Definitions

Definition of “Swap Dealer”

The definition of “swap dealer” (“SD”) may be the most important definition under Title VII of the Dodd-Frank Act. It will largely determine which market participants are pervasively regulated. How the Commission defines the term will fundamentally alter markets for swaps referencing energy and agriculture commodities as market participants will incur costs and/or substantially change their trading practices and businesses to adjust to the SD definition. Once such costs are incurred or changes made, they cannot be readily unwound. Thus, the Commission should carefully fashion guidance to clarify the SD definition well before it applies such term to market participants.

(I) The Final Rule Should Provide Guidance on the Phrase “Makes a Market in Swaps”.

• The Final Rule should contain affirmative, clear guidance regarding what constitutes “making a market” in swaps set forth in proposed CFTC Rule 1.3(1)(ii). The proposed rule provided no affirmative guidance at all.

• “Making a market” in swaps should require specific intent to do so.

• If the Commission seeks to adopt a test where “liquidity providing” market activities may constitute “making a market,” it must:

  • o define what conduct would be covered by this test in clear guidance and the levels of activity that would constitute “liquidity providing,” and

    o issue a notice seeking pubic comment.

(II) The Final Rule Should Provide Guidance on the Phrase “Facilitating or Accommodating Demand”.

• The Entity Definitions NOPR properly ties together prong (iii) of the SD definition1 and the general exception.2 The proposal suggests that the remaining conduct, which is defined as swap dealing, involves transactions for which a party facilitates or accommodates demand for swaps from third parties. However, the interpretive guidance specifically addressing “facilitating or accommodating” third-party access to swap markets is too vague for practical application.

• Only transactions for which an entity solicits transactions for the purpose of accommodating or facilitating a customer’s access to over-the-counter bilateral swap markets should be considered swap dealing transactions.

• Examples of what is NOT “facilitating or accommodating” access to swap markets:

  • o An entity should not be deemed to be “facilitating or accommodating” access to markets solely because it has bids and offers in the market (or hits bids or lifts offers from the market) in support of its own business objectives in commodity markets.

    o Integrated financial and physical transactions that involve swaps should not be swap dealing activity.

    o Arm’s-length swap transactions between two physical market counterparties should not constitute swap dealing. Several practical issues are raised by treating such activity as swap dealing, including, but not limited to:

    o Transactions executed on a designated contract market (“DCM”) or swap execution facility (“SEF’), as well as voice broker initiated transactions, should not constitute swap dealing transactions.

    • • Staff have commented frequently that the provision of risk management services in connection with physical commodity transactions could be swap dealing.

      • This concept is not addressed in the Entity Definitions NOPR.

      • Which party would be deemed to have accommodated the other?

      • Where terms are proposed, counter-proposed and negotiated, how would a party determine whether it was the “accommodator” or the “accommodated”?

(III) The Final Rule Should Include Guidance Based on a Dealer/Market-User Distinction Appropriate for the Commodity Markets.

• Notwithstanding the Entity Definition NOPR’s rejection of interpretive guidance based on the SEC’s historical “dealer/trader” distinction, such guidance is appropriate and workable if properly focused and tailored to reflect the unique characteristics of commodity derivatives markets.

• The Commission should adopt the SEC’s two-step analysis for prong (iii) of the SD definition. Specifically, the SEC asks:

• The criteria below may be used as general guidance when evaluating the facts and circumstances surrounding an entity’s role in swap markets for answering the second step of this analysis:

  • o “Is one buying and selling securities for its own account,” and

    o “Is one engaged in the business” of that activity “as part of a regular business?”

    o The counterparty to the swap is a “customer” if it relies on the advice or expertise of the initial counterparty in determining whether or not to enter the swap;

    o The party solicits financial swap transactions from customers;

    o The party engages in swap transactions for the benefit of third-parties, rather than solely for the purpose of its own market objectives;

    o The party is solely a financial market participant;

    o The transaction is not ancillary to the party’s primary underlying physical market operations;

    o The party publishes generally available quotations for a range of swap transactions other than on a SEF or DCM platform; or

    o The party otherwise holds itself out as a dealer or market-maker.

(IV) The De Minimis Exemption - and the Entire SD Definition - Should Focus Only on Swaps with “Customers”.

• To ensure consistency with the Congressional intent underlying the de minimis exemption, the exemption must clearly take into consideration “transactions with or on behalf of…customers”3

• Only transactions for which an entity (i) holds itself out as a dealer or (ii) solicits transactions for the purpose of accommodating or facilitating a customer’s access to over-the-counter bilateral swap markets should be considered swap dealing transactions.

(V) Scope.

  • • A swap dealer with respect to any physical commodity will be deemed a swap dealer, at a minimum, for the entire “other commodity” class. As a result:

    o A market participant that “makes a market in swaps” for one region of the U.S. power market would be a swap dealer for crude oil, gasoline, heating oil, gold and wheat.

    o A market participant that is a “market maker” in swaps in milk would be a swap dealer in natural gas and silver.

    • This approach will result in the overregulation of entities that may be deemed a swap dealer for a particular product(s) or particular swap instrument(s).

(VI) Timing and Implementation of the Definition of Swap Dealer and Regulations Applicable to Swap Dealers Must Be Carefully Considered.

• These timing concerns are highlighted by the Commission’s implementation of the Large Trader Reporting Final Rule.

  • • The issue of overregulation across swaps with different referenced commodities (identified in Section V, above) is exacerbated by timing issues.

    • Commercial market participants that were not viewed as dealers in swap markets prior to the Dodd-Frank Act will need extensive time to:

    o Analyze each product line in their business to determine which, if any, involve swap dealing activities;

    o Determine whether to:

    o Implement the steps necessary to effectuate the determination made in ii., above, including:

    o Avoid sunk costs. Once an entity decides to leave the market or modify its line of business in order to be in compliance with the Final Rule, it will not easily, if at all, be able to return to the market or resume its prior line of business if it is later determined that such entity should not have been classified as a swap dealer.

    • • exit, or modify its activities within, that line of business;

      • reduce that line of business to below a de minimis level;

      • move that line of business to a single-purpose legal entity so as to limit the impact of swap dealing regulatory obligations.

      • terminating contracts;

      • making personnel decisions;

      • incorporating new legal entities; and

      • novating agreements and transferring positions.

    o Under the Large Trader Reporting Final Rule, a non-clearing member of a DCM or SEF that must register as a swap dealer is required to implement a large trader reporting system on the date that the swap dealer definition becomes effective. New potential swap dealers need to use that period to perform the analysis described in subsection b., above, not build systems that may be unnecessary or prepare petitions for extensions of time that may or may not be granted.

    o If similar compliance rules take effect upon the effective date of the SD definition, then market participants may have numerous rules with which to comply in a short time frame, even if such rules were issued over time, at the very time that such entities are engaging in the analysis outlined in “b” above.

1 Proposed CFTC Rule 1.3(ppp)(1)(iii).

2 Proposed CFTC Rule 1.3(ppp)(2).

3 New CEA Section 1a(49)(D).