps markets. In particular, the Dodd-Frank Act divides regulatory authority over swaps between the SEC and the Commodity Futures Trading Commission (CFTC).
Among other things, Title VII of the Act authorizes the SEC to provide for the registration and regulation of security-based swap dealers and major security-based swap participants. Dealers and major participants would be subject to several statutory requirements, including those related to capital, margin and business conduct.
Title VII further provides that the SEC and the CFTC, in consultation with the Board of Governors of the Federal Reserve System, must work jointly to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant.”
The joint proposal of the SEC and the CFTC in part would add new rules under the Securities Exchange Act of 1934 in connection with the definitions of “security-based swap dealer” and “major security-based swap participant.”
The Dodd-Frank Act defines “security-based swap dealers” as persons who:
(i) hold themselves out as a dealer in security-based swaps;
(ii) make a market in security-based swaps;
(iii) regularly enter into security-based swaps with counterparties as an ordinary course of business for their own account; or
(iv) engage in activity causing themselves to be commonly known in the trade as a dealer or market maker in security-based swaps.
The statute also specifies, however, that the term “security-based swap dealer” does not include a person who enters into security-based swaps for their own account “not as a part of a regular business.”
The Commission intends to interpret this definition in a manner that builds on the dealer-trader distinction that already is used to identify dealing activity involving other types of securities, while taking into account the special attributes of security-based swap markets.
The Dodd-Frank Act directs the Commission to exempt a person (who otherwise would be deemed a “security-based swap dealer”) who “engages in a de minimis quantity of security-based swap dealing. . . ” It also directs the Commission to establish factors for determining when someone should be exempt. The proposed rule would require that a person meet all of the following conditions to be exempt from the dealer definition on the basis of de minimis activity:
There are three parts to the definition of “major security-based swap participant” under the Dodd-Frank Act. A person who satisfies any one of them is a major security-based swap participant:
The statutory definition excludes security-based swap dealers.
The Dodd-Frank Act provides that the Commission should define “substantial position” at a threshold it deems to be “prudent for the effective monitoring, management or oversight of entities that are systemically important or can significantly impact the financial system of the United States.”
The Commission proposes to define “substantial position” using objective numerical criteria which promote the predictable application and enforcement of the requirements governing major participants. The Commission proposes tests that would account for both current uncollateralized exposure and potential future exposure. A position that satisfies either test would be a “substantial position.” The first “substantial position” test noted above would exclude positions hedging commercial risk and employee benefit plan positions from the substantial position analysis.
The proposed tests would apply to a person’s security-based swap positions in each of two major security-based swap categories: security-based credit derivatives (any security-based swap based on instruments of indebtedness, including loans, or on credit events relating to one or more issuers or securities), and other security-based swaps.
As noted above, the first test of the major participant definition excludes positions held for “hedging or mitigating commercial risk” from the substantial position analysis.
The proposed definition of “hedging or mitigating commercial risk” would encompass any security-based swap position that is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from a potential change in the value of: (i) assets that a person owns, produces, manufactures, processes, or merchandises, (ii) liabilities that a person incurs, or (iii) services that a person provides or purchases
The proposed definition of hedging or mitigating commercial risk would not encompass any security-based swap position that is held for a purpose that is in the nature of speculation or trading.
The Commission proposes to define substantial counterparty exposure using a calculation method that is the same as the method used to calculate substantial position. However, the definition of substantial counterparty exposure is not limited to the major categories of security-based swaps, and it does not exclude hedging or employee benefit plan positions. Rather it encompasses all of a person’s security-based swap positions.
The proposed thresholds for substantial counterparty exposure are a current uncollateralized exposure of $2 billion, or a sum of current uncollateralized exposure and potential future exposure of $4 billion, across the entirety of a person’s security-based swap positions.
The third aspect of the statutory definition of major security-based swap participant addresses any “financial entity,” other than one subject to capital requirements established by an appropriate Federal banking agency, that is “highly leveraged” relative to the amount of capital it holds, and that maintains a substantial position in a major category of security-based swaps. For this part of the definition, the Commission proposes to use the same definition of substantial position described above, without excluding hedging or employee benefit plan positions.
For this aspect of the definition, the Commission proposes to use the definition of “financial entity” that is based on the definition of that term in the Dodd-Frank Act provision for an end-user exception from mandatory clearing in Exchange Act Section 3C(g)(3). For the definition of “highly leveraged,” the Commission proposes two possible definitions – either a ratio of total liabilities to equity, as determined in accordance with U.S. GAAP, of 8 to 1, or a ratio of 15 to 1 measured in the same way.
Under the Dodd-Frank Act, the Commission has been engaging in significant rulemaking:
The proposal seeks public comment and data on a broad range of issues relating to the proposed rules, including the costs and benefits associated with the proposal. After careful review of comments, the SEC and the CFTC will consider whether to adopt the proposed rules or modify them.