Federal Register, Volume 77 Issue 139 (Thursday, July 19, 2012)[Federal Register Volume 77, Number 139 (Thursday, July 19, 2012)]
[Rules and Regulations]
[Pages 42559-42591]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-17291]
[[Page 42559]]
Vol. 77
Thursday,
No. 139
July 19, 2012
Part II
Commodity Futures Trading Commission
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17 CFR Part 39
End-User Exception to the Clearing Requirement for Swaps; Final Rule
Federal Register / Vol. 77 , No. 139 / Thursday, July 19, 2012 /
Rules and Regulations
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 39
RIN 3038-AD10
End-User Exception to the Clearing Requirement for Swaps
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is adopting final regulations to implement certain provisions of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act). These regulations govern the exception to the clearing
requirement available to swap counterparties meeting certain conditions
under the Commodity Exchange Act (CEA), as amended by the Dodd-Frank
Act.
DATES: Effective September 17, 2012.
FOR FURTHER INFORMATION CONTACT: Erik F. Remmler, Associate Director,
202-418-7630, [email protected]; or Eileen A. Donovan, Associate
Director, 202-418-5096, [email protected], Division of Clearing and
Risk, Commodity Futures Trading Commission, Three Lafayette Centre,
1155 21st Street NW., Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
I. Background
The CEA, as amended by Title VII of the Dodd-Frank Act, establishes
a comprehensive new regulatory framework for swaps. The CEA requires a
swap: (1) To be cleared through a derivatives clearing organization
(DCO) if the Commission has determined that the swap is required to be
cleared, unless an exception to the clearing requirement applies; (2)
to be reported to a swap data repository (SDR) or the Commission; and
(3) if the swap is subject to a clearing requirement, to be executed on
a designated contract market (DCM) or swap execution facility (SEF),
unless no DCM or SEF has made the swap available to trade.
Section 2(h)(1)(A) of the CEA establishes a clearing requirement
for swaps, providing that ``it shall be unlawful for any person to
engage in a swap unless that person submits such swap for clearing to a
[DCO] that is registered under [the CEA] or a [DCO] that is exempt from
registration under [the CEA] if the swap is required to be cleared.''
\1\ However, Section 2(h)(7)(A) of the CEA provides that the clearing
requirement of Section 2(h)(1)(A) shall not apply to a swap if one of
the counterparties to the swap: ``(i) Is not a financial entity; (ii)
is using swaps to hedge or mitigate commercial risk; and (iii) notifies
the Commission, in a manner set forth by the Commission, how it
generally meets its financial obligations associated with entering into
non-cleared swaps'' (referred to hereinafter as the ``end-user
exception'').\2\ The Commission is adopting Sec. 39.6 herein to
implement certain provisions of Section 2(h)(7). Accordingly, any swap
that is required to be cleared by the Commission pursuant to Section
2(h)(2) of the CEA must be submitted to a DCO for clearing by the
parties thereto unless the conditions of Section 2(h)(7)(A) and Sec.
39.6 are satisfied.
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\1\ See Section 2(h)(1)(A) of the CEA, 7 U.S.C. 2(h)(1)(A).
\2\ See Section 2(h)(7)(A) of the CEA, 7 U.S.C. 2(h)(7)(A).
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Congress promulgated the end-user exception in Section 2h(7) of the
CEA to permit non-financial companies to continue using non-cleared
swaps to hedge risks associated with their underlying business, such as
manufacturing, energy exploration, farming, transportation, or other
commercial activities. Additionally, Section 2(h)(7)(F) gives the
Commission the authority to prescribe rules (or interpretations of such
rules) that may be necessary to prevent abuse of the end-user
exception, and Section 2(h)(4)(A) requires the Commission to prescribe
rules as determined by the Commission to be necessary to prevent
evasions of the clearing requirement.\3\
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\3\ 7 U.S.C. 2(h)(7)(F) and 7 U.S.C. 2(h)(4)(A).
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Regulation 39.6 implements Section 2(h)(7) of the CEA by: (1)
Establishing the criteria for determining whether a swap hedges or
mitigates commercial risk for purposes of Section 2(h)(7)(A)(ii); (2)
specifying the information that counterparties must report to satisfy
the notification requirement of Section 2(h)(7)(A)(iii); and (3)
establishing an exemption for small financial institutions pursuant to
Section 2(h)(7)(C)(ii) of the CEA. The rule also requires reporting of
certain information that the Commission will use to monitor compliance
with, and prevent abuse or evasion of, the end-user exception.
On December 23, 2010, the Commission published for public comment a
notice of proposed rulemaking (NPRM) for Sec. 39.6.\4\ The Commission
received approximately 2,000 comment letters, approximately 1,650 of
which were form letters (cited herein as ``Form Letters''), and
Commission staff participated in approximately 30 ex parte meetings and
teleconferences concerning the rulemaking.\5\ The Commission considered
each of these comments in formulating the final regulations, as
discussed below.\6\
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\4\ See 75 FR 80747 (Dec. 23, 2010).
\5\ The comment file for the proposed rulemaking can be found on
the Commission Web site, www.cftc.gov.
\6\ The Commission notes that the Securities and Exchange
Commission has proposed regulations concerning an exception for end-
users from clearing requirements applicable to security-based swaps.
See 75 FR 79992 (Dec. 21, 2010). The Commission has reviewed the
SEC's proposal and consulted with SEC staff regarding the SEC's
proposal and this final rulemaking.
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II. Comments on the Notice of Proposed Rulemaking
A. Scope of the End-User Exception
As proposed, Sec. 39.6(a) would provide that a counterparty to a
swap (an ``electing counterparty'') may elect the end-user exception to
the clearing requirement provided in Section 2(h)(7)(A) of the CEA
(i.e., the end-user exception) if the electing counterparty: (1) Is not
a ``financial entity'' as defined in Section 2(h)(7)(C)(i) of the CEA;
(2) is using the swap to hedge or mitigate commercial risk as defined
in Sec. 39.6(c); and (3) provides or causes to be provided to a SDR
or, if no SDR is available, the Commission, the information specified
in proposed Sec. 39.6(b).
1. General Scope of Regulation 39.6(a)
The Commission received a number of comments regarding the general
scope of Sec. 39.6(a). Commodity Markets Council (CMC) and Riverside
Risk Advisors, LLC (Riverside) recommended that the end-user exception
should be available to a wide variety of entities. According to CMC,
many market participants rely on customized over-the-counter swaps
because they have small volume transactions or there are no
standardized contracts available to hedge their specific commercial
risks. Riverside requested that the Commission allow all potential
counterparties other than swap dealers or major swap participants
(MSPs) to elect the end-user exception.
In contrast, Idaho Petroleum Marketers & Convenience Store
Association (IPM&CSA) stated that the end-user exception should be
narrowly tailored to businesses that produce, refine, process, market,
or consume underlying commodities and to counterparties transacting
with non-financial counterparties. The Form Letters generally agreed
with the scope of the proposed rule's exception from
[[Page 42561]]
clearing for non-financial companies engaging in commercial hedging and
expressed concern with broadening the rule to include financial
institutions or non-commercial hedges.\7\
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\7\ The Form Letters stated:
``The big banks and their allies * * * are calling for
exemptions for a very broad array of companies from the clearing and
margin requirements of the act. Dodd-Frank already contains an
exception for legitimate end-users, such as airlines and farmers,
who are doing commercial hedging as part of their business from
clearing and exchange trading requirements. We must not broaden this
narrow, commonsense exception to include financial and commercial
institutions that want to gamble in the derivatives markets. Doing
so would allow systemically important companies to enter into risky
trades in a market with zero transparency and accountability.''
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In response to the comments from CMC and Riverside seeking a
broader end-user exception, the Commission notes that the exception to
the clearing requirement provided by Section 2(h)(7)(A) is based on the
type of counterparty (e.g., the electing counterparty must not be a
financial entity) and the type of risk hedged or mitigated (commercial
risk). The Commission believes the general scope of the rule provides
an appropriately flexible exception to the clearing requirement for
commercial entities within the limits of these two parameters
established in the CEA. In response to Riverside's other comment, the
Commission notes that Congress specifically required all financial
entities as defined in Section 2(h)(7)(C) (with certain exceptions
specifically identified in that section) to submit for clearing swaps
that are subject to the clearing requirement. Therefore, the Commission
is adopting Sec. 39.6(a) largely as proposed, except for changes to
clarify the rule language and to make it consistent with other
provisions of the rule as finalized.
2. Application of the End-User Exception to Certain Entities
The Commission received a number of specific requests from
commenters that the Commission determine that certain entities, or
types of entities, are able to elect the end-user exception.\8\ The
commenters asked for relief in one of two ways: (i) That the Commission
provide an express exemption from the clearing requirement for such
entity; or (ii) that the Commission determine that the specific entity
in question is not a financial entity and is hedging commercial risk.
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\8\ See, e.g., American Securitization Forum (ASF), American
Public Gas Association (APGA), National Rural Utilities Cooperative
Finance Corp. (CFC), Coalition of Physical Energy Companies (COPE),
Dairy Farmers of America (DFA), EDF Trading North America, LLC (EDF
Trading), Farm Credit Council (FCC), Garkane Energy Cooperative
(Garkane), Government Finance Officers Association (GFOA), Kraft
Foods, Inc. (Kraft), National Association of Regulatory Utility
Commissioners (NARUC), National Council of State Housing Agencies
(NCSHA), Not for Profit Electricity End-Users (NFPEEU), National
Milk Producers Foundation (NMPF), and Pacific Gas and Electric Co.
(PG&E).
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Regulation 39.6(a), as adopted, sets forth the basic conditions
that an entity must satisfy to elect the end-user exception. Except
with respect to foreign governments, foreign central banks,
international financial institutions, and state and local government
entities as discussed below, the Commission is declining to determine
at this time whether certain specific entities, or types of entities,
are exempt from the clearing requirement or would qualify for the end-
user exception based on their specific circumstances.\9\ This release
addresses comments and questions that are generally applicable to the
rule. Any exemptive or interpretive determinations based on the
specific nature or circumstances of a particular entity can better be
addressed on a case-by-case basis, with the benefit of all relevant
facts and circumstances, through the interpretive or exemptive relief
processes available for such purposes under the CEA and the
Commission's regulations.
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\9\ An exemption for small financial institutions from the
definition of ``financial entity,'' which Congress directed the
Commission to consider in Section 2(h)(7)(C)(ii) of the CEA, is
addressed in section II.D hereof.
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3. Definition of ``Financial Entity'' and ``Financial Institution'' for
Purposes of FDICIA
The International Energy Credit Association (IECA) requested that
the Commission clarify the meaning of ``financial entity'' in the
regulation. According to IECA, because of the implications of being
labeled a ``financial entity'' under the Dodd-Frank Act, an entity may
be reluctant to represent that it is a ``financial institution'' for
purposes of the Federal Deposit Insurance Corporation Improvement Act
(FDICIA).\10\ IECA recommended that proposed Sec. 39.6(a) be revised
in part to state that a counterparty may elect the end-user exception
if the electing counterparty (new language emphasized): ``Is not a
`financial entity' as defined in section 2(h)(7)(C)(i) of the Act
(determined without regard to whether such entity believes itself to
be, or in fact constitutes, a `financial institution' within the
meaning of FDICIA).''
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\10\ Public Law 102-242, 105 Stat. 2236 (1991).
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The Commission declines to revise proposed Sec. 39.6(a) as
requested by IECA because ``financial entity'' and ``financial
institution'' are different terms referenced in different statutes.
Interpreting the meaning and use of ``financial institution'' under
FDICIA is within the jurisdiction of the Federal Deposit Insurance
Corporation. Accordingly, the Commission is not inclined to render a
view on the meaning of that term.
4. Status of Foreign Governments, Foreign Central Banks, and
International Financial Institutions as ``Financial Entities''
The Commission received a comment from Milbank, Tweed, Hadley &
McCloy LLP (Milbank) recommending that foreign governments and their
agencies be excluded from the definition of ``financial entity.''
Milbank cited central banks, treasury ministries, export agencies, and
housing finance authorities as examples of agencies of foreign
governments that could be affected. Milbank expressed concern that
these entities might be treated as ``financial entities'' that would
not be permitted to use the end-user exception if, for example, they
are viewed as ``predominately engaged in * * * activities that are
financial in nature, as defined by Section 4(k) of the Bank Holding
Company Act of 1956.'' \11\ In a separate letter, the World Bank
commented that it should not be subject to the clearing requirement
under Section 2(h)(1) of the CEA.
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\11\ 12 U.S.C. 1841 et seq.
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The Commission recognizes that there are important public policy
implications related to the application of the end-user exception, and
the clearing requirement generally, to foreign governments,\12\ foreign
central banks,\13\ and international financial institutions.\14\ The
Commission expects
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that if any of the Federal Government, Federal Reserve Banks, or
international financial institutions of which the United States is a
member were to engage in swap transactions in foreign jurisdictions,
the actions of those entities with respect to those transactions would
not be subject to foreign regulation. However, if foreign governments,
foreign central banks, or international financial institutions were
subjected to regulation by the Commission in connection with their swap
transactions, foreign regulators could treat the Federal Government,
Federal Reserve Banks, or international financial institutions of which
the United States is a member in a similar manner. The Commission notes
that the Federal Reserve Banks and the Federal Government are not
subject to the clearing requirement under the Dodd-Frank Act.
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\12\ For this purpose, the Commission considers that the term
``foreign government'' includes KfW, which is a non-profit, public
sector entity responsible to and owned by the federal and state
authorities in Germany, mandated to serve a public purpose, and
backed by an explicit, full statutory guarantee provided by the
German federal government.
\13\ For this purpose, the Commission considers the Bank for
International Settlements, in which the Federal Reserve and foreign
central banks are members, to be a foreign central bank. See http://www.bis.org/about/orggov.htm.
\14\ For this purpose, the Commission considers the
``international financial institutions'' to be those institutions
defined as such in 22 U.S.C. 262r(c)(2) and the institutions defined
as ``multilateral development banks'' in the Proposal for the
Regulation of the European Parliament and of the Council on OTC
Derivative Transactions, Central Counterparties and Trade
Repositories, Council of the European Union Final Compromise Text,
Article 1(4a(a)) (March 19, 2012). There is overlap between the two
definitions, but together they include the following institutions:
The International Monetary Fund, International Bank for
Reconstruction and Development, European Bank for Reconstruction and
Development, International Development Association, International
Finance Corporation, Multilateral Investment Guarantee Agency,
African Development Bank, African Development Fund, Asian
Development Bank, Inter-American Development Bank, Bank for Economic
Cooperation and Development in the Middle East and North Africa,
Inter-American Investment Corporation, Council of Europe Development
Bank, Nordic Investment Bank, Caribbean Development Bank, European
Investment Bank and European Investment Fund. (The International
Bank for Reconstruction and Development, the International Finance
Corporation and the Multilateral Investment Guarantee Agency are
parts of the World Bank Group.)
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Canons of statutory construction ``assume that legislators take
account of the legitimate sovereign interests of other nations when
they write American laws.'' \15\ In addition, international financial
institutions operate with the benefit of certain privileges and
immunities under U.S. law indicating that such entities may be viewed
similarly under certain circumstances.\16\ There is nothing in the text
or history of the swap-related provisions of Title VII of the Dodd-
Frank Act to establish that Congress intended to deviate from these
traditions of the international system by subjecting foreign
governments, foreign central banks, or international financial
institutions to the clearing requirement set forth in Section 2(h)(1)
of the CEA.\17\
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\15\ 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).
\16\ See, e.g., the International Organization and Immunities
Act (22 U.S.C. 288) and the Foreign Sovereign Immunities Act (28
U.S.C. 1602). The United States has taken appropriate actions to
implement international obligations with respect to such immunities
and privileges. See, e.g., International Bank for Reconstruction and
Development (the ``World Bank'') and International Monetary Fund (22
U.S.C. Sec. 286g and 22 U.S.C. 286h), the European Bank for
Reconstruction and Development (22 U.S.C. 290l-6), the Multilateral
Investment Guarantee Agency (22 U.S.C. 290k-10), the Africa
Development Bank (22 U.S.C. 290i-8), the African Development Fund
(22 U.S.C. 290g-7), the Asian Development Bank (22 U.S.C. 285g), the
Inter-American Development Bank (22 U.S.C. 283g), the Bank for
Economic Cooperation and Development in the Middle East and North
Africa (22 U.S.C. 290o), and the Inter-American Investment
Corporation (22 U.S.C. 283hh). See, e.g., CFTC Interpretative Letter
regarding World Bank Group, dated October 30, 1991. ``Based on the
unique attributes and status of the World Bank Group as a
multinational member agency, * * * the CFTC believes that the World
Bank Group need not be treated as a U.S. person for purposes of
application of the CFTC's Part 30 rules.'' See, also e.g., Board of
Governors of the Federal Reserve approval of the application of BCI
to acquire LITCO Bancorporation of New York, Inc., 68 Federal
Reserve Bulletin 423 (1982) (the Bank Holding Company Act does not
apply to foreign governments because they are not ``companies'' as
such term is defined in the Bank Holding Company Act).
\17\ To the contrary, Section 752(a) of the Dodd-Frank Act
directs the Commission to consult and coordinate with other
regulators ``on the establishment of consistent international
standards with respect to the regulation (including fees) of swaps
[and] swap entities. * * *''
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Given these considerations of comity and in keeping with the
traditions of the international system, the Commission believes that
foreign governments, foreign central banks, and international financial
institutions should not be subject to Section 2(h)(1) of the CEA.\18\
Accordingly, it is not necessary to determine whether these entities
are ``financial entities'' under Section 2(h)(7) of the CEA.
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\18\ The foregoing rationale and considerations do not, however,
extend to sovereign wealth funds or similar entities due to the
predominantly commercial nature of their activities. Accordingly,
the Commission clarifies that sovereign wealth funds and similar
entities are subject to Section 2(h)(1) of the CEA.
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The Commission notes, however, that if a foreign government,
foreign central bank, or international financial institution enters
into a non-cleared swap with a counterparty who is subject to the CEA
and Commission regulations with regard to that transaction, then the
counterparty still must comply with the CEA and Commission regulations
as they pertain to non-cleared swaps. For example, the party must
comply with the recordkeeping and reporting requirements under Parts 23
and 45 of the Commission's regulations.
5. Status of State and Local Government Entities as ``Financial
Entities''
NCSHA recommended that the Commission explicitly provide that state
and local governmental entities, specifically housing finance agencies,
are not ``financial entities'' as defined in Section 2(h)(7) of CEA. In
particular, NCSHA expressed concern regarding the applicability of
Section 2(h)(7)(C)(VIII), which provides that a person is a financial
entity if the person is ``predominantly engaged in activities that are
in the business of banking, or in activities that are financial in
nature, as defined in section 4(k) of the Bank Holding Company Act of
1956.''
As an initial matter, the Commission notes that Congress did not
expressly exclude state and local government entities from the
``financial entity'' definition. On the contrary, in Section
2(h)(7)(C)(VII), Congress expressly included employee benefit plans of
state and local governments in the ``financial entity'' definition,
thereby prohibiting them from using the end-user exception.\19\ A per
se exclusion for state and local government entities from the
``financial entity'' definition is inappropriate. A state or local
government entity's swap activity may be commercial in nature and such
entity may also meet the definition of a ``financial entity'' in
Section 2(h)(7)(C) of the CEA. Under such circumstances, the entity
would be subject to compliance with the clearing requirement of Section
2(h)(1)(A). As an example, much like state and local government
employee benefit plans that are expressly identified in Section
2(h)(7)(C) as financial entities, other state or local government
entities that act in the market in the same manner as private asset
managers, such as local government investment pools, would need to
comply.
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\19\ The Commission is not convinced by NCHSA's suggestion that
Congress would have expressly included in the definition housing
finance entities and other state and local government entities if it
had intended for them to be ``financial entities.'' Congress did not
list every type of entity that is a financial entity, but provided a
catch-all definition in Section 2(h)(7)(C)(VIII) to capture various
types of entities it did not specifically list. The reference to
government employee benefit plans is part of Section
2(h)(7)(C)(VII), which includes various types of employee benefit
plans specifically in the definition of ``financial entity,'' does
not appear to have been intended as a singular identification of the
only type of governmental entity that could be captured by the
definition of ``financial entity.''
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The ``business of banking'' is a term of art found in the National
Bank Act \20\ and is within the jurisdiction of, and therefore subject
to interpretation by, the Office of the Comptroller of the
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Currency.\21\ Similarly, Section 4(k) of the Bank Holding Company Act
is within the jurisdiction of, and therefore subject to interpretation
by, the Board of Governors of the Federal Reserve System. Accordingly,
the Commission is not inclined to interpret these provisions. However,
even assuming that many state and local government entities may engage
in some limited activities that are in the business of banking or are
financial in nature as defined by Section 4(k), such activities are
likely to be incidental, not primary, activities of those entities.
Therefore, most state and local government entities are not likely to
be ``financial entities'' under Section 2(h)(7)(C)(VIII), because they
are not predominantly engaged in activities that are in the business of
banking, or are financial in nature, as defined by Section 4(k) of the
Bank Holding Company Act of 1956. Instead, most state and local
government entities are ``predominantly engaged'' in other, non-banking
and non-financial, activities related to their core public purposes and
functions. Such entities therefore would not be ``financial entities''
by virtue of Section 2(h)(7)(C)(VIII) of the CEA.
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\20\ 12 U.S.C. 24 (Seventh).
\21\ Nationsbank of N.C., N.A. v. Variable Annuity Life Ins.
Co., 513 U.S. 251, 258 & n.2 (1995).
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Regarding NCHSA's request for a specific determination for housing
finance agencies, the Commission is not inclined to make such a
determination without the opportunity to consider all relevant facts
and circumstances.
6. Affiliates
Section 2(h)(7)(D)(i) of the CEA provides that an affiliate of a
person that qualifies for the end-user exception (including affiliate
entities predominantly engaged in providing financing for the purchase
of the merchandise or manufactured goods of the person) may qualify for
the exception only if the affiliate, acting on behalf of the person and
as an agent, uses the swap to hedge or mitigate the commercial risk of
the person or other affiliate of the person that is not a financial
entity. The clear implication of this provision is that such an
affiliate may elect the end-user exception, even if it is a financial
entity, if the swap and the affiliate relationship otherwise comply
with the requirements of Section 2(h)(7) and in particular, Section
2(h)(7)(D). Section 2(h)(7)(D)(ii), however, provides that this
affiliate exception shall not apply to certain types of entities
including, among others, swap dealers or MSPs.
Shell Energy North America (US), L.P. (Shell) commented that,
absent clear guidance by the Commission, potential electing
counterparties that centralize their risk management through a hedging
affiliate that is designated as a swap dealer or MSP may be unable to
benefit from the end-user exception. As a result, many potential
electing counterparties may need to restructure their businesses and
risk management techniques, thereby losing the many benefits of
centralized hedging. According to Shell, such a loss might require
potential electing counterparties to take on additional risk or to
transact with third parties.
In response, the Commission notes that it lacks discretion in this
regard because Congress specifically defined financial entities (which
cannot use the end-user exception) to include swap dealers and MSPs,
and Section 2(h)(7)(D) specifically prohibits swap dealers or MSPs
acting on behalf of affiliates from using that provision to elect the
end-user exception.\22\
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\22\ The Commission notes that the definition of ``major swap
participant'' in Section 1a(33) of the CEA, in which the term
``financial entity'' is also used, does not include a provision that
is similar to Section 2(h)(7)(D). In the absence of such a
provision, the Commission has defined the term ``financial entity''
in Sec. 1.3(mmm)(1) for purposes of the ``major swap participant''
definition in Section 1a(33) of the CEA and Sec. 1.3(hhh), to
exclude certain centralized hedging and treasury entities. See 77 FR
30596 at 30750 (May 23, 2012). The Commission does not believe it
would be appropriate to take a similar approach with respect to the
end-user exception, however, because Section 2(h)(7)(D) specifically
addresses when affiliates may be eligible for the end-user
exception.
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Similarly, Kraft, Philip Morris International, Inc. (Philip
Morris), and Siemens Corp. (Siemens) commented that the Commission
should exclude wholly-owned treasury subsidiaries of non-financial
companies from the ``financial entity'' definition, to the extent that
they solely engage in swap transactions to hedge or mitigate the
commercial risks of an entire corporate group. These commenters noted
in particular that the treasury subsidiaries may be, or are likely to
be, ``financial entities'' under Section 2(h)(7)(C)(VIII), because they
are predominantly engaged in activities of a financial nature as
defined in Section 4(k) of the Bank Holding Company Act. Siemens
believes the Commission should amend the proposed rule to clarify that
a financial entity acting as a ``Treasury Affiliate'' satisfies the
statutory criteria for ``acting on behalf of the person and as an
agent,'' as required by section 2(h)(7)(D)(i) of the CEA.
Here too, the Commission notes that Congress specifically defined
``financial entity'' for purposes of Section 2(h)(7) of the CEA, and
proposed Sec. 39.6(b)(2) (renumbered as Sec. 39.6(a)(1)(i) in the
final rule) simply adopts that definition. Likewise, Congress
specifically set out in Section 2(h)(7)(D) who may qualify as an
affiliate eligible for the end-user exception. The specificity with
which Congress defines ``financial entity'' and sets out when
affiliates, including affiliates that may be financial entities, may
elect the end-user exception on behalf of an affiliate that is not a
financial entity (i.e., the treasury affiliate would need to be
``acting on behalf of the [other affiliate] and as agent''), constrains
the Commission's discretion in this area.
However, the Commission notes that it is important to distinguish
where the treasury function operates in the corporate structure.
Treasury affiliates that are separate legal entities and whose sole or
primary function is to undertake activities that are financial in
nature as defined under Section 4(k) of the Bank Holding Company Act
are financial entities as defined in Section 2(h)(7)(C)(VIII) of the
CEA because they are ``predominantly engaged'' in such activities. If,
on the other hand, the treasury function through which hedging or
mitigating the commercial risks of an entire corporate group is
undertaken by the parent or another corporate entity, and that parent
or other entity is entering into swaps in its own name, then the
application of the end-user exception to those swaps would be analyzed
from the perspective of the parent or other corporate entity directly.
For example, consider a parent company or other corporate entity
predominantly engaged in manufacturing, agriculture, retailing, energy,
or other non-``financial entity'' businesses and which is not one of
the types of financial entities described in Sections 2(h)(7)(C)(I)
through (VII). If that parent or other corporate entity enters into
swaps with an affiliate that hedge or mitigate commercial risk of the
affiliate, the affiliate may elect the end-user exception for those
inter-affiliate swaps if the affiliate is not a financial entity. If
the parent or other corporate entity then aggregates the commercial
risks of those swaps with other risks of the commercial enterprise and
hedges the aggregated commercial risk using a swap with a swap dealer,
that entity may, in its own right, elect the end-user exception for
that hedging swap. The parent or other corporate entity in the example
is not a ``financial entity'' as defined in Section 2(h)(7)(C)(VIII) of
the CEA, because that entity is ``predominantly engaged'' in other,
non-financial activities undertaken to fulfill its core commercial
enterprise purpose. However, if the parent or other
[[Page 42564]]
corporate entity, including, for example, a separately incorporated
treasury affiliate, is a ``financial entity,'' then that entity cannot
elect the end-user exception unless one of the specific affiliate
provisions of the statute, Section 2(h)(7)(C)(iii) or Section
2(h)(7)(D), apply.
CFC recommended that the Commission clarify that the definition of
``an affiliate of a person'' includes a nonprofit, tax-exempt
cooperative of which the person is a member and which is not a
depository institution. Section 2(h)(7)(D)(ii) of the CEA lists certain
types of entities that do not qualify as affiliates able to elect the
end-user exception. The Commission declines to determine at this time
whether specific types of entities would qualify as affiliates able to
elect the end-user exception because such determinations are best made
on a case-by-case basis with the benefit of all relevant facts and
circumstances.
Cravath, Swaine, and Moore, LLP (Cravath), EDF Trading, The
Prudential Insurance Company of America (Prudential), and Working Group
of Commercial Energy Firms (WGCEF) commented that the Commission should
provide an explicit exemption from clearing and notification
requirements for inter-affiliate swaps, i.e., swaps between companies
that are part of a single group of affiliated companies. EEI & EPSA
recommended that the Commission clarify in the regulatory text that
``acting on behalf of the person and as an agent'' to hedge or mitigate
commercial risk includes inter-affiliate transactions.
As a general matter, the Commission notes that Congress did not
treat inter-affiliate swaps differently from other swaps in Section
2(h)(7) of the CEA. Accordingly, the fact that a swap is between two
affiliates would not change the analysis of whether one of the parties
to the swap can elect the end-user exception. If one of the affiliates
is not a financial entity and is using the swap to hedge or mitigate
commercial risk, even if the other affiliate is a financial entity, the
non-financial entity affiliate may elect the end-user exception and
neither affiliate needs to clear the swap. However, whether the
Commission should provide general clearing relief for inter-affiliate
swaps for which the statutory requirements of the end-user exception
are not satisfied is outside the scope of this rulemaking.
Notwithstanding the foregoing, the Commission acknowledges that
commenters have raised issues regarding inter-affiliate swaps that
warrant further review and the Commission is considering other options
regarding these issues.
7. Captive Finance Companies
Section 2(h)(7)(C)(iii) of the CEA provides that the definition of
``financial entity'' in Section 2(h)(7)(C)(i) of the CEA ``shall not
include an entity whose primary business is providing financing, and
uses 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.'' In
connection with this ``captive finance company'' exception, the U.S.
Chamber of Commerce and the Coalition for Derivatives End Users (CDEU)
requested that the Commission interpret the phrase ``90 percent or more
of which are manufactured by the parent company or another subsidiary
of the parent company'' to include component parts, attachments,
systems, and other products that may be manufactured by others, but
sold together with the company's products as well as attachments and
labor costs that are incidental to the primary purchase.
The Commission believes that the captive finance company exception
must be interpreted in a manner consistent with the plain language of
the statute. As a result, a person that seeks to fall within the
captive finance company exception must be in the ``primary business''
of providing financing of purchases or leases from its parent company
or subsidiaries thereof. Consistent with this requirement, the
Commission states that the captive finance company exception can be
applied when this financing activity finances the purchase or lease of
products sold by the parent company or its subsidiaries in a broad
sense, including service, labor, component parts, and attachments that
are related to the products.
A group of captive finance companies or affiliates of captive
finance companies (the ``Captive Finance Companies'') \23\ asked the
Commission to create a simple test to determine whether an entity
qualifies for the captive finance company exception and to clarify
whether the two ``90 percent'' prongs should be read separately or
together. The Commission believes the test is set out plainly in the
statute and only allows for limited interpretation. As to the two
prongs, the Commission interprets them separately. That is, 90 percent
or more of the interest rate and currency exposures for which the
captive finance company is using derivatives to hedge the related
underlying commercial risks must arise from financing that facilitates
the purchase or lease of products. Ninety percent or more of the
products, the purchase or sale of which are being facilitated by the
financing, must be manufactured by the parent company or its
subsidiary. An entity must satisfy both prongs in order to be eligible
for the captive finance company exception.
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\23\ American Honda Finance Corp., John Deere Financial
Services, Inc., Nissan North America, Inc., Toyota Financial
Services, and Caterpillar Financial Services Corp.
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The Captive Finance Companies expressed concern that the Commission
would require a product, in order to qualify as ``manufactured'' by the
parent company or a subsidiary, to have 90 percent or more of its
components manufactured by the parent company or subsidiary. The
Commission requires only that the final product being purchased or
sold, regardless of its components, be manufactured by the parent
company or subsidiary in order to qualify.
The Captive Finance Companies also asked the Commission whether the
``financing that facilitates the purchase or lease of products'' should
be measured on a single-entity or consolidated basis that includes the
entity's consolidated subsidiaries. They recommended that it be
measured on a consolidated basis to prevent an entity that is a part of
a larger group of entities from using corporate structures to
manipulate the outcome and because most entities manage the reporting
of their finance and leasing portfolios on that basis. The Commission
agrees that the financing should be measured on a consolidated basis.
Further, the Captive Finance Companies discussed the ways in which
a captive finance company might ``facilitate'' the purchase or lease of
the parent company's and subsidiaries' products. For example, a captive
finance company for an engine manufacturer may finance the sale of a
boat that includes the manufacturer's engine in order to facilitate the
sale of the engine, even if the boat itself were manufactured by a
different company. As a second example, a captive finance company may
provide working capital and related financing to a dealer that sells
the parent company's products, even though such financing is not
directly related to the sale of products. The Commission agrees that
the word ``facilitates'' as used in Section 2(h)(7)(C)(iii) should be
interpreted
[[Page 42565]]
broadly to include financing that may indirectly help to facilitate the
purchase or lease of products.
CFC commented that it should be viewed as a captive finance
subsidiary of the entities that own it in a cooperative structure. CFC
also discussed whether the captive finance company exception should be
available when it provides financing to its member-owners to support
their general business activities, rather than to finance purchases
from its member-owners. The Commission is declining to determine at
this time whether specific entities would qualify for the captive
finance company exception because such determinations are best made on
a case-by-case basis with the benefit of all relevant facts and
circumstances.
B. Reporting Requirements
Section 2(h)(7)(A)(iii) of the CEA requires that, for the end-user
exception to apply, one of the counterparties to the swap must notify
``the Commission in a manner set forth by the Commission how it
generally meets its financial obligations associated with entering into
non-cleared swaps.'' Section 2(h)(7)(F) of the CEA allows the
Commission to ``prescribe such rules or issue interpretations of the
rules as the Commission determines to be necessary to prevent abuse''
of the end-user exception and to ``request information from those
persons claiming the clearing exception as necessary to prevent
abuse.'' \24\
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\24\ In addition, Section 2(h)(4)(A) requires the Commission to
prescribe rules as determined by the Commission to be necessary to
prevent evasion of the clearing requirements.
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Proposed Sec. 39.6(b) would implement Section 2(h)(7)(A)(iii) by
requiring one of the counterparties (the ``reporting counterparty'') to
provide, or cause to be provided, to a registered SDR, or if no
registered SDR is available, to the Commission, information about how
the electing counterparty generally expects to meet its financial
obligations associated with the non-cleared swap. In addition, proposed
Sec. 39.6(b) would require the reporting counterparty to provide
certain information that the Commission will use to monitor compliance
with, and prevent abuse of, the end-user exception. The reporting
counterparty would be required to provide the information at the time
the electing counterparty elects the end-user exception.
1. Frequency of Reporting
The Commission received numerous comments suggesting that reporting
of the information specified under proposed Sec. 39.6(b) for each swap
transaction would be burdensome.\25\ A number of commenters recommended
that the Commission permit entities to report some or all of the
required items on an annual or periodic basis with updates for any
material changes.\26\ According to these commenters, an annual or
periodic filing would provide sufficient notice to the Commission
because the reasons for which each entity enters into hedge
transactions, and the manner in which each entity generally meets its
financial obligations associated with those transactions, do not change
materially on a frequent basis.\27\ Several commenters believe that a
one-time filing of some or all of the required items should
suffice.\28\
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\25\ See, e.g., American Bankers Association (ABA), American Gas
Association (AGA), APGA, American Petroleum Institute (API), Air
Transport Association (ATA), CDEU, COPE, Cravath, EDF Trading,
Edison Electric Institute (EEI), EEI and Electric Power Supply
Association (EEI & EPSA), Encana Marketing (USA) Inc. (EMUS), IECA,
Independent Petroleum Association (IPA), National Council of Farmer
Cooperatives (NCFC), NCSHA, National Energy Marketers Association
(NEMA), Natural Gas Supply Association (NGSA), NMPF, Noble Energy,
Inc. (Noble), National Rural Electric Cooperative Association
(NRECA), Peabody Energy Corp. (Peabody), Retail Energy Supply
Association (RESA), San Diego Gas and Electric Co. (SDG&E), Shell,
Swap Financial Group, LLC (SFG), WGCEF, and WSPP, Inc. (WSPP).
\26\ See, e.g., ABA, AGA, API, ATA, CDEU, CFI Industries, Inc.
(CFI), Hess Corp. (Hess), NCFC, NCSHA, NFPEEU, Noble, Peabody,
SDG&E, Shell, and WGCEF.
\27\ Id.
\28\ See, e.g., APGA, COPE, Cravath, EDF Trading, EEI & EPSA,
EMUS, Hess, IECA, IPA, NCSHA, NMPF, Petroleum Marketers Association
of America and New England Fuel Institute (PMAA & NEFI), RESA, and
SFG.
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Hess suggested that, instead of imposing additional reporting
requirements, the Commission could prevent abuse of the end-user
exception by requiring electing counterparties to represent that they
satisfy the requirements of Sections 2(h)(7) and 2(j) of the CEA in
swap contracts that they elect not to clear. EEI & EPSA also
recommended that if the Commission were to require swap-by-swap
reporting, it should adopt a flexible requirement that establishes
reasonable time frames for reporting. ATA recommended that the
Commission streamline the notice requirement by providing that notice
may be satisfied on a one-time basis as part of the ISDA master
agreement.
IECA recommended that the rule be revised to state that if more
than one, but less than all, parties to a swap are electing
counterparties, the information specified in proposed Sec. 39.6(b)
shall be provided with respect to each of the electing counterparties.
According to IECA, if all parties to a swap are electing
counterparties, no report should be required.
NMPF requested that the Commission simplify the reporting
requirements, especially for those smaller hedgers for whom the typical
reporting requirements would be burdensome, and exempt agricultural
swaps between non-financial counterparties from all or most reporting
requirements. Federal Home Loan Banks (FHL Banks) commented that
certain non-financial entities should have no reporting obligation.
As proposed, the swap-by-swap reporting frequency for all
information to be reported may impose unnecessary burdens, and
therefore the Commission is revising proposed Sec. 39.6(b) to require
only swap-by-swap reporting of the election of the end-user exception
and the identity of the electing counterparty to the swap. The other
information for which proposed Sec. 39.6(b) would have required
reporting on a swap-by-swap basis does not have to be reported for each
swap if the electing counterparty has previously provided the
information in an annual filing.
In practice, the reporting counterparty will be required to check
at least three boxes for each swap for which the end-user exception is
elected, indicating: (1) The election of the exception; (2) which party
is the electing counterparty; and (3) whether the electing counterparty
has already provided the additional required information through an
annual filing. If the third box is checked ``no,'' the reporting
counterparty will have to provide the additional required information
for that swap. The Commission is requiring certain information on a
swap-by-swap basis so it can verify that the end-user exception is
being elected in compliance with the CEA and Commission
regulations.\29\ In addition, if a counterparty is eligible to claim
the end-user exception for one asset class but not another (for
example, if the counterparty is a swap dealer granted limited
designation by the Commission pursuant to Sec. 1.3(ggg)(3)), the
Commission must be able to distinguish those swaps for which the
counterparty may legitimately claim the end-user exception from those
for which it cannot. The Commission does not believe this reporting
requirement will impose a significant burden on parties because other
detailed information for every swap must be reported under
[[Page 42566]]
other provisions of the CEA and Commission regulations.\30\
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\29\ The Commission's Part 43 rules on real-time public
reporting of swap transaction data also require the reporting
counterparty to indicate election of the end-user exception on a
swap-by-swap basis. See 77 FR 1182 at 1250 (Jan. 9, 2012).
Indication of the election of the end-user exception will be
publicly disseminated as required in Part 43, but the additional
information required under Sec. 39.6(b) will not be.
\30\ See, e.g., Sections 4(g) and 4(r) of the CEA; and Part 45
of the Commission's regulations.
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The Commission agrees with commenters that an annual filing for the
remaining information will provide sufficient notice to the Commission
because the general reasons for which electing counterparties enter
into hedge transactions, and the manner in which they generally meet
their financial obligations for those transactions, do not change
frequently. While this approach may impose additional costs on SDRs and
the Commission because each will have to establish and maintain two
reporting alternatives,\31\ the Commission believes that this approach
will impose lower costs on the swap parties than they would incur if
all information were required to be reported on a swap-by-swap basis.
Accordingly, Sec. 39.6(b) is being revised to permit the following
information to be reported on a swap-by-swap or an annual basis: (1)
Whether the electing counterparty is a financial entity or a finance
affiliate (i.e., is a financial entity electing the end-user exception
by virtue of Sections 2(h)(7)(C)(ii) or (iii) or 2(h)(7)(D) of the
CEA); (2) whether the swap hedges or mitigates commercial risk (the
annual filing will state that the electing counterparty will only elect
the end-user exception for swaps that hedge or mitigate commercial
risk); (3) how the electing counterparty generally expects to meet its
financial obligations; and (4) information related to whether the
electing counterparty is an issuer of securities with board approval to
not clear the swaps for which the end-user exception is elected.
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\31\ The Commission believes that the cost of establishing an
additional reporting alternative is unlikely to be significant
because the SDR and the Commission may do so in conjunction with
establishing numerous other reporting processes, such as those
required by the Commission's Part 43 rules on real-time public
reporting of swap transaction data (77 FR 1182 (Jan. 9, 2012)).
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The Commission has determined not to grant any exemptions to the
Sec. 39.6(b) reporting requirements at this time because any such
determinations require a consideration of all relevant facts and
circumstances. The modified reporting requirements should reduce some
of the burdens cited by the commenters and given the low reporting
burden under the rule and the general swap-by-swap reporting
requirements in other regulations (e.g., Part 45), the Commission does
not believe that a special, lesser reporting requirement for smaller
parties or certain types of swaps is consistent with the statute. The
Commission believes it would not be appropriate to require contract
representations instead of reporting, or eliminate all or some
reporting requirements for certain types of electing counterparties,
because Section 2(h)(7)(A)(iii) of the CEA specifically requires
notification to the Commission. Finally, the information required under
Sec. 39.6(b) will help to prevent abuse of the end-user exception by
allowing the Commission to track when the exception is elected and who
is electing it.
2. Identifying the Reporting Counterparty
As noted above, proposed Sec. 39.6(b) would require one of the
counterparties to the swap to act as the ``reporting counterparty.''
WSPP requested that the Commission clarify who the reporting
counterparty is. WSPP noted that the Commission indicated in the NPRM
that the reporting counterparty would be determined in accordance with
the swap data recordkeeping and reporting rules and that if one of the
counterparties is an MSP or swap dealer, then that entity would be the
reporting counterparty. WSPP further noted that proposed Sec. 39.6
itself would not impose such a requirement, and recommended that the
Commission either cross-reference the relevant swap reporting rules in
Sec. 39.6 or define ``reporting counterparty'' for purposes of Sec.
39.6. WSPP also requested clarification as to how two electing
counterparties in an electing counterparty-to-electing counterparty
transaction would determine which counterparty is the reporting
counterparty, and whether the reporting counterparty would provide
information on both electing counterparties at the same time.
The Commission notes that Sec. 45.8 of its swap data recordkeeping
and reporting rules sets out how the determination of which
counterparty is the reporting counterparty for a swap is to be
made.\32\ The Commission is revising Sec. 39.6(b) to include a
reference to Sec. 45.8.
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\32\ See 77 FR 2136 at 2207 (Jan. 13, 2012) (Swap Data
Recordkeeping and Reporting Requirements; final rule).
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3. Reporting Methods
As noted above, proposed Sec. 39.6(b) would require the reporting
counterparty to provide or cause to be provided to a registered SDR, or
if no registered SDR is available, to the Commission, the information
set forth in that paragraph. CFI recommended that the Commission revise
the proposed rule to permit an electing counterparty to summarize or
submit copies of ISDA agreements and credit support agreements to the
Commission to demonstrate how the electing counterparty generally meets
its financial obligations related to non-cleared swaps. Similarly, EDF
Trading stated that for transactions where neither party is a swap
dealer or MSP, the Commission should provide an alternative to SDR
reporting, such as the opportunity to submit hard copy records.
Better Markets, Inc. (Better Markets) recommended that the
Commission require electing counterparties to report directly to the
Commission, in addition to an SDR. According to Better Markets, this
would ensure that the Commission receives complete and timely
information regarding reliance upon the end-user exception. Hess
requested that the Commission permit electing counterparties who are
not swap dealers or MSPs to report directly to an SDR or the
Commission, rather than rely on a swap dealer or MSP counterparty to
report. Hess commented that such a requirement would be more efficient
and reliable.
The Commission has determined not to revise Sec. 39.6(b) in
response to these comments. As discussed further in the considerations
of costs and benefits in Section III hereof, the Commission believes
that adopting alternative approaches to reporting is unnecessary,
unduly burdensome, and may complicate data management and review. In
response to Hess' comment, the Commission notes that, as previously
discussed, the final rule has been revised to permit electing
counterparties to report much of the information required by the rule
directly to an SDR or the Commission on an annual basis. For the
information required to be reported on a swap-by-swap basis, the
reporting counterparty must be determined in accordance with Sec.
45.8.
In the NPRM, the Commission stated that a reporting counterparty
would provide the information required by proposed Sec. 39.6(b) via a
``check-the-box'' approach and asked whether such an approach would be
appropriate.
EMUS, IECA, National Grain and Feed Association (NGFA), and WSPP
commented that a check-the-box approach is sufficient to collect the
information required. IECA recommended that the Commission specify the
check-the-box system in the rule text.
In contrast, Professor Michael Greenberger commented that a check-
the-box approach is inadequate. According to Professor Greenberger,
this
[[Page 42567]]
approach will almost certainly be unreliable because the Commission
will not have the necessary information to monitor and prevent
potential abuse of the end-user exception.
EMUS expressed concern that different reporting counterparties
could provide the same information to a registered SDR in different
formats. It recommended that the Commission adopt a yes-or-no schema
for each of the items set forth in proposed Sec. 39.6(b)(1)-(6).
According to EMUS, such a system would standardize reporting, which
would provide more useful information. EMUS also commented that a
standardized submission format would reduce costs and facilitate
reporting for electing counterparties.
The Commission is satisfied that a check-the-box approach is an
appropriate method to collect the information that the Commission
requires to exercise regulatory oversight and that it mitigates the
costs of compliance for the electing and reporting counterparties. In
addition, a check-the-box approach provides a standardized data
collection method for voluminous amounts of data, which will facilitate
effective review by the Commission. It would be inefficient for the
Commission to monitor and analyze a large volume of unique data points
from a potentially wide range of electing counterparties.
The final rule itself does not specify the exact format for
reporting purposes because the Commission's Part 45 rules establish the
reporting requirements for all swap data, including the information
required under Sec. 39.6.
4. Reporting of Inter-Affiliate or Cooperative-to-Member Swaps
A few commenters raised issues regarding reporting of swaps between
particular types of counterparties. Shell requested that the Commission
clarify that swaps between affiliates need not be reported because such
reporting for inter-affiliate swaps provides no useful information to
the Commission and would be burdensome.
NCFC requested clarification regarding who provides the financial
obligation information in a transaction between a cooperative and its
members (such as producers or elevators) or customers (e.g., an
electing counterparty-to-electing counterparty transaction). NCFC also
questioned whether an SDR or the Commission will accept the data for
transactions that cooperatives enter into with their members and
customers and whether the Commission has the resources to accept such
data.
In response to Shell's comment, the Commission notes that, although
Congress expressly addressed in Section 2(h)(7)(D) of the CEA when an
affiliate executing a swap on behalf of another affiliate may qualify
for the end-user exception, Congress did not exempt such inter-
affiliate swaps from the reporting requirements. Because inter-
affiliate swaps must be reported, the parties also must provide the
information required under Sec. 39.6(b) so that the Commission will
know why a swap that would otherwise be subject to clearing is not
being cleared. In response to NCFC's request for clarification as to
who provides the financial obligation information for cooperative-to-
member swaps, the Commission notes that the reporting counterparty in
such electing counterparty-to-electing counterparty transactions is to
be determined in accordance with Sec. 45.8, as previously discussed.
5. Finance Affiliates
As previously noted, Section 2(h)(7)(C)(iii) of the CEA provides
that the definition of ``financial entity'' ``shall not include an
entity whose primary business is providing financing, and uses
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.'' Section
2(h)(7)(D)(i) of the CEA provides that an affiliate of a person that
qualifies for the end-user exception also may qualify for the exception
but only if the affiliate, acting on behalf of the person and as an
agent, uses the swap to hedge or mitigate the commercial risk of the
person or other affiliate of the person that is not a financial entity.
Section 2(h)(7)(D)(ii) identifies certain types of financial entities
that cannot act as an affiliate electing counterparty on behalf of
another person under Section 2(h)(7)(D)(i), indicating that financial
entities that are not identified in Section 2(h)(7)(D)(ii) may do so.
Proposed Sec. 39.6(b)(3) would implement these provisions and require
the reporting counterparty to report, or cause to be reported, whether
the electing counterparty is a ``finance affiliate'', i.e., a financial
entity electing the end-user exception by virtue of Section
2(h)(7)(C)(iii) or 2(h)(7)(D) of the CEA.
EMUS requested that the Commission clarify whether the reporting
counterparty must report that the electing counterparty is an affiliate
of another person qualifying for the end-user exception under Section
2(h)(7)(D)(i) of the CEA or a finance affiliate of such a person.
According to EMUS, the NPRM indicated that the notification requirement
would apply to all affiliates, while the rule text indicated a
notification requirement would apply only to finance affiliates.
In response to EMUS, the Commission is revising Sec. 39.6(b)(3)
(renumbered in the final rule as Sec. 39.6(b)(1)(iii)(A)(1)) to
clarify that the notification requirement only applies to financial
entities acting as affiliates. While identification of financial
entities acting as affiliates is important because they are an
exception to the prohibition on financial entities electing the end-
user exception, the Commission does not believe that identification of
non-financial entities acting as agents for affiliated entities is
necessary. Similarly, the Commission is further revising this provision
to add a requirement for electing counterparties to report whether they
are ``financial entities'' as defined in Section 2(h)(7)(C)(i) of the
CEA that are nevertheless exempt from the definition of ``financial
entity'' as described in Sec. 39.6(d). But for the exemption provided
in Sec. 39.6(d), such entities would be prohibited from electing the
end-user exception (the exemption in Sec. 39.6(d) is discussed in
Section D below).
6. Reporting How an Electing Counterparty Generally Meets Financial
Obligations Associated With Non-Cleared Swaps
As noted above, Section 2(h)(7)(A)(iii) of the CEA requires that
the Commission be notified as to how an electing counterparty generally
meets its financial obligations associated with entering into non-
cleared swaps. Proposed Sec. 39.6(b)(5) would implement this
provision.
NGSA recommended that the Commission modify the language of its
proposed rule to be identical to the statutory language--namely, that
the words ``expects to meet'' and ``swap'' in proposed Sec. 39.6(b)(5)
should be replaced with the words ``meets'' and ``swaps,''
respectively.
CFC recommended that the information contained in the notice should
be general enough to encompass all transactions of an electing
counterparty, and the notice should contain information as to how
entities meet the obligations of multiple types of non-cleared swaps,
not individual swaps.
CDEU and EMUS commented that the information the Commission
proposed
[[Page 42568]]
to collect is sufficient. According to CDEU, any additional information
on meeting obligations would be non-standardized information that is
not easily captured and reportable in a systematic fashion. CDEU
commented that non-financial counterparties do not pose systemic risk
and it is not clear how the reporting of more information on meeting
financial obligations comports with the legislative intent of the Dodd-
Frank Act.
Several commenters recommended that the Commission collect
substantially more information, including specific information such as
the types of collateral the electing counterparty will use to satisfy
its financial obligations, the exact collateral terms and arrangements,
and the contractual terms and provisions.\33\
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\33\ See, e.g., Americans for Financial Reform (AFR), American
Federation of State, County and Municipal Employees (AFSCME), Better
Markets, PMAA & NEFI, and Professor Greenberger.
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The Commission is modifying proposed Sec. 39.6(b)(5) (renumbered
in the final rule as Sec. 39.6(b)(1)(iii)(C)) to read as follows:
``How the electing counterparty generally meets its financial
obligations associated with entering into non-cleared swaps by
identifying one or more of the following categories, as applicable. * *
*'' The Commission believes this revision more accurately reflects the
Dodd-Frank Act's intent that an electing counterparty must demonstrate
how it ``generally meets its financial obligations'' (emphasis added)
with respect to non-cleared swaps. Furthermore, the Commission is
declining to modify proposed Sec. 39.6(b)(5) to require reporting of
additional, specific information because the statute only requires the
electing counterparty to provide notice of how it ``generally meets its
financial obligations.'' The Commission believes that the information
required by the regulation will enable the Commission to exercise its
regulatory oversight in an efficient and effective manner given the
wide variety of different types of swaps and swap hedging strategies
used by commercial entities.
7. How a Counterparty Meets Its Financial Obligations
Proposed Sec. 39.6(b)(5)(i) through (v) would set forth categories
of means by which an electing counterparty could generally meet its
financial obligations associated with non-cleared swaps.
The National Rural Electric Cooperative Association (NRECA) asked
the Commission to confirm that, in representing which swaps are secured
by collateral, the counterparty should check the box under proposed
Sec. 39.6(b)(5)(ii) only if all or any portion of the financial
obligations associated with the reported swap are secured by collateral
that has been pledged to the swap counterparty at the time the swap is
entered into. NRECA also asked whether that counterparty should check
the box under proposed Sec. 39.6(b)(5)(i) only if the obligations
associated with the reported swap are to be secured in the future by
collateral that is to be, or may in the future be, pledged to the swap
counterparty pursuant to a master agreement or other credit support
agreement applicable to the swap. NRECA also asked whether proposed
Sec. 39.6(b)(5)(i) is the appropriate box to check when the
counterparties have in place collateralization arrangements subject to
agreed-upon unsecured credit thresholds.
NRECA asked how a reporting counterparty may satisfy proposed Sec.
39.6(b)(5) where the financial obligations are not satisfied by any of
the collateral set forth under proposed Sec. 39.6(b)(5)(i) through
(iii) and the electing counterparty ``intends to generally meet its
financial obligations associated with non-cleared swaps'' by managing
its commercial risks prudently, offsetting its obligations under its
non-cleared swaps against those commercial risks and, for a not-for-
profit electricity provider, passing through its costs and benefits of
hedging to its retail energy customers during the time period(s) for
which a swap hedges or mitigates commercial risk. NRECA asked the
Commission to clarify whether such a reporting counterparty should
check the box for proposed Sec. 39.6(b)(iv) or (v). NRECA also asked
whether the financial resources must be ``available'' for purposes of
proposed Sec. 39.6(b) at the time the swap is executed or by the time
the swap is expected to settle and hedge or mitigate the commercial
risk.
In response to NRECA's comments, the Commission is modifying the
text of proposed Sec. 39.6(b)(5)(i)-(v) (renumbered in the final rule
as Sec. 39.6(b)(1)(iii)(C)(1) through (5)) to provide greater clarity
as follows (new language emphasized): ``(1) A written credit support
agreement; (2) Pledged or segregated assets (including posting or
receiving margin pursuant to a credit support agreement or otherwise);
(3) A written third-party guarantee; (4) The electing counterparty's
available financial resources; or (5) Means other than those described
in paragraphs (b)(1)(iii)(C)(1), (2), (3) or (4) of this section * *
*.''
In response to the comment regarding reporting of multiple sources,
the Commission believes the word ``solely'' in proposed Sec.
39.6(b)(5)(iv) may have created some uncertainty and has deleted this
word from the final rule text. The NPRM stated that parties are
required to check multiple boxes if multiple sources of financial
resources may be used. For clarity, the Commission is modifying the
text of proposed Sec. 39.6(b)(5) (renumbered as Sec.
39.6(b)(1)(iii)(C)) to expressly require the checking of all applicable
categories. In the example provided by NRECA, where the parties have a
credit support arrangement subject to a threshold, the reporting
counterparty would check one or more of the following: (1) Proposed
Sec. 39.6(b)(5)(i) if the credit support arrangement is subject to a
credit support agreement; (2) proposed Sec. 39.6(b)(5)(ii) if the
credit support arrangement provided for pledging or segregating assets;
and (3) proposed Sec. 39.6(b)(5)(iv) if the electing counterparty will
use available financial resources to cover any amount up to the
threshold listed in the credit support agreement.
Finally, the Commission believes that NRECA's example, where no
collateral is used to satisfy obligations, falls squarely in proposed
Sec. 39.6(b)(5)(iv). The rule only requires that the electing
counterparty identify how it generally meets its financial obligations
with regard to uncleared swaps.
8. Board Approval for SEC Filers
Under Section 2(j) of the CEA, exemptions from the requirements of
Section 2(h)(1) to clear a swap and Section 2(h)(8) to execute a swap
through a board of trade or SEF are available to a counterparty that is
an issuer of securities that are registered under Section 12 of the
Securities Exchange Act of 1934 or that is required to file reports
pursuant to Section 15(d) of the Securities Exchange Act of 1934 (an
``SEC Filer''), but only if an appropriate committee of the issuer's
board or governing body has reviewed and approved the decision to enter
into swaps that are subject to such exemptions. Proposed Sec.
39.6(b)(6) would implement this provision and require an SEC Filer to
report, on a swap-by-swap basis, whether an appropriate committee of
its board of directors (or equivalent body) has reviewed and approved
the decision not to clear the swap subject to the clearing requirement.
A number of commenters interpreted proposed Sec. 39.6(b)(6) as
requiring an SEC Filer's board of directors to approve each decision to
not clear a swap (i.e., to grant approval on a swap-by-swap basis) and
commented that Section 2(j)
[[Page 42569]]
of the Dodd-Frank Act does not impose such a requirement.\34\ COPE
noted that companies generally do not engage in transaction-specific
board actions.
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\34\ See, e.g., AGA, API, CDEU, COPE, Cravath, EEI & EPSA, EMUS,
EPSA, IECA, NFPEEU, NGSA, NRECA, Mr. Steve Quinlivan, RESA, SDG&E,
WGCEF, and WSPP.
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According to most of these commenters, swap-by-swap board approval
would impose excessive costs and burdens on companies.\35\ AGA stated
that a requirement that a board convene, review, and approve each and
every decision to enter into a non-cleared swap transaction would be so
administratively burdensome as to preclude its use.
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\35\ See, e.g., AGA, COPE, Cravath, EEI, EMUS, Hess, IECA, NGSA,
NREC, NYCBA, Mr. Quinlivan, SDG&E, and WSPP.
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Several commenters remarked that boards should be given broad
discretion over their hedging strategies and how they choose to
authorize entering into non-cleared swaps.\36\ Commenters also
recommended that companies should be able to delegate board approval to
the appropriate board, committee, or corporate official on a general or
``blanket'' basis for either all swaps or various categories of
swaps.\37\ For example, COPE recommended that the Commission revise
proposed Sec. 39.6(b)(6)(ii) to state that a board or committee may
authorize the company to adopt a policy which grants general and
continuing authority to enter into one or more swaps which are not
cleared, and that specific approval is not required before entering
into each and every swap. NGSA and the Committee on Futures and
Derivatives Regulation of the New York City Bar Association (NYCBA)
commented that the Commission should clarify footnote 18 \38\ of the
NPRM and revise proposed Sec. 39.6(b)(6)(ii) by replacing the words
``the decision not to clear the swap'' with the words ``the decision
not to clear such swaps.''
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\36\ See, e.g., ATA, COPE, EMUS, SDG&E, and WGCEF.
\37\ See, e.g., AGA, API, ATA, Cope, Cravath, EEI, EEI & EPSA,
Hess, NFPEEU, NRECA, NYCBA, NGSA, Mr. Quinlivan, SDG&E, and WGCEF.
\38\ Footnote 18 of the NPRM stated: ``For example, a board
resolution or an amendment to a board committee's charter could
expressly authorize such committee to review and approve decisions
of the electing person not to clear the swap being reported. In
turn, such board committee could adopt policies and procedures to
review and approve decisions not to clear swaps, on a periodic basis
or subject to other conditions determined to be satisfactory to the
board committee.'' 75 FR at 80750.
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Cravath commented that the requirements should be flexible enough
such that companies are able to manage and supervise their non-cleared
swaps in a manner that is consistent with their existing governance
policies.
On the other hand, Better Markets suggested imposing additional
disclosure requirements on the companies, including specific
justification for why each swap is not cleared. Better Markets also
recommended that the SEC Filer's CEO and CFO be required to certify
that they have conducted a substantive review of the board committee's
action and decision not to clear the swaps.
The Commission believes that Section 2(j) of the Dodd-Frank Act
does not require board approval of each decision by an SEC Filer to
enter into a swap that is exempt from the clearing requirement. As
noted above, Section 2(j) of the CEA states that exemptions from
Sections 2(h)(1) and 2(h)(8) (i.e., the clearing and trade execution
requirements) shall be available to an SEC Filer ``only if an
appropriate committee of the [SEC Filer]'s board or governing body has
reviewed and approved its decision to enter into swaps that are subject
to such exemptions.'' The Commission interprets this language to allow
board approval on a general basis. To remove any ambiguity, the
Commission is modifying proposed Sec. 39.6(b)(6)(ii) (renumbered as
Sec. 39.6(b)(1)(iii)(D)(2)) to read as follows: ``Whether an
appropriate committee of that counterparty's board of directors (or
equivalent body) has reviewed and approved the decision to enter into
swaps that are exempt from the requirements of sections 2(h)(1) and
2(h)(8) of the Act.'' This change allows for board approval on a
general, as opposed to swap-by-swap, basis. Also, the reference to both
Sections 2(h)(1) and 2(h)(8) makes clear that the board must have
approved the decision to enter into swaps that are neither cleared nor
executed on a DCM or SEF, as required by Section 2(j).
Commenters also discussed how frequently the counterparty should be
required to provide notice that the board has approved use of the end-
user exception and how frequently the board must renew its approval. A
number of commenters suggested that an annual certification of board
approval of a general hedging policy would be sufficient.\39\ NRECA
stated that annual certification should be sufficient unless there is
an intervening material change in the board approval information
previously submitted. AGA commented that the Commission should be
satisfied if the company's officers and/or risk committee annually
reports to the board to ensure that the board remains informed of
hedging activities. Hess, NRECA, and Shell commented that boards or
board-appointed committees should be able to approve swaps on a
periodic basis for either several months or years. IECA recommended
that board approval be required whenever a company enters into a new
ISDA agreement for swap transactions.
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\39\ See, e.g., AGA, EEI, EMUS, Hess, NEMA, and SDG&E.
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EEI and RESA recommended a one-time notice that the board has
approved the use of the end-user exception. WGCEF commented that
companies should be able to adopt a single continuing resolution
approving any decision to use the end-user exception. Peabody agreed
that a single determination by a committee, which would only be
revisited as the committee deems necessary, is appropriate.
As noted above, the Commission has revised proposed Sec.
39.6(b)(6) so that entities have the option to report board approval
information annually or on a swap-by-swap basis. The Commission would
expect an SEC Filer's board to set appropriate policies governing the
SEC Filer's use of swaps subject to the end-user exception and to
review those policies at least annually and, as appropriate, more often
upon a triggering event (e.g., a new hedging strategy is to be
implemented that was not contemplated in the original board approval).
A number of commenters requested that the Commission clarify some
of the terms used in proposed Sec. 39.6(b)(6)(ii). NYCBA requested
clarification as to what constitutes an ``appropriate committee'' for
purposes of reviewing and approving the decision not to clear a swap.
AGA asked the Commission to confirm that if a utility is a subsidiary
of an SEC Filer, then the subsidiary's board committee would authorize
the swap, not the board of the SEC Filer. IECA recommended that the
rule be revised to expressly provide that approval must be given by the
board of the transacting entity, not the board of an affiliate.
Finally, EMUS requested clarification as to the meaning of ``issuer of
securities.''
The Commission considers a committee to be appropriate if it is
specifically authorized to review and approve the SEC Filer's decision
to enter into swaps.\40\ The SEC Filer's board would have reasonable
discretion to determine the appropriate committee for approving
decisions on swaps for its subsidiaries or affiliates.
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\40\ See 75 FR at 80750 n. 16.
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[[Page 42570]]
In response to the comment regarding the meaning of ``issuer of
securities,'' the Commission notes that Section 2(j) of the CEA refers
to an ``an issuer of securities that are registered under section 12 of
the Securities Exchange Act of 1934 (15 U.S.C. 78l) or that is required
to file reports pursuant to section 15(d) of the Securities Exchange
Act of 1934 (15 U.S.C. 78o).'' The SEC has stated that, for purposes of
its proposed rule governing the end-user exception to mandatory
clearing of security-based swaps, ``a counterparty invoking the end-
user clearing exception is considered by the [SEC] to be an issuer of
securities registered under Exchange Act Section 12 or required to file
reports pursuant to Exchange Act Section 15(d) if it is controlled by a
person that is an issuer of securities registered under Exchange Act
Section 12 or required to file reports pursuant to Exchange Act Section
15(d).'' \41\ The Commission is interpreting this term in the same
manner as the SEC.
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\41\ See 75 FR 79992 at 79996 n. 34 (Dec. 21, 2010) (End-User
Exception to Mandatory Clearing of Security-Based Swaps).
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9. Liability for Reporting
Several commenters recommended that the Commission provide a safe
harbor from liability for firms who report on behalf of other
firms.\42\ These commenters expressed concern that the proposed
regulations may not protect the electing counterparty from potential
liability if the reporting counterparty misreports information
regarding the electing counterparty. These commenters also expressed
concern that a swap dealer or MSP may be liable if the electing
counterparty provides the swap dealer or MSP with false information and
the swap dealer or MSP then provides the false information to an SDR or
the Commission. NGSA, CDEU, and RESA commented that the Commission
should authorize a reporting entity to rely on the written
representations or affirmations of the electing counterparty. NCFC
stated that the Commission should not require a reporting firm to
verify the information provided by the electing counterparty. In the
event that a reporting counterparty incorrectly reports a swap, CDEU
recommended that the Commission provide a procedure to cure a notice
failure.
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\42\ See, e.g., Cravath, EMUS, IECA, NCFC, NGSA & NCGA, NRECA,
and Peabody.
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The Commission notes that proposed Sec. 23.505 addresses obtaining
and reporting end-user exception information by swap dealers and
MSPs.\43\ Under that proposed rule, ``[e]ach swap dealer and major swap
participant shall obtain documentation sufficient to provide a
reasonable basis on which to believe that its counterparty meets the
statutory conditions required for an exception from a mandatory
clearing requirement, as defined in section 2(h)(7) of the Act and
Sec. 39.6 of this chapter.''
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\43\ See 76 FR 6715 at 6726 (Feb. 8, 2011) (Swap Trading
Relationship Documentation Requirements for Swap Dealers and Major
Swap Participants).
---------------------------------------------------------------------------
To provide greater clarification for the end-user exception, the
Commission is modifying Sec. 39.6 to add Sec. 39.6(b)(3), which
states: ``Each reporting counterparty shall have a reasonable basis to
believe that the electing counterparty meets the requirements for an
exception to the clearing requirement under section 2(h)(7) of the Act
and this section.'' \44\ The Commission believes that establishing this
explicit standard will give reporting counterparties greater clarity as
to how to comply with the requirements of the rule and will help
prevent abuse of the end-user exception. What constitutes a
``reasonable basis to believe'' will depend on the applicable facts and
circumstances. For example, a reporting counterparty that has a long-
standing business relationship with the electing counterparty and knows
that the electing counterparty is doing the same repetitive swap trades
for the same commercial risk hedging purposes may be able to rely on
its due diligence for the initial swap in the series and not need to
re-establish the due diligence for every subsequent swap trade. As a
further example, it may be reasonable in many circumstances for the
reporting counterparty to rely on appropriate representations from the
electing counterparty. On the other hand, if the reporting counterparty
has a reasonable basis to believe that the representations of the
electing counterparty are not accurate for a particular swap being
considered, then the reporting counterparty may not reasonably rely on
those representations for that swap.
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\44\ Unlike proposed Sec. 23.505, this provision does not
include a requirement to ``obtain documentation.'' This is because
proposed Sec. 23.505 applies only to swap dealers and MSPs, whereas
the reporting counterparty under Sec. 39.6 may be a non-swap
dealer/MSP. Such entities are less likely to have standardized
documentation compliance systems in place and therefore obtaining
documentation may be burdensome. To reduce this burden, the
Commission has determined to provide greater flexibility in this
rule.
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In response to comments concerning the liability of electing
counterparties that are dependent on reporting counterparties to
fulfill the reporting requirements of the rule, the electing
counterparty is entitled to rely on reasonable representations by the
reporting counterparty that the notification information has been
properly transmitted. In such circumstances, the electing counterparty
would not be subject to adverse consequences and the swap will not be
deemed ineligible for the end-user exception for failure of the
reporting counterparty to properly report the information.
Regarding CDEU's comment on correcting information later determined
to have been reported incorrectly, the Commission notes that its swap
data recordkeeping and reporting rules address this issue for reported
information generally in Sec. 45.14.\45\
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\45\ See 77 FR 2136 at 2210 (Jan. 13, 2012) (Swap Data
Recordkeeping and Reporting Requirements; final rule).
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10. Commission Approval for Use of the End-User Exception
NCSHA requested that the Commission clarify how the notification
and reporting requirements of Sec. 39.6 will affect the approval
process for eligible counterparties electing the end-user exception.
According to NCSHA, it is unclear whether the Commission will deny a
counterparty the right to elect the end-user exception on the basis of
``insufficiently meeting the Commission's notification and reporting
requirements.'' NCSHA does not believe the Commission has the authority
to reject eligible counterparties from electing the end-user exception
on the basis of a failure to meet the Commission reporting or
notification standards. However, if the Commission determines that it
has that authority, NCSHA requested that the Commission provide a
detailed list of the criteria it deems as necessary for a counterparty
to sufficiently meet the CEA's notification and reporting requirements.
The Commission notes that Sec. 39.6 does not include a process for
approving a counterparty's election of the end-user exception, but a
potential electing counterparty must meet the notification and
reporting requirements in order to be eligible to elect the exception.
C. Hedging or Mitigating Commercial Risk
Section 2(h)(7)(A)(2) of the CEA provides that a swap shall not be
subject to the clearing requirement if, among other things, one of the
counterparties to the swap ``is using swaps to hedge or mitigate
commercial risk * * *.'' Proposed Sec. 39.6(c) provides potential
electing counterparties with criteria for
[[Page 42571]]
determining whether a swap hedges or mitigates commercial risk.\46\
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\46\ The phrase ``hedge or mitigate commercial risk'' was also
the subject of joint rulemaking by the Commission and the SEC for
purposes of the ``major swap participant'' definition under Section
1a(33) of the CEA. The overlap of that joint rulemaking and Sec.
39.6(c) is addressed in Section II.C.11 below.
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1. Breadth of the Criteria
As noted in the NPRM, the criteria for what constitutes hedging or
mitigating commercial risk in proposed Sec. 39.6(c) are generally
designed to allow a wide variety of potential electing counterparties
to structure their swaps in a manner that fits their particular
businesses while also providing guidance and a measure of certainty in
discerning the line between swaps used for hedging or mitigating
commercial risk and swaps used for other purposes.
Many commenters supported a broad set of criteria that would
provide entities with sufficient flexibility to accommodate different
risk mitigation strategies.\47\ EEI & EPSA stated that a limited set of
criteria (particularly with regard to hedging financial risks, as
discussed in Section II.C.2 below) would prevent non-financial entities
from effectively hedging risks associated with significant parts of
their commercial businesses and could conflict with Section 737 of the
Dodd-Frank Act (which concerns position limits). CDEU recommended that
commercial risk be construed more broadly to incorporate all risks
associated with an entity's operations, including, but not limited to,
interest rate risk, currency risk, credit risk, equity price risk, and
risks arising from the purchase, ownership, production, storage, sale,
financing, or transportation of commodities.
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\47\ See, e.g., CDEU, API, APGA, EEI & EPSA, Kraft, CMC,
Milbank, and Philip Morris.
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Conversely, other commenters suggested that the Commission should
construe commercial risk more narrowly.\48\ A number of commenters
recommended that the definition of ``commercial risk'' be narrowly
tailored to apply only to those entities whose business activities
expose them to risk from physical commodity price fluctuations.\49\
According to these commenters, ``commercial risk'' should not include
risks that are purely financial in nature. AFR expressed concern that
the proposed rule construes commercial risk too broadly and would
provide little direction as to whether a swap position is hedging or
mitigating commercial risk. In AFR's view, any business risks might
qualify under the proposed regulations. AFR recommended that the
Commission provide a narrower, prescriptive definition.
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\48\ See, e.g., AFR, AFSCME, WDM, IPM&CSA, East Coast Petroleum
(ECP), Pennsylvania Petroleum Marketers and Convenience Store
Association (PPMCSA), Commodity Markets Oversight Coalition (CMOC),
Fuel Merchants of New Jersey (FMNJ), Georgia Oilmen's Association
(GOA), Skylands Energy Service, Inc. (Skylands), Weiss, Edward M.
Minicozzi, Medford Heating (Medford), Tobin, Sullivan, Fay &
Grunebaum, and Form Letters.
\49\ See, e.g., CMOC, ECP, FMNJ, IPM&CSA, Medford, General
Utilities, Inc., PPMCSA, and Skylands.
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The Commission has determined that the criteria described in
proposed Sec. 39.6(c) should not change except for certain limited
changes specifically discussed below. The Commission believes that by
limiting the end-user exception to swaps that hedge or mitigate
commercial risk, Congress made clear that it did not intend the
exception to be applicable for all types of risk. Given the wide
variety of potential electing counterparties, swaps, and hedging
scenarios, the Commission believes that the rule strikes an appropriate
balance between providing flexibility for entities to qualify for the
end-user exception and clarity on the limits of the exception.
2. Treatment of Commodity Risks and Financial Risks
Proposed Sec. 39.6(c) sets out criteria for hedging certain
financial risks such as interest, currency, or foreign exchange rate
risks. The Commission asked in the NPRM whether the rule should only
apply to swaps involving non-financial commodities.
Several commenters noted that non-financial entities regularly
hedge financial risks related to their business operations and that
limiting the rule to risks related to non-financial commodities would
be unduly restrictive.\50\ In contrast, other commenters stated that
the rule should be limited to risks related to physical commodity price
fluctuations and the principal business of the electing counterparty
and should not include purely financial risks.\51\ Some commenters
expressed the view that the end-user exception should be limited so
that it can only be used in direct proportion to the electing
counterparty's physical holdings.\52\ These commenters believe this
approach would prevent an entity that is engaged in commercial activity
from claiming the end-user exception for risks that are not commercial.
AFSCME expressed concern about including foreign exchange hedging
because foreign exchange transactions are alleged to be regularly
abused and manipulated.
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\50\ See, e.g., Independent Community Bankers of America (ICBA),
COPE, Peabody, WSPP, and SIFMA.
\51\ See, e.g., WDM, IPM&CSA, ECP, PPMCSA, CMOC, FMNJ, GOA,
Skylands, General Utilities, Inc., Medford, and Ms. Roselyn Devlin.
\52\ See, e.g., Skylands, FMNJ, General Utilities, Inc.,
Cochrans, ECP, and Medford.
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The Commission declines to revise proposed Sec. 39.6 to exclude
hedging of commercial ``financial'' risks from the end-user exception.
The Commission believes that an entity that may elect the end-user
exception can be subject to financial risks related to its commercial
activities and that these risks can constitute commercial risks. For
example, a change in interest rate risk on a non-financial entity's
debt incurred for commercial business operations (e.g., to fund the
purchase of inputs or to build a factory for the entity) can constitute
commercial risk. As a further example, Sec. 39.6(c)(1)(i)(F) addresses
the risk of a change in interest, currency or foreign exchange risk
exposures arising from a person's current or anticipated assets or
liabilities in the ordinary course of business.\53\
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\53\ Proposed Sec. 39.6(c)(1)(i)(E) addressed similar financial
risks arising from rate ``movements'' rather than ``exposures.''
However, the text of proposed Sec. 39.6(c)(1)(i)(E) inadvertently
referred only to foreign exchange rates. Accordingly, the final rule
text has been revised to include interest and currency rates to be
consistent with Sec. 39.6(c)(1)(i)(F).
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Furthermore, the Commission does not believe the end-user exception
was intended to apply only to physical commodity hedging. The
Commission notes that the Dodd-Frank Act did not limit the end-user
exception to physical position hedging. However, the Commission
acknowledges the concern of commenters that allowing the end-user
exception to be used for financial risk hedging might increase the
potential for abuse of the exception. The Commission emphasizes that
the use by non-financial entities of the end-user exception for
financial risk hedging or mitigation must be an incidental part of
(i.e., not central to) the electing counterparty's business and must
fully qualify under all other applicable provisions of the CEA and
Sec. 39.6. The Commission will monitor the use of the end-user
exception, particularly when it is used for hedging financial risks. If
the Commission finds that the end-user exception is being abused in
this regard, it will take appropriate action.
3. Facts and Circumstances Test
The Commission noted in the NPRM that it preliminarily believed
that whether a position is used to hedge or mitigate commercial risk
should be determined by the facts and circumstances existing at the
time the
[[Page 42572]]
swap is entered into, and should take into account the person's overall
hedging and risk mitigation strategies.
A number of commenters generally agreed with the Commission's
preliminary view.\54\ EDF Trading suggested that such an approach is
the only commercially practical way to implement the rule. NRECA
commented that the Commission should make clear in its rules that it
will not second-guess the decision of an electing counterparty to enter
into the swap and the decisions related to the terms of the swap for
which the end-user exception is elected, and should not provide for
review of such commercial risk management decisions with the benefit of
hindsight.
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\54\ See, e.g., CDEU, Peabody, Philip Morris, EDF Trading,
Kraft, NRECA, and AFSCME.
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The Commission confirms that counterparties should look to the
facts and circumstances that exist at the time the swap is executed to
determine whether a swap satisfies the criteria for hedging or
mitigating commercial risk as set forth in the final rule. In response
to NRECA's comment, the Commission does not believe it is necessary to
expressly set forth the facts and circumstances test in Sec. 39.6. The
Commission notes that nothing in Sec. 39.6 would require ongoing
reporting or testing of a swap's hedge effectiveness.\55\ The
Commission further notes, however, that it may review whether the
election of the end-user exception was made in compliance with the CEA
and the Commission's regulations at the time such election was made.
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\55\ Hedge effectiveness testing is discussed in further detail
below in section II.C.9.
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4. Commercial Status of the Electing Counterparty
The Commission received a number of comments on whether
``commercial'' refers to (i) the underlying activity being hedged or
(ii) the nature of the general activities of the entity claiming the
end-user exception. CDEU, ICBA, WSPP, and the Securities Industry and
Financial Markets Association (SIFMA) agreed with the Commission's
general view expressed in the NPRM that the determinant of whether a
risk is ``commercial'' should be based on the underlying activity to
which the swap relates and not the general nature of the electing
counterparty's activities. A number of commenters requested that, to
avoid any uncertainty, the rule language clarify that governmental and
non-profit entities can incur commercial risks (such as interest rate
risk associated with debt).\56\ Similarly, Norges Bank Investment
Management asked the Commission to confirm that use of the word
``commercial'' does not preclude foreign central banks and other
sovereign entities from relying on the end-user exception.\57\
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\56\ See, e.g., SIFMA, SIFMA MFP, SFG, Milbank, NCHSA, and WSPP.
\57\ Based on the language of some of the comments, it appears
that part of this concern may arise from the use of the phrase
``commercial enterprise'' in the proposed rule. That phrase is used
to be consistent with existing Sec. 1.3(z) of the Commission's
regulations, which identifies activities that qualify as hedging in
the futures markets.
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In response to a question asked in the NPRM, ICBA commented that
agricultural cooperatives and non-profit, governmental, or municipal
entities should not receive any special considerations. ICBA reasoned
that adding further gradations or special considerations could create
competitive disadvantages for other entities. ICBA further noted that
the Dodd-Frank Act contemplates special treatment under the end-user
exception only for small financial institutions and accordingly,
special treatment for other types of entities might contravene
Congressional intent.
In response to these comments, the Commission confirms that the
determination of whether the risk being hedged or mitigated is
``commercial'' will be based on the underlying activity to which the
risk relates, not on the type of entity claiming the end-user
exception.\58\ The Commission confirms that this distinction applies to
all potential electing counterparties including governmental entities,
both domestic and foreign, and non-profit entities. Their status as
governmental or non-profit entities does not control the determination
of whether they are hedging or mitigating ``commercial'' risk. Rather,
that determination will depend on the nature of the underlying activity
to which the risk being hedged or mitigated relates.
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\58\ The exception to this approach is with respect to financial
entities, which are defined in Section 2(h)(7)(C) of the CEA based
on who they are or what they do generally. Financial entities are
prohibited from electing the end-user exception under Section
2(h)(7)(A)(i) of the CEA.
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Finally, the Commission believes that any additional language
adding further gradations or special considerations in this regard
could create confusion or unintended distinctions among different types
of entities.
5. ``Economically Appropriate'' Standard
Under proposed Sec. 39.6(c)(1)(i), a swap is used to hedge or
mitigate commercial risk if the swap is ``economically appropriate'' to
the reduction of any of six different categories of commercial risk
listed in that section.\59\ Kraft commented that the ``economically
appropriate'' standard should not be further defined because ``bright-
line'' definitions or limitations will result in less effective hedges
and increased costs.
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\59\ In the alternative to meeting the requirements of Sec.
39.6(c)(1)(i), a swap executed by an electing counterparty may also
be eligible for the end-user exception if the swap qualifies as a
bona fide hedge for purposes of an exception from position limits
under the CEA as provided in Sec. 39.6(c)(1)(ii), or if it
qualifies for hedging treatment under FASB Accounting Standards
Codification Topic 815 or under GASB Statement 53 as provided in
Sec. 39.6(c)(1)(iii). Consequently, the universe of swaps that can
qualify for the exception 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 Sec. 39.6(c)(1)(ii).
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Better Markets expressed concern that the proposed ``economically
appropriate'' standard may allow the end-user exception to be elected
for swaps that do not hedge commercial risk precisely. Better Markets
recommended that the Commission adopt a ``congruence'' standard that
Better Markets believes fits the statutory language better. The
``congruence'' standard would require each risk in the swap to be
congruent with a corresponding commercial risk being hedged.
On the other hand, SFG believes the ``economically appropriate''
standard is too narrow and should be replaced with a ``management or
reduction of risks'' standard.
The Commission is adopting the ``economically appropriate''
standard as proposed. The Commission believes that this standard will
help interested parties distinguish those swaps that hedge or mitigate
commercial risks from those that do not, thereby reducing regulatory
uncertainty and helping prevent abuse of Section 2(h)(7) of the CEA.
The facts and circumstances will determine whether the swap is
economically appropriate to hedge or mitigate commercial risks. While
the Commission acknowledges that this standard leaves room for judgment
in its application, the Commission believes this flexible approach is
needed given the wide variety of swaps, potential electing
counterparties, and hedging strategies to which the rule applies. The
Commission believes the ``economically appropriate'' standard, together
with the identification of the six different categories of permissible
commercial risks listed in proposed Sec. 39.6(c)(1)(i), is specific
enough, when reasonably applied, to determine whether a swap is being
used to hedge or mitigate commercial risk.
The Commission is not adopting a ``congruence'' standard because it
[[Page 42573]]
believes the standard, which would require that each component risk of
the swap be congruent with each risk being hedged, may be too
restrictive and difficult to apply given the range of potential
electing counterparties, types of swaps, and hedging strategies. Nor is
the Commission adopting a ``management or reduction of risks''
standard. SFG's recommendation does not explain what risk
``management'' means. Furthermore, the Commission is concerned that a
standard based on ``management'' of risks may be overly inclusive and
could apply to any swap that changes risk levels, including swaps that
increase risk contrary to the goals of the Dodd-Frank Act.
6. Hedging Treatment Under Accounting Standards
Under proposed Sec. 39.6(c)(1)(iii), a swap may be deemed to hedge
or mitigate commercial risk if the swap qualifies for hedging treatment
under Financial Accounting Standards Board (FASB) Accounting Standards
Codification Topic 815. Professor Greenberger commented that
transactions that meet the definition of hedging under accounting
standards should qualify as commercial hedges.
SIFMA, SIFMA's Municipal Financial Products Committee (SIFMA MFP),
and GFOA asked that the Commission revise the proposed rule to include
swaps that qualify for hedging treatment under the Governmental
Accounting Standards Board (GASB) Statement 53, Accounting and
Financial Reporting for Derivative Instruments (Statement 53).
Statement 53 is the accounting standard for establishing a bona fide
hedge under the GASB accounting standards used by many local government
entities in the United States. Although different from the FASB
accounting standard for hedging treatment, Statement 53 is similar in
effect.
The Commission agrees that entities that use GASB accounting
standards should be able to use Statement 53 to demonstrate that a swap
hedges or mitigates commercial risk in the same way that the FASB
hedging standard is used. Accordingly, the Commission is revising
proposed Sec. 39.6(c)(1)(iii) to include swaps that qualify for
hedging treatment under Statement 53.
7. Speculation, Investing, or Trading
Under proposed Sec. 39.6(c)(2)(i), a swap does not hedge or
mitigate commercial risk if it is used for a purpose that is in the
nature of ``speculation, investing, or trading.'' Commenters expressed
different views on whether swaps held for speculative, investing, or
trading purposes should qualify as hedging or mitigating commercial
risk and whether it is practical for the Commission to include the
limitation in the rule. The Commission also received a number of
comments that addressed application of the proposed limitation
specifically to physical commodity swaps.
A number of commenters agreed that swaps which are used for one or
more of the purposes of speculation, trading or investing should not
qualify for the end-user exception.\60\ Philip Morris commented that
the proposed criteria for hedging or mitigating commercial risk
sufficiently encompass swaps legitimately used to hedge commercial
risks, while excluding those used for speculation, trading, or other
non-hedging purposes. The Form Letters supported the general concept of
this limitation, noting that the ``common sense'' exception for end
users should not be broadened to allow institutions to ``gamble'' in
the derivatives markets. AFR agreed with the Commission's approach as
explained in footnote 23 of the NPRM, but also expressed concern that
the proposed rule may be too flexible and could create a loophole for
speculators claiming to be hedging commercial risk when in fact they
are not.
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\60\ See, e.g., BG Americas & Global LNG (BG LNG), Peabody,
Philip Morris, Form Letters, and Cravath.
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Several commenters suggested revising the proposed rule to limit
the possibility that the provision would be applied in an overly
restrictive manner. IECA recommended that the words ``investing or
trading'' be eliminated from Sec. 39.6(c)(2)(i). IECA believes that,
because swaps are ``traded'' and can appear on an entity's balance
sheet, it is inappropriate to prohibit swaps used for investing or
trading purposes. Vitol, Inc. (Vitol) expressed concern that excluding
speculative or trading activities might preclude commercial firms that
merchandise commodities or act as intermediaries in the supply chain
from treating such positions as hedging or mitigating their commercial
risk.
Commenters expressed particular concern that the term ``trading''
could be interpreted to include entering and exiting swap positions
used to hedge or mitigate commercial risk and therefore such swaps
would be ineligible for the end-user exception.\61\ For example, WGCEF
commented that a ``trading'' position held in anticipation of a
potential price increase should qualify as hedging commercial risk, but
under the proposed rule it could be interpreted as a ``trading''
position and not qualify for the end-user exception.
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\61\ See, e.g., Hess, WGCEF, EPSA, and Peabody.
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Similarly, BG LNG, API, and WGCEF believe, based on their reading
of footnote 23 of the NPRM, that certain swaps entered into for the
purpose of hedging physical market positions could be excluded.
According to BG LNG and EPSA, any rule that prohibits the end-user
exception from being applied generally to swaps that hedge physical
market positions because they are classified as ``trading'' positions
or ``speculative'' positions would have serious, adverse consequences
to physical markets for energy and other commodities. Also in reference
to footnote 23 in the NPRM, WGCEF and BG LNG commented that many swaps
that represent ``arbitrage'' positions are themselves hedges of
commercial risk and not the type of speculative swaps that should be
denied the end-user exception. BG LNG further commented that the
unwinding or offsetting of such swaps should not change their
characterization as ``hedging or mitigating commercial risk.''
API, EPSA, and WGCEF recommended that the Commission clarify that
swap positions that hedge other speculative or trading swap positions
are also speculative or trading positions, unless such swap positions
hedge physical commodity positions.
Cravath and Riverside commented that ``investments'' should be
deleted from the limitation, noting that certain swaps that hedge or
mitigate commercial risks specified in the rule may be treated as
investments for accounting or other purposes.
Finally, WGCEF noted that ``trading,'' ``speculation,'' and
``investing'' were not defined in the proposed rule or the CEA.
The Commission is adopting Sec. 39.6(c)(2)(i) as proposed. While
the line between hedging or mitigating commercial risk and other uses
of swaps can be difficult to discern at times, the Dodd-Frank Act
nonetheless requires such determinations to be made. The Commission
believes that explicitly prohibiting the end-user exception for swaps
entered into for the purpose of speculating, investing, or trading, as
opposed to swaps used for the purpose of hedging or mitigating
commercial risk, will help entities to understand the limits of hedging
or mitigating commercial risk for purposes of Sec. 39.6 and will help
prevent abuse of the exception.
The Commission believes that the meaning of Sec. 39.6(c)(2)(i) is
apparent when read in the overall context of Sec. 39.6(c), which
addresses the requirement in Section 2(h)(7)(A)(ii) of the CEA that the
electing counterparty be using the swap to hedge or mitigate commercial
risk. This requirement
[[Page 42574]]
focuses on the purpose for which the potential electing counterparty is
using the swap. Swaps executed for the purpose of speculating,
investing, or trading are not being used to hedge or mitigate
commercial risk. Such positions are, generally speaking, being executed
primarily for the purpose of taking 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. For example, swap 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.
As noted above, several commenters expressed concern regarding the
inclusion of ``trading'' in Sec. 39.6(c)(2)(i). In the context of the
rule, ``trading'' is not used to mean simply buying and selling.
Rather, a party is using a swap for the purpose of trading under the
rule in this context 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 Sec. 39.6(c)(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.\62\
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\62\ The Commission 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(ttt)(1)(ii).
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The Commission acknowledges that some swaps that may be
characterized as ``arbitrage'' transactions in certain contexts may
also reduce commercial risks enumerated in Sec. 39.6(c)(1). The
discussion in footnote 23 of the NPRM was intended to clarify 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 23 was intended to provide an example of what is commonly a
speculative swap, not to characterize all arbitrage swaps as
speculative.
The Commission is not revising Sec. 39.6(c)(2)(i) to provide an
express exception for swaps related to physical commodity positions.
Swaps related to physical positions are not always hedging or
mitigating commercial risk. For example, a swap related to physical
positions may be a speculative position taking an outright view of the
underlying commodity market. In limiting the end-user exception to
swaps that hedge or mitigate commercial risk, Congress did not provide
an exception from that limitation for swaps related to physical
positions.
The Commission also notes that some commenters may have interpreted
the proposed rule as prohibiting an entity that claims the end-user
exception with respect to certain swaps from entering into other swaps
for the purpose of speculation, investing, or trading. The Commission
reiterates that a party's ability to elect the end-user exception for a
particular swap is a function of the purpose of the particular swap in
question. The fact that a party enters into other unrelated swaps for
the purpose of speculating, investing, or trading will have no effect
on the counterparty's assessment of whether its other swaps meet the
requirements of the rule.
8. Swaps Hedging Other Swaps
Under proposed Sec. 39.6(c)(2)(ii), a swap that hedges or
mitigates the risk of another swap or security-based swap may qualify
as hedging or mitigating commercial risk only if the underlying swap or
security-based swap itself is used to hedge or mitigate commercial
risk.
Professor Greenberger generally agreed with the limitation in the
proposed rule and recommended that the limitation be extended to all
swaps hedging other swaps. In his view, hedges of other hedging swaps
are inherently speculative and should not be allowed under the end-user
exception.
Reval.com, Inc. (Reval) suggested that swap transactions that are
executed on a ``matched book'' basis with swaps that are excepted from
the clearing requirement should also be eligible for the clearing end-
user exception. Several small or regional financial entities commented
that swaps executed on a matched book or back-to-back basis with swap
dealers, which hedge swaps executed with non-financial entities who
themselves are using the swaps to hedge commercial risks, should get
the benefit of the end-user exception.\63\
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\63\ See, e.g., Susquehanna Bancshares, Inc., The Private Bank
and Trust Company, Commerce Bank, Atlantic Capital Bank, Trustmark,
Webster Bank, UMB Bank, Chatham Financial, and Wintrust.
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The Commission considered whether a swap that hedges another swap
that itself is used to hedge or mitigate commercial risk could qualify
for the end-user exception. The Commission determined that such a swap
could qualify if it in fact hedges or mitigates commercial risk for a
party entering into the swap. In connection therewith, the Commission
has determined that ``matched book'' or ``back-to-back'' swaps that
hedge or mitigate risks of other swaps may qualify for the end-user
exception if the swap is used to reduce risks in the conduct and
management of a commercial enterprise as set forth in Sec. 39.6(c)(1)
and the ``other swap'' itself qualifies for the end-user exception.
This is why Sec. 39.6(c)(2)(ii) provides that a swap that hedges or
mitigates the risk of another swap or security-based swap may qualify
as hedging or mitigating commercial risk, so long as the underlying
swap or security-based swap itself is used to hedge or mitigate
commercial risk. This provision allows successive swaps in a chain of
back-to-back swaps to qualify for the end-user exception if the first
underlying swap qualifies for the exception, and each such successive
swap is used by a party to that successive swap that qualifies for the
end-user exception to hedge or mitigate commercial risk. This result is
only applicable to entities that could otherwise qualify for the end-
user exception. Accordingly, in a chain of qualifying swaps involving
only qualifying entities, if the ``last'' qualifying entity in the
chain hedges its qualifying swap (its ``underlying swap'') by entering
into a qualifying swap with a non-qualifying financial entity (its
``hedging swap''), then although the qualifying entity can elect to use
the end-user exception with respect to its hedging swap, that financial
entity cannot elect the end-user exception for any further swap used by
that financial entity to hedge or mitigate its position. In effect, the
chain is then broken.
Reval's comment indicates that the text of proposed Sec.
39.6(c)(2) may be unclear. When the wording of proposed Sec. 39.6(c)
is read as a whole, the proposed rule provides that a swap qualifies
for the end-user exception if it meets one of the conditions stated in
proposed Sec. 39.6(c)(1) and if, as stated in proposed Sec.
39.6(c)(2), the swap is (i) not held for a speculative, investing, or
trading purpose, or (ii) not hedging another swap unless that swap
itself is held for hedging purposes. Accordingly, the literal text of
proposed Sec. 39.6(c)(2) could be interpreted to permit a swap to
qualify for the end-user exception if the
[[Page 42575]]
swap is not hedging another swap (i.e., if the second clause is
satisfied), even if the swap is itself held for a speculative,
investing, or trading purpose (i.e., if the first clause is not
satisfied).
The NPRM stated that ``[p]roposed Sec. 39.6(c)(2) further
provides, however, that a swap is disqualified from the end-user
exception if it is held for a speculative, investing, or trading
purpose, or if it hedges another swap unless that swap itself is held
for hedging purposes.'' \64\ In other words, proposed Sec. 39.6(c)(2)
provides that a swap would be disqualified from the end-user exception
if either of two conditions were true: If the swap is held for a
speculative, investing, or trading purpose, or if the swap hedges
another swap unless that swap itself is held for hedging or mitigating
purposes.
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\64\ 75 FR at 80752 (footnote omitted).
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Accordingly, the Commission is revising the text of Sec.
39.6(c)(2) to clarify the rule text in accordance with the intended
purpose by replacing the conjunction ``or'' between clauses (i) and
(ii) in Sec. 39.6(c)(2) with the conjunction ``and.'' \65\ This
clarifies that, in order to qualify for the end-user exception, the
swap must not be used for the purposes stated in Sec. 39.6(c)(2)(i),
and it must not be used for the purposes stated in Sec.
39.6(c)(2)(ii). The final rule adopted by the Commission includes this
change.
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\65\ The Commission notes that in the definition of ``hedge or
mitigate commercial risk'' proposed by the Commission for purposes
of defining ``major swap participant'' under Section 1a(33) of the
CEA, there was no conjunction between clauses (i) and (ii). See
Further Definition of ``Swap Dealer,'' ``Security-Based Swap
Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap
Participant'' and ``Eligible Contract Participant,'' 75 FR 80174,
80214, 80217 (Dec. 21, 2010) (proposed Sec. 1.3(ttt)(2)). However,
the Commission added the conjunction in the final definition. See 77
FR 30596 at 30750 (May 23, 2012) (final Sec. 1.3(kkk)(2)).
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In response to Professor Greenberger's comment, the Commission does
not believe that a swap that hedges an existing hedge is always
speculative. The CEA does not require that the end-user exception be
available only if the swap is a perfect or exact hedge. A swap
originally designed to hedge commercial risk in compliance with the
criteria of the rule may, over time, no longer fully serve its original
hedging purpose. For example, if the underlying commercial risk hedged
by the original swap or security-based swap no longer exists or changes
as a result of changing market conditions or changes in the business
needs of the electing counterparty, the risk now posed by the original
swap or security-based swap itself is like other commercial risks that
arose in the ordinary course of business because that swap originated
as a hedge of commercial risk. Accordingly, as the Commission has
stated that the entities shall evaluate the facts and circumstances
existing at the time a hedge position is initiated \66\ when electing
the end-user exception, the entity should have the option to elect the
end-user exception for swaps that hedge or mitigate risks created by
the original swap or security-based swap, even if the original risk
hedged no longer exists or has changed.
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\66\ See section II.C.9 herein.
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9. Portfolio and Dynamic Hedging, and Hedge Effectiveness Testing
In the NPRM, the Commission asked whether the end-user exception
should apply to swaps that hedge or mitigate commercial risk on a
single-risk basis or an aggregate-risk basis or to swaps that
facilitate dynamic hedging. The Commission also asked whether hedge
effectiveness should be addressed.
A number of commenters stated that portfolio hedging and dynamic
hedging may hedge or mitigate commercial risk, and are commonly used by
certain potential electing counterparties, and therefore the hedging
techniques should be eligible for the end-user exception.\67\ WGCEF,
Shell, and ATA noted that commercial firms in the physical energy and
other markets often hedge underlying physical assets and related
positions on a portfolio or aggregate basis and also may dynamically
hedge. WGCEF stated that in such cases it would be impracticable to
have one-to-one matching of each swap to a specific physical
transaction or asset for purposes of complying with the end-user
exception. EEI & EPSA and WGCEF commented that excluding hedging of
commercial risks on a portfolio basis or dynamic hedging could
introduce uncertainty and limit the ability of non-financial entities
to effectively manage their commercial risks.
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\67\ See, e.g., EEI & EPSA, ATA, WGCEF, RESA, Peabody, Kraft,
and American Public Power Association & Large Public Power Council.
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Regarding hedge effectiveness, a number of commenters stated that
it is important for entities to know at the time a transaction is
executed whether the end-user exception applies. According to these
commenters, an effectiveness test should not be used because it can
only determine whether the swap appropriately hedges or mitigates
commercial risk at the time of the test and not at the time of swap
execution.\68\ EDF Trading suggested that ``reasonable efforts to hedge
commercial risks'' should be considered hedging. EDF Trading noted that
tracking and analyzing the hedging or mitigating characteristics of a
swap after its inception would be difficult because the hedging value
of a swap fluctuates over time and is subject to market forces. EDF
Trading further noted that such uncertain market fluctuations are the
principal reason for entering into hedging transactions in the first
place. EDF Trading believes that requiring an ongoing, periodic
assessment of a hedge's effectiveness or purpose would be burdensome
for commercial entities and would do little to reduce systemic risk.
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\68\ See, e.g., ATA, APGA, Cravath, EDF Trading, and Kraft.
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CFI suggested that a requirement to report the related risk being
hedged, which would be necessary to test hedge effectiveness, would
impose an unnecessary burden on electing counterparties. In contrast,
Better Markets and PMAA & NEFI commented that entities should be
required to disclose what specific risks they are hedging and how the
swap hedges those risks so that regulators can police the end-user
exception. Furthermore, Better Markets stated that entities should have
to certify that excepted swaps are not entered into for speculation
either in whole or in part.
The Commission has determined that a swap that facilitates
portfolio hedging or dynamic hedging may be eligible for the end-user
exception if that swap hedges or mitigates commercial risk. The
Commission acknowledges that portfolio hedging and dynamic hedging \69\
can be economically appropriate to hedge or mitigate commercial risk,
depending on the relevant facts and circumstances.
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\69\ Regarding commenters' queries about dynamic hedging, which
WGCEF described as the ability to modify the hedging structure
related to physical assets or positions when relevant pricing
relationships applicable to that asset change, the Commission notes
that qualification as bona fide hedging does not require that
hedges, once entered into, must remain static. The Commission
recognizes that entities may update their hedges periodically when
pricing relationships or other market factors applicable to the
hedges change.
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The Commission has also determined that parties will not be
required to demonstrate hedge effectiveness or engage in periodic hedge
effectiveness testing. The Commission agrees with commenters that
entities need to know whether the swap is eligible for the end-user
exception at the time it is executed and should not be subject to
second guessing if subsequent hedge effectiveness testing finds that
the swap does not, over time, hedge the intended risk as such
ineffectiveness may be beyond the control of the electing counterparty.
Furthermore, the Commission believes that such a
[[Page 42576]]
requirement could potentially add costs and burdens with potentially
limited added benefit.
Finally, the Commission has determined not to require entities to
document and report the risk being hedged. The Commission believes that
such a requirement would create a large volume of unique data that
would be difficult to meaningfully review. Although the Commission has
determined not to modify Sec. 39.6 to address portfolio hedging or
dynamic hedging at this time, the Commission recognizes that the end-
user exception could be more easily abused in these contexts. The
Commission intends to monitor use of the end-user exception and if such
abuse becomes prevalent, it may impose appropriate hedge identification
and/or hedge effectiveness testing or reporting requirements.
10. Swap-by-Swap or Swap Portfolio Approach
In a comment submitted prior to publication of the NPRM, NYCBA
requested clarification as to whether all swaps entered into by a
party, or only a certain percentage of the party's swap portfolio, must
hedge or mitigate commercial risk for the party to qualify for the end-
user exception. In proposed Sec. 39.6, whether a commercial risk is
being hedged or mitigated would be determined for each swap, not for
all or a portion of a party's swap portfolio.
As noted above, Section 2(h)(7)(A)(ii) of the CEA provides that a
swap shall not be subject to the clearing requirement if, among other
things, one of the counterparties to the swap ``is using swaps to hedge
or mitigate commercial risk * * *.'' The Commission does not believe
that Congress intended this language to automatically apply to all
swaps--no matter how numerous and no matter what their purpose--used by
an entity that uses some swaps to hedge or mitigate commercial risk.
Such an interpretation would extend the end-user exception beyond its
purpose of facilitating the use of swaps for hedging or mitigating
commercial risk. Conversely, the statutory language does not clearly
limit the end-user exception to entities that use swaps solely to hedge
or mitigate commercial risk. Implementation of Section 2(h)(7)(A)(ii)
thus requires the Commission to determine how the provision should be
applied to entities that use swaps to hedge or mitigate commercial risk
but also for other purposes.
Broadly speaking, there are two possible ways to do this: Either on
a swap-by-swap basis or based on an entity's overall portfolio of
swaps. The former approach has a number of important advantages and the
Commission therefore is adopting the swap-by-swap approach as proposed.
This approach is consistent with the swap-by-swap clearing requirement
in Section 2(h)(1) of the CEA. The portfolio approach would present
numerous issues that would be difficult to overcome or would render the
end-user exception less effective for achieving the stated goals of the
Dodd-Frank Act. For example, if the Commission required that a certain
minimum percentage of a party's swaps must hedge or mitigate commercial
risk, the end-user exception would be unavailable to parties who do not
reach the minimum threshold. This could prevent a large number of non-
financial entities from using the end-user exception at all. It is
unlikely that Congress intended such a result. In addition, if the
Commission required a high percentage of a party's swap portfolio to
hedge or mitigate commercial risk, potential electing counterparties
could be more inclined to abuse the end-user exception and evade
clearing by classifying non-hedging swaps as hedges to meet the
threshold set forth in the rule. Another concern is that, if a party's
swap portfolio satisfied the percentage requirement, the party could
elect the end-user exception for all swaps, including swaps that do not
hedge or mitigate commercial risk, thereby undermining the systemic
risk reduction benefits of the clearing requirement. A swap-by-swap
approach is thus consistent with Section 2(h)(7)(F), which authorizes
the Commission to prescribe rules to prevent abuse of the end-user
exception to the clearing requirement, and Section 2(h)(4)(A), which
directs the Commission to prescribe rules as determined by the
Commission to be necessary to prevent evasions of the clearing
requirement.
The Commission also believes the percentage approach would be
difficult to apply as a rule. In addition to determining whether each
swap hedges or mitigates commercial risk to calculate a swap portfolio
percentage, each such entity would need to repeatedly measure and
report portfolio hedging percentages to maintain compliance. A
percentage-of-portfolio test could lead to significant regulatory
uncertainty given the difficulty of measuring the percentage of swaps
that hedge or mitigate commercial risk over time as the portfolio
changes.
11. Consistency Across Commission Regulations
The Commission asked in the NPRM whether the criteria for hedging
or mitigating commercial risk should be consistent across all
Commission regulations. Section 1a(33) of the CEA, which defines
``major swap participant,'' provides for an exclusion of certain swap
positions held for ``hedging or mitigating commercial risk'' from the
determination of whether an entity maintains a substantial position in
swaps. For purposes of Section 1a(33) and the Commission's definition
of ``major swap participant'' in Sec. 1.3(hhh), the Commission has
adopted Sec. 1.3(kkk) to provide criteria for what constitutes
``hedging or mitigating commercial risk.'' \70\
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\70\ 77 FR 30596 at 30750 (May 23, 2012).
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A number of commenters recommended that the criteria for hedging or
mitigating commercial risk be consistent across all Commission
regulations. These commenters do not believe it is appropriate to have
different hedging criteria under the ``major swap participant''
definition and end-user exception.\71\ The ABA recommended that the
Commission cross-reference the hedging criteria used in the ``major
swap participant'' definition rather than include separate but
identical criteria in the end-user exception to avoid the possibility
of inadvertent or inconsistent amendments and interpretations.
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\71\ See, e.g., ABA, COPE, EMUS, ICBA, Reval, FHL Banks, Philip
Morris, and EDF Trading.
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The ``hedging or mitigating commercial risk'' criteria set forth in
Sec. 1.3(kkk) and Sec. 39.6(c) are consistent. The Commission has
determined that the criteria will remain as consistent as possible to
facilitate consistent interpretation across the CEA and Commission
regulations. However, application of the phrase ``hedging or mitigating
commercial risk'' serves similar, but different purposes in the two
rules. In addition, while the ``major swap participant'' definition
allows for application of the criteria to financial entities, pursuant
to the limitations in Section 3(h)(7)(C) of the CEA, the end-user
exception does not. Accordingly, there is a reasonable possibility that
the Commission may determine that the two criteria should be modified
in different ways in the future. Therefore, the Commission has
determined to publish the criteria in separate rules rather than
incorporate them by reference.
[[Page 42577]]
D. Exemption of Small Banks, Savings Associations, Farm Credit System
Institutions, and Credit Unions From the Definition of ``Financial
Entity''
Section 2(h)(7)(C)(ii) of the CEA provides that the Commission
``shall consider whether to exempt from the definition of `financial
entity' small banks, savings associations, farm credit system
institutions and credit unions including:
(I) Depository institutions with total assets of $10,000,000,000 or
less;
(II) Farm credit system institutions with total assets of
$10,000,000,000 or less; or
(III) Credit unions with total assets of $10,000,000,000 or less.''
For purposes of this discussion, all banks, savings associations,
farm credit system institutions, and credit unions, regardless of size,
are referred to as ``Section 2(h)(7)(C)(ii) institutions'' and the
subgroup of Section 2(h)(7)(C)(ii) institutions that are eligible for
exemption from the ``financial entity'' definition are collectively
referred to as ``small financial institutions'' or ``SFIs.''
In the NPRM, the Commission requested comment regarding the
appropriateness, breadth, risk issues, and limits of an exemption for
Section 2(h)(7)(C)(ii) institutions. The Commission also asked whether
there are appropriate measures for determining whether a Section
2(h)(7)(C)(ii) institution qualifies as a small financial institution
other than the $10 billion or less total assets test referenced in the
CEA.
A number of commenters supported defining SFIs broadly,\72\ but AFR
stated that only those small banks that engage in de minimis swap
activity should be exempted. CII opposed extending the end-user
exception to small Section 2(h)(7)(C)(ii) institutions because doing so
``would help preserve a hole in the oversight and regulation of
derivatives that would likely be exploited to the detriment of the
capital markets.''
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\72\ See, e.g., CUNA, FHL Banks, 19 Small Banks, MBCA, Frost,
FTNF, ICBA, PCBB, and Reval.
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A number of commenters \73\ recommended that the Commission provide
an exemption for SFIs because most small Section 2(h)(7)(C)(ii)
institutions only offer swaps to customers in connection with loans for
the customers' commercial business activities, and the related swaps
hedge interest rate risk. These commenters noted that such swaps are
not speculative in nature and are generally low risk. The small Section
2(h)(7)(C)(ii) institutions then enter into swaps with other financial
institutions, often on a matched or back-to-back swap basis, to hedge
the underlying risk of those customer swaps. According to these
commenters, such matched or back-to-back swaps pose less risk to the
small Section 2(h)(7)(C)(ii) institutions. For example, MBCA commented
that ``[small Section 2(h)(7)(C)(ii) institutions] participate in the
swaps markets for purposes of hedging interest rate risk on their
balance sheets and offering swaps in connection with loans as a means
to deliver long-term fixed rate financing to commercial borrowers.''
Also, these commenters noted that the swaps are often secured by assets
funded by the loans and those assets are not liquid. The lack of
liquidity of the security means that the small Section 2(h)(7)(C)(ii)
institutions cannot simply pass on the security to a DCO as collateral
for the matched swaps and must fund the collateral posted to DCOs in
other ways.
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\73\ See, e.g., ICBA, 19 Small Banks, MBCA, FCC, Chatham, FTNF,
Trustmark, UMB, Webster Bank, and Wintrust.
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Commenters also claimed that requiring small Section 2(h)(7)(C)(ii)
institutions to clear swaps would impose inordinate costs on them.
Chatham and Webster Bank noted that the fees charged by futures
commission merchants to clear swaps could be significant for Section
2(h)(7)(C)(ii) institutions that are ineligible for the end-user
exception and did not previously clear their swaps, especially those
institutions that transact only a small number of swaps. They indicated
that these fees generally take the form of a fixed minimum monthly fee,
plus a ``ticket'' fee that varies with the volume of swap transactions
processed.\74\ ABA and ICBA commented that if small Section
2(h)(7)(C)(ii) institutions have to incur high fixed costs for
clearing, they might refrain from entering into swaps to avoid having
to incur such costs.
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\74\ Chatham indicated that Section 2(h)(7)(C)(ii) institutions
will spend between $2,500 and $25,000 in legal fees related to
reviewing and negotiating clearing-related documentation, and a
Section 2(h)(7)(C)(ii) institution will spend a minimum of between
$75,000 and $125,000 per year on fees paid to each FCM with which it
maintains a relationship. Webster Bank corroborated these numbers
and also noted that a Section 2(h)(7)(C)(ii) institution will incur
additional costs from DCO fees, which vary based on collateral
delivered.
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ABA and 19 Small Banks commented that Section 2(h)(7)(C)(ii)
institutions should be exempted because applicable banking regulations
and guidance require banks to establish internal risk management
policies and procedures for all operations and activities, including,
in some cases, for swap transactions. ABA also noted that banks are
limited by the banking regulations applicable to them as to the amount
of credit they can extend to each individual or entity to a specified
percentage of capital and reserves.
FCC recommended that the Commission adopt rules that would permit
farm credit system (FCS) associations and banks to exercise the end-
user exception. FCC noted that FCS associations have, on average, total
assets under $10 billion, and that FCS banks may have total assets
exceeding $10 billion. According to FCC, these FCS institutions are
cooperatives owned by their members, and a major function of each
cooperative is to act on behalf of its members in the financial
markets. FCC further noted that the members of these cooperatives are
generally either non-financial entities or small financial
institutions. FCC reasoned that, because an FCS cooperative essentially
is taking the place of its members to face the larger financial markets
on behalf of the members, the end-user exception that would be
available to the cooperative's members should pass through to the
cooperative. In addition, FCC noted that the Farm Credit Administration
effectively regulates FCS institutions; FCS institutions only enter
into safe, non-speculative swaps primarily related to member loans
backed by collateral; and, unlike large banks, the FCS institutions are
not as interconnected with other financial entities.
Regarding the criteria for determining whether a Section
2(h)(7)(C)(ii) institution is eligible for the exemption, a number of
commenters recommended that the Commission allow institutions with more
than $10 billion in assets to qualify for the exemption.\75\ FCC
commented that Congress provided the Commission with the authority to
exempt financial institutions with more than $10 billion in assets. A
number of commenters \76\ suggested raising the threshold to $30
billion or higher. Frost, FTN, and MBCA recommended a $50 billion
threshold. 19 Small Banks recommended that institutions with assets
less than $50 billion and with uncollateralized exposure less than $1
billion should qualify for the exemption. These commenters suggested
that historically, the swap activity of financial institutions with
these higher asset levels is only a small percentage of the total swaps
market
[[Page 42578]]
and therefore exempting them would not pose risk to the market or the
financial system.
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\75\ See, e.g., ABA, FCC, Frost, FTNF, MBCA, Devlin, FHL Banks,
19 Small Banks, Susquehanna Bancshares, Inc., The Private Bank and
Trust Company, Commerce Bank, Atlantic Capital Bank, Trustmark,
Webster Bank, UMB Bank, Chatham Financial, and Wintrust.
\76\ ABA, Susquehanna Bancshares, Inc., The Private Bank and
Trust Company, Commerce Bank, Atlantic Capital Bank, Trustmark,
Webster Bank, UMB Bank, Chatham Financial, and Wintrust.
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FHL Banks commented that the $10 billion asset level should be the
baseline for the exemption. For Section 2(h)(7)(C)(ii) institutions
with more assets, FHL Banks recommended that the Commission establish
objective criteria for the exemption based on the risk that the
institution poses to the U.S. financial system. For example, FHL Banks
suggested that the Commission could look to the institution's current
uncollateralized exposure as well as its potential future exposure.
Similarly, FCC commented that the systemic risk created by
derivatives is not a function of an institution's asset size, but a
function of the type and amount of derivative activity after netting
offsetting positions and collateral. According to FCC, small
institutions that enter into many risky trades pose greater risk to the
financial system than larger institutions that carefully manage their
derivatives portfolios. Accordingly, FCC recommended that the
Commission focus on risk instead of asset size and recommended defining
``financial entity'' to mean entities with current uncollateralized
exposure and potential future exposure of $3 billion in rate swaps and
$1 billion in other major swap categories. FCC noted that such entities
could be required to report compliance with the risk-based exposure
test when electing the end-user exception. Similarly, CUNA recommended
that the Commission should only allow entities with at least $10
billion in assets and that engage in a ``significant volume'' of swaps
to qualify for the exemption.
The Commission is adopting Sec. 39.6(d) to provide an exemption
from the definition of ``financial entity'' for small Section
2(h)(7)(C)(ii) institutions. The Commission acknowledges that small
Section 2(h)(7)(C)(ii) institutions, which tend to serve smaller, local
markets, are well situated to provide swaps to the customers in their
markets for the purpose of hedging commercial risk. The Commission also
acknowledges that historically, as indicated by commenters, a large
portion of the swaps executed by small Section 2(h)(7)(C)(ii)
institutions with customers likely hedge interest rate risk associated
with commercial loans. Many of these loans and the related swaps are
not secured by cash or other highly liquid collateral, but by less
liquid assets of the customer such as the property or inventory
purchased with the loan proceeds. Based on the comments received, it
appears that small Section 2(h)(7)(C)(ii) institutions typically hedge
customer swaps by entering into matching swaps in the swap market, and
if those matched swaps had to be cleared, the small Section
2(h)(7)(C)(ii) institutions would have to post margin to satisfy the
requirements of the DCOs.\77\ This arrangement could raise the costs
for small Section 2(h)(7)(C)(ii) institutions of hedging the risks
related to these types of customer swaps to the extent they need to
fund the cost of the margin posted. In addition, the Commission
acknowledges that some small Section 2(h)(7)(C)(ii) institutions may
incur initial and annual fixed clearing fees and other expenses that
may be incrementally higher relative to the small number of swaps they
execute over a given period of time. Lastly, given the relatively low
notional volume swap books held by small Section 2(h)(7)(C)(ii)
institutions \78\ and the commercial customer purposes these swaps
satisfy, the Commission believes that swaps executed by small Section
2(h)(7)(C)(ii) institutions are what Congress was considering when it
directed the Commission to consider an exemption from the ``financial
entity'' definition for small financial institutions in Section
2(h)(7)(C)(ii) of the CEA. Accordingly, the Commission believes that it
is appropriate to exempt small Section 2(h)(7)(C)(ii) institutions from
the definition of ``financial entity'' in Section 2(h)(7)(C), thereby
permitting small Section 2(h)(7)(C)(ii) institutions to elect not to
clear swaps that are otherwise eligible for the end-user exception.\79\
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\77\ The Commission notes that if a Section 2(h)(7)(C)(ii)
institution, regardless of its size, executes a swap with a
customer/counterparty who properly elects the end-user exception for
that swap, then neither the customer/counterparty nor the Section
2(h)(7)(C)(ii) institution needs to clear its position in that swap.
\78\ See Section III.E hereof for information on the volume of
swaps executed by Section 2(h)(7)(C)(ii) institutions.
\79\ As noted by the 19 Small Banks in their comment letter,
``it is important to note that an SFI would not be exempt from
clearing and trading for any speculative trades. Indeed, SFIs would
have to meet the same conditions required for the end-user exception
to mandatory clearing of swaps under Proposed Rule 39.6.''
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Having determined that an exemption for small Section
2(h)(7)(C)(ii) institutions is appropriate, the Commission considered
the comments received regarding whether to use the $10 billion total
assets threshold identified in Section 2(h)(7)(C)(ii) of the CEA for
determining what is a ``small'' Section 2(h)(7)(C)(ii) institution, or
whether to use another test. The Commission has determined to limit the
exemption to Section 2(h)(7)(C)(ii) institutions with $10 billion in
total assets or less.\80\ The Commission acknowledges that the $10
billion level is not required by the CEA. However, the Commission also
believes that by specifically identifying that asset level three times,
once for each type of Section 2(h)(7)(C)(ii) institution, Congress
expressed its clear intent that the Commission should base its
consideration of what is a ``small'' institution on the $10 billion
asset level. The Commission therefore believes that it is appropriate
to use the $10 billion level absent strong and convincing facts or
circumstances supporting alternative measures.
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\80\ The Commission's $10 billion threshold is in harmony with
the SEC's proposed approach to exempt SFIs from clearing security-
based swaps that are subject to mandatory clearing. 75 FR 79992 at
80011 (Dec. 21, 2010).
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The Commission believes that it would be inappropriate to exempt
Section 2(h)(7)(C)(ii) institutions with substantially higher total
asset amounts, such as the $30 billion, $50 billion, or higher levels
recommended by several commenters. Congress has identified large
financial institutions as more likely to cause systemic risk and has
directed prudential regulators to consider prudential standards for
``large'' institutions having assets of $50 billion or more.\81\
Although $30 billion in assets is less than the $50 billion level
identified by Congress as being indicative of ``large'' financial
institutions, $30 billion is three times greater than the $10 billion
level identified by Congress in Section 2(h)(7)(C)(ii) as indicative of
a ``small'' financial institution that should have the benefit of the
exemption. While some commenters asserted that Section 2(h)(7)(C)(ii)
institutions with assets in excess of $10 billion have commonly
executed swaps with customers for the same purposes that smaller
institutions do, and that these institutions pose less risk to the
financial system than much larger institutions, these commenters did
not provide specific data applicable to institutions with $10 billion
or more of assets that would confirm these assertions.\82\ Accordingly,
commenters
[[Page 42579]]
did not provide strong and convincing evidence that an asset level
higher than $10 billion would be more appropriate than the $10 billion
or less test for distinguishing ``small'' Section 2(h)(7)(C)(ii)
institutions from others.
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\81\ See, e.g., Section 165 of the Dodd-Frank Act. (``In order
to prevent or mitigate risks to the financial stability of the
United States that could arise from the material financial distress
or failure, or ongoing activities, of large, interconnected
financial institutions, the Board of Governors shall, on its own or
pursuant to recommendations by the Council under section 115,
establish prudential standards for nonbank financial companies
supervised by the Board of Governors and bank holding companies with
total consolidated assets equal to or greater than
$50,000,000,000.'')
\82\ Furthermore, although not determinative as to what is
``small,'' the Commission is concerned that if Section
2(h)(7)(C)(ii) institutions with assets greater than $10 billion can
avail themselves of the exemption, these larger institutions, which
have greater capabilities than institutions with less than $10
billion of assets, are more likely to increase their swap activities
at the regional or national level using the commercial advantage
that the exemption will provide. Accordingly, it is possible that
the amount of swap activity of these larger institutions could
increase significantly over time if the exemption were available to
them.
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As a basic check on how many institutions could use the exemption
at the $10 billion total assets level, the Commission looked at how
many Section 2(h)(7)(C)(ii) institutions had total assets less than $10
billion and how many had more. Approximately 14,700 Section
2(h)(7)(C)(ii) institutions were operating in the United States as of
December 31, 2011. Of those, approximately 120 had total assets greater
than $10 billion.\83\ The remaining 14,580 institutions had less than
$10 billion in total assets. In other words, about 99 percent of banks,
savings associations, farm credit system institutions, and credit
unions will qualify as SFIs using the $10 billion or less test.\84\
While this data did not influence the Commission's consideration of
what constitutes a ``small'' Section 2(h)(7)(C)(ii) institution, it
indicates that a high number of Section 2(h)(7)(C)(ii) institutions
would be able to use the exemption for their hedging swap activities.
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\83\ Asset level data for banks and savings associations is
available at fdic.gov, and for credit unions at ncua.gov. Data for
farm credit system institutions was provided to the Commission by
the Farm Credit Administration.
\84\ In mid-2010, the most recent period for which Section
2(h)(7)(C)(ii) institution swap data could be obtained,
approximately 1,015 Section 2(h)(7)(C)(ii) institutions had
outstanding swap exposure. Of those institutions, 138 had total
assets over $10 billion and 876 had total assets below $10 billion.
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The Commission also considered whether it should adopt an
alternative or additional uncollateralized exposure test, as
recommended by some commenters. As noted above, several commenters
recommended defining financial institutions that can use the exemption
based on whether an institution's current and potential future
uncollateralized swap exposure exceeds a certain threshold. Commenters
suggested $1 billion or $3 billion as acceptable levels of
uncollateralized exposure.
The Commission determined that an uncollateralized exposure test is
not consistent with the statutory language of Section 2(h)(7)(C) of the
CEA or the reasons for including a central clearing requirement in the
Dodd-Frank Act. The Commission takes particular note of the fact that
in Section 2(h)(7)(C)(ii), Congress focused exclusively on the size of
the entity, based on total amount of assets, for measuring whether a
financial institution should be exempt from the ``financial entity''
definition. Congress did not direct the Commission to consider whether
uncollateralized risk exposure should be used for this purpose.
Furthermore, it is not readily apparent how even full collateralization
of exposure on a bilateral basis is an effective substitute for
required clearing in the event of a severe financial shock such as
occurred in 2008.
Commenters did not establish how an uncollateralized exposure test
would be consistent with a definition of ``small'' financial
institutions. An uncollateralized exposure test based on an entity's
current and potential future exposure from swaps is not linked to the
size of the financial institution or its significance to the financial
system. For example, an uncollateralized exposure test allowing up to
$1 billion in uncollateralized exposure could allow institutions with
over $100 billion in assets to qualify as ``small.'' The Commission
does not believe such a definition would be consistent with the intent
of allowing an exemption for ``small'' Section 2(h)(7)(C)(ii)
institutions from the clearing requirement. Had Congress intended such
a result, it would have directed the Commission to consider exempting
``low-risk'' institutions.
In addition, the entity-by-entity uncollateralized exposure tests
proposed by commenters may not capture the different risks non-cleared
swaps may pose to the financial system. Any such test would need to
carefully consider risk factors that the clearing requirement under the
Dodd-Frank Act addresses, including opaque, non-public risk
transference among market participants; buildup of risks in individual
entities (such as the swap dealers with whom Section 2(h)(7)(C)(ii)
institutions generally hedge swap exposure); effective measurement of
risk in ever changing markets; and effective risk management frameworks
for extreme market conditions. In this regard, the Commission does not
believe that an entity-by-entity uncollateralized exposure test would
account for: systemic risks that could arise if many Section
2(h)(7)(C)(ii) institutions are executing non-cleared swaps with only
one swap dealer that fails, thereby concentrating uncleared
counterparty risk; whether the Section 2(h)(7)(C)(ii) institutions
hedging trades are creating other risks because they cannot perfectly
match the risks being hedged; \85\ rapidly changing market conditions;
or a systemic liquidity freeze.
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\85\ For example, if the SFIs internally net large numbers of
customer trades and then partially hedge the aggregate risk, or use
hedging swaps based on interest rates or durations that do not match
the customer swaps precisely, basis risk could be created that could
become significant in another financial crisis.
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These risks are mitigated through central clearing. DCOs set margin
levels and recalculate and collect margin amounts daily (sometimes
intra-daily) based on changing market conditions. DCOs also use
established and tested processes to swiftly calculate and cover losses
resulting from a counterparty default, rapidly closing out or
transferring the defaulted positions, and using the liquid collateral
posted as margin by the defaulting party (plus other liquid assets
available to the DCO, if necessary) to satisfy any losses incurred by
the DCO in connection with the default. In this way, DCOs are able to
make whole the market participants using its clearing services,
notwithstanding a default by a member that may otherwise have been a
counterparty to many of those market participants on a bilateral
trading basis. As such, a swap clearing requirement protects the
financial system from the risks that attend to the interconnectedness
of the financial system. The interconnectedness of financial
institutions, particularly large institutions, means that severe shocks
to the financial system, such as occurred in late 2008, can cause
liquidity to dry up in a matter of days or change the perceived credit
quality of institutions overnight, vastly increasing their capital
requirements. Such rapid changes can cause entities, particularly in
the banking system, to fail with little or no forewarning. Notably,
these risks are not necessarily ameliorated by a test that looks at
uncollateralized exposure, because in the event of a severe financial
shock, even swaps that are fully collateralized at the mark-to-market
value on one day can fall into default the next as credit conditions
change rapidly. In such event, the non-defaulting counterparties become
exposed to losses that accumulate rapidly, which in turn can lead to
their default.
Because the comments have not demonstrated why the Commission
should interpret ``small'' to mean ``low-risk'' based upon an
uncollateralized exposure calculus, and why such a calculus is an
adequate substitute for the benefits provided by required clearing, the
Commission declines to
[[Page 42580]]
adopt an uncollateralized exposure test at this time.
With regard to FCC's comments regarding FCS institutions, the
Commission notes that if any such institution has total assets equal to
or less than $10 billion, then it is a small financial institution that
can elect the end-user exception. However, for those FCS institutions
with assets greater than $10 billion, Section 2(h)(7)(C)(ii) of the CEA
does not provide special consideration for cooperatives that meet the
definition of ``financial entity'' and therefore the asset size limit
applies to them.
The Commission recognizes that cooperatives exist to serve their
member owners. The Commission further recognizes that, as described
above, some cooperatives represent their members in the financial
markets, and the members of some of these cooperatives are entities
that could elect the end-user exception if acting alone. Accordingly,
the Commission may consider providing exemptive relief for financial
cooperatives through a separate action under its authority in Section
4(c) of the CEA.
E. Additional Considerations
1. Consultation With Other Regulatory Agencies; Jurisdictional Issues
Staff of the Federal Energy Regulatory Commission (FERC Staff)
commented that ``the CFTC should interpret and apply the CEA as amended
by Dodd-Frank to ensure that CFTC jurisdiction and FERC jurisdiction do
not overlap.'' FERC Staff believes that, due to FERC's existing
comprehensive regulation, ``Dodd-Frank terms should be interpreted as
not applying to any contract or instrument traded in an RTO/ISO market
pursuant to a FERC accepted or approved rate schedule or tariff.
Applying Dodd-Frank swaps regulation to RTOs/ISOs is not only
unnecessary but also potentially harmful.''
PG&E and SDG&E recommended that the Commission consult and
coordinate with other regulatory agencies and state commissions (such
as FERC and the California Public Utilities Commission (CPUC)) to
assure regulatory consistency and comparability to the extent that
hedging activities are already regulated. They noted that the costs and
burdens associated with duplicative or inconsistent regulation would be
passed through to ratepayers. As an example, PG&E noted that in certain
instances, the CPUC may direct PG&E, as part of their obligation to
serve customer load, to perform hedging on behalf of third parties, or
assist municipalities in making decisions about hedging transactions.
In such cases where the utility is directed to engage in certain
derivative transactions by the CPUC, PG&E commented that these
activities should be exempt from Commission regulation.
Finally, NRECA stated that the Commission should create a
``Commission-lite'' regime for non-financial entities that are already
subject to regulation by energy or environmental federal agencies and
do not have the infrastructure/personnel of financial entities.
The Commission has determined not to revise Sec. 39.6 in response
to these comments. The Commission does not believe the commenters have
identified a conflict between Sec. 39.6 and other regulations.
Regulation 39.6 would not prevent entities from entering into swaps
that do not hedge commercial risk; it would only identify when a swap
may be excepted from the clearing requirement in accordance with the
CEA. Accordingly, if other regulators require an entity to enter into
swaps that do not hedge commercial risk, these entities can still
execute those swaps and clear them as required under the CEA. However,
the Commission recognizes that conflict between regulatory regimes may
arise and the Commission plans to consult with other regulators as
appropriate.
Regarding the FERC comment, the Commission notes that Section
722(f) of the Dodd-Frank Act \86\ provides that the Commission may
exempt transactions entered into pursuant to, inter alia, a tariff
approved by FERC or the Public Utility Commission of Texas (which would
include RTO/ISO transactions) if the Commission determines that such an
exemption would be consistent with the public interest and the purposes
of the CEA. Six RTO/ISOs \87\ have submitted a petition for an order of
exemption pursuant to Section 722(f) of the Dodd-Frank Act. The
Commission intends to act on this petition expeditiously.
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\86\ 7 U.S.C. 4(c)(6).
\87\ The six RTO/ISOs are California Independent System Operator
Corporation, Electric Reliability Council of Texas, Inc., ISO New
England Inc., Midwest Independent Transmission System Operator,
Inc., New York Independent System Operator, Inc., and PJM
Interconnection, L.L.C.
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Regarding FCC's comment, Section 2(h)(7)(C)(ii) of the CEA
expressly provides the Commission with the authority to exempt certain
farm credit system institutions from the definition of ``financial
entity'' along with other SFIs. Such exemptive authority would be
unnecessary if the clearing requirement was not intended to apply to
farm credit system institutions.
2. Implementation and Compliance
The Committee on Capital Markets Regulation (CCMR) and CME Group,
Inc. (CME) recommended that the end-user exception be finalized early
in the establishment of the clearing requirement process. CME commented
that the end-user exception should be finalized early so companies know
who will be subject to the clearing requirement.
Other commenters, including EEI & EPSA, Shell, EDF Trading, EEI,
and CDEU, recommended that the implementation deadline for the Dodd-
Frank Act be extended. EDF Trading and EEI recommended that the
Commission allow a one-year ``transition period'' following the
effective date of the Dodd-Frank Act to allow entities to comply with
the new end-user exception regulations.
Finally, a number of commenters recommended that the Commission
delay the Sec. 39.6 reporting requirements. ATA recommended that the
Commission key implementation of the end-user notification regime to
the time when SDRs become operational. COPE suggested that the
reporting requirement not be enforced until reporting systems have been
largely standardized to avoid the development of multiple, bespoke
software programs or systems for compliance. NEMA noted that
significant terms have not been defined and that an overly aggressive
compliance schedule could force many of its members out of the market
for financial products because of their concern of being treated as a
financial entity. NEMA also commented that parties must have sufficient
time to make the requisite investment in information technology systems
and to develop compliance plans.
The Commission has determined that Sec. 39.6 will become effective
60 days after publication in the Federal Register. However, the
Commission notes that compliance with Sec. 39.6 will not be necessary
or possible until swaps become subject to the clearing requirement. The
Commission's proposed compliance and implementation schedule for the
clearing requirement gives non-financial entities a minimum of 270 days
to comply after the Commission issues a clearing requirement
determination for a swap or group, category, type or class of
swaps.\88\ Moreover, the Commission has
[[Page 42581]]
stated that no such clearing requirement determinations will become
effective until the Commission adopts certain related rules.
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\88\ See 76 FR 58186 (Sept. 20, 2011) (Swap Transaction
Compliance and Implementation Schedule: Clearing and Trade Execution
Requirements under Section 2(h) of the CEA).
---------------------------------------------------------------------------
3. Revocation of Election of the End-User Exception
IECA recommended that the Commission establish regulations that
would make an election not to clear a swap irrevocable without the
consent of both parties.
The Commission notes that Section 2(h)(7)(B) of the CEA provides
that the application of the end-user exception is solely at the
discretion of the counterparty to the swap that meets the conditions
set forth in Section 2(h)(7)(A). Section 2(h)(7) does not address,
however, whether the electing counterparty may revoke its election and
choose to clear the swap. The Commission believes that any decision to
change the clearing status of the swap after it is entered into is a
contractual matter between the two parties.
III. Consideration of Costs and Benefits
A. Introduction
The regulations being adopted herein interpret and establish
qualifying criteria for the end-user exception provided in Section
2(h)(7) of the CEA from the clearing requirement established in Section
2(h)(1)(A) of the CEA, as amended by the Dodd-Frank Act. An
understanding of the costs and benefits of the end-user exception
requires background understanding of the Section 2(h)(1)(A) clearing
requirement.\89\
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\89\ As previously noted, this section states: ``It shall be
unlawful for any person to engage in a swap unless that person
submits such swap for clearing to a [DCO] that is registered under
this Act or a [DCO] that is exempt from registration under [the CEA]
if the swap is required to be cleared.''
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Prior to the passage of the Dodd-Frank Act, swap transactions were
not required to be cleared. In the wake of the financial crisis of
2008, Congress adopted the Dodd-Frank Act, which, among other things,
requires the Commission to determine whether a particular swap, or
group, category, type or class of swaps, shall be required to be
cleared.\90\ Specifically, Section 723(a)(3) of the Dodd-Frank Act
amended Section 2(h)(1)(A) of the CEA to make it ``unlawful for any
person to engage in a swap unless that person submits such swap for
clearing to a derivatives clearing organization that is registered
under [the CEA] or a derivatives clearing organization that is exempt
from registration under [the CEA] if the swap is required to be
cleared.'' This clearing requirement is designed to reduce counterparty
risk associated with swaps and, in turn, mitigate the potential
systemic impact of such risk and reduce the likelihood for swaps to
cause or exacerbate instability in the financial system.\91\ It
reflects a fundamental premise of the Dodd-Frank Act: The use of
properly regulated and functioning central clearing can reduce systemic
risk.
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\90\ See Section 2(h)(2) of the CEA, 7 U.S.C. 2(h)(2).
\91\ When a bilateral swap is moved into clearing, the
clearinghouse becomes the counterparty to each of the original
participants in the swap. This standardizes counterparty risk for
the original swap participants in that they each bear the same risk
attributable to facing the clearinghouse as counterparty. In
addition, clearing mitigates counterparty risk to the extent that
the clearinghouse is a more creditworthy counterparty relative to
those that each participant in the trade might have otherwise faced.
Clearinghouses have demonstrated resilience in the face of past
market stress. Most recently, they remained financially sound and
effectively settled positions in the midst of turbulent events in
2007-2008 that threatened the financial health and stability of many
other types of entities.
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Notwithstanding the benefits of clearing, Section 2(h)(7) of the
CEA provides for the end-user exception if one of the swap
counterparties: ``(i) Is not a financial entity; (ii) is using swaps to
hedge or mitigate commercial risk; and (iii) notifies the Commission,
in a manner set forth by the Commission, how it generally meets its
financial obligations associated with entering into non-cleared
swaps.'' Section 2(h)(7)(C)(ii) directs the Commission to consider
making the end-user exception available to small banks, savings
associations, credit unions, and farm credit institutions, including
those institutions with total assets of $10 billion or less, through an
exemption from the statutory definition of ``financial entity.'' \92\
As noted above in section D hereof, for purposes of this final release,
all banks, savings associations, farm credit system institutions, and
credit unions, regardless of size, are referred to as ``Section
2(h)(7)(C)(ii) institutions'' and the subgroup of Section
2(h)(7)(C)(ii) institutions that are eligible for exemption from the
``financial entity'' definition are collectively referred to as ``small
financial institutions'' or ``SFIs.''
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\92\ See CEA 2(h)(7)(C)(ii).
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In this final rulemaking, the Commission is adopting rules
implementing the end-user exception. More specifically, the final
rules: (1) Specify the content and manner to effect the required
Commission notification (i.e., the reporting requirements); (2)
establish the criteria for determining whether a swap is ``hedging or
mitigating commercial risk''; and (3) exclude SFIs from the definition
of ``financial entity'' for purposes of Section 2(h)(7)(A)(i) of the
CEA, making it possible for them to avail themselves of the end-user
exception. It is the costs and benefits of this rulemaking that the
Commission considers in the discussion that follows.
Important to the Commission's consideration of costs and benefits
is that this rulemaking is permissive--that is, the election of the
end-user exception is at the discretion of the counterparty to the swap
that meets the requisite conditions set forth in the statute and the
final rule. In addition, except for the reporting required for those
electing the end-user exception set forth in Sec. 39.6(b), the final
rule imposes no substantive obligations on the electing parties.
Rather, the final rule largely clarifies the statute it implements and
provides specific criteria for certain key terms in the statute
including ``financial entity'' and ``hedging or mitigating commercial
risk.''
This notice also provides statutory interpretation and guidance to
potential electing counterparties as to whether they are, for example,
a ``financial entity.'' Although that term is defined in statute, the
Commission's response to comments regarding application of the
definition to certain types of entities should yield a substantial, if
unquantifiable, benefit by providing clarity and reducing uncertainty
about a market participant's status for purposes of determining the
availability of the end-user exception. The added clarity provided by
the Commission's statutory interpretation and guidance, although beyond
the scope of the Commission's obligation to consider the costs and
benefits of its regulations or orders under Section 15(a) of the CEA,
should nevertheless promote greater confidence and integrity in the
market.
In the NPRM, the Commission asked for public comment on the costs
and benefits of the proposed regulations, and specifically invited
comments on whether: (1) It would be difficult or prohibitively
expensive for persons to report the information required under the
proposed rule; (2) there are more feasible and cost effective ways for
the Commission to receive notification regarding the use of the end-
user exception; (3) the Commission should consider requiring electing
counterparties to report additional types of information; (4)
collecting notice information regarding use of the end-user exception
through SDRs would create significantly greater burdens for some
parties to swaps compared to others; and (5) the Commission should
[[Page 42582]]
extend the end-user exception to SFIs.\93\ The Commission also asked
for commenters to provide an explanation for any preferred alternative
and data to support their comments.\94\
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\93\ See 75 FR at 80750-80751.
\94\ Id. at 80754.
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The Commission received numerous comments addressing various cost
and benefit considerations of the proposed rule and sought to
promulgate a final rule that will help swap market participants apply
the end-user exception in a uniform and accurate manner, balance the
tradeoff of costs and benefits associated with the exemption, and
minimize reporting burdens on market participants who elect the
exception while still providing the Commission the information that it
needs to monitor the markets and use of the exception by market
participants. The Commission adopted a number of the alternatives posed
by commenters, particularly with regard to the final rule's reporting
requirements.\95\
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\95\ See, e.g., sections II.B.1, 6, 7, 8, and 9 and II.C.6.
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Informed by commenters, the discussion below considers the rule's
costs and benefits as well as alternatives to the rule. The discussion
concludes with a consideration of the rule's costs and benefits in
light of the five factors specified in Section 15(a) of the CEA.
B. Requirement To Consider the Costs and Benefits of the Commission's
Action Under Section 15(a) of the CEA
Section 15(a) of the CEA \96\ requires the Commission to consider
the costs and benefits of its actions before promulgating a regulation
under the CEA or issuing certain orders. Section 15(a) further
specifies that the costs and benefits shall be evaluated in light of
five broad areas of market and public concern: (1) Protection of market
participants and the public; (2) efficiency, competitiveness and
financial integrity of futures markets; (3) price discovery; (4) sound
risk management practices; and (5) other public interest
considerations. The Commission considers the costs and benefits
resulting from its discretionary determinations with respect to the
Section 15(a) factors.
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\96\ 7 U.S.C. 19(a).
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In the sections that follow, the Commission considers the costs and
benefits of final Sec. 39.6, namely: (1) The costs and benefits of the
reporting requirements; and (2) the costs and benefits of the
established criteria for determining whether a swap hedges or mitigates
commercial risk for purposes of Section 2(h)(7)(A)(ii). The former is
in large part amenable to quantification, but the latter is not due to
a lack of data about the manner in which swaps are currently being used
to hedge or mitigate commercial risk and the economic terms thereof.
Nevertheless, the Commission provides qualitative consideration of the
costs and benefits of its approach to establishing criteria for
determining whether a swap hedges or mitigates commercial risk.
Finally, as required by Sections 2(h)(7)(C)(ii) and 15(a) of the CEA,
the Commission considers the costs and benefits of exempting SFIs with
total assets of $10 billion or less from the definition of ``financial
entity.''
The costs and benefits of the Commission's action in this
rulemaking are measured against the level of costs and benefits that
would exist absent this rulemaking. With respect to each of this
rulemaking's three elements this is as follows:
Establishing the reporting requirements. The requirement
that counterparties availing themselves of the end-user exception
provide notification to the Commission remains a statutory requisite to
invoke the exemption, albeit one that is not self-executing.\97\ Thus,
the foundation against which this rulemaking's costs and benefits are
measured is the minimum notification that the Commission could
prescribe to meet the statutory requirement.
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\97\ See Section 2(h)(7)(A)(iii) of the CEA.
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The ``hedge or mitigate commercial risk'' element. Absent
this rulemaking, ``hedging or mitigating commercial risk'' remains a
statutory requisite to invoke the end-user exception.\98\ This
rulemaking clarifies the Commission's interpretation of the term for
purposes of implementing and enforcing the CEA's statutory
requirements. Thus, the foundation against which this rulemaking's
costs and benefits are measured is the statutory requirement standing
alone without the clarification that the rulemaking provides.
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\98\ See Section 2(h)(7)(A)(ii) of the CEA.
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Excluding qualifying SFIs from the definition of
``financial entity.'' Absent this rulemaking, all financial entities as
defined in Section 2(h)(7)(C) of the CEA, including all SFIs, are
statutorily disqualified from the end-user exception pursuant to
Section 2(h)(7)(A)(i) of the CEA, which specifies that to qualify for
the end-user exception the counterparty must not be a financial entity.
Thus, the foundation against which this rulemaking's costs and benefits
are measured is the statutory requirement that SFIs, as financial
entities, remain subject to the clearing requirement of Section
2(h)(1)(A) of the CEA.
Additionally, with respect to the second and third elements, the
Commission considers the rulemaking's costs and benefits relative to
alternatives besides that of abstaining from action. In the case of
articulating reporting requirements, which is statutorily required, the
Commission considers the rulemaking's costs and benefits relative to
prescribing the minimum obligation.
As discussed in more detail below, the Commission is able to
estimate certain reporting costs. The dollar estimates are offered as
ranges with upper and lower bounds, which is necessary to accommodate
the uncertainty that surrounds them. The Commission notes that the most
likely outcome with respect to each estimate is a cost above the lower
bound and below the upper bound. The costs and benefits associated with
compliance with the Commission's interpretation of the term ``hedging
or mitigating commercial risk,'' as well as those that result from the
exemption for SFIs, however, are not readily susceptible to meaningful
quantification because the requisite data is not available.
For example, to reasonably estimate quantifiable costs and benefits
of compliance with this rule's interpretation of ``hedging or
mitigating commercial risk,'' relative to alternatives, the Commission
would need sufficient information to determine what swaps would be or
would not be eligible for the end-user exception under different
approaches considered by the Commission. This would require the
Commission to identify a representative sample of market participants
and collect detailed proprietary information regarding each swap
position currently on their books, as well as the economic terms of the
swap transactions entered into by those entities over a certain period
of time. The Commission would also need detailed information regarding
each sample member's business practices, current assets, anticipated
acquisition or disposition of assets, and other financial positions
related to their commercial operations to determine what swaps are
``hedging or mitigating commercial risk'' under various approaches
considered by the Commission.
To estimate the costs and benefits related to the exemption for
SFIs, the Commission would need similar information regarding SFIs,
including detailed information regarding the swap positions and
activities of those entities and sufficient knowledge of their business
models, as well as their current and future assets, to determine what
[[Page 42583]]
swaps constitute ``hedging or mitigating commercial risk.'' Again, the
data necessary to calculate such estimates is largely proprietary, not
available to the Commission, and was not provided by commenters.
Notwithstanding these limitations, the Commission identifies and
considers the costs and benefits of these aspects of the rule in
qualitative terms.
C. Reporting Requirements
1. Introduction
Under Section 2(h)(7)(A)(iii) of the CEA, a condition to electing
the end-user exception is that the electing counterparty ``notifies the
Commission in a manner set forth by the Commission how it generally
meets its financial obligations associated with entering into non-
cleared swaps.'' Regulation 39.6(b) provides a mechanism for such
reporting to the Commission and also requires the reporting
counterparty to report that the end-user exception is being elected,
who the electing counterparty is, and that the swap hedges or mitigates
commercial risk. In addition, Section 2(j) of the CEA provides that any
exception to the clearing requirement of Section 2(h)(1) of the CEA and
the trading requirement of Section 2(h)(8) of the CEA are only
available to an SEC Filer if the decision to enter into swaps subject
to such exceptions has been reviewed by an appropriate committee of the
governing body of the SEC Filer. Regulation 39.6(b)(1)(iii)(D)(2) would
require reporting of confirmation by the SEC Filer that such review has
occurred. The information reported under Sec. 39.6(b) is needed for
the Commission to be able to determine when the end-user exception is
being used and to monitor compliance with the exception.
In the NPRM, the Commission contemplated swap-by-swap reporting of
all the information required. As described below, the Commission
received comments in response suggesting that the reporting
requirements were burdensome and that less costly options may be
available. In response to those comments, the Commission has made
changes to the final rule that allow an electing counterparty to report
certain information on an annual basis and to clarify that SEC Filers
can obtain general approval of the end-user exception. The Commission
believes that these changes will create significant cost reductions and
benefits for electing and reporting counterparties, as described below.
In addition, as described in more detail in Section II.B.3 above, the
Commission has confirmed that the simple ``check-the-box'' reporting
mechanism proposed in the NPRM may be used. A number of commenters
agreed that this mechanism would greatly minimize the reporting burden
and would provide standardized information that will be easily
reviewable for regulatory purposes.
The discussion below of the rule's reporting requirements is
divided into three parts. The first part covers the reporting
requirements under the rule generally, the second addresses the SEC
Filer reporting requirements, and the third provides specific cost
estimates. Consideration of alternatives is incorporated within the
first two parts.
2. Reporting Generally
In the NPRM, the Commission contemplated requiring the reporting
counterparty to provide all information required under the rule on a
swap-by-swap basis. The Commission received comments that swap-by-swap
reporting of all information required to be reported under the rule
could be more burdensome than necessary and that other alternatives are
available, such as annual or other periodic reporting, submission of
contracts or contract summaries, separate reduced reporting
requirements for certain small entities, or reliance on contract
representations by electing counterparties instead of reporting.\99\
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\99\ See, e.g., Cravath, AGA, APGA, SFG, Noble, NCHSA, API,
CDEU, Shell, SDG & E, Peabody, FHL Banks, NRECA, WSPP, IPA, COPE,
WGCEF, EDF Trading, Hess, EEI & EPSA, API, IECA, and NMPF.
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After consideration of these comments, the Commission believes that
certain information required to be reported by Sec. 39.6(b) could be
reported on an annual basis without significantly compromising its
value to the Commission and the public, and that such an approach is
likely to be more cost-effective. Therefore, in response to these
comments, the Commission revised the rule to require reporting of the
following for each swap for which the end-user exception is elected:
(1) That the election of the exception is being made; (2) which party
is the electing counterparty; and (3) certain information specific to
the electing counterparty unless that information has already been
provided by the electing counterparty through an annual filing. The
third set of information comprises data that is likely to remain
relatively constant for many electing counterparties and therefore can
be reported less frequently.
In making this change in the final rule, the Commission believes
that allowing the third set of information to be reported on either a
swap-by-swap basis or on an annual basis is likely to mitigate
reporting costs from the solely swap-by-swap approach proposed in the
NPRM because entities will be able to select the most cost-effective
option.
As an estimate of cost savings, the Commission expects that the
annual report will take approximately 30 minutes to 90 minutes to
complete, but then that information will not have to be reported on a
swap-by-swap basis, generating incremental savings of one to five
minutes per transaction. The Commission does not have adequate data to
estimate these costs in the aggregate. However, the Commission believes
that the number of swap transactions subject to this rule is likely to
be quite large, and therefore, the aggregate savings of one to five
minutes per transaction could be significant. Also, the approach has
benefits for market participants generally in that the form of data
provided to the Commission will enable it to exercise its regulatory
oversight in an efficient and effective manner given the wide variety
of different types of swaps and swap hedging strategies used by
potential electing counterparties. Lastly, standardized reports make it
more feasible for the Commission to conduct periodic auditing, which
will be less costly to regulators than examining on a case-by-case
basis possibly unstructured financial data or different contract
security provisions submitted by electing counterparties.
The Commission considered the other reporting frequency and
mechanism alternatives proposed in the comments, but other than the
annual reporting option provided in Sec. 39.6(b)(2) of the rule,
determined not to adopt them for several reasons. First, as mentioned
above, Section 2(h)(7)(A) of the CEA requires an electing counterparty
to notify the Commission how the counterparty meets its financial
obligations associated with entering into non-cleared swaps as a
condition to electing the end-user exception. Accordingly, the
requirement to report some information is statutory and beyond the
discretion of the Commission. Second, for swaps that are subject to the
clearing requirement but are not being cleared, the Commission needs
notice that the end-user exception is being elected and certain other
information to assess compliance with Sections 2(h)(1) and (2)(h)(7) of
the CEA and Sec. 39.6. Third, delivery of agreements to the Commission
would be almost as burdensome as the check-the-box approach (and in
some cases more so) and would provide information in non-standard
formats that would be
[[Page 42584]]
difficult to review for regulatory purposes. Standardized data, on the
other hand, will facilitate effective review by the Commission. Fourth,
given the low reporting burden under these rules and the general swap-
by-swap reporting requirements in other regulations (e.g., Part 45),
the Commission does not believe that a special, lesser reporting
requirement for smaller parties would result in a materially lower
burden while still maintaining compliance with the CEA. And last, the
Commission believes that the check-the-box reporting method, and
addition of the annual reporting option described above (together with
the fact that various other information will already be reported for
each swap pursuant to other provisions of the CEA and other regulations
promulgated thereunder), minimize the reporting burden.
EDF Trading, API, MarkitSERV, and COPE raised another concern about
the costs of reporting. They commented that some potential electing
counterparties may bear costs in order to implement new reporting
systems to comply with the reporting requirements. The Commission notes
that electing counterparties will only incur such costs if they engage
in swaps with other electing counterparties. If the electing
counterparty enters into swaps with a swap dealer or a major swap
participant, the swap dealer or major swap participant will be the
reporting counterparty.\100\ Based on historical experience, the
Commission believes that electing counterparties will generally enter
into swaps with swap dealers and major swap participants, and therefore
will not be responsible for reporting the swap-by-swap information
required in this rule. Moreover, even in the absence of this rule, if
electing counterparties entered into swaps with one another they would
be required to implement reporting systems in order to meet other swap-
by-swap reporting requirements in the CEA and Commission regulations
promulgated thereunder. Therefore, the Commission believes that the
large majority of costs to implement reporting systems are properly
recognized as the result of swap-by-swap reporting requirements that
are beyond the scope of this rule. Accordingly, this rule will only
result in costs to modify those reporting systems in order to provide
the additional information required by this rule.
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\100\ See 77 FR 2136 at 2207 (Jan. 13, 2012) (Swap Data
Recordkeeping and Reporting Requirements; final rule).
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NGSA, NRECA, IECA, and EEI recommended that the Commission provide
a safe harbor from liability for firms who report on behalf of the
electing counterparty. The Commission expects that if the electing
counterparty has not filed an annual report to provide the information
required in Sec. 39.6(b)(1)(iii), the reporting counterparty may
choose to conduct some measure of due diligence in order to develop a
reasonable basis for believing that the information it reports on
behalf of the electing counterparty is accurate and the swap is
eligible for the end-user exception. These costs are likely to vary
depending on the number of electing counterparties with whom each
reporting counterparty transacts, and the amount of due diligence that
they choose to conduct, which can vary substantially depending on
whether the electing counterparty has done an annual filing, the number
of swaps the reporting counterparty executes within a year, and how
well the reporting party already knows the electing counterparty's
financial strategies and policies. The Commission does not believe that
there is sufficient data to estimate the burden hours that will result
from this requirement, but believes that: (1) The cost is likely to be
relatively low; and (2) such information will frequently be collected
along with other information the reporting counterparty will gather
from the electing counterparty as part of the process of executing the
swap and reporting other details required by the CEA and Commission
regulations. Moreover, it is important to consider these costs in light
of the benefits achieved by the requirement. The Commission believes
that the ``reasonable basis'' standard is likely to deter abuse of the
end-user exception, which could mitigate risks and costs that market
participants and the public might otherwise face. If the end-user
exception were abused, it would lead to reduced clearing and
counterparty protection. If such abuse became widespread, it could also
reduce the ability of clearinghouses to mitigate the transfer of
financial instability among counterparties, thereby increasing risks to
the public.
Some commenters favored requiring more information regarding the
types of collateral, exact collateral terms and arrangements, and swap
contractual terms and provisions.\101\ The Commission determined not to
require additional information because, on the one hand, the
information would be costly for counterparties to provide and on the
other, any such requirement would provide little benefit because it
would be difficult to capture much of this information in a
parameterized form, making it challenging to review the information in
a systematic way.
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\101\ See, e.g., AFR, AFSCME, Better Markets, PMAA & NEFI, and
Professor Greenberger.
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According to EMUS, the NPRM indicated that the notification
requirement would apply to all affiliates, while the rule text
indicated a notification requirement would apply only to finance
affiliates. In response to EMUS, the Commission is revising proposed
Sec. 39.6(b)(3) to clarify that the notification requirement only
applies to financial entities acting as affiliates. The Commission is
also adding a requirement that electing counterparties report whether
they are ``financial entities'' as defined in Section 2(h)(7)(C)(i) of
the CEA that are nevertheless exempt from the definition of ``financial
entity'' as described in Sec. 39.6(d). For entities affected by these
provisions, the total impact is the removal or addition of one check-
box when reporting.
3. SEC Filers
In accordance with Section 2(j) of the CEA, the proposed rule
required a committee of the board of directors (or equivalent body) of
an SEC Filer to approve the decision not to clear the swap for which
the end-user exception would be elected. The Commission received
comments that requiring swap-by-swap board approval would impose excess
costs and burdens on SEC Filers.\102\ The Commission determined that
any additional benefit of a swap-by-swap approval, as compared to a
more general approval, was insufficient to justify such an approach and
accordingly, has revised the final rule to only require reporting (in
the annual or swap-by-swap filing) whether such committee has generally
approved entering into swaps subject to an exception to the clearing
and trading requirements. The Commission believes this change will
mitigate the potential burdens commenters raised by allowing such
committees to provide blanket or more limited approvals for the end-
user exception on a periodic basis as they deem appropriate for such
approval and in a manner that may be consistent with general corporate
practice. At the same time, the reporting requirement, while limited,
still confirms that a committee of the governing board of the SEC Filer
using the end-user exception has
[[Page 42585]]
considered such exceptions as required by Section 2(j) of the CEA.
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\102\ See, e.g., Hess, EEI & EPSA, NGSA, CDEU, EMUS, SDG & E,
WGCEF, Mr. Quinlivan, Cravath, AGA, EMUS, COPE, NYCBA, Shell, ATA,
Noble, WSPP, IPA, Hess, IECA, EEI, PMAA & NEFI, CDEU, and NYCBA.
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4. Cost Estimates \103\
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\103\ As discussed above, the statute itself requires some level
of reporting. Absent an ability to demarcate between the minimum
reporting that the statute would require and that resulting from
this rule, the Commission has estimated the costs attributable to
this rule from a base of zero, recognizing that the costs
attributable to its discretion in this action must necessarily start
from some higher base. Accordingly the costs attributable to the
Commission's action in this rulemaking are necessarily something
below the estimates provided. Also, because the statute requires
some reporting, the Commission has not articulated separate benefits
attributable to this rulemaking. However, to the extent benefits
distinguish this rule from considered alternatives, they are
considered in the preceding discussion.
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The Commission lacks data to estimate the precise number of non-
financial entities that may be eligible for the end-user exception, and
therefore cannot estimate total reporting costs with great accuracy.
However, for informational purposes, the Commission has endeavored,
where feasible, to estimate quantifiable costs. It has done so by using
assumptions to define what it believes to be reasonable parameters for
various uncertainties. At times, as noted with more specificity in the
discussion that follows, the uncertainties are such that costs are
reasonably estimable only within a wide range. For the purposes of
these estimates, the Commission assumes a total of 30,000 electing
counterparties (which includes SFIs), and that approximately 1,000 of
them will function as reporting counterparties in any given year. The
Commission further estimates that approximately 125 swap dealers and
major swap participants will function as reporting counterparties for
swaps for which the end-use exception is elected each year. All of
these reporting counterparties likely will need to modify their
reporting systems in order to accommodate the additional data fields
required by this rule. The Commission estimates that those
modifications will create a one-time expense of approximately one to
ten burden hours per entity, for a total of approximately 1,125 to
11,250 burden hours. The hourly wage for a senior programmer is $292,
which means that the aggregate one-time cost for modifying reporting
systems is likely to be between $328,811 and $3,288,110.\104\
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\104\ All salaries in these calculations are taken from the 2010
SIFMA Report on Management and Professional Earnings in the
Securities Industry. Annual wages were converted to hourly wages
assuming 2,000 work hours per year (40 hours per week for 50 weeks),
and then multiplying by 5.35 to account for bonuses, firm size,
employee benefits and overhead. The remaining calculations used in
these cost-benefit considerations are also derived from this source
and modified in the same manner.
In addition, for each range of aggregate costs presented in this
discussion, the lower bound would be the aggregate cost if every
relevant entity experienced the minimum per entity cost, and the
upper bound would be the aggregate cost if every relevant entity
experienced the maximum per entity cost. It is highly improbable
that every entity would experience either the minimum or the maximum
per entity cost, and as a consequence, the actual aggregate cost to
market participants is likely to lie somewhere in the midst of each
range that has been estimated in this section.
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Furthermore, the 29,000 electing counterparties who do not function
as reporting counterparties may, at certain times, need to communicate
information to their respective reporting counterparties in order to
facilitate reporting. That information may include, among other things,
whether the electing counterparty has filed an annual report pursuant
to Sec. 39.6(b)(2) and information to facilitate any due diligence
that the reporting counterparty may conduct. These costs will likely
vary substantially depending on the number of different reporting
counterparties with whom an electing counterparty conducts
transactions, how frequently the electing counterparty enters into
swaps, whether the electing counterparty undertakes an annual filing,
and the due diligence that the reporting counterparty chooses to
conduct. Therefore, the Commission believes that it is very difficult
to estimate these costs reliably at this time. However, the Commission
has endeavored to do so given the concerns commenters expressed about
relying on other parties to provide information and to report the
information. Accordingly, the Commission estimates that non-reporting
electing counterparties will incur between five minutes and ten hours
of annual burden hours. The hourly wage for a compliance attorney is
$320, which means that the annual per entity cost for communicating
information to the reporting counterparty is likely to be between $27
and $3,210. Given the unknowns associated with this cost estimate noted
above, the Commission does not believe this wide range can be narrowed
at this time.
Also, the Commission estimates that approximately two-thirds of
electing counterparties (or 20,000 electing counterparties) will choose
to file an annual report pursuant to Sec. 39.6(b)(2). The annual
filing option was added in the final rule and therefore an estimate of
costs related thereto was not included in the NPRM. The annual filing
option will reduce reporting costs overall because it is less costly
than swap-by-swap reporting. The Commission estimates that it will take
an average of 30 minutes to 90 minutes to complete and submit this
filing, for an aggregate total of 10,000 to 30,000 burden hours. The
average hourly wage for a compliance attorney is $320, which means that
the aggregate annual cost for submitting the annual report is likely to
be approximately $3,200,000 to $9,600,000. Other costs and benefits
associated with the rule's reporting requirements cannot be monetized
at this time because the Commission lacks adequate information to do
so.
The rule requires reporting of the following for each swap for
which the end-user exception is elected: (1) That the election of the
exception is being made; (2) which party is the electing counterparty;
and (3) certain information specific to the electing counterparty
unless that information has already been provided by the electing
counterparty through an annual filing. The third set of information
comprises data that is likely to remain relatively constant for many
electing counterparties and therefore can be reported either on a
transaction-by-transaction basis or through an annual report that is
updated as necessary.
As a recurring expense, the reporting counterparty will have to
report the information required in Sec. 39.6(b)(1)(i) and (ii) for
each swap and the information required in Sec. 39.6(b)(1)(iii) for
each swap only if the electing counterparty has not filed an annual
report. To comply with Sec. 39.6(b)(1)(i) and (ii), the reporting
counterparty will be required to check one box indicating the end-user
exception is being elected and complete one field identifying the
electing counterparty. The Commission expects that this information
will be entered into the appropriate reporting system concurrently with
additional information that is required under the CEA and other
Commission regulations promulgated thereunder. Therefore, each
reporting counterparty is likely to spend 15 seconds to two minutes per
transaction in incremental time entering the swap-by-swap information
that is required in Sec. 39.6(b)(1)(i) and (ii) into the reporting
system. Regarding the Sec. 39.6(b)(1)(iii) information, the Commission
expects that, for the first swap conducted involving a particular
electing counterparty, it will take approximately 30 minutes to 90
minutes to collect and submit the information required and then
approximately one to five minutes to collect and submit this
information for subsequent transactions with that same counterparty.
The Commission does not have sufficient data to estimate the number of
swaps that will be subject to this rule, so it is not possible to
estimate these costs in the aggregate.
[[Page 42586]]
D. Hedging or Mitigating Commercial Risk
1. Introduction
Regulation 39.6(c) provides a broad set of criteria for determining
what constitutes hedging or mitigating commercial risk for the end-user
exception to apply. The Commission's flexible set of criteria allows
counterparties to use the end-user exception when appropriate given
their specific circumstances. At the same time, the criteria are
designed to prevent abuse of the end-user exception, which would hinder
one of the primary goals of the Dodd-Frank Act: Moving swaps into
central clearing, thereby reducing counterparty risk and its potential
to create instability in the financial system.
Congress prescribed ``hedging or mitigating commercial risk'' as a
condition for applying the end-user exception, without providing
further statutory definition of its meaning. The Commission is
exercising its discretion to do so. Thus, relative to the statutory
requirement, the costs and benefits of the rule are those attributable
to clarifying the Commission's understanding of the term for
implementation and enforcement purposes rather than implementing and
enforcing the condition without clarifying its interpretation. Relative
to other alternatives that the Commission could have selected, the
costs or benefits of the rule are generally a function of whether the
Commission adopts a more- or less-inclusive approach in articulating
what constitutes hedging or mitigating commercial risk for purposes of
the end-user exception relative to the theoretically optimal level that
Congress presumably intended the statutory language to effect.\105\ In
addition, a potential electing counterparty will incur some costs in
applying the standard set forth in the rule to determine whether a
specific swap qualifies as hedging or mitigating commercial risk. Each
category--clarification costs and benefits, inclusion costs and
benefits, and determination costs--is discussed below.
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\105\ In either case, costs and benefits are not readily
quantifiable. Such quantification would require data and information
that the Commission does not possess nor have at its disposal. This
includes data regarding the number, characteristics, and notional
value of swaps that are impacted by these decisions, as well as
information about the required margin for the swaps if they are
cleared or not cleared, the type and amount of collateral that
counterparties require for the swaps, estimates for the affected
firms of the cost of capital used to post margin, and pricing for
cleared swaps and non-cleared swaps.
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2. Clarification Costs and Benefits
As stated above, even in the absence of this rulemaking, ``hedging
or mitigating commercial risk'' is a necessary condition for being
eligible to claim the end-user exception with respect to a particular
swap. By clarifying the Commission's interpretation of this term, this
rule provides market participants with the benefit of greater
regulatory certainty, which will reduce costs associated with, for
example, legal opinions to interpret the term or the costs of foregoing
the end-user exception to which market participants might otherwise be
entitled.
3. Inclusion Costs and Benefits
Regulation 39.6(c)(1)(i) identifies six possible sources of
commercial risk and sets forth an ``economically appropriate'' standard
for assessing the correspondence between a given swap and the
commercial risk that it hedges or mitigates.\106\
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\106\ In the alternative to meeting the requirements of Sec.
39.6(c)(1)(i), a swap executed by an electing counterparty may also
be eligible for the end-user exception if the swap qualifies as a
bona fide hedge for purposes of an exception from position limits
under the CEA as provided in Sec. 39.6(c)(1)(ii), or if it
qualifies for hedging treatment under FASB Accounting Standards
Codification Topic 815 or under GASB Statement 53 as provided in
Sec. 39.6(c)(1)(iii). No comments raised cost/benefit issues
regarding these two bases for electing the end-user exception other
than supporting the benefits offered by including these additional
alternatives.
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As noted above, the Commission has determined not to provide a
bright-line definition of ``economically appropriate'' to allow greater
flexibility in application of the standard. The Commission cannot
anticipate and account for all of the types of potential electing
counterparties, swaps, and strategies that might be used to hedge or
mitigate commercial risk, so a bright-line approach not allowing for
judgment and consideration of all relevant facts and circumstances
would likely lead to outcomes in some circumstances that
inappropriately include or exclude certain swaps from the end-user
exception, particularly with respect to custom swaps and unique hedging
strategies.\107\ Therefore, the Commission did not adopt alternatives
that relied on a bright-line approach.
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\107\ The Commission agrees with Kraft that ``[a]ny bright-line
definition or exclusion, such as those previously discussed, would
infringe on a swap counterparty's ability to effectively hedge or
mitigate its commercial risk. * * *''
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In addition, the Commission described the six categories of
commercial risk in a way that it believes are inclusive of the many
different types of commercial risk that can be hedged or mitigated. At
the same time, by delineating specific types of commercial risk that
can be hedged or mitigated for the end-user exception to apply, the
Commission has created boundaries that provide greater clarity for
application of the exception and prevent abuse or evasion of the
exception thereby reducing the costs that can result from uncertainty
or abuse or evasion.
The Commission has determined that alternative approaches proposed
by commenters that are significantly more or less inclusive assign
undue weight to various costs and benefits that increase or decrease
with varying degrees of inclusiveness. The ``management or reduction of
risks'' standard proposed by SFG would create the possibility that
swaps could be excepted from clearing when they are merely being used
to ``manage'' risks. That approach would be contrary to the statute
because it could include swaps that are used to increase risk rather
than to hedge or mitigate commercial risks. On the other hand, as
explained above in Section II.C.5, the ``congruence'' standard proposed
by Better Markets would require ``an exact match'' between each
component of commercial risk being hedged and the swap that hedges it.
However, a hedge does not have to be economically perfect in order to
reduce rather than increase risk. Moreover, commenters emphasized the
prevalence and necessity of dynamic hedging strategies, which
continually rebalance hedges in light of changes or anticipated changes
in underlying positions and their alignment with the hedges that offset
their risk.\108\ In light of this, the Commission believes that the
additional costs created by a ``congruence standard'' would not be
justified by its benefits and therefore has not adopted that
alternative.\109\
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\108\ See, e.g., Kraft, RESA, WGCEF, Peabody, NRECA, American
Public Power Association & Large Public Power Council, and EEI &
EPSA.
\109\ See section II.C.5 above.
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Several commenters suggested that excluding swaps that hedge or
mitigate financial risks would prevent abuse of the end-user exception
by making the exception unavailable for speculative swaps.\110\
However, as stated above, the Commission acknowledges that there are
various financial risks that may be commercial risks for potential
electing counterparties. Section 2(h)(7) of the CEA clearly allows
swaps used by qualifying entities to hedge or mitigate commercial risks
to be excepted out of the clearing requirement. The
[[Page 42587]]
Commission believes that imposing such a limitation on using the end-
user exception for financial swaps without consideration of whether
they in fact do hedge or mitigate commercial risk would be inconsistent
with the statute, and therefore has not adopted that alternative and
accordingly, this alternative is beyond the reach of consideration
under Section 15(a) of the CEA.
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\110\ See, e.g., Tobin, Sullivan, Fay & Grunebaum, CMOC,
Skylands, IPM & CSA, and FMNJ.
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Various commenters suggested that Sec. 39.6(c)(2)(i), which
prohibits use of the end-user exception for swaps used for the purpose
of speculation, trading, and investing, would prevent use of the
exception for swaps that hedge or mitigate commercial risk.\111\ Some
of these comments also indicate that the meaning of ``speculation,
trading or investing'' is unclear, which could cause some regulatory
uncertainty, leading participants to refrain from electing the end-user
exception in appropriate circumstances or to avoid entering into some
swaps that hedge or mitigate commercial risk altogether.
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\111\ See section II.C.7 above.
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The Commission has addressed these concerns by clarifying how Sec.
39.6(c)(2)(i) is to be applied in the context of the entire rule. As
explained in greater detail in section II.C.7 above, the focus of the
limitation is on the purpose of the swap for the potential electing
counterparty, i.e., if it is principally used for hedging or mitigating
commercial risk as characterized in the rule, then the end-user
exception may be elected notwithstanding how the swap may otherwise be
characterized, but if it is used for speculative, trading or investing
purposes with little or no intent to hedge or mitigate commercial risk,
then the end-user exception is not available. Accordingly, the
Commission believes that this provision, if applied as intended,
provides a benefit to market participants by clarifying the
circumstances under which they may claim the end-user exception in
accordance with the general requirement in Section 2(h)(7)(A)(ii) of
the CEA that the swap must ``hedge or mitigate commercial risk''.
4. Determination Costs
To avail themselves of the end-user exception, potential electing
counterparties must determine whether the specific swap in question is
being used to ``hedge or mitigate commercial risk'' under the
rule.\112\ The Commission expects that entities will incur direct costs
in the form of personnel hours devoted to analyzing this question. The
cost of determining whether a specific swap is being used to ``hedge or
mitigate commercial risk'' will depend on the nature of the entity's
hedging activities in the relevant situation. Some entities will incur
relatively few costs in confirming that they are hedging or mitigating
commercial risk. Others will incur little or no cost confirming that
they are not covered by the definition. However, for some entities,
especially those that use swaps to hedge in a variety of ways and
circumstances, the determination could be more complex and may require
that personnel with financial and legal expertise review the
circumstances of the entity's swap activities to make the determination
of whether the swap in question is being used to hedge or mitigate
commercial risk.
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\112\ Entities will also have to determine whether or not they
are financial entities according to Section 2(h)(7)(C) of the CEA.
Such costs result from the requirements of the Dodd-Frank Act and
therefore do not arise as a result of the exercise of discretion by
the Commission.
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Notably, entities would incur determination costs regardless of the
terms of the rule, because they must in any event interpret the
statutory definition to determine whether they, and the swap in
question, are eligible. Thus, at a minimum, a significant portion of
the costs discussed here are attributable to the inclusion in the Dodd-
Frank Act of a restriction on eligible swaps to those that ``hedge or
mitigate commercial risk,'' and not from any aspect of this rule.
Indeed, the final rule mitigates these costs by providing guidance
about the application of the statutory requirements.
The time and resources that must be expended by an entity on this
exercise will vary considerably depending on a number of factors,
including (1) whether the entity in question must determine whether it
is a financial entity; (2) the number and diversity of swaps executed
by the entity; and (3) the complexity of the swap strategies being used
by the entity. The Commission did not receive any comments quantifying
the costs that an entity may incur in making these determinations. The
Commission believes that, for most entities and swaps, making the
determinations necessary will involve little or no cost because the
nature of the electing counterparty and the use of the swaps in the
context of the rule will be readily apparent. The Commission also
recognizes that for some swaps and entities that have mixed purposes or
that have unique characteristics, there will be determination costs;
and in limited cases, such costs could be significant. However, it is
not possible to estimate such costs for the entire market because the
Commission does not have available to it detailed data for the swap
market that would be needed to make such an estimate and also because
such determinations are highly fact specific and can vary substantially
from one swap to the next.
E. Exemption for Small Financial Institutions
Section 2(h)(7)(C)(ii) of the CEA directs the Commission to
consider exempting small banks, savings associations, farm credit
institutions, and credit unions with $10 billion or less in total
assets from the definition of ``financial entity.'' As discussed above,
the Commission is adopting such an exemption in Sec. 39.6(d).\113\ The
Commission notes that as of December 31, 2011, there were approximately
14,700 Section 2(h)(7)(C)(ii) institutions operating in the United
States. Of those institutions, approximately 120 of them had total
assets greater than $10 billion, while the remaining 14,580
institutions had less than $10 billion in total assets making them SFIs
that could elect the end-user exception when using swaps to hedge or
mitigate commercial risk.\114\ In other words, about 99 percent of
banks, savings associations, farm credit system institutions, and
credit unions will qualify as SFIs using the $10 billion level.\115\ In
addition, analysis conducted by the Commission suggests that 99 percent
of Section 2(h)(7)(C)(ii) institutions with less than $10 billion in
total assets that had open swap positions had gross notional swap books
of $2 billion or less. While this data did not influence the
Commission's consideration of what constitutes a ``small'' Section
2(h)(7)(C)(ii) institution, it does indicate how many institutions may
benefit from the exemption as adopted by the Commission.
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\113\ See Section II.D.
\114\ Asset level data for banks and savings associations is
available at fdic.gov, and credit unions at ncua.gov. Data for farm
credit system institutions was provided to the Commission by the
Farm Credit Administration.
\115\ In mid-2010, the most recent period for which Section
2(h)(7)(C)(ii) institution swap data could be obtained,
approximately 1,015 Section 2(h)(7)(C)(ii) institutions had
outstanding swap exposure. Of those institutions, 138 had total
assets over $10 billion and 876 had total assets below $10 billion.
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Commenters suggested alternative approaches to the exemption for
SFIs, such as asset test thresholds above $10 billion, or a test that
focuses on uncollateralized exposure. However, commenters did not
provide sufficient quantitative or qualitative evidence to persuade the
Commission that a threshold greater than $10 billion in
[[Page 42588]]
assets would provide benefits that justify any corresponding costs. In
the absence of compelling evidence for a threshold other than that
which was suggested by Congress, the Commission has adopted the
threshold identified in the statute.
F. Consideration of Section 15(a) Factors
1. Protection of Market Participants and the Public
The reporting requirements help to discourage abuse of the end-user
exception by requiring electing counterparties to provide, or cause to
be provided, information to the Commission that demonstrates compliance
with the legal conditions for using the exception. This helps protect
market participants and the public. If the end-user exception were
abused or evaded (i.e., if entities wrongfully avoided clearing and
trading on an exchange swaps that were required to be cleared and
traded), market participants would be exposed to additional
counterparty risk. Moreover, the public could be exposed to systemic
risk, and the costs associated with large-scale financial system
failure, if large aggregate positions of non-cleared, speculative swaps
were to accumulate in systemically important institutions.
Although reporting counterparties will incur reporting costs, the
rule seeks to minimize these costs and provide flexibility as to the
frequency at which the information is reported. The Commission has
promulgated rules that require electing counterparties to provide, or
cause to be provided, the limited information needed to effectively
regulate the end-user exception and meet the statutory requirements. In
addition, certain reporting requirements may be satisfied by submitting
the required information on a swap-by-swap or annual basis. This
enables entities to adopt reporting practices that reduce their
reporting costs without compromising the Commission's ability to
regulate the market.
The rules also help to protect market participants and the public
because they permit boards of SEC Filers to approve swaps on a swap-by-
swap or more general basis. The Commission believes that either basis
is sufficient to ensure that members of the board are aware that the
end-user exception may be elected and to ensure that such an election
has been appropriately considered at the top of the corporate
responsibility hierarchy. The Commission recognizes that swap-by-swap
approval might reduce risk to market participants and the public to a
somewhat greater degree than general approval, but it agrees with
commenters that any such incremental improvement does not warrant the
additional burden.
The ``reasonable basis'' standard required of reporting
counterparties is likely to create some costs for market participants
who are reporting entities.\116\ The Commission expects that if a
reporting counterparty is not the electing counterparty and is
reporting all information on a swap-by-swap basis, reporting
counterparties may choose to conduct some due diligence in order to
verify that their counterparty and the swap meet the requirements for
eligibility. However, the Commission expects that most reporting
entities are likely to know their customers, which will mitigate any
costs associated with due diligence. Moreover, these costs must be
considered in light of the benefits of such a requirement, namely
enhanced compliance with clearing requirements, which serves to protect
public interests, as well as the competitiveness and integrity of swap
markets.
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\116\ See, e.g., NGSA, Reval, RESA, NRECA, IECA, and EEI.
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Finally, as described above, the ``economically appropriate''
hedging standard, together with the six types of commercial risk and
specific safe harbors for hedging or mitigating risk that are
recognized in the rule, mitigates the risk that market participants
could abuse the exception or evade the clearing requirement, which
could increase counterparty risk and potentially harm market
participants and the public.
2. Efficiency, Competitiveness, and Financial Integrity of Swap Markets
Section 2(h)(8) of the CEA provides that swaps that are subject to
the clearing requirement shall be executed on a board of trade or swap
execution facility unless no such board or facility makes the swap
available for trading. Preventing abuse of the end-user exception
promotes exchange trading as intended by the Dodd-Frank Act by ensuring
that more swaps that are supposed to be cleared are in fact cleared.
This is likely to increase liquidity for these swaps, which should
promote competitiveness by increasing the number of market participants
that offer certain swaps in any one place. It should also enhance the
efficiency of swap markets by reducing the amount of time that market
participants must spend looking for willing counterparties and
receiving actionable quotes for such swaps.
Certain provisions of this rule, such as the information required
to be reported, the requirement for board approval, and the requirement
that reporting entities gather sufficient information to have a
reasonable basis for concluding that their counterparty is eligible for
the end-user exception, will discourage abuse of the exception, thereby
promoting the financial integrity of swap markets and financial markets
as a whole. Market participants should have confidence that swaps that
are not being used to hedge or mitigate commercial risk will be
cleared.
3. Price Discovery
As described in greater detail above in Section III.C.1, the
Commission believes that the rule reduces the potential for abuse or
evasion (which could result in reduced exchange trading and therefore
reduced price discovery) while also giving effect to the statutory
requirement to create an exception from clearing for non-financial
entities and SFIs using swaps to hedge or mitigate commercial risk. To
the extent that reducing abuse or evasion results in greater liquidity
on boards of trade and swap execution facilities, it promotes improved
price discovery.
4. Sound Risk Management Practices
The Commission believes that the rule will lead to sound risk
management practices. By requiring that swaps be ``economically
appropriate'' to the reduction of the commercial risks that they hedge
or mitigate, the rule helps to ensure that changes in the value of non-
cleared swaps that otherwise would be subject to clearing are largely
offset by changes in the value of assets or liabilities that electing
counterparties have or reasonably expect to have (e.g., future changes
in variable interest rates, foreign exchange rates, or the price of
commodities). The offset should partially or fully ensure that the
electing counterparty has sufficient resources to meet the financial
commitments incumbent on them by virtue of their hedging positions.
Electing counterparties may be exposed to certain financial risks
in the course of ordinary business, such as the risk of exchange rate
fluctuations related to foreign transactions and interest rate risk
that could impact a potential electing counterparty's cost of debt
incurred for commercial business purposes. The rule promotes sound risk
management practices by mitigating the cost of collateral for entities
to use swaps to hedge these types of financial risks related to their
commercial activities.
[[Page 42589]]
For SEC Filers, the governing board or equivalent body is directly
responsible to shareholders for the financial condition and performance
of the firm, and also has access to information that would give them a
comprehensive picture of the company's financial condition and risk
management strategies. Therefore, any oversight they provide to the
firm's risk management strategies is likely to encourage sound
practices. However, the requirement contemplated in the NPRM that
boards approve decisions to exempt swaps from clearing on a swap-by-
swap basis could have been difficult for some firms to operationalize,
and therefore could have undermined a firm's ability to implement risk
management strategies that take advantage of the end-user exception. In
other words, there is a tradeoff between the risk management benefits
associated with more direct and intimate board oversight, and the risk
management costs of the same. The Commission believes that the addition
of the option to approve use of the end-user exception on a broad
basis, rather than swap by swap, effectively balances these concerns,
retaining direct board involvement in the firm's decision to exercise
the exemption, but in a manner that does not hinder the firm's ability
to operationalize their risk management strategies.
5. Other Public Interest Considerations
For purposes of determining whether a swap hedges or mitigates
commercial risk, the rule includes swaps that qualify for hedging
treatment under Statement 53, Accounting and Financial Reporting for
Derivative Instruments, issued by GASB. This change in the final rule
expands the range of swaps that state and local government entities can
except from the clearing requirement to provide a safe harbor for swaps
that are bona fide hedges under Statement 53. As a consequence, the
change helps to ensure that U.S. local governmental entities who use
what are definitively hedging swaps under accounting standards are able
to take advantage of the end-user exception for such purposes.
In addition, the Commission provides guidance in Section II.A.4
that foreign governments, foreign central banks and certain
international financial institutions will not be subject to the
clearing requirements of Section 2(h)(1) of the CEA as a matter of
comity. This guidance is in the public interest because it is premised
on the expectation that foreign regulators will reciprocate and provide
similar relief to the Federal Government, the Federal Reserve Banks of
the United States and the international financial institutions of which
the United States is a member.
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) requires federal agencies, in
promulgating regulations, to consider whether those regulations will
have a significant economic impact on a substantial number of small
entities and, if so, provide a regulatory flexibility analysis
respecting the impact.\117\ As noted in the NPRM, the regulations
adopted herein would affect eligible contract participants (ECPs) and
SDRs. The Commission has previously determined that neither ECPs nor
SDRs are small entities for purposes of the RFA.\118\ Accordingly, the
Chairman, on behalf of the Commission, certified in the NPRM pursuant
to 5 U.S.C. 605(b) that these regulations will not have a significant
economic impact on a substantial number of small entities.
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\117\ 5 U.S.C. 601 et seq.
\118\ See 66 FR 20740 at 20743 (Apr. 25, 2001) (regarding ECPs)
and 75 FR 80898 at 80926 (Dec. 23, 2010) (regarding SDRs).
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B. Paperwork Reduction Act
The Paperwork Reduction Act (PRA) \119\ imposes certain
requirements on Federal agencies (including the Commission) in
connection with conducting or sponsoring any collection of information
as defined by the PRA. An agency may not conduct or sponsor, and a
person is not required to respond to, a collection of information
unless it displays a currently valid control number. This rulemaking
imposes new collection of information requirements within the meaning
of the PRA. Accordingly, the Commission requested and the Office of
Management and Budget (OMB) assigned a control number for the new
collection of information: OMB control number 3038-0085. The Commission
has submitted this final rule along with supporting documentation for
OMB's review. Responses to this collection of information will be
mandatory.
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\119\ 44 U.S.C. 3501 et seq.
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The Commission will protect proprietary information according to
the Freedom of Information Act and 17 CFR part 145, ``Commission
Records and Information.'' In addition, section 8(a)(1) of the CEA
strictly prohibits the Commission, unless specifically authorized by
the CEA, from making public ``data and information that would
separately disclose the business transactions or market positions of
any person and trade secrets or names of customers.'' The Commission is
also required to protect certain information contained in a government
system of records according to the Privacy Act of 1974, 5 U.S.C. 552a.
1. Information Provided by Reporting Entities/Persons
Regulation 39.6 will require an electing counterparty to provide or
cause to be provided certain information about the swap to a registered
SDR or, if no registered SDR is available to receive the information,
the Commission in the form and manner specified by the Commission. The
reporting will occur only once at the beginning of the swap life cycle.
If one of the counterparties to the swap is a swap dealer or a major
swap participant, the electing counterparty would cause such
information to be reported by that swap dealer or major swap
participant. The electing counterparty would act as the reporting
counterparty only if its counterparty is not a swap dealer or a major
swap participant.
As noted in the NPRM, the Commission estimates that there are
approximately 30,000 non-financial entities that are counterparties to
a swap in a given year. Of those entities, the Commission estimates
that the majority will not be required to report under Regulation 39.6
because their counterparty will be a swap dealer or major swap
participant. In that case, as described above, the swap dealer or major
swap participant will be required to report on behalf of the electing
counterparty. Also, the reporting under Regulation 39.6 is only
required to be made one time for each swap, with no further
notifications or other reporting required in subsequent years. Reducing
the number of annual potential electing counterparties by these
factors, the Commission estimates that there are approximately 1,000
electing counterparties who will be required to report in a given year.
The Commission estimates that the report will require between 10
minutes and one hour of burden, per electing counterparty per year. The
number of burden hours per electing counterparty may vary depending on
various factors, such as the number of swaps entered into by that
electing counterparty in the given year. Therefore, the number of
estimated aggregate annual burden hours is between 167 and 1,000 hours.
2. Information Collection Comments
The Commission received a comment from the Electric Trade
Associations stating that the Commission rulemakings under the Dodd-
Frank Act constitute an accumulation of interrelated regulatory burdens
and
[[Page 42590]]
costs on nonfinancial small entities and the Commission should conduct
a comprehensive analysis under the PRA and other statutes. However, the
comment did not specifically address this rulemaking.
List of Subjects in 17 CFR Part 39
Business and industry, Reporting requirements, Swaps.
For the reasons stated in the preamble, amend 17 CFR part 39 as
follows:
PART 39--DERIVATIVES CLEARING ORGANIZATIONS
0
1. The authority citation for part 39 is revised to read as follows:
Authority: 7 U.S.C. 2 and 7a-1 as amended by Pub. L. 111-203,
124 Stat. 1376.
0
2. Add Sec. 39.6 to read as follows:
Sec. 39.6 Exceptions to the clearing requirement.
(a) Non-financial entities. (1) A counterparty to a swap may elect
the exception to the clearing requirement under section 2(h)(7)(A) of
the Act if the counterparty:
(i) Is not a ``financial entity'' as defined in section
2(h)(7)(C)(i) of the Act;
(ii) Is using the swap to hedge or mitigate commercial risk as
provided in paragraph (c) of this section; and
(iii) Provides, or causes to be provided, the information specified
in paragraph (b) of this section to a registered swap data repository
or, if no registered swap data repository is available to receive the
information from the reporting counterparty, to the Commission. A
counterparty that satisfies the criteria in this paragraph (a)(1) and
elects the exception is an ``electing counterparty.''
(2) If there is more than one electing counterparty to a swap, the
information specified in paragraph (b) of this section shall be
provided with respect to each of the electing counterparties.
(b) Reporting. (1) When a counterparty elects the exception to the
clearing requirement under section 2(h)(7)(A) of the Act, one of the
counterparties to the swap (the ``reporting counterparty,'' as
determined in accordance with Sec. 45.8 of this part) shall provide,
or cause to be provided, the following information to a registered swap
data repository or, if no registered swap data repository is available
to receive the information from the reporting counterparty, to the
Commission, in the form and manner specified by the Commission:
(i) Notice of the election of the exception;
(ii) The identity of the electing counterparty to the swap; and
(iii) The following information, unless such information has
previously been provided by the electing counterparty in a current
annual filing pursuant to paragraph (b)(2) of this section:
(A) Whether the electing counterparty is a ``financial entity'' as
defined in section 2(h)(7)(C)(i) of the Act, and if the electing
counterparty is a financial entity, whether it is:
(1) Electing the exception in accordance with section
2(h)(7)(C)(iii) or section 2(h)(7)(D) of the Act; or
(2) Exempt from the definition of ``financial entity'' as described
in paragraph (d) of this section;
(B) Whether the swap or swaps for which the electing counterparty
is electing the exception are used by the electing counterparty to
hedge or mitigate commercial risk as provided in paragraph (c) of this
section;
(C) How the electing counterparty generally meets its financial
obligations associated with entering into non-cleared swaps by
identifying one or more of the following categories, as applicable:
(1) A written credit support agreement;
(2) Pledged or segregated assets (including posting or receiving
margin pursuant to a credit support agreement or otherwise);
(3) A written third-party guarantee;
(4) The electing counterparty's available financial resources; or
(5) Means other than those described in paragraphs
(b)(1)(iii)(C)(1), (2), (3), or (4) of this section; and
(D) Whether the electing counterparty is an entity that is an
issuer of securities registered under section 12 of, or is required to
file reports under section 15(d) of, the Securities Exchange Act of
1934, and if so:
(1) The relevant SEC Central Index Key number for that
counterparty; and
(2) Whether an appropriate committee of that counterparty's board
of directors (or equivalent body) has reviewed and approved the
decision to enter into swaps that are exempt from the requirements of
sections 2(h)(1) and 2(h)(8) of the Act.
(2) An entity that qualifies for an exception to the clearing
requirement under this section may report the information listed in
paragraph (b)(1)(iii) of this section annually in anticipation of
electing the exception for one or more swaps. Any such reporting under
this paragraph shall be effective for purposes of paragraph (b)(1)(iii)
of this section for swaps entered into by the entity for 365 days
following the date of such reporting. During such period, the entity
shall amend such information as necessary to reflect any material
changes to the information reported.
(3) Each reporting counterparty shall have a reasonable basis to
believe that the electing counterparty meets the requirements for an
exception to the clearing requirement under this section.
(c) Hedging or mitigating commercial risk. For purposes of section
2(h)(7)(A)(ii) of the Act and paragraph (b)(1)(iii)(B) of this section,
a swap is used to hedge or mitigate commercial risk if:
(1) Such swap:
(i) Is economically appropriate to the reduction of risks in the
conduct and management of a commercial enterprise, where the risks
arise from:
(A) The potential change in the value of assets that a person owns,
produces, manufactures, processes, or merchandises or reasonably
anticipates owning, producing, manufacturing, processing, or
merchandising in the ordinary course of business of the enterprise;
(B) The potential change in the value of liabilities that a person
has incurred or reasonably anticipates incurring in the ordinary course
of business of the enterprise;
(C) The potential change in the value of services that a person
provides, purchases, or reasonably anticipates providing or purchasing
in the ordinary course of business of the enterprise;
(D) The potential change in the value of assets, services, inputs,
products, or commodities that a person owns, produces, manufactures,
processes, merchandises, leases, or sells, or reasonably anticipates
owning, producing, manufacturing, processing, merchandising, leasing,
or selling in the ordinary course of business of the enterprise;
(E) Any potential change in value related to any of the foregoing
arising from interest, currency, or foreign exchange rate movements
associated with such assets, liabilities, services, inputs, products,
or commodities; or
(F) Any fluctuation in interest, currency, or foreign exchange rate
exposures arising from a person's current or anticipated assets or
liabilities; or
(ii) Qualifies as bona fide hedging for purposes of an exemption
from position limits under the Act; or
(iii) Qualifies for hedging treatment under:
(A) Financial Accounting Standards Board Accounting Standards
Codification Topic 815, Derivatives and Hedging (formerly known as
Statement No. 133); or
[[Page 42591]]
(B) Governmental Accounting Standards Board Statement 53,
Accounting and Financial Reporting for Derivative Instruments; and
(2) Such swap is:
(i) Not used for a purpose that is in the nature of speculation,
investing, or trading; and
(ii) Not used to hedge or mitigate the risk of another swap or
security-based swap position, unless that other position itself is used
to hedge or mitigate commercial risk as defined by this rule or Sec.
240.3a67-4 of this title.
(d) For purposes of section 2(h)(7)(A) of the Act, a person that is
a ``financial entity'' solely because of section 2(h)(7)(C)(i)(VIII)
shall be exempt from the definition of ``financial entity'' if such
person:
(i) Is organized as a bank, as defined in section 3(a) of the
Federal Deposit Insurance Act, the deposits of which are insured by the
Federal Deposit Insurance Corporation; a savings association, as
defined in section 3(b) of the Federal Deposit Insurance Act, the
deposits of which are insured by the Federal Deposit Insurance
Corporation; a farm credit system institution chartered under the Farm
Credit Act of 1971; or an insured Federal credit union or State-
chartered credit union under the Federal Credit Union Act; and
(ii) Has total assets of $10,000,000,000 or less on the last day of
such person's most recent fiscal year.
Issued in Washington, DC, on July 10, 2012, by the Commission.
David A. Stawick,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to End-User Exception to Mandatory Clearing of Swaps--
Commission Voting Summary and Statements of Commissioners
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Sommers,
Chilton, O'Malia and Wetjen voted in the affirmative; no
Commissioner voted in the negative.
Appendix 2--Statement of Chairman Gary Gensler
I support the final rule on the end-user exception to the
clearing requirement for swaps. One of the primary goals of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act) was to lower risk to the interconnected financial system
by requiring standardized swaps between financial entities to be
cleared.
Congress provided that non-financial entities, such as farmers,
ranchers, manufacturers and other end-users, should be able to
choose whether or not to clear those swaps that hedge or mitigate
commercial risks. The Commission's final rule implements this
exception for non-financial entities, establishing criteria for
hedging or mitigating commercial risk and imposing minimal reporting
requirements for those swaps that come under the end-user exception.
The final rule benefited from significant public input, including
requiring that most of the information be reported annually, rather
than transaction by transaction as had been proposed.
In the Dodd-Frank Act, Congress also directed the Commission to
consider exempting from the definition of ``financial entity'' small
financial institutions with total assets of $10 billion or less,
thus making them eligible for the end-user exception. After
considering the comments received on the end-user exception
proposal, the Commission is exempting small financial institutions,
including small banks, savings associations, farm credit system
institutions and credit unions, at the $10 billion total asset
level, as identified by Congress.
[FR Doc. 2012-17291 Filed 7-18-12; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: July 19, 2012