2012-10562

Federal Register, Volume 77 Issue 100 (Wednesday, May 23, 2012)[Federal Register Volume 77, Number 100 (Wednesday, May 23, 2012)]
[Rules and Regulations]
[Pages 30596-30764]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-10562]

[[Page 30595]]

Vol. 77

Wednesday,

No. 100

May 23, 2012

Part II

Commodity Futures Trading Commission

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17 CFR Part 1

Securities and Exchange Commission

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17 CFR Part 240

Further Definition of ``Swap Dealer,'' ``Security-Based Swap Dealer,''
``Major Swap Participant,'' ``Major Security-Based Swap Participant''
and ``Eligible Contract Participant;'' Final Rules

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

[[Page 30596]]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AD06

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-66868; File No. S7-39-10]
RIN 3235-AK65

Further Definition of ``Swap Dealer,'' ``Security-Based Swap
Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap
Participant'' and ``Eligible Contract Participant''

AGENCY: Commodity Futures Trading Commission; Securities and Exchange
Commission.

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

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SUMMARY: In accordance with the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010 (``Dodd-Frank Act''), the Commodity
Futures Trading Commission (``CFTC'') and the Securities and Exchange
Commission (``SEC'') (collectively, the ``Commissions''), in
consultation with the Board of Governors of the Federal Reserve System
(``Board''), are adopting new rules and interpretive guidance under the
Commodity Exchange Act (``CEA''), and the Securities Exchange Act of
1934 (``Exchange Act''), to further define the terms ``swap dealer,''
``security-based swap dealer,'' ``major swap participant,'' ``major
security-based swap participant,'' and ``eligible contract
participant.''

DATES: Effective date. The effective date for this joint final rule and
joint interim final rule: July 23, 2012, except for CFTC regulations at
17 CFR 1.3(m)(5) and (6), which are effective December 31, 2012.
Comment date. The comment period for the interim final rule (CFTC
regulation at 17 CFR 1.3(ggg)(6)(iii)) will close July 23, 2012.
Compliance date. Compliance with the element of the CFTC regulation
at 17 CFR 1.3(m)(8)(iii) requiring that a commodity pool be formed by a
registered CPO shall be required with respect to a commodity pool
formed on or after December 31, 2012 for any person seeking to rely on
such regulation; compliance with such element shall not be required
with respect to a commodity pool formed prior to December 31, 2012.

FOR FURTHER INFORMATION CONTACT:
CFTC: Jeffrey P. Burns, Assistant General Counsel, at 202- 418-
5101, [email protected], Mark Fajfar, Assistant General Counsel, at 202-
418-6636, [email protected], Julian E. Hammar, Assistant General
Counsel, at 202-418-5118, [email protected], or David E. Aron, Counsel,
at 202-418-6621, [email protected], Office of General Counsel; Gary
Barnett, Director, at 202-418-5977, [email protected], or Frank
Fisanich, Deputy Director, at 202-418-5949, [email protected],
Division of Swap Dealer and Intermediary Oversight,Commodity Futures
Trading Commission, Three Lafayette Centre, 1155 21st Street NW.,
Washington, DC 20581;
SEC: Joshua Kans, Senior Special Counsel, Richard Grant, Special
Counsel, or Richard Gabbert, Attorney Advisor, at 202-551-5550,
Division of Trading and Markets, Securities and Exchange Commission,
100 F Street NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

I. Background

On July 21, 2010, President Obama signed the Dodd-Frank Act into
law.\1\ Title VII of the Dodd-Frank Act established a statutory
framework to reduce risk, increase transparency, and promote market
integrity within the financial system by, among other things: (i)
providing for the registration and regulation of swap dealers and major
swap participants; (ii) imposing clearing and trade execution
requirements on standardized derivative products; (iii) creating
recordkeeping and real-time reporting regimes; and (iv) enhancing the
Commissions' rulemaking and enforcement authorities with respect to all
registered entities and intermediaries subject to the Commissions'
oversight.
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\1\ See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the
Dodd-Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
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The Dodd-Frank Act particularly provides that the CFTC will
regulate ``swaps,'' and that the SEC will regulate ``security-based
swaps.'' The Dodd-Frank Act also adds definitions of the terms ``swap
dealer,'' ``security-based swap dealer,'' ``major swap participant,''
``major security-based swap participant'' and ``eligible contract
participant'' to the CEA and Exchange Act.\2\ Section 712(d)(1) of the
Dodd-Frank Act further directs the CFTC and the SEC, in consultation
with the Board, jointly to further define those terms, among others.\3\
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\2\ See Dodd-Frank Act sections 721 and 761. Sections 721(b)(2)
and 761(b)(2) also provide that the CFTC and SEC may by rule further
define any other term included in an amendment made by Title VII to
the CEA or the Exchange Act, respectively.
\3\ In addition, section 712(d)(1) directs the CFTC and SEC, in
consultation with the Board, jointly to further define the terms
``swap,'' ``security-based swap,'' and ``security-based swap
agreement.'' These further definitions are the subject of a separate
rulemaking by the Commissions. See CFTC and SEC, Notice of Proposed
Joint Rulemaking, Further Definition of ``Swap,'' ``Security-Based
Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps;
Security-Based Swap Agreement Recordkeeping, 76 FR 29818 (May 23,
2011) (``Product Definitions Proposal''). Section 712(d)(2)(A), in
turn, provides that the Commissions shall jointly adopt such other
rules regarding the definitions set forth in section 712(d)(1) as
they ``determine are necessary and appropriate, in the public
interest, and for the protection of investors.''
In addition, section 721(c) of the Dodd-Frank Act requires the
CFTC to adopt a rule to further define the terms ``swap dealer,''
``major swap participant,'' and ``eligible contract participant''
for the purpose of including transactions and entities that have
been structured to evade Title VII. Also, section 761(b) of the
Dodd-Frank Act permits the SEC to adopt a rule to further define the
terms ``security-based swap dealer,'' ``major security-based swap
participant,'' and ``eligible contract participant,'' with regard to
security-based swaps, for the purpose of including transactions and
entities that have been structured to evade Title VII.
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In December 2010, the Commissions proposed rules and
interpretations to further define the meaning of the terms ``swap
dealer,'' ``security-based swap dealer,'' ``major swap participant,''
``major security-based swap participant,'' and ``eligible contract
participant.'' \4\ The Commissions received approximately 968 written
comments in response to the Proposing Release.\5\ In addition, the
Staffs of the Commissions participated in approximately 114 meetings
with market participants and other members of the public about the
Proposing Release,\6\ and the Commissions held a

[[Page 30597]]

Joint Public Roundtable on the proposed dealer and major participant
definitions.\7\ After considering the comments received, the
Commissions are adopting final rules and interpretations to further
define these terms.
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\4\ See CFTC and SEC, Notice of Proposed Joint Rulemaking:
Further Definition of ``Swap Dealer,'' ``Security-Based Swap
Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap
Participant'' and ``Eligible Contract Participant,'' Securities
Exchange Act Release No. 63452, 75 FR 80174 (Dec. 21, 2010)
(``Proposing Release'').
Prior to issuing the Proposing Release, the Commissions issued a
joint Advance Notice of Proposed Rulemaking (``ANPRM'') requesting
public comment regarding the definitions of the terms ``swap,''
``security-based swap,'' ``security-based swap agreement,'' ``swap
dealer,'' ``security-based swap dealer,'' ``major swap
participant,'' ``major security-based swap participant,'' and
``eligible contract participant.'' See CFTC and SEC, Advance Notice
of Proposed Joint Rulemaking: Definitions Contained in Title VII of
Dodd-Frank Wall Street Reform and Consumer Protection Act,
Securities Exchange Act Release No. 62717, 75 FR 51429 (Aug. 20,
2010). The Proposing Release and these final rules both reflect
comments received in response to the ANPRM.
\5\ Comment letters received in response to the Proposing
Release may be found on the Commissions' Web sites at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=933 and at
http://www.sec.gov/comments/s7-39-10/s73910.shtml.
\6\ Summaries of these staff meetings may be found on the
Commissions' Web sites at http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_2_Definitions/index.htm and http://www.sec.gov/comments/s7-39-10/s73910.shtml#meetings.
\7\ A transcript of the roundtable discussion and public
comments received with respect to the roundtable may be found on the
CFTC's Web site at http://www.cftc.gov/PressRoom/Events/opaevent_cftcsecstaff061611.
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II. Definitions of ``Swap Dealer'' and ``Security-Based Swap Dealer''

The Dodd-Frank Act definitions of the terms ``swap dealer'' and
``security-based swap dealer'' focus on whether a person engages in
particular types of activities involving swaps or security-based
swaps.\8\ Persons that meet either of those definitions are subject to
statutory requirements related to, among other things, registration,
margin, capital and business conduct.\9\
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\8\ See section 721 of the Dodd-Frank Act (adding Section 1a(49)
of the CEA, 7 U.S.C. 1a(49), to define ``swap dealer'') and section
761 of the Dodd-Frank Act (adding Section 3(a)(71) of the Exchange
Act, 15 U.S.C. 78c(a)(71), to define ``security-based swap
dealer'').
\9\ The Dodd-Frank Act excludes from the Exchange Act definition
of ``dealer'' persons who engage in security-based swaps with
eligible contract participants. See section 3(a)(5) of the Exchange
Act, 15 U.S.C. 78c(a)(5), as amended by section 761(a)(1) of the
Dodd-Frank Act.
The Dodd-Frank Act does not include comparable amendments for
persons who act as brokers in swaps and security-based swaps.
Because security-based swaps, as defined in section 3(a)(68) of the
Exchange Act, are included in the Exchange Act section 3(a)(10)
definition of ``security,'' persons who act as brokers in connection
with security-based swaps must, absent an exception or exemption,
register with the SEC as a broker pursuant to Exchange Act section
15(a), and comply with the Exchange Act's requirements applicable to
brokers.
In mid-2011, the SEC issued temporary exemptions under the
Exchange Act in connection with the revision of the ``security''
definition to encompass security-based swaps. Among other aspects,
these temporary exemptions extended to certain broker activities
involving security-based swaps. See ``Order Granting Temporary
Exemptions under the Securities Exchange Act of 1934 in Connection
with the Pending Revision of the Definition of ``Security'' to
Encompass Security-Based Swaps, and Request for Comment,''
Securities Exchange Act Release No. 64795 (Jul. 1, 2011), 76 FR
39927, 39939 (Jul. 7, 2011) (addressing availability of exemption to
registration requirement for securities brokers).
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The CEA and Exchange Act definitions in general encompass persons
that engage in any of the following types of activity:
(i) Holding oneself out as a dealer in swaps or security-based
swaps,
(ii) making a market in swaps or security-based swaps,
(iii) regularly entering into swaps or security-based swaps with
counterparties as an ordinary course of business for one's own account,
or
(iv) engaging in any activity causing oneself to be commonly known
in the trade as a dealer or market maker in swaps or security-based
swaps.\10\

\10\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A); Exchange Act
section 3(a)(71)(A), 15 U.S.C. 78c(a)(71)(A).
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These dealer activities are enumerated in the CEA and Exchange Act in
the disjunctive, in that a person that engages in any one of these
activities is a swap dealer under the CEA or security-based swap dealer
under the Exchange Act, even if such person does not engage in one or
more of the other identified activities.

At the same time, the statutory dealer definitions provide
exceptions for a person that enters into swaps or security-based swaps
for the person's own account, either individually or in a fiduciary
capacity, but not as a part of a ``regular business.'' \11\ The Dodd-
Frank Act also instructs the Commissions to exempt from designation as
a dealer a person that ``engages in a de minimis quantity of [swap or
security-based swap] dealing in connection with transactions with or on
behalf of its customers.'' \12\ Moreover, the definition of ``swap
dealer'' (but not the definition of ``security-based swap dealer'')
provides that an insured depository institution is not to be considered
a swap dealer ``to the extent it offers to enter into a swap with a
customer in connection with originating a loan with that customer.''
\13\ The statutory definitions further provide that a person may be
designated as a dealer for one or more types, classes or categories of
swaps or security-based swaps, or activities without being designated a
dealer for other types, classes or categories or activities.\14\
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\11\ See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C); Exchange Act
section 3(a)(71)(C), 15 U.S.C. 78c(a)(71)(C).
\12\ See CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange Act
section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).
\13\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).
\14\ See CEA section 1a(49)(B), 7 U.S.C. 1a(49)(B); Exchange Act
section 3(a)(71)(B), 15 U.S.C. 78c(a)(71)(B).
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In the Proposing Release, the Commissions proposed rules to
identify the activity that would cause a person to be a dealer,\15\ to
implement the exception for de minimis dealing activity,\16\ to
implement the exception from the swap dealer definition in connection
with the origination of loans by insured depository institutions,\17\
and to provide for the limited purpose designation of dealers.\18\ The
release also set forth proposed interpretive guidance related to the
definitions.
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\15\ See proposed CFTC Regulation Sec. 1.3(ggg)(1); proposed
Exchange Act rule 3a71-1(a), (b).
\16\ See proposed CFTC Regulation Sec. 1.3(ggg)(4); proposed
Exchange Act rule 3a71-2.
\17\ See proposed CFTC Regulation Sec. 1.3(ggg)(5).
\18\ See proposed CFTC Regulation Sec. 1.3(ggg)(3); proposed
Exchange Act rule 3a71-1(c).
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After considering the comments received, the Commissions are
adopting final rules and interpretations to further define the terms
``swap dealer'' and ``security-based swap dealer.'' In this Adopting
Release, we particularly address: (i) The general analysis for
identifying dealing activity involving swaps and security-based swaps;
(ii) the exclusion from the ``swap dealer'' definition in connection
with the origination of loans by insured depository institutions; (iii)
the application of the dealer analysis to inter-affiliate swaps and
security-based swaps; (iv) the application of the de minimis exception
from the dealer definitions; and (v) the limited designation of swap
dealers and security-based swap dealers.

A. General Considerations for the Dealer Analysis

1. Proposed Approach
The proposed rules to define the activities that would lead a
person to be a ``swap dealer'' and ``security-based swap dealer'' were
based closely on the corresponding language of the statutory
definitions.\19\ The Proposing Release further noted that the Dodd-
Frank Act defined the terms ``swap dealer'' and ``security-based swap
dealer'' in a functional manner, and stated that those statutory
definitions should not be interpreted in a constrained, overly
technical or rigid manner, particularly given the diversity of the swap
and security-based swap markets. The Proposing Release also identified
potential distinguishing characteristics of swap dealers and security-
based swap dealers based on the functional role that dealers fulfill in
the swap and security-based swap markets, such as: dealers tend to
accommodate demand from other parties; dealers generally are available
to enter into swaps or security-based swaps to facilitate other
parties' interest; dealers tend not to request that other parties
propose the terms of swaps or security-based swaps, but instead tend to
enter into those instruments on their own standard terms or on terms
they arrange in response to other parties' interest; and dealers tend
to be able to arrange customized terms for

[[Page 30598]]

swaps or security-based swaps upon request, or to create new types of
swaps or security-based swaps at the dealer's own initiative.\20\
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\19\ See CFTC Regulation Sec. 1.3(ggg); Exchange Act rule 3a71-
1(a), (b).
\20\ Proposing Release, 75 FR at 80176.
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The proposal recognized that the principles for identifying dealing
activity involving swaps can differ from principles for identifying
dealing activity involving security-based swaps, in part due to
differences in how those instruments are used.\21\
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\21\ Id.
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a. ``Swap Dealer'' Activity
Consistent with the statutory definition, the proposed rule stated
that the term ``swap dealer'' includes a person that ``regularly enters
into swaps with counterparties as an ordinary course of business for
its own account,'' but also that ``the term swap dealer does not
include a person that enters into swaps for such person's own account,
either individually or in a fiduciary capacity, but not as a part of a
regular business.'' The Proposing Release stated that these two
provisions should be read in combination with each other, and explained
that the difference between the two provisions is whether or not the
person enters into swaps as a part of, or as an ordinary course of, a
``regular business.'' Thus, the Proposing Release equated the phrases
``ordinary course of business'' and ``regular business.'' The Proposing
Release also stated that persons who enter into swaps as a part of a
``regular business'' are those persons whose function is to accommodate
demand for swaps from other parties and enter into swaps in response to
interest expressed by other parties. Such persons would be swap
dealers.\22\ Conversely, the Proposing Release said that persons who do
not fulfill this function in connection with swaps should not be deemed
to enter into swaps as part of a ``regular business,'' and thus would
not likely be swap dealers.\23\
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\22\ In addition, the Proposing Release explained that (in
general, and not specifically limited to the provisions relating to
entering into swaps as part of a ``regular business'') the proposed
swap dealer definition does not depend on whether a person's
activity as a swap dealer is the person's sole or predominant
business (other than through the de minimis exception discussed
below).
\23\ See Proposing Release, 75 FR at 80177.
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In addition, the Proposing Release noted that the nature of swaps
precludes importing concepts used to identify dealers in other areas.
The Proposing Release explained that because swaps are typically not
bought and sold, concepts such as whether a person buys and sells
swaps, makes a two-sided market in swaps, or trades within a bid/offer
spread cannot necessarily be used to determine if the person is a swap
dealer, even if such concepts are useful in determining whether a
person is a dealer in other financial instruments.\24\
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\24\ See id. at 80176-77.
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The Proposing Release further stated that swap dealers can be
identified through their relationships with counterparties, explaining
that swap dealers tend to enter into swaps with more counterparties
than do non-dealers, and in some markets, non-dealers tend to
constitute a large portion of swap dealers' counterparties. In
contrast, the Proposing Release said, non-dealers tend to enter into
swaps with swap dealers more often than with other non-dealers. The
Proposing Release noted that it is likely that swap dealers are
involved in most or all significant parts of the swap markets.\25\
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\25\ See id. at 80177.
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The Proposing Release concluded that this functional approach would
identify as swap dealers those persons whose function is to serve as
the points of connection in the swap markets. Thus, requiring
registration and compliance with the requirements of the Dodd-Frank Act
by such persons would thereby reduce risk and enhance operational
standards and fair dealing in those markets.\26\
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\26\ See id.
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The Proposing Release also noted that the swap markets are diverse
and encompass a wide variety of situations in which parties enter into
swaps with each other, and invited comment as to what aspects of the
parties' activities in particular situations should, or should not, be
considered swap dealing activities. Specifically, the Proposing Release
invited comment regarding persons who enter into swaps: (i) As
aggregators; (ii) as part of their participation in physical markets;
or (iii) in connection with the generation and transmission of
electricity.\27\
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\27\ See id. at 80183-84.
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First, regarding aggregators, the Proposing Release noted that some
persons, including certain cooperatives, enter into swaps with other
parties in order to aggregate the swap positions of the other parties
into a size that would be more amenable to entering into swaps in the
larger swap market. The Proposing Release explained that, for example,
certain cooperatives enter into swaps with smaller businesses because
the smaller business cannot establish a commodity position large enough
to be traded on a swap or futures market, or large enough to be of
interest to larger financial institutions. The Proposing Release said
that while such persons engage in activities that are similar in many
respects to those of a swap dealer, it may be that the swap dealing
activities of these aggregators would not exceed the de minimis
threshold, and therefore they would not be swap dealers. The CFTC
requested comment as to how the de minimis threshold would apply to
such persons, and in general on the application of the swap dealer
definition to this activity. The Proposing Release also noted that the
CFTC was engaged in a separate rulemaking pursuant to section
723(c)(3)(B) of the Dodd-Frank Act regarding swaps in agricultural
commodities, and requested comment on the application of the swap
dealer definition to dealers, including potentially agricultural
cooperatives, that limit their dealing activity primarily to swaps in
agricultural commodities.\28\
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\28\ After publication of the Proposing Release, the CFTC
adopted a final rule on agricultural swaps under which swaps in
agricultural commodities will be permitted to transact subject to
the same rules as all other swaps. See Agricultural Swaps; Final
Rule, 76 FR 49291 (Aug. 10, 2011).
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Second, the Proposing Release noted that the markets in physical
commodities such as oil, natural gas, chemicals and metals have
developed highly customized transactions, some of which would be
encompassed by the statutory definition of the term ``swap,'' and that
some participants in these markets engage in swap dealing activities
that are above the proposed de minimis threshold. The CFTC invited
comment as to any different or additional factors that should be
considered in applying the swap dealer definition to participants in
these markets.
Third, the Proposing Release noted a number of complexities that
arise when applying the swap dealer definition in connection with the
generation and transmission of electricity. In particular, the
Proposing Release noted that additional complexity results because
electricity is generated, transmitted and used on a continuous, real-
time basis, and because the number and variety of participants in the
electricity market is very large, and some electricity services are
provided as a public good rather than for profit. The CFTC invited
comment as to any different or additional factors that should be
considered in applying the swap dealer definition to participants in
the generation and transmission of electricity. Specifically, the CFTC
invited comment on whether there are special considerations, including
without limitation special considerations arising from section

[[Page 30599]]

201(f) of the Federal Power Act,\29\ related to not-for-profit power
systems such as rural electric cooperatives and entities operating as
political subdivisions of a state and on the applicability of the
exemptive authority in section 722(f) of the Dodd-Frank Act to address
those considerations.
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\29\ 16 U.S.C. 824(f).
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b. ``Security-Based Swap Dealer'' Activity
The Proposing Release noted the parallels between the definition of
``security-based swap dealer'' and the definition of ``dealer'' under
the Exchange Act,\30\ as well as the fact that security-based swaps may
be used to hedge risks associated with owning certain types of
securities or to gain economic exposure akin to ownership of certain
types of securities. As a result, the Proposing Release took the view
that the same factors that are relevant to determining whether a person
is a ``dealer'' under the Exchange Act also are generally relevant to
the analysis of whether a person is a security-based swap dealer. The
Proposing Release also addressed the relevance of the ``dealer-trader''
distinction for identifying dealing activity involving security-based
swaps,\31\ while recognizing that certain concepts associated with the
dealer-trader distinction--particularly concepts involving ``turnover
of inventory'' and ``regular place of business''--appeared potentially
less applicable to the security-based swap dealer definition. In
addition, the Proposing Release noted that under the dealer-trader
distinction, we would expect that entities that use security-based
swaps to hedge business risks, absent other activities, likely would
not be dealers.\32\
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\30\ See Exchange Act sections 3(a)(5)(A), (B), 15 U.S.C.
78c(a)(5)(A), (B), as amended by Section 761(a)(1) of the Dodd-Frank
Act.
\31\ The Proposing Release referred to the fact that the SEC
previously has noted that the dealer-trader distinction:
``recognizes that dealers normally have a regular clientele, hold
themselves out as buying or selling securities at a regular place of
business, have a regular turnover of inventory (or participate in
the sale or distribution of new issues, such as by acting as an
underwriter), and generally provide liquidity services in
transactions with investors (or, in the case of dealers who are
market makers, for other professionals).'' Proposing Release, 75 FR
at 80177 (citing Securities Exchange Act Release No. 47364 (Feb. 13,
2003) (footnotes omitted)). The Proposing Release further noted that
other non-exclusive factors that are relevant for distinguishing
between dealers and non-dealers can include receipt of customer
property and the furnishing of incidental advice in connection with
transactions. See id.
\32\ See Proposing Release, 75 FR at 80177-78.
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c. Additional Principles Common to Both Definitions
i. ``Hold Themselves Out'' and ``Commonly Known in the Trade'' Tests
The Proposing Release identified the following non-exclusive list
of factors as potentially indicating that a person meets the ``hold
themselves out'' and ``commonly known in the trade'' tests of the
statutory dealer definitions:
Contacting potential counterparties to solicit interest in
swaps or security-based swaps;
Developing new types of swaps or security-based swaps
(which may include financial products that contain swaps or security-
based swaps) and informing potential counterparties of the availability
of such swaps or security-based swaps and a willingness to enter into
such swaps or security-based swaps with the potential counterparties;
Membership in a swap association in a category reserved
for dealers;
Providing marketing materials (such as a Web site) that
describe the types of swaps or security-based swaps that one is willing
to enter into with other parties; or
Generally expressing a willingness to offer or provide a
range of financial products that would include swaps or security-based
swaps.\33\
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\33\ See id. at 80178.
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The Proposing Release further stated that the test for being
``commonly known in the trade'' as a swap dealer or security-based swap
dealer may appropriately reflect, among other factors, the perspective
of persons with substantial experience with and knowledge of the swap
and security-based swap markets (regardless of whether a particular
entity is known as a dealer by persons without that experience or
knowledge). The Proposing Release also stated that holding oneself out
as a security-based swap dealer likely would encompass a person who is
a dealer in another type of security entering into a security-based
swap with a customer, as well as a person expressing its availability
to enter into security-based swaps, regardless of the direction of the
transaction or across a broad spectrum of risks.\34\
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\34\ See id.
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ii. Market Making
In addressing the statutory definitions' ``making a market'' test,
the Proposing Release noted that while continuous two-sided quotations
and a willingness to buy and sell a security are important indicators
of market making in the equities market, these indicia may not be
appropriate in the swap and security-based swap markets. The proposal
also noted that nothing in the statutory text or legislative history
suggested the intent to impute a ``continuous'' activity requirement to
the dealer definitions.\35\
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\35\ See id.
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iii. No Predominance Test
The Proposing Release further addressed whether a person should be
a dealer only if that activity is the person's sole or predominant
business, and took the view that such an approach was not consistent
with the statutory definition. The Proposing Release rejected this as
an unworkable test of dealer status because many parties that commonly
are acknowledged as dealers also engage in other businesses that
outweigh their swap or security-based swap dealing business in terms of
transaction volume or other measures.\36\
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\36\ See id. at 80178-79.
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iv. Application to New Types of Wwaps and New Activities
The Proposing Release noted that the Commissions intended to apply
the dealer definitions flexibly when the development of innovative
business models is accompanied by new types of dealer activity,
following a facts-and-circumstances approach.\37\
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\37\ See id. at 80179.
---------------------------------------------------------------------------

2. Commenters' Views
Numerous commenters addressed the proposed rules and
interpretations in connection with the ``swap dealer'' and ``security-
based swap dealer'' definitions. Several commenters addressed
principles that are common to the two dealer definitions, while a
number of commenters also addressed interpretations in the Proposing
Release that were specific to the ``swap dealer'' definition.
a. ``Hold Themselves Out'' and ``Commonly Known in the Trade'' Tests
Some commenters expressed the view that the persons that hold
themselves out as or are commonly known as dealers are easy to
identify.\38\ In addressing the ``hold themselves out'' and ``commonly
known'' criteria of the dealer definitions, commenters placed
particular focus on whether only dealers engage in the activities cited
by the

[[Page 30600]]

Proposing Release, or whether those activities are common both to
dealers and to other users of swaps and security-based swaps.
Commenters particularly stated that end users contact potential
counterparties,\39\ develop new types of swaps or security-based
swaps,\40\ and propose terms or language for swap or security-based
swap agreements.\41\ One commenter further stated that identifying
dealing activity based on whether a person develops new types of swaps
or proposes swap terms would discourage innovation and the free
negotiation of swaps.\42\ Some commenters stated that merely responding
to a request for proposals or quotations should not, in itself,
constitute dealing.\43\ Commenters also criticized the Proposing
Release's suggestion that criteria for identifying dealing activity
include membership in a dealer category of a trade association,\44\ as
well as providing marketing materials and offering a range of financial
products.\45\ Commenters also argued for more objective criteria for
identifying persons ``commonly known'' as dealers.\46\
---------------------------------------------------------------------------

\38\ See transcript of Joint CFTC-SEC Staff Roundtable
Discussion on Proposed Dealer and Major Participant Definitions
Under Dodd-Frank Act, June 16, 2011 (``Roundtable Transcript'') at
22-23 (remarks of Ron Filler, New York Law School), 50-51 (remarks
of Ron Oppenheimer, Working Group of Commercial Energy Firms), 215
(remarks of Bella Sanevich, NISA Investment Advisors LLC).
\39\ See letters from the Financial Services Roundtable
(``FSR'') dated February 22, 2011 (``FSR I''), the International
Swap Dealers Association (``ISDA'') dated February 22, 2011 (``ISDA
I'') and the Midsize Bank Coalition of America (``Midsize Banks'').
\40\ See letters from the Committee on Capital Markets
Regulation (``CCMR'') dated February 22, 2011 (``CCMR I''), FSR I,
ISDA I and Midsize Banks.
\41\ See letters from the BG Americas & Global LNG (``BG LNG'')
dated February 22, 2011 (``BG LNG I''), CCMR I, EDF Trading North
America, LLC (``EDF Trading'') and The Gavilon Group, LLC
(``Gavilon'') dated February 21, 2011 (``Gavilon II'').
\42\ See letter from EDF Trading.
\43\ See meeting with American Electric Power, Calpine
Corporation (``Calpine''), Constellation, DC Energy LLC (``DC
Energy''), Edison International (``Edison Int'l''), Exelon Corp.,
GenOn, Southern Company, Edison Electric Institute (``EEI'') and
Electric Power Supply Association (``ESPA'') (collectively
``Electric Companies'') on April 13, 2011.
\44\ See letter from ISDA I and joint letter from National Corn
Growers Association (``NCGA'') and Natural Gas Supply Association
(``NGSA'') (``NCGA/NGSA'') dated February 22, 2011 (``NCGA/NGSA
I'').
\45\ See letter from ISDA I.
\46\ See letters from ISDA I and Peabody Energy Corporation
(``Peabody'').
---------------------------------------------------------------------------

Conversely, one commenter said that three particular activities
cited in the Proposing Release--membership in a swap association
category reserved for dealers, providing marketing materials and
expressing a willingness to offer a range of financial products--are
indicative of holding oneself out as a dealer or being commonly known
in the trade as a dealer, and should be codified in the final rule.\47\
Another commenter suggested other factors, such as having a derivatives
sales team, that should be treated as indicators of dealer
activity.\48\ Commenters also expressed the view that this aspect of
the dealer definition should focus on whether a person solicits
expressions of interest in swaps from a range of market
participants,\49\ and that end users of swaps can actively seek out and
negotiate swaps without necessarily being swap dealers.\50\
---------------------------------------------------------------------------

\47\ See letter from FSR I.
\48\ See meeting with Vitol, Inc. (``Vitol'') on February 16,
2011.
\49\ See letter from Midsize Banks.
\50\ See letter from EDF Trading.
---------------------------------------------------------------------------

b. Market Making
Several commenters generally requested that the Commissions provide
more guidance as to which activities constitute making a market in
swaps or security-based swaps.\51\ Commenters also described various
activities as indicating, or not indicating, market making activity.
For example, two commenters expressed the view that market making is
characterized by entering into swaps on one side of the market and then
establishing offsetting positions on the other side of the market.\52\
Other commenters equated market making to providing liquidity by
regularly quoting bid and offer prices for swaps, and standing ready to
enter into swaps.\53\ One commenter stated that market making activity
is indicated by a person consistently presenting itself as willing to
take either side of a trade.\54\ Two commenters said that market makers
receive tangible benefits (such as reduced trading fees) in return for
the obligation to transact when liquidity is required.\55\
---------------------------------------------------------------------------

\51\ See joint letter from American Benefits Council and the
Committee on Investment of Employee Benefits Assets (``ABC/CIEBA'')
and letters from FSR I.
\52\ See letters from DC Energy and FSR I.
\53\ See letters from Edison Int'l, NextEra Energy Resources,
LLC (``NextEra'') dated February 22, 2011 (``NextEra I'') and Vitol,
and joint letter from American Electric Power, Edison Int'l, Exelon
Corp., and Southern Company (``Utility Group'').
\54\ See letter from ISDA I.
\55\ See joint letter from EEI and EPSA (``EEI/EPSA'') and
letter from Vitol.
---------------------------------------------------------------------------

In contrast, one commenter said the proposal correctly did not
limit market making to consistently quoting a two-sided market, because
to do so would insert a loophole into the definition.\56\ Some
commenters expressed the view that mere active participation in a
market or entering into swaps on both sides of a market does not
necessarily constitute market making.\57\ Others said that occasionally
quoting prices on both sides of the market is not market making when
done to obtain information about the market or to mask one's view of
the market.\58\ One commenter stated that futures commission merchants
(``FCMs'') and broker-dealers that facilitate customers' entering into
swaps are not necessarily market makers.\59\ Other commenters urged the
Commissions to reject the view that market making requires continuous
activity.\60\
---------------------------------------------------------------------------

\56\ See letter from Americans for Financial Reform (``AFR'').
\57\ See letters from ABC/CIEBA, Managed Funds Association
(``MFA'') dated February 22, 2011 (``MFA I''), and Vitol.
\58\ See letters from NextEra Iand Vitol.
\59\ See letter from Newedge USA LLC (``Newedge''); see also
Roundtable Transcript at 39 (remarks of Eric Chern, Chicago Trading
Company).
\60\ See letters from American Federation of State, County and
Municipal Employees (``AFSCME''), and FSR I.
---------------------------------------------------------------------------

A number of commenters addressed the issue of how the dealer
definitions should treat swaps or security-based swaps entered into on
a trading platform such as a designated contract market (``DCM''),
national securities exchange, swap execution facility (``SEF''), or
security-based SEF (collectively referred to herein as
``exchanges'').\61\ Several stated that entering into swaps or
security-based swaps on exchanges should not be considered in
determining if a person is a dealer.\62\ Some of these commenters
emphasized the fact that parties would not know the identity of the
counterparty to the swap executed on an exchange (i.e., such swaps are
``anonymous''),\63\ while other commenters said that such swaps do not
constitute ``accommodating demand'' for swaps or ``facilitating
interest'' in swaps.\64\ Another commenter said that future means of
executing swaps on exchanges are likely to be diverse, and it is
premature to draw conclusions

[[Page 30601]]

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

\61\ While some of these commenters specially addressed this
issue in the context of whether a person is a market maker in swaps,
others more generally addressed the issue in terms of whether a
person is a dealer. For clarity, all of those comments are being
addressed in the market maker context.
\62\ See letters from EEI/EPSA, International Energy Credit
Association (``IECA-Credit'') dated February 22, 2011 (``IECA-Credit
I''), and NextEra I, joint letter from Shell Trading (US) Company
and Shell Energy North America (US), L.P. (``Shell Trading'') dated
February 22, 2011 (``Shell Trading I''), and joint letter from
Allston Trading, LLC, Atlantic Trading USA LLC, Bluefin Trading LLC,
Chopper Trading LLC, DRW Holdings, LLC, Eagle Seven, LLC, Endeavor
Trading, LLC, Geneva Trading USA, LLC, GETCO, Hard Eight Futures,
LLC, HTG Capital Partners, IMC Financial Markets, Infinium Capital
Management LLC, Kottke Associates, LLC, Liger Investments Limited,
Marquette Partners, LP, Nico Holdings LLC, Optiver US, Quantlab
Financial, LLC, RGM Advisors, LLC, Tibra Trading America LLC,
Traditum Group LLC, WH Trading and XR Trading LLC (``Traders
Coalition'').
\63\ See letters from Shell Trading I and Traders Coalition.
\64\ See letters from EEI/EPSA, IECA-Credit I, and NextEra I.
For further discussion of this issue, see parts II.A.4 and II.A.5
below.
\65\ See letter from Metropolitan Life Insurance Company
(``MetLife'').
---------------------------------------------------------------------------

Two commenters asserted that firms that provide liquidity in
cleared and exchange-executed swaps by actively participating in the
market provide heterogeneity among liquidity providers and thereby
disperse risk, and further stated that to regulate such persons as swap
dealers subject to increased capital requirements would discourage
their participation in the market and increase risk.\66\
---------------------------------------------------------------------------

\66\ See letters from Newedge and Traders Coalition; Roundtable
Transcript at 39 (remarks of Eric Chern, Chicago Trading Company).
---------------------------------------------------------------------------

One commenter expressed the view that the statutory definition uses
dealing and market making interchangeably, and suggested that the
analysis of whether a person acts as a dealer should be subsumed within
the analysis of whether it acts as a market maker.\67\
---------------------------------------------------------------------------

\67\ See letter from ISDA I.
---------------------------------------------------------------------------

c. Exception for Activities Not Part of a ``Regular Business''
Several commenters addressed the exception from the dealer
definitions for swap or security-based swap activities that are not
part of a ``regular business.'' Some commenters supported the
Commissions' proposed interpretation in the context of the ``swap
dealer'' definition and stated that this interpretation should be
codified in the text of the final rule.\68\
---------------------------------------------------------------------------

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

Many commenters said that the activity of entering into swaps or
security-based swaps should not be deemed to be a ``regular business,''
and thus not indicative of dealing activity, when the person's use of
swaps or security-based swaps are ancillary to, or in connection with,
a separate non-swap business that is the person's primary business.\69\
Some commenters making this point said that when the person's primary
business relates to physical commodities, the person's use of swaps
relating to those commodities does not constitute a ``regular
business.'' \70\ Other commenters stated that where a person enters
into swaps to serve its own business needs, as opposed to serving the
business needs of the counterparty, the person's use of swaps does not
constitute a ``regular business.'' \71\ Other commenters said that the
use of swaps to hedge the commercial risks of a business does not
constitute a ``regular business'' of entering into swaps.\72\ Some
commenters also suggested that the ``regular business'' exclusion
should be interpreted to mean ``regular swap dealing business'' or
``regular security-based swap dealing business'' to prevent the dealer
definitions from capturing hedgers.\73\
---------------------------------------------------------------------------

\69\ See Roundtable Transcript at 88 (remarks of Steve Walton,
Bank of Oklahoma).
\70\ See letters from Atmos Energy Corporation (``Atmos
Energy''), Dominion Resources, Inc. (``Dominion Resources''), EDF
Trading, Edison Int'l, EEI/EPSA, Gavilon II, Hess Corporation and
its affiliates (``Hess''), Mississippi Public Utility Staff, NextEra
I, National Milk Producers Federation (``NMPF''), Shell Trading I,
Utility Group and Working Group of Commercial Energy Firms
(``WGCEF'') on the swap dealer definition dated February 22, 2011
(``WGCEF I''), and meeting with Bunge on February 23, 2011.
\71\ See letters from BT Pension Scheme Management Limited
(``BTPS''), EDF Trading, EEI/EPSA and Vitol.
\72\ See letters from American Petroleum Institute (``API'')
dated February 22, 2011 (``API I''), Calpine, Coalition of Physical
Energy Companies (``COPE'') dated February 22, 2011 (``COPE I''),
Dominion Resources, EDF Trading, Edison Int'l and Peabody; see also
Roundtable Transcript at 45 (remarks of Ed Prosser, Gavilon) and
letter from Church Alliance. In addition, three commenters said that
the interpretation of the provisions relating to a ``regular
business'' in the Proposing Release is correct, because it will
exclude from the definition of swap dealer those persons using swaps
to hedge commercial risk. See letters from Air Transport Association
of America, Inc. (``ATAA''), IECA-Credit I and joint letter from
Petroleum Marketers Association of America and New England Fuel
Institute.
\73\ See letters from Church Alliance and Peabody.
---------------------------------------------------------------------------

On the other hand, two commenters said that the proposed
interpretation was correct in the view that the test of whether a
person has a ``regular business'' of entering into swaps does not
necessarily depend on whether a person's swap activities are a
predominant activity, because such an approach would allow a person to
engage in a significant level of swap dealing activity without
registering as a swap dealer simply because the person also has
substantial activities in a non-swap business or businesses.\74\
---------------------------------------------------------------------------

\74\ See letters from AFR and Better Markets, Inc. (``Better
Markets'') dated February 22, 2011 (``Better Markets I'').
---------------------------------------------------------------------------

Other commenters suggested that the types of swap activities that a
person engages in are relevant to determining whether the person has a
``regular business'' of entering into swaps. One commenter stated that
a person has a ``regular business'' of entering into swaps when the
person has a primary business of accommodating demand or facilitating
interest in swaps,\75\ while others similarly emphasized that a
``regular business'' of entering into swaps is characterized by
financial intermediation activities.\76\ One commenter took the view
that a person that enters into swaps primarily with financial
intermediaries does not have a ``regular business'' of entering into
swaps.\77\
---------------------------------------------------------------------------

\75\ See letter from IECA-Credit I.
\76\ See letter from NextEra I and Shell Trading I. Another
commenter disagreed with this approach, however, saying that a
person who enters into swaps as an intermediary between smaller
customers and larger financial institutions is not entering into
swaps for its ``own account'' and therefore is not a swap dealer,
but rather would be an FCM or introducing broker. See letter from
MFX Solutions, Inc. (``MFX'') dated February 22, 2011 (``MFX I'').
\77\ See letter from Traders Coalition.
---------------------------------------------------------------------------

Some commenters said that the final rule should clarify the point
at which a person's episodic or occasional swap activities become a
``regular business'' of entering into swaps.\78\ Others stated that the
fact that a person enters into swaps frequently or with a large number
of counterparties does not necessarily mean that the person has a
``regular business'' of entering into swaps.\79\
---------------------------------------------------------------------------

\78\ See letters from BG LNG I and WGCEF I.
\79\ See letters from NCGA/NGSA I and Vitol. One of these
commenters asked that the final rule clarify that simply because a
person engages in swap activity exceeding the thresholds for the de
minimis exception from the swap dealer definition does not
necessarily mean that the person is engaged in a ``regular
business'' of swap dealing. See letter from Vitol.
---------------------------------------------------------------------------

Commenters proposed specific tests for determining if a person has
a ``regular business'' of entering into swaps. One commenter said the
determination should look to whether a person enters into swaps to
accommodate demand from other parties and to profit from a bid/ask
spread on swaps (as opposed to swaps that are substitutes for physical
transactions or positions and used by at least one party to hedge
commercial risk), and consider specifically the volume, revenues and
profits of such activities, the person's value at risk (VaR) and
exposure from such activities, and its resources devoted to such
activities.\80\ Another commenter said that the determination should be
based on the nature of the person's business, the person's business
purpose for using swaps, and the person's method of executing swap
transactions (e.g., a person whose business primarily relates to
physical commodities, who uses swaps to hedge commercial risk, and who
executes swaps on an exchange would be less likely to have a ``regular
business'' of entering into swaps).\81\
---------------------------------------------------------------------------

\80\ See letter from NextEra I; see also letter from Hess
(proposing similar criteria).
\81\ See letter from Shell Trading I.
---------------------------------------------------------------------------

One commenter argued that the ``regular business'' exception should
apply to all four of the dealer tests--not only the test for persons
that regularly enters into swaps or security-based swaps as an
``ordinary course of business''--and further argued that the ``regular
business'' exception should be linked to a ``two-way market'' base

[[Page 30602]]

requirement to avoid commercial hedgers being encompassed by the dealer
definitions.\82\
---------------------------------------------------------------------------

\82\ See letter from ISDA dated I.
---------------------------------------------------------------------------

d. Other Dealer Issues
Commenters also addressed other issues in the Proposing Release,
including: (i) Whether Congress intended that there be implicit
preconditions to dealer status; (ii) whether the concepts of
``accommodating demand'' for swaps or security-based swaps or
``facilitating interest'' in swaps are useful in identifying dealers;
and (iii) whether the interpretation of the dealer definitions should
depend on pre-defined, objective criteria.
i. Preconditions
Several commenters said that the proposal is overbroad and would
encompass persons that Congress did not intend to regulate as
dealers.\83\ Comments in this vein said that the statutory definition
should be interpreted to require that persons meet certain criteria or
engage in certain activity, not explicitly stated in the statute, to be
covered by the swap dealer definition. For instance, some commenters
said that a dealer is a person who enters into swaps or security-based
swaps on either side of the market and who profits from fees for doing
so, or from the spread between the terms of swaps on either side of the
market.\84\ Other commenters made a similar point, saying that swap
dealers are those persons that intermediate between swap users on
either side of the market.\85\
---------------------------------------------------------------------------

\83\ See, e.g., letters from BG LNG I, EDF Trading, ISDA I,
NCGA/NGSA dated February 17, 2012 (``NCGA/NGSA II'') and WGCEF I,
and joint letter from American Farm Bureau Federation, American
Soybean Association, National Association of Wheat Growers, National
Cattlemen's Beef Association, National Corn Growers Association,
National Council of Farmer Cooperatives, National Grain and Feed
Association, National Milk Producers Federation and National Pork
Producers Council (``Farmers' Associations'').
\84\ See letters from COPE I, Edison Int'l, Hess, ISDA I, Shell
Trading I, Utility Group, Vitol and WGCEF I; see also Roundtable
Transcript at 43-45 (remarks of Ed Prosser, Gavilon). However, other
commenters questioned whether profiting from a bid/ask spread is a
relevant test of dealer status, and emphasized that dealers are
those persons who take risk by entering into swaps or security-based
swaps on both sides of the market. See Roundtable Transcript at 21,
56 (remarks of Richard Ostrander, Morgan Stanley) and 43 (remarks of
Russ Wasson, National Rural Electric Cooperative Association
(``NRECA'')). Another commenter pointed out that it could be
difficult to determine how a person is profiting from entering into
swaps. See Roundtable Transcript at 42 (remarks of Michael Masters,
Better Markets).
\85\ See letters from API I, BG LNG I and NCGA/NGSA II.
---------------------------------------------------------------------------

The commenters were not all in agreement on this, however. Several
commenters (including some of those that said swap dealers enter into
swaps on both sides of the market) also stated that there are a variety
of situations in which a person's activity of contemporaneously
entering into swaps on both sides of the market is not indicative of
dealing activity.\86\ One commenter said that it would not be
appropriate to require that a person enter into swaps or security-based
swaps on both sides of the market as a litmus test for dealer status,
because to do so would create loopholes in the definition.\87\ Two
commenters also supported rejection of any interpretation that would
limit the dealer definitions to encompass only those entities that
solely or predominately act as dealers.\88\
---------------------------------------------------------------------------

\86\ The examples cited were: entering into swaps on either side
of a market depending on a firm's commercial purpose for entering
each particular swap (see letters from the Industrial Energy
Consumers of America (``IECA-Consumers'') and WGCEF I, and letter
from the Not-For-Profit Electric End User Coalition (``NFPEEU''),
consisting of NRECA, American Public Power Association (``APPA'')
and Large Public Power Council (``LPPC''); see also Roundtable
Transcript at 44 (remarks of Ed Prosser, Gavilon)); entering into
swaps on both sides of an illiquid market for purposes of price
discovery or to elicit bids and offers from other market
participants (see letters from Hess, Vitol and WGCEF I); and
entering into swaps on both sides of the market as part of an
investment strategy (see letter from ABC/CIEBA).
\87\ See letter from AFR.
\88\ See letters from AFR and Better Markets I.
---------------------------------------------------------------------------

In addition, commenters were particularly divided as to whether
acting as an intermediary always is indicative of swap dealing, as some
commenters said that a person is not a swap dealer when it simply
stands between two parties by entering into offsetting swaps with each
party.\89\
---------------------------------------------------------------------------

\89\ See letters from BOKF, National Association (``BOK'') dated
January 13, 2012 (``BOK V''), MFX I, Newedge and Northland Energy
Trading LLC (``Northland Energy''); see also Roundtable Transcript
at 48 (remarks of John Nicholas, Newedge). One commenter queried
whether the final rule should clarify whether a customer
relationship between the parties to a swap is necessary in order for
the swap to be relevant in determining whether either of the parties
is a swap dealer. See letter from Representative Scott Desjarlais
(``Rep. Desjarlais'').
---------------------------------------------------------------------------

ii. ``Accommodating Demand'' and ``Facilitating Interest''
A number of commenters addressed the Proposing Release's view that
a tendency to accommodate demand for swaps and a general availability
to enter into swaps to facilitate other parties' interest in swaps
(referred to here as ``accommodating demand'' and ``facilitating
interest'') are characteristic of swap dealers. Some commenters stated
that accommodating demand and facilitating interest would not be
effective factors to identify swap dealers, particularly in bilateral
negotiations where it is difficult to say which party is accommodating
demand for swaps.\90\ Other commenters said the activities of
accommodating demand or facilitating interest are indicative of swap
dealing only in certain circumstances, such as when they are not
related to a person's commodity business,\91\ or when done with the
purpose of serving the needs of the other party to the swap.\92\ Some
commenters argued that the statement in the Proposing Release that swap
dealers are likely involved in most or all significant parts of the
swap markets is incorrect in the market for energy swaps. There, the
commenters said, persons can find counterparties for swaps without the
intermediation of a swap dealer, and swaps entered into directly by two
end users are more frequent.\93\
---------------------------------------------------------------------------

\90\ See letters from NextEra I and Peabody and meeting with
Vitol on February 15, 2011.
\91\ See letter from Shell Trading I.
\92\ See letters from IECA-Credit I, National Association of
Insurance Commissioners (``NAIC''), Vitol and WGCEF I. One of these
commenters also said that entering into a bespoke swap with a
registered swap dealer, in which the swap dealer lays off risk,
should not be viewed as accommodating demand or facilitating
interest. See letter from Vitol.
\93\ See letter from BG LNG I, NCGA/NGSA I, NFPEEU, NRG Energy,
Inc. (``NRG Energy'') and WGCEF I and meeting with Vitol on February
16, 2011.
---------------------------------------------------------------------------

Other commenters, though, said that the proposal's focus on
accommodating demand and facilitating interest strikes the right
balance and that the proposed approach is generally correct.\94\
Another commenter did not object to including accommodating demand and
facilitating risk as factors in the definition, but said that those
factors should be applied flexibly.\95\
---------------------------------------------------------------------------

\94\ See letters from AFR and MFX I.
\95\ See letter from National Grain and Feed Association
(``NGFA'') dated February 22, 2011 (``NGFA I'').
---------------------------------------------------------------------------

iii. Application of Objective Criteria, and Additional Factors
Some commenters, specifically addressing the CFTC's proposed
interpretive approach to the ``swap dealer'' definition, said that the
final rule should set out objective criteria that market participants
could use to determine whether or not they are covered by the
definition and therefore required to register as swap dealers.\96\

[[Page 30603]]

Others focused especially on statements in the Proposing Release to the
effect that swap dealers are those persons who ``tend to'' engage in
certain activities, and that persons who engage in certain activities
are ``likely'' to be swap dealers, as being overly subjective and
difficult to interpret.\97\
---------------------------------------------------------------------------

\96\ See letters from BG LNG I, EEI/EPSA, Peabody, Rep.
Desjarlais and Utility Group. Some commenters said that the CFTC's
interpretive approach to the swap dealer definition should be
codified in the text of the final rule. See letters from Alternative
Investment Management Association Limited (``AIMA'') dated February
22, 2011 (``AIMA I'') and COPE I.
\97\ See letters from BG LNG I, Chesapeake Energy Corporation
(``Chesapeake Energy''), COPE I, ISDA I, Vitol and WGCEF I. Some
commenters focused on particular aspects of the swap dealer
definition as requiring further detail, such as, for example, what
it means to be ``commonly known in the trade'' as a swap dealer (see
letter from Peabody) and the definition of market making (see
letters from Midsize Banks and Peabody).
---------------------------------------------------------------------------

Certain commenters suggested specific objective criteria to use to
identify swap dealers. One commenter said that swap dealing activity is
characterized by more frequent use of swaps; having substantial staff
and technological resources devoted to swaps; a larger portion of
revenue and profit being derived from swap activity; and owning fewer
physical assets related to the type of swaps entered into.\98\ Another
commenter said that to identify swap dealers, the CFTC should compare a
person's revenue or profits generated by swap activity to its overall
revenue or profits; compare a person's total business volume to the
volume, VaR and exposure associated with the swap activity; compare a
person's total business resources to the resources devoted to swap
activity; and consider ownership or control of physical assets in the
specific market or region to which the person's swap activity is
tied.\99\
---------------------------------------------------------------------------

\98\ See letter from Hess.
\99\ See letter from NextEra I.
---------------------------------------------------------------------------

More generally, some commenters supported codification of more
concrete tests in connection with the dealer definitions.\100\ However,
other commenters said that the use of bright line rules to determine
whether a person is a dealer would be inappropriate given the dynamic
nature of the swap and security-based swap markets. These commenters
supported a facts and circumstances approach to the dealer definition
as a better approach.\101\ One commenter also raised issues about the
sources of information that may be considered as part of a dealer
determination.\102\
---------------------------------------------------------------------------

\100\ See, e.g., letters from EEI/EPSA, FSR I, ISDA I, NextEra I
and WGCEF I.
\101\ See letters from Better Markets I, Chris Barnard
(``Barnard'') and Prof. Michael Greenberger, University of Maryland
School of Law (``Greenberger'').
\102\ See letter from ISDA I (stating that sources of
information considered by the Commissions in determining dealer
status should be revealed to the entity being evaluated).
---------------------------------------------------------------------------

e. Application of Exchange Act ``Dealer-Trader'' distinction
i. Security-Based Swap Dealer Definition
A number of commenters supported the proposed use of the dealer-
trader distinction under the Exchange Act to interpret the ``security-
based swap dealer'' definition.\103\ Two commenters, however,
specifically opposed use of the distinction in the context of security-
based swaps, arguing that use of the distinction would create confusion
or would be inconsistent with the goal of improved transparency.\104\
---------------------------------------------------------------------------

\103\ See, e.g., letters from Coalition for Derivatives End-
Users (``CDEU''), CCMR I, ISDA I and MetLife.
\104\ See letters from AFR and AFSCME.
---------------------------------------------------------------------------

ii. Swap Dealer Definition
Some commenters said that the CFTC should apply the dealer-trader
distinction as it has been interpreted with respect to the definition
of ``dealer'' under the Exchange Act to identify swap dealers.\105\
Some commenters said that the applicable interpretations under the
Exchange Act mean that swaps a person uses for proprietary trading
(including for speculative purposes) should not be considered in
determining if the person is a swap dealer because dealers enter into
transactions in order to profit from spreads or fees regardless of
their view of the market for the underlying item, whereas traders enter
into transactions in order to take a view on the direction of the
market or to obtain exposure to movements in the price of the
underlying item.\106\ Two commenters said that if the CFTC applied the
distinction, traders should be subject to potential registration as
major swap participants, and dealers should be subject to regulation as
swap dealers.\107\ Commenters acknowledged differences between the
market for swaps and the market for securities, but said that the
Exchange Act interpretations are still relevant.\108\
---------------------------------------------------------------------------

\105\ Some of these commenters said that, since some provisions
in the statutory swap dealer definition are similar to the
definition of a ``dealer'' under the Exchange Act, Congress intended
that the two definitions would be applied in the same way. See
letters from API I, BG LNG I, CDEU, IECA-Consumers and WGCEF I.
Others said that the CFTC should apply these interpretations because
they have been effectively applied for a long time in the context of
securities. See letters from CCMR I and MFA I.
\106\ See letters from Gavilon II, and Next Era I, and meetings
with Electric Companies on April 13, 2011 and WGCEF on April 28,
2011. Another commenter said the interpretations mean that dealers
and traders can be distinguished by their activities: dealers hold
themselves out as buying and selling on a regular basis, derive
income from providing services in the chain of distribution, and
profit from price spreads, while traders do not provide services or
extend credit but, rather, profit from changes in the market value
of underlying items. See letter from API I.
\107\ See letters from EDF Trading and IECA-Consumers.
\108\ See letters from API I, Gavilon I and IECA-Consumers.
---------------------------------------------------------------------------

On the other hand, some commenters agreed with the CFTC's view not
to apply Exchange Act interpretations to the definition of the term
``swap dealer.'' These commenters said that it is appropriate not to
apply the interpretations under the Exchange Act to identify persons
that meet the swap dealer definition under the CEA.\109\
---------------------------------------------------------------------------

\109\ See letters from AFR and AFSCME; see also joint meeting
with AFR and Better Markets on March 17, 2011 (dealer-trader
distinction not helpful in identifying swap dealers because the
transparency and operational robustness of the swap market is much
lower than in the securities market). One commenter said the
precedents should be applied only by the SEC to identify security-
based swap dealers. See letter from NAIC.
---------------------------------------------------------------------------

e. Application to Particular Swap Markets
i. Aggregators
Certain commenters addressed persons who enter into swaps as
aggregators, with most of those commenters discussing agricultural
cooperatives. Commenters said that agricultural cooperatives that hedge
their own risks or the risks of their members regarding agricultural
commodities should be excluded from the swap dealer definition because
Congress did not intend to treat agricultural cooperatives as swap
dealers and because agricultural cooperatives are in effect an
extension of their members.\110\ Some commenters said that the
agricultural cooperatives' use of swaps allows their members to hedge
risks when the members' transactions are too small for (or otherwise
not qualified for) the futures markets.\111\
---------------------------------------------------------------------------

\110\ See letters from Dairy Farmers of America (``DFA''),
Growmark, Land O'Lakes, Inc. (``Land O'Lakes'') dated February 22,
2011 (``Land O'Lakes II''), National Council of Farmer Cooperatives
(``NCFC'') dated February 22, 2011 (``NCFC I'') and NMPF. One
commenter also said that a subsidiary of an agricultural cooperative
that enters into swaps with its parent cooperative, and the members
of the parent cooperative, should be excluded from the swap dealer
definition for the same reason. See meeting with Agrivisor. Another
commenter said that an agricultural cooperative's swaps with farmers
and other persons for risk management should be disregarded in
determining if the cooperative is a swap dealer so long as the swaps
relate to the marketing function of the cooperative, even if the
swaps are not with members of the cooperative. See letter from NMPF.
\111\ See letters from DFA and Growmark.
---------------------------------------------------------------------------

Some commenters said that an exclusion from the swap dealer
definition also should be available to private companies that serve as
aggregators for swaps in agricultural commodities or otherwise offer
swaps

[[Page 30604]]

for agricultural risk management.\112\ These commenters said that such
an exclusion would reduce the costs and regulatory burdens imposed on
such companies and therefore provide a broader choice of swap providers
to farmers and other agricultural market participants, which they said
would reduce risks.\113\
---------------------------------------------------------------------------

\112\ See letters from Farmers' Associations, NGFA I and NMPF.
\113\ See id.
---------------------------------------------------------------------------

One commenter discussed a small energy firm that aggregates demand
for swaps from small energy retailers and consumers. This commenter
said that such aggregators should be excluded from the swap dealer
definition because imposing the swap dealer regulations (which would be
promulgated with large financial firms in mind) on such firms would
increase costs for the aggregators, discourage the aggregators'
offering of swaps, and thereby reduce choice and efficiency in the
market.\114\ Another commenter said that a firm that enters into swaps
with microfinance lenders and offsetting swaps with commercial banks is
akin to an introducing broker or FCM, and should be excluded from the
swap dealer definition on the grounds that it does not enter into swaps
on its own initiative, but rather to provide access to the swap markets
to smaller counterparties.\115\
---------------------------------------------------------------------------

\114\ See letter from Northland Energy. This commenter defined
an ``aggregator'' as a person who: (i) Enters into swaps
predominantly in one direction with counterparties that are using
swaps to establish bona fide hedges; and (ii) offsets risks
associated with such swaps using regulated futures contracts or
cleared swaps.
\115\ See letter from MFX dated June 3, 2011 (``MFX II''). This
commenter said that the exclusion should be available to a person
who operates primarily on a not-for-profit basis and limits its swap
activities to offering swaps to persons in underserved markets and
offsetting such swaps, and who meets other requirements to limit the
scope of the exclusion.
---------------------------------------------------------------------------

Another commenter said that there is no need for any special
treatment of aggregators in the swap dealer definition. According to
this commenter, the CFTC's guidance regarding the definition and the de
minimis exception from the definition address the relevant issues
properly and completely.\116\
---------------------------------------------------------------------------

\116\ See letter from Better Markets I.
---------------------------------------------------------------------------

ii. Physical Commodity Swaps
Commenters that discussed physical commodity swaps primarily
focused on swaps related to energy commodities such as oil, natural gas
and electricity. The commenters said that the market for these swaps is
different from the market for swaps on interest rates and other
financial commodities because, among other things, the swaps are used
to mitigate price and delivery risks directly linked to a commercial
enterprise; less swap activity flows through intermediaries; the
markets for the underlying physical commodities are separately
regulated; and the failure of a commodity market participant is not
likely to impact financial markets as a whole.\117\ Therefore, these
commenters believe, the application of the swap dealer definition to
participants in these physical commodity swap markets should be
different from the application to participants in the financial
commodity swap markets.\118\ Some commenters said that imposing the
costs of swap dealer regulation on participants in the markets for
physical commodity swaps would discourage participation in the market,
thereby reducing liquidity and increasing market concentration.\119\
---------------------------------------------------------------------------

\117\ See letters from BG LNG I, Dominion Resources, National
Energy Marketers Association (``NEM''), NFPEEU, Vitol and WGCEF I
joint letter from Senator Debbie Stabenow and Representative Frank
Lucas (many commercial end-users of swaps with inherent physical
commodity price risk use swaps to hedge such risk and otherwise for
their own trading objectives and not for the benefit of others) and
meetings with Bunge on May 18, 2011 and Electric Companies on April
13, 2011.
\118\ See id.
\119\ See letters from Dominion Resources, NEM and NFPEEU.
---------------------------------------------------------------------------

iii. Electricity Swaps
Commenters on the use of swaps in connection with the generation
and transmission of electricity addressed a variety of issues. First,
commenters said that markets related to electricity are different from
markets for other physical commodities in that electricity must be
generated and transmitted at the time it is needed (it cannot be stored
for future use); the overall demand for electricity is inelastic but
demand at any particular time is subject to external variables, such as
weather; the generation, transmission and use of electricity is widely
dispersed and geographically specific; the markets are overseen by
regulators such as state Public Utility Commissions, regional
transmission organizations (``RTOs'') and the Federal Energy Regulatory
Commission (``FERC''); and government mandates require continuous
supply of electricity and treat electricity as a ``public good.'' \120\
Commenters said that because of these differences, the use of swaps
related to electricity is different from the use of swaps on other
physical commodities in that electricity swaps: Are more highly
customized to a particular place and time; are more likely to relate to
a short time period or be more frequently entered into; typically can
be tied to a specific generation, transmission or use of electricity;
are more likely to be entered into directly by end-users rather than
through dealers; are likely to be entered into by electricity companies
on both sides of the market; and in many cases were subject to
regulatory oversight prior to the Dodd-Frank Act.\121\
---------------------------------------------------------------------------

\120\ See letters from Edison Int'l, the staff of the FERC
(``FERC Staff''), National Association of Regulatory Utility
Commissioners (``NARUC''), NEM, NextEra I, NFPEEU and National Rural
Utilities Cooperative Finance Corporation (``NRU CFC'') dated
February 14, 2011 (``NRU CFC I''), joint letter from NRECA, APPA,
LPPC, EEI and EPSA (``Electric Trade Associations'') and meetings
with Electric Companies on April 13, 2011 and NFPEEU on January 29,
2011.
\121\ See letters from Edison Int'l, EEI/EPSA, Electric Trade
Associations, FERC Staff, NextEra I and NFPEEU and meeting with
Electric Companies on April 13, 2011.
---------------------------------------------------------------------------

Commenters made various points regarding how swaps related to
electricity should be treated for purposes of the swap dealer
definition. A coalition of not-for-profit power utilities and electric
cooperatives said that electricity cooperatives should be excluded from
the swap dealer definition because they are non-profit entities that
enter into swaps for the benefit of their members, they do not hold
themselves out as swap dealers, they do not make markets, and their
swaps are not necessarily reflective of market rates.\122\ Other
commenters said that swaps related to transactions on tariff schedules
approved by FERC or the Electric Reliability Council of Texas should be
disregarded in determining if a person is a swap dealer.\123\ And, some
commenters said that any special treatment of swaps related to
electricity should apply not only to companies that generate, transmit
or distribute electricity, but also to energy marketing companies that
use swaps to benefit from price changes in the underlying energy
commodities or to hedge related risks.\124\
---------------------------------------------------------------------------

\122\ See letter from NFPEEU. This commenter said the exclusion
from the swap dealer definition should extend to persons acting as
an operating or purchasing agent for other utilities in connection
with energy infrastructure products, or otherwise entering into
energy commodity swaps on behalf of other end users.
\123\ See letters from EDF Trading, FERC Staff and NARUC.
\124\ See letters from DC Energy, EDF Trading and EEI/EPSA.
---------------------------------------------------------------------------

On the other hand, some commenters acknowledged that a person who
makes a market in swaps related to electricity by standing ready to
enter into such swaps in order to profit from a bid/ask spread would be
a swap dealer, even if the person was in the business of generating,
transmitting or distributing

[[Page 30605]]

electricity and owned physical facilities for that purpose.\125\
---------------------------------------------------------------------------

\125\ See letter from EEI/EPSA and meeting with Electric
Companies on April 13, 2011.
---------------------------------------------------------------------------

f. Suggested Exlusions From the Dealer Definitions
Several commenters took the view that the swap dealer and security-
based swap dealer definitions should categorically exclude, or should
be interpreted in a way that would be expected to exclude, a variety of
types of persons or transactions. Commenters particularly suggested
that the following categories of persons should be excluded from the
dealer definitions: Agricultural cooperatives and electric cooperatives
(as addressed above), employee benefit plans as defined in the Employee
Retirement Income Security Act of 1974 (``ERISA''),\126\ farm credit
system institutions,\127\ Federal Home Loan Banks,\128\ insured
depository institutions that limit their swap dealing activity to
riskless principal transactions,\129\ FCMs and broker-dealers that
limit their swap dealing activity to riskless principal
transactions,\130\ financial guaranty insurers and their affiliates
that do not enter into new swaps,\131\ asset managers,\132\ non-
financial companies offering swaps related to their physical commodity
business,\133\ any person who enters into swaps or security-based swaps
only with registered dealers and major participants,\134\ persons that
do not pose systemic risk,\135\ hedge funds \136\ and entities that
enter into swaps or security-based swaps solely in a fiduciary
capacity.\137\
---------------------------------------------------------------------------

\126\ See letter from ABC/CIEBA.
\127\ See letter from Farm Credit Council dated February 22,
2011 (``Farm Credit Council I'').
\128\ See letters from Credit Union National Association
(``CUNA'') and Federal Home Loan Banks (``FHLB'') dated February 22,
2011 (``FHLB I'').
\129\ See letter from BOK dated January 31, 2011 (``BOK I'');
but see letter from Vitol at 7 (riskless principal transactions are
a ``good model for true swap dealing activity'').
\130\ See letter from Newedge.
\131\ See letter from Association of Financial Guaranty Insurers
(``AFGI'').
\132\ See letter from BlackRock, Inc. (``BlackRock'') dated
February 22, 2011 (``BlackRock I'').
\133\ Commenters making this point varied in their phrasing of
potential exclusions, and particularly suggested exclusions for:
Agricultural firms offering swaps as risk management tools related
to physical commodities (see letter from NGFA I); all firms, other
than financial entities whose primary business is swap dealing (see
letter from NEM); any person that uses swaps only to reduce price
volatility, enters into a volume of swaps relating to any physical
commodity that is less than the volume of its trading in that
commodity, and is not making a market (see letter from Chesapeake
Energy); or any person that limit its use of swaps to hedging or
speculating (see letters from API I).
\134\ See letter from ISDA I.
\135\ See letters from NARUC and NCGA/NGSA I.
\136\ See letter from MFA I.
\137\ See letters from FSR dated February 22, 2011 and Midsize
Banks.
---------------------------------------------------------------------------

Commenters also suggested that the dealer definitions categorically
exclude, or should be interpreted to exclude, the following types of
swaps and security-based swaps: Exchange-cleared swaps and security-
based swaps,\138\ options to make or receive delivery of physical
commodities,\139\ cash forward transactions with embedded swaps and
book-out transactions,\140\ swaps or security-based swaps that are used
for hedging or mitigating commercial risk,\141\ swaps entered into to
profit from future changes in the price of the underlying
commodity,\142\ swaps or security-based swaps entered into as a
fiduciary or agent for another person,\143\ swaps or security-based
swaps entered into for purposes of price discovery,\144\ and, as noted
above, swaps related to items that are covered by a tariff approved by
FERC or the Electric Reliability Council of Texas.\145\
---------------------------------------------------------------------------

\138\ See letters from Commodity Markets Council (``CMC''), EEI/
EPSA, IECA-Credit I, NextEra I, Shell Trading I, Utility Group and
Vitol.
\139\ See letters from NextEra I and WGCEF I. The commenters
acknowledged that such options may or may not be included in the
definition of ``swap.''
\140\ See letter from CMC.
\141\ See, e.g., letters from Edison Int'l and WGCEF I and joint
letter from Senator Stabenow and Representative Lucas (also saying
that definition of ``hedging'' should be consistent with respect to
the dealer and major participant definitions and the end-user
exception from clearing).
\142\ See letters from EEI/EPSA, NextEra I, Utility Group and
WGCEF I.
\143\ See letters from Midsize Banks, NFPEEU and FSR I.
\144\ See letters from EEI/EPSA, Vitol and WGCEF I.
\145\ See letters from EDF Trading, FERC Staff and NARUC.
---------------------------------------------------------------------------

In contrast, some commenters opposed providing any categorical
exclusions from the dealer definitions. One commenter stated that the
definitions' focus on a person's activities--as opposed to whether that
person falls within a particular category--is a better means of
determining whether the person is a swap dealer.\146\ Another commenter
described the requested exclusions as attempts to achieve carve-outs
that are not provided for in the statute.\147\
---------------------------------------------------------------------------

\146\ See letter from Better Markets I.
\147\ See letter from AFSCME. Additional commenters emphasized
the need for transparency about swaps and swap activities. See
letters from Jason Cropping and BJ D'Milli.
---------------------------------------------------------------------------

Lastly, several commenters addressed the extraterritorial
application of the definitions of the terms ``swap dealer,''
``security-based swap dealer,'' ``major swap participant,'' ``major
security-based swap participant,'' and ``eligible contract
participant.'' In general, the commenters addressed when and how the
definitions should be applied to persons based outside the U.S. and how
the definitions should take account of non-U.S. requirements that may
be applicable to such persons.\148\ The Commissions intend to
separately address issues related to the application of these
definitions to non-U.S. persons in the context of the application of
Title VII to non-U.S. persons.
---------------------------------------------------------------------------

\148\ See, e.g., letters from FSR I, Institute of International
Bankers, ISDA I, Investment Management Association, Japan Financial
Services Agency, Securities Industry and Financial Markets
Association (``SIFMA'') dated February 3, 2011 (``SIFMA I''), and
the World Bank Group, joint letter from the Autorit[eacute] de
contr[ocirc]le prudential and the Autorit[eacute] des marches
financiers, joint letter from Bank of America Merrill Lynch,
Barclays Capital, BNP Paribas S.A. (``BNP Paribas''), Citi,
Cr[eacute]dit Agricole Corporate and Investment Bank, Credit Suisse
Securities (USA), Deutsche Bank AG (``Deutsche Bank''), HSBC, Morgan
Stanley, Nomura Securities International, Inc. (``Nomura
Securities''), Soci[eacute]t[eacute] G[eacute]n[eacute]rale and UBS
Securities LLC (``Twelve Firms''), joint letter from the Bank of
Tokyo-Mitsubishi UFJ, Ltd., Mizuho Corporate Bank, Ltd. and Sumitomo
Mitsui Banking Corporation, and joint letter from Barclays Bank PLC,
BNP Paribas, Credit Suisse AG, Deutsche Bank, HSBC, Nomura
Securities, Rabobank Nederland, Royal Bank of Canada, the Royal Bank
of Scotland Group pLc, Soci[eacute]t[eacute] G[eacute]n[eacute]rale,
the Toronto-Dominion Bank and UBS AG.
---------------------------------------------------------------------------

g. Cost-Benefit Issues and Hedging Deterrence
Several commenters emphasized the cost of being regulated as a
dealer, and emphasized that an overbroad scope of the dealer
definitions would impose significant unwarranted costs on entities
contrary to the goals of the Dodd-Frank Act, and would deter the use of
swaps and security-based swaps for hedging.\149\ Some commenters also
noted that impact of the provisions of section 716 of the Dodd-Frank
Act on entities that are deemed to be swap

[[Page 30606]]

dealers or security-based swap dealers.\150\ Also, one commenter
suggested that using a qualitative test for the dealer definition might
increase costs due to regulatory uncertainty.\151\
---------------------------------------------------------------------------

\149\ See joint letter from Representatives Spencer Bachus and
Frank Lucas at 2 (``Casting an overly-broad net in defining [dealer
and major participant] could force some smaller participants to
leave the marketplace as a result of increased costs, or eliminate
certain types of contracts used for hedging. If either occurs,
businesses will be left exposed to market volatility and the
consequences will ultimately be felt by Americans in the form of
increased consumer costs.'') and letters from ISDA Iat 7 (``The
substantial additional burdens and costs of Dealer regulation must
be reserved for those whose business it is to `make the market,'
that is, those who consistently both buy and sell. This is in accord
with Dodd-Frank Act's market regulatory goals, as well as the
legislation's obvious intent to preserve healthy growth and
innovation in the U.S. swap markets.'' (footnote omitted)), Peabody
at 2-3 (``Legal uncertainty over the application to end users of the
significant regulatory requirements for [swap dealers] could lead
end users to minimize their use of swaps in order to avoid the risk
of being deemed to be [a swap dealer].''), and Church Alliance
(stating that the risk of incurring the costs of dealer regulation
would harm employee benefit plans by reducing their use of swaps and
security-based swaps for hedging and risk mitigation).
\150\ See letters from American Bankers Association (``ABA'')
dated November 3, 2011 (``ABA I''), BOK I, and ISDA I. Section 716
of the Dodd-Frank Act prohibits any ``swaps entity''--a term that
encompasses swap dealers and security-based swap dealers--from
receiving Federal assistance with respect to any swap, security-
based swap, or other activity of the swaps entity.
\151\ See letter from API I (stating that costs of regulatory
uncertainty stem from the use of qualitative factors for identifying
dealing, and from regulatory efforts to reach beyond ``true'' swap
dealers); see also letter from Dominion Resources (the opportunity
costs associated with regulatory uncertainty should be considered).
---------------------------------------------------------------------------

One commenter specifically suggested that in considering the final
rules, the Commissions should consider empirical data regarding the
costs and benefits flowing from the rules and issue a second analysis
of the costs and benefits of the rules for public comment,\152\ while
other commenters said that the consideration of cost and benefits
should include the cumulative cost of interrelated regulatory burdens
arising from all the rules proposed under the Dodd-Frank Act.\153\
Other commenters said the Commissions should consider alternatives that
would impose fewer costs.\154\
---------------------------------------------------------------------------

\152\ See letter from WGCEF I.
\153\ See letters from ABA I, NFPEEU and WGCEF dated December
20, 2011, enclosing a report prepared by NERA Economic Consulting
(``NERA'') (``WGCEF VIII''); see also letter from NERA dated March
13, 2012.
\154\ See letters from NextEra I (referring to alternative de
minimis tests) and NFPEEU.
---------------------------------------------------------------------------

Another commenter said that the cost-benefit analyses in the
Proposing Release may have understated the benefits of the proposed
rules, because focusing on individual aspects of all the rules proposed
under the Dodd-Frank Act prevents consideration of the full range of
benefits that arise from the rules as a whole, in terms of providing
greater financial stability, reducing systemic risk and avoiding the
expense of assistance to financial institutions in the future.\155\
This commenter said the consideration of benefits of the proposed rules
should include the mitigated risk of a financial crisis.\156\
---------------------------------------------------------------------------

\155\ See letter from Better Markets dated June 3, 2011
(``Better Markets II'').
\156\ Better Markets cited estimates that the worldwide cost of
the 2008 financial crisis in terms of lost output was between $60
trillion and $200 trillion, depending primarily on the long term
persistence of the effects. See letter from Better Markets II.
---------------------------------------------------------------------------

3. Final Rules and Interpretation--General Principles
Consistent with the Proposing Release, the final rules that define
the terms ``swap dealer'' and ``security-based swap dealer'' closely
follow the statutory definitions' four tests and exclusion for
activities that are not part of a ``regular business.'' \157\ In
addition, this Adopting Release sets forth interpretive guidance
regarding various elements of the final rules.
---------------------------------------------------------------------------

\157\ See CFTC Regulation Sec. 1.3(ggg)(1), (2); Exchange Act
rule 3a71-1(a), (b).
---------------------------------------------------------------------------

Because the definitions of the terms ``swap dealer'' in the CEA and
``security-based swap dealer'' in the Exchange Act are substantially
similar, the rules further defining those terms and the accompanying
interpretations in this Adopting Release reflect common underlying
principles. At the same time, the interpretations regarding the
application of the definitions differ in certain respects given the
differences in the uses of and markets for swaps and security-based
swaps.\158\ For example, because security-based swaps may be used to
hedge or gain economic exposure to underlying individual securities
(while recognizing distinctions between security-based swaps and other
types of securities, as discussed below), there is a basis to build
upon the same principles that presently are used to identify dealers
for other types of securities. These same principles, though
instructive, may be inapplicable to swaps in certain circumstances or
may be applied differently in the context of dealing activities
involving commodity, interest rate, or other types of swaps.
---------------------------------------------------------------------------

\158\ Section 712(a)(7)(A) of the Dodd-Frank Act provides that
in adopting rules and orders implementing Title VII, the Commissions
shall treat functionally or economically similar products or
entities in a similar manner. Section 712(a)(7)(B), though, provides
that the Commissions need not act in an identical manner.
---------------------------------------------------------------------------

For these reasons, we separately are addressing the interpretation
of the ``swap dealer'' and ``security-based swap dealer'' definitions.
Also, as discussed below, the Commissions are directing their
respective staffs to report separately regarding the rules being
adopted in connection with the definition and related interpretations.
These staff reports will help the Commissions evaluate the ``swap
dealer'' and ``security-based swap dealer'' definitions in all
respects, including whether new or revised tests or approaches would be
appropriate for identifying swap dealers and security-based swap
dealers.\159\
---------------------------------------------------------------------------

\159\ See part V, infra.
---------------------------------------------------------------------------

4. Final Rules and Interpretation--Definition of ``Swap Dealer''
The Dodd-Frank Act contains a comprehensive definition of the term
``swap dealer,'' based upon types of activities. As noted above, we are
adopting a final rule under the CEA that, like the proposed rule,
defines the term ``swap dealer'' using terms from the four statutory
tests and the exclusion for swap activities that are not part of ``a
regular business.'' \160\ The final rule includes modifications from
the proposed rule that are described below, including provisions
stating that swaps entered into for hedging physical positions as
defined in the rule, swaps between majority-owned affiliates, swaps
entered into by a cooperative with its members, and certain swaps
entered into by registered floor traders, are excluded from the swap
dealer determination.\161\ The Commissions, in consideration of
comments received, are also making certain modifications to the
interpretive guidance set out in the Proposing Release with respect to
various elements of the statutory definition of the term ``swap
dealer,'' as described below.
---------------------------------------------------------------------------

\160\ See CFTC Regulation Sec. 1.3(ggg)(1), (2).
\161\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii), (iii).
---------------------------------------------------------------------------

The determination of whether a person is covered by the statutory
definition of the term ``swap dealer'' requires application of various
provisions of the rule further defining that term, as well as the
interpretive guidance in this Adopting Release, depending on the
person's particular circumstances. We intend that the determination
with respect to a particular person would proceed as follows.
The person would begin by applying the statutory definition, and
the provisions of the rule which implement the four statutory tests and
the exclusion for swap activities that are not part of ``a regular
business,'' \162\ in order to determine if the person is engaged in
swap dealing activity. In that analysis, the person would apply the
interpretive guidance described in this part II.A.4, which provides for
consideration of the relevant facts and circumstances. As part of this
consideration, the person would apply elements of the dealer-trader
distinction, as appropriate, including as described in part II.A.4.a,
below.
---------------------------------------------------------------------------

\162\ See CFTC Regulation Sec. 1.3(ggg)(1), (2).
---------------------------------------------------------------------------

The rule provides that certain swaps are not considered in the
determination of whether a person is a swap dealer.\163\ In particular,
swaps entered into by an insured depository institution with a customer
in connection with originating a loan with that customer, \164\ swaps

[[Page 30607]]

between majority-owned affiliates, \165\ swaps entered into by a
cooperative with its members,\166\ swaps entered into for hedging
physical positions as defined in the rule,\167\ and certain swaps
entered into by registered floor traders \168\ are excluded from the
swap dealer determination.
---------------------------------------------------------------------------

\163\ See CFTC Regulation Sec. 1.3(ggg)(5), (6).
\164\ See CFTC Regulation Sec. 1.3(ggg)(5); see also part II.B,
infra.
\165\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); see also part
II.C, infra.
\166\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii); see also part
II.C, infra.
\167\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii); see also part
II.B.4.e, infra.
\168\ See CFTC Regulation Sec. 1.3(ggg)(6)(iv); see also part
II.B.4.f, infra.
---------------------------------------------------------------------------

If, after completing this review (taking into account the
applicable interpretive guidance and excluding any swaps as noted
above), the person determines that it is engaged in swap dealing
activity, the next step is to determine if the person is engaged in
more than a de minimis quantity of swap dealing.\169\ If so, the person
is a swap dealer. When the person registers, it may apply to limit its
designation as a swap dealer to specified categories of swaps or
specified activities of the person in connection with swaps.\170\
---------------------------------------------------------------------------

\169\ See CFTC Regulation Sec. 1.3(ggg)(4); see also part II.D,
infra.
\170\ See CFTC Regulation Sec. 1.3(ggg)(3); see also part II.E,
infra.
---------------------------------------------------------------------------

In this part II.A.4., we provide interpretive guidance on the
application of the ``swap dealer'' definition, modified from the
Proposing Release as appropriate based on comments received. This
guidance separately addresses the following: application of the dealer-
trader framework; the ``holding out'' and ``commonly known'' criteria;
market making; the not part of ``a regular business'' exception; the
exclusion of swaps entered into for hedging physical positions as
defined in the rule; and the overall interpretive approach to the
definition.\171\
---------------------------------------------------------------------------

\171\ The Commissions note that interpretations of the
applicability of the dealer-trader distinction to the ``swap
dealer'' definition under the CEA do not affect existing, or future,
interpretations of the dealer-trader distinction under the Exchange
Act.
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a. Use of the Dealer-Trader Distinction
We believe that the dealer-trader distinction \172\--which already
forms a basis for identifying which persons fall within the
longstanding Exchange Act definition of ``dealer''--in general provides
an appropriate framework for interpreting the statutory definition of
the term ``swap dealer.'' \173\ While there are differences in the
structure of those two statutory definitions,\174\ we believe that
their parallels--particularly their exclusions for activities that are
``not part of a regular business''--warrant analogous interpretive
approaches for distinguishing dealers from non-dealers.\175\ Thus, the
dealer-trader distinction forms the basis for a framework that
appropriately distinguishes between persons who should be regulated as
swap dealers and those who should not. We also believe that the
distinction affords an appropriate degree of flexibility to the
analysis, and that it would not be appropriate to seek to codify the
distinction in rule text.
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\172\ See note 31, supra. The principles embedded within the
``dealer-trader distinction'' are also applicable to distinguishing
dealers from non-dealers such as hedgers or investors. See note 250,
infra.
\173\ The Commissions note that interpretations of the
applicability of the dealer-trader distinction to the ``swap
dealer'' definition under the CEA do not affect existing, or future,
interpretations of the dealer-trader distinction under the Exchange
Act.
\174\ For example, while the ``dealer'' definition encompasses
certain persons in the business of ``buying and selling''
securities, the ``swap dealer'' definition does not address either
``buying'' or ``selling.'' We also note that the ``dealer''
definition requires the conjunctive ``buying and selling''--which
connotes a degree of offsetting two-sided activity. In contrast, the
swap dealer definition (particularly the ``regularly enters into''
swaps language of the definition's third prong) lacks that
conjunctive terminology.
\175\ In the Proposing Release, the CFTC did not propose to use
principles from the dealer-trader distinction to interpret the
definition of the term ``swap dealer,'' instead proposing an
interpretive approach that focused on, among other things, a
person's functional role in the swap markets and its relationships
with swap counterparties. See Proposing Release, 75 FR at 80177.
There was, however, some overlap in practice between the factors
identified in the Proposing Release relating to a swap dealer's
functional role and relationships and the principles of the dealer-
trader distinction that were proposed to be applied to identify
security-based swap dealers. Moreover, the changes to the
interpretive approach to the swap dealer definition that we are
adopting here and discussed in this part II.A.4 are in many respects
similar to the principles of the dealer-trader distinction. We also
acknowledge the commenters who asked for additional guidance
regarding the application of the definitions. See, e.g., letters
from Gavilon II, Peabody and the Utility Group, and meeting with
CDEU on April 7, 2011.
Thus, while the incorporation of the dealer-trader distinction
in the interpretation of the term ``swap dealer'' constitutes a
change from the Proposing Release, this is simply reflective of the
other changes to the CFTC's interpretive approach that we are
adopting for the final rule and the overlap between the factors
relating to a swap dealer's functional role and counterparty
relationships and the principles of the dealer-trader distinction.
---------------------------------------------------------------------------

The Commissions recognize that the dealer-trader distinction needs
to be adapted to apply to swap activities in light of the special
characteristics of swaps and the differences between the ``dealer''
definition, on the one hand, and the ``swap dealer'' definition, on the
other. Relevant differences between the swap market and the markets for
securities (other than security-based swaps) include:
Level of activity--Swap markets are marked by less
activity than markets involving certain types of securities (while
recognizing that some debt and equity securities are not actively
traded). This suggests that in the swap context, concepts of
``regularity'' should account for a participant's level of activity in
the market relative to the total size of the market.
No separate issuer--Each counterparty to a swap in essence
is the ``issuer'' of that instrument; in contrast, dealers in cash
market securities generally transact in securities issued by another
party. This distinction suggests that the concept of maintaining an
``inventory'' of securities is inapposite in the context of swaps.
Moreover, this distinction--along with the fact that the ``swap
dealer'' definition lacks the conjunctive ``buying and selling''
language of the ``dealer'' definition--suggests that concepts of two-
sided markets at times would be less relevant for identifying swap
dealers than they would be for identifying dealers.\176\
---------------------------------------------------------------------------

\176\ The analysis also should account for the fact that a party
to a swap can use other derivatives or cash market instruments to
hedge the risks associated with the swap position, meaning that two-
way trading is not necessary to maintain a flat risk book.
---------------------------------------------------------------------------

Predominance of over-the-counter and non-standardized
instruments--Swaps an thus far are not significantly traded on
exchanges or other trading systems, in contrast to some cash market
securities (while recognizing that many cash market securities also are
not significantly traded on those systems).\177\ These attributes--
along with the lack of ``buying and selling'' language in the swap
dealer definition, as noted above--suggest that concepts of what it
means to make a market need to be construed flexibly in the contexts of
the swap markets.
---------------------------------------------------------------------------

\177\ Even though we expect trading of swaps on exchanges
following the implementation of Title VII, we expect there to remain
a significant amount of over-the-counter activity involving swaps.
---------------------------------------------------------------------------

Mutuality of obligations and significance to ``customer''
relationship--In contrast to a secondary market transaction involving
equity or debt securities, in which the completion of a purchase or
sale transaction can be expected to terminate the mutual obligations of
the parties to the transaction, the parties to a swap often will have
an ongoing obligation to exchange cash flows over the life of the
agreement. In light of this attribute, some market participants have
expressed the view that they have ``counterparties'' rather than
``customers'' in the context of their swap activities.
In applying the dealer-trader distinction, it also is necessary to
apply

[[Page 30608]]

the statutory provisions that will govern swap dealers in an effective
and logical way. Those statutory provisions added by the Dodd-Frank Act
advance financial responsibility (e.g., the ability to satisfy
obligations, and the maintenance of counterparties' funds and assets)
associated with swap dealers' activities,\178\ other counterparty
protections,\179\ and the promotion of market efficiency and
transparency.\180\ As a whole, the relevant statutory provisions
suggest that we should interpret the ``swap dealer'' definition to
identify those persons for which regulation is warranted either: (i)
Due to the nature of their interactions with counterparties; or (ii) to
promote market stability and transparency, in light of the role those
persons occupy within the swap and security-based swap markets.
---------------------------------------------------------------------------

\178\ E.g., capital and margin requirements (CEA section 4s(e)),
and requirements for segregation of collateral (CEA sections 4d(f),
4s(l)).
\179\ E.g., requirements with respect to business conduct when
transacting with special entities (CEA sections 4s(h)(2), 4s(h)(4),
4s(h)(5)); disclosure requirements (CEA section 4s(h)(3)(B));
requirements for fair and balanced communications (CEA section
4s(h)(3)(D)); other requirements related to the public interest and
investor protection (CEA section 4s(h)(3)(D)); and conflict of
interest provisions (CEA section 4s(j)(5)).
\180\ E.g., reporting and recordkeeping requirements (CEA
section 4s(f)); daily trading records requirements (CEA section
4s(g)); regulatory standards related to the confirmation,
processing, netting, documentation and valuation of security-based
swaps (CEA section 4s(i)); position limit monitoring requirements
(CEA section 4s(j)(1)); risk management procedure requirements (CEA
section 4s(j)(2)); and requirements related to the disclosure of
information to regulators (CEA section 4s(j)(3)).
---------------------------------------------------------------------------

There are several aspects of our interpretive approach to the swap
dealer definition that are particularly similar to the dealer-trader
distinction as it will be applied to determine if a person is a
security-based swap dealer. In particular, the following activities,
which are indicative of dealing activity in the application of the
dealer-trader distinction,\181\ similarly are indicative that a person
is acting as a swap dealer: \182\ (i) Providing liquidity by
accommodating demand for or facilitating interest in the instrument
(swaps, in this case), holding oneself out as willing to enter into
swaps (independent of whether another party has already expressed
interest), or being known in the industry as being available to
accommodate demand for swaps; (ii) advising a counterparty as to how to
use swaps to meet the counterparty's hedging goals, or structuring
swaps on behalf of a counterparty; (iii) having a regular clientele and
actively advertising or soliciting clients in connection with swaps;
\183\ (iv) acting in a market maker capacity on an organized exchange
or trading system for swaps; \184\ and (v) helping to set the prices
offered in the market (such as by acting as a market maker) rather than
taking those prices, although the fact that a person regularly takes
the market price for its swaps does not foreclose the possibility that
the person may be a swap dealer.
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\181\ See generally part II.A.5, infra.
\182\ To clarify, the activities listed in the text are
indicative of acting as a swap dealer. Engaging in one or more of
these activities is not a prerequisite to a person being covered by
the swap dealer definition.
\183\ As with the interpretation of the dealer-trader
distinction with respect to securities, a nomenclature distinction
between ``counterparties'' and ``customers'' is not significant for
purposes of applying the dealer-trader distinction to swap
activities. Contractual provisions related to nomenclature, such as
a provision stating that no ``customer'' relationship is present,
would not be significant if the reality of the situation is
different. See note 271, infra, and accompanying text.
\184\ As with the dealer-trader distinction as it has been
interpreted under the Exchange Act with respect to securities (and
as noted below in the discussion of the ``makes a market in swaps''
prong of the swap dealer definition), the presence of an organized
exchange or trading system is not a prerequisite to being a market
maker for purposes of the swap dealer definition, nor is acting as a
market maker a prerequisite to being a swap dealer.
---------------------------------------------------------------------------

The Commissions further note that the following elements of the
interpretive approach to the swap dealer definition are also generally
consistent with the dealer-trader distinction as it will be applied to
determine if a person is a security-based swap dealer: (i) A
willingness to enter into swaps on either side of the market is not a
prerequisite to swap dealer status; (ii) the swap dealer analysis does
not turn on whether a person's swap dealing activity constitutes that
person's sole or predominant business; (iii) a customer relationship is
not a prerequisite to swap dealer status; and (iv) in general, entering
into a swap for the purpose of hedging, absent other activity, is
unlikely to be indicative of dealing. Last, under the interpretive
approach to the definition of both the terms ``swap dealer'' and
``security-based swap dealer,'' whether a person is acting as a dealer
will turn upon the relevant facts and circumstances, as informed by the
interpretive guidance set forth in this Adopting Release.
At the same time, the Commissions recognize that the dealer-trader
distinction is not static, but rather has evolved over time through
interpretive materials. The Commissions expect the dealer-trader
distinction to evolve over time with respect to swaps independently of
its evolution over time with respect to securities or security-based
swaps. Prior interpretations and future developments in the law
regarding securities or security-based swaps may inform the
interpretation of the swap dealer definition, but will not be
dispositive in identifying dealers in the swap markets.\185\
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\185\ In interpreting the term ``swap dealer,'' we intend to
consider, but do not formally adopt, the body of court decisions,
SEC releases, and SEC staff no-action letters that have interpreted
the dealer-trader distinction.
---------------------------------------------------------------------------

b. Indicia of Holding Oneself Out as a Dealer in Swaps or Being
Commonly Known in the Trade as a Dealer in Swaps
The final rule further defining the term ``swap dealer'' includes
the provisions in the proposed rule which incorporate the statutory
requirements that the term includes a person that is holding itself out
as a dealer in swaps or is engaging in any activity causing it to be
commonly known in the trade as a dealer or market maker in swaps.\186\
---------------------------------------------------------------------------

\186\ See CFTC Regulation Sec. 1.3(ggg)(1)(i) and (iv).
---------------------------------------------------------------------------

We continue to believe that the Proposing Release appropriately
identifies a number of factors as indicia of ``hold[ing] itself out as
a dealer in swaps'' and ``engag[ing] in any activity causing [itself]
to be commonly known in the trade as a dealer or market maker in
swaps.'' \187\ In our view, those factors thus are relevant to
determining if a person is a swap dealer. For example, regarding the
proposed factor of ``membership in a swap association in a category
reserved for dealers,'' we note that the bylaws of the International
Swaps and Derivatives Association (``ISDA'') provide that any business
organization that:

\187\ These factors are as follows: Contacting potential
counterparties to solicit interest; developing new types of swaps or
security-based swaps and informing potential counterparties of their
availability and of the person's willingness to enter into the swap
or security-based swap; membership in a swap association in a
category reserved for dealers; providing marketing materials
describing the type of swaps or security-based swaps the party is
willing to enter into; and generally expressing a willingness to
offer or provide a range of products or services that include swaps
or security-based swaps. See Proposing Release, 75 FR at 80178.

Directly or through an affiliate, as part of its business
(whether for its own account or as agent), deals in derivatives
shall be eligible for election to membership in the Association as a
Primary Member, provided that no person or entity shall be eligible
for membership as a Primary Member if such person or entity
participates in derivatives transactions solely for the purpose of
risk hedging or asset or liability management.\188\
---------------------------------------------------------------------------

\188\ See By-laws of ISDA at 3, available at: https://www.isdadocs.org/membership. The Commissions note that the Primary
Members of ISDA are not limited to only financial firms.

We believe that in circumstances such as this, where a category of
association

[[Page 30609]]

membership requires that a person deal in derivatives and not limit its
participation in derivative transactions to solely risk hedging,
membership in the category is an indicator of swap dealer status.\189\
---------------------------------------------------------------------------

\189\ However, while such membership is an indicator of swap
dealer status, a person holding such membership could nonetheless be
excluded by other provisions of the definition of the term ``swap
dealer.'' For example, an insured depository institution that limits
its activity to offering swaps in connection with the origination of
loans, as discussed below in part II.B, would not be covered by the
definition simply because it holds such membership.
---------------------------------------------------------------------------

We take note, however, of the comments that these activities may be
insufficient to establish that a person is a swap dealer. In
particular, we generally agree with commenters that many commercial end
users of swaps do, from time to time, actively seek out and negotiate
swaps. Yet, based on the applicable facts and circumstances, these end
users do not necessarily fall within the definition of a swap dealer
solely because they actively seek out and negotiate swaps from time to
time.
The activities described in the Proposing Release as indicia of
holding oneself out as a swap dealer or engaging in any activity
causing oneself to be commonly known as a swap dealer should not be
considered in a vacuum, but should instead be considered in the context
of all the activities of the swap participant. While the activities
listed in the Proposing Release are indicators that a person is holding
itself out or is commonly known as a swap dealer, these are factors to
be considered in the analysis. They are not per se conclusive, and
could be countered by other factors indicating that the person is not a
swap dealer.\190\ Because of the flexibility--including the
consideration of applicable facts and circumstances--needed for such an
analysis, we do not believe that it is appropriate to codify this
guidance in rule text, as suggested by some commenters.
---------------------------------------------------------------------------

\190\ The statutory definition of the term ``swap dealer''
contains four separate clauses, or ``prongs,'' joined by the
disjunctive ``or,'' the ordinary meaning of which is that the prongs
are stated as alternative types of swap dealer. Accordingly, where
an assessment of all the activities of a swap participant
demonstrates that the person is not holding itself out as a swap
dealer or engaging in any activity that causes it to be commonly
known as a swap dealer, that person may, nonetheless, be a swap
dealer based on the market making or regular business prongs of the
swap dealer definition, discussed below. The Commissions note,
however, that as discussed below in part II.A.4.g, the CFTC's
overall interpretive guidance, including guidance regarding the
dealer-trader framework, applies to identify swap dealers under all
four prongs of the statutory ``swap dealer'' definition.
---------------------------------------------------------------------------

c. Market Making
The final rule defining ``swap dealer'' includes the provision from
the proposed rule which incorporates the statutory requirement that
this term include a person that ``makes a market in swaps.'' \191\
---------------------------------------------------------------------------

\191\ See CFTC Regulation Sec. 1.3(ggg)(1)(ii). Because the
statutory swap dealer definition contains four disjunctive prongs,
the CFTC does not agree with a commenter (see letter from ISDA I)
who asserted that status as a market maker in swaps is a
prerequisite to a person being a swap dealer.
---------------------------------------------------------------------------

We have considered the comments suggesting various descriptions of
activities that should and should not be deemed to be market making in
swaps for purposes of this rule. In consideration of these comments, we
clarify that making a market in swaps is appropriately described as
routinely standing ready to enter into swaps at the request or demand
of a counterparty. In this regard, ``routinely'' means that the person
must do so more frequently than occasionally, but there is no
requirement that the person do so continuously.\192\
---------------------------------------------------------------------------

\192\ A person that occasionally, or less than routinely, enters
into a swap at the request of a counterparty is not a maker of a
market in swaps, and therefore is not a swap dealer on that basis.
However, we reiterate, as stated in the Proposing Release, that
since many types of swaps are not entered into on a continuous
basis, it is not necessary that a person enter into swaps at the
request or demand of counterparties on a continuous basis in order
for the person to be a market maker in swaps and, therefore, a swap
dealer.
---------------------------------------------------------------------------

It is appropriate, in response to comments asking for further
guidance regarding what activities constitute making a market in swaps,
to describe some of the activities indicative of whether a person is
routinely standing ready to enter into swaps at the request or demand
of a counterparty. Such activities include routinely: (i) Quoting bid
or offer prices, rates or other financial terms for swaps on an
exchange; (ii) responding to requests made directly, or indirectly
through an interdealer broker, by potential counterparties for bid or
offer prices, rates or other similar terms for bilaterally negotiated
swaps; (iii) placing limit orders for swaps; or (iv) receiving
compensation for acting in a market maker capacity on an organized
exchange or trading system for swaps.\193\ These examples are not
exhaustive, and other activities also may be indicative of making a
market in swaps if the person engaging in them routinely stands ready
to enter into swaps as principal at the request or demand of a
counterparty.
---------------------------------------------------------------------------

\193\ In addition, section 619 of the Dodd-Frank Act (the
``Volcker Rule'') generally prohibits banking entities from engaging
in proprietary trading, but contains an exception for certain market
making-related activities. The Commissions have proposed an approach
to the Volcker Rule under which a person could seek to avoid the
Volcker Rule in connection with swap activities by asserting the
availability of that market making exception. See SEC, Board, Office
of the Comptroller of the Currency (``OCC''), and Federal Deposit
Insurance Corporation (``FDIC''), Prohibitions and Restrictions on
Proprietary Trading and Certain Interests in, and Relationships
With, Hedge Funds and Private Equity Funds; Proposed Rule, 76 FR
68846 (Nov. 7, 2011); CFTC, Prohibitions and Restrictions on
Proprietary Trading and Certain Interests in, and Relationships
With, Hedge Funds and Private Equity Funds; Proposed Rule, 77 FR
8332 (Feb. 14, 2012). Under this approach, such a person would
likely also be required to register as a swap dealer (unless the
person is excluded from the swap dealer definition, such as by the
exclusion of certain swaps entered into in connection with the
origination of a loan). The SEC has proposed to adopt the same
approach with respect to the interplay of the Volcker Rule and the
definition of the term ``security-based swap dealer.'' See note 272,
infra.
---------------------------------------------------------------------------

In determining whether a person's routine presence in the market
constitutes market making under these four factors, the dealer-trader
interpretative framework may be usefully applied.\194\ Under the
dealer-trader distinction, seeking to profit by providing liquidity to
the market is an indication of dealer activity.\195\ Thus, in applying
these four factors, it is useful to consider whether the person is
seeking, through presence in the market, compensation for providing
liquidity, compensation through spreads or fees, or other compensation
not attributable to changes in the value of the swaps it enters
into.\196\ If not, such activity would not be indicative of market
making.
---------------------------------------------------------------------------

\194\ We recognize that routine presence in the swap market is
not necessarily indicative of making a market in swaps. For example,
persons may be routinely present in the market in order to engage in
swaps for purposes of hedging, to advance their investment
objectives, or to engage in proprietary trading.
\195\ See note 265, infra, and accompanying text.
\196\ In this case, the spread from which a person profits may
be between two or more swaps, or it may be between a swap and
another position or financial instrument. In contrast, entering into
swaps in order to obtain compensation attributable to changes in the
value of the swaps is indicative of using swaps for a hedging,
investment or trading purpose.
---------------------------------------------------------------------------

Some commenters suggested that, in order to be a market maker in
swaps, a person must make a two-way market in swaps.\197\ Nonetheless,
it is possible for a person making a one-way market in swaps to be a
maker of a market in swaps and, therefore, within the swap dealer
definition. This may be true, for example, where a person routinely

[[Page 30610]]

stands ready to enter into swaps on a particular side of the market--
say, routinely bidding for floating exposures on a swap trading
platform--while entering into transactions on the other side of the
market in other instruments (such as futures contracts). The relevant
indicator of market maker status is the willingness of the person to
routinely stand ready to enter into swaps at the request or demand of a
counterparty (as opposed to entering into swaps to accommodate one's
own demand or desire to participate in a particular market), be it on
one or both sides of the market, and then to enter into offsetting
positions, either in the swap market or in other markets.
---------------------------------------------------------------------------

\197\ See letters cited in notes 52 to 58, supra. Although swaps
are notional contracts requiring the performance of agreed upon
terms by each party, it is possible to describe swap users in
practical terms as being on either ``side'' of a market. For
example, for many swaps the party paying a fixed amount is on one
``side'' of the market and the party paying a floating amount is on
the other ``side.''
---------------------------------------------------------------------------

The Commissions disagree with the commenters who said that swaps
executed on an exchange should not be considered in determining if a
person is a market maker in swaps and thus a swap dealer.\198\ First,
the statutory definition of the term ``swap dealer'' makes no
distinction between swaps executed on an exchange and swaps that are
not, suggesting that the same protections should apply regardless of
the method of executing the swap. Second, from the perspective of an
end user seeking to execute a swap on an exchange, the important
consideration under our analysis is whether a market maker is ready to
enter into swaps, not whether the market maker is aware of the
counterparty's identity. A market maker in swaps routinely stands ready
to enter into swaps at the request or demand of a counterparty,
regardless of whether the counterparty and the market maker meet on a
disclosed basis through bilateral negotiations or anonymously through
an exchange.\199\ Similarly, the issue of whether a person is a
registered FCM or broker-dealer is not necessarily relevant to whether
the person is a maker of a market in swaps, if the person is routinely
standing ready to enter into swaps at the request or demand of a
counterparty. Third, we believe it would be inappropriate to disregard
swaps executed on exchanges in order, as some commenters
suggested,\200\ to encourage market participants to use, or to provide
liquidity to, exchanges. Finally, variety of exchanges, markets, and
other facilities for the execution of swaps are likely to evolve in
response to the requirements of the Dodd-Frank Act, and there is no
basis for any bright-line rule excluding swaps executed on an exchange,
given the impossibility of obtaining information about how market
participants will interact and execute swaps in the future, after the
requirements under the Dodd-Frank Act are fully in effect. For all
these reasons, we have determined that it is inappropriate to restrict
the ``making a market in swaps'' prong of the swap dealer definition
(i.e., routinely standing ready to enter into swaps at the request or
demand of a counterparty) to swaps that are not executed on an
exchange.\201\
---------------------------------------------------------------------------

\198\ See, e.g., letters cited in note 62, supra.
\199\ As discussed above, in many cases routine presence in the
swap market, without more, would not constitute market making
activity. Nevertheless, the CFTC will, in connection with
promulgation of final rules relating to capital requirements for
swap dealers and major swap participants, consider institution of
reduced capital requirements for entities or individuals that fall
within the swap dealer definition and that execute swaps only on
exchanges, using only proprietary funds. Similarly, the CFTC also
will consider the applicability to such entities or individuals of
the other requirements imposed on swap dealers (e.g., internal
business conduct standards, external business conduct standards with
counterparties), and may adjust those swap dealer requirements as
appropriate.
\200\ See, e.g., letters cited in note 66, supra. Since the
structures of the markets on which swaps will be executed are still
in development, and market obligations have not been established,
there is little support for comments asserting that market makers
should be defined as only those persons who receive benefits from
the market (such as reduced trading fees) in return for the
obligation to transact when the market requires liquidity.
\201\ By contrast, it may be appropriate, over time, to tailor
the specific requirements imposed on swap dealers depending on the
facility on which the swap dealer executes swaps. For example, the
application of certain business conduct requirements may vary
depending on how the swap is executed, and it may be appropriate, as
the swap markets evolve, to consider adjusting certain of those
requirements for swaps that are executed on an exchange or through
particular modes of execution.
---------------------------------------------------------------------------

d. Exception for Activities Not Part of ``a Regular Business''
The final rule includes the provisions in the proposed rule that
incorporate the provisions of the statutory definition regarding
activities that are not part of ``a regular business'' of entering into
swaps. One provision states that the term ``swap dealer'' includes a
person that ``regularly enters into swaps with counterparties as an
ordinary course of business for its own account''; the other provision
states that the term ``swap dealer'' does not include a person that
``enters into swaps for such person's own account, either individually
or in a fiduciary capacity, but not as a part of a regular business.''
\202\
---------------------------------------------------------------------------

\202\ Final CFTC Regulation Sec. 1.3(ggg)(2) is modified from
the proposal to include the word ``a'' before the words ``regular
business,'' to conform the text of the rule to the text of the
statute. See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C).
As stated in the Proposing Release, we interpret the reference
in the definition of the term ``swap dealer'' to a person entering
into swaps ``with counterparties * * * for its own account'' to
refer to a person who enters into a swap as a principal, and not as
an agent. A person who enters into swaps as an agent for customers
(i.e., for the customers' accounts) would be required to register as
either an FCM, introducing broker, commodity pool operator or
commodity trading advisor, depending on the nature of the person's
activity.
---------------------------------------------------------------------------

The Commissions continue to believe, as stated in the Proposing
Release, that the phrases ``ordinary course of business'' and ``a
regular business'' are, for purposes of the definition of ``swap
dealer'' essentially synonymous. In this context, we interpret these
phrases to focus on activities of a person that are usual and normal in
the person's course of business and identifiable as a swap dealing
business. It is not necessarily relevant whether the person conducts
its swap-related activities in a dedicated subsidiary, division,
department or trading desk, or whether such activities are a person's
``primary'' business or an ``ancillary'' business, so long as the
person's swap dealing business is identifiable.\203\
---------------------------------------------------------------------------

\203\ We recognize, as noted by one commenter (see letter from
ISDA I), that the ``regular business'' exclusion is not limited
solely to the ``ordinary course of business'' test of the swap
dealer definition. Our interpretations of the other three tests are,
and should be read to be, consistent with the exclusion of
activities that are not part of a regular business.
---------------------------------------------------------------------------

We have taken into consideration comments seeking additional
guidance regarding the types and levels of activities that constitute
having ``a regular business'' of entering into swaps.\204\ In this
regard, any one of the following activities would generally constitute
both entering into swaps ``as an ordinary course of business'' and ``as
a part of a regular business'': \205\ (i) Entering into swaps with the
purpose of satisfying the business or risk management needs of the
counterparty (as opposed to entering into swaps to accommodate one's
own demand or desire to participate in a particular market); (ii)
maintaining a separate profit and loss statement reflecting the results
of swap activity or treating swap activity as a separate profit center;
or (iii) having staff and resources allocated to dealer-type activities
with counterparties, including activities relating to credit analysis,
customer onboarding, document negotiation, confirmation generation,
requests for novations and amendments, exposure monitoring and
collateral calls, covenant monitoring, and reconciliation.\206\
---------------------------------------------------------------------------

\204\ See, e.g., letters from BG LNG I, COPE I, IECA-Credit I,
Shell Trading I, WGCEF I and Vitol (stating that the proposed
approach was overly subjective and requesting guidance as to the
specific activities that are covered by the statutory definition).
\205\ These activities are inconsistent with entering into a
swap to hedge a physical position as defined in Sec.
1.3(ggg)(6)(iii). As discussed below, such hedging is not dealing
activity.
\206\ The three indicators of being engaged in ``a regular
business'' of entering into swaps described here are set forth in
the alternative. Any one of these indicators may be sufficient,
based on a facts and circumstances analysis, to reach a conclusion
that an entity is engaged in ``a regular business'' of entering into
swaps.

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[[Page 30611]]

The Commissions see merit in the comments saying that ``a regular
business'' of entering into swaps can be characterized by entering into
swaps to satisfy the business or risk management needs of the other
party to the swap, and so incorporate this element into our
interpretation of the rule.\207\ Also, an objective indicator of a
person being engaged in ``a regular business'' of entering into swaps
is when the person accounts for the results of its swap activities
separately, by maintaining a separate profit and loss statement for
those activities or treating them as a separate profit center. Our
interpretation incorporates this indicator of activity that is ``a
regular business'' of entering into swaps.
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\207\ This element of the interpretation reflects our agreement
with those commenters who said that ``a regular business'' of
entering into swaps is characterized by having a business of
accommodating demand or facilitating interest in swaps (see letter
from IECA-Credit I), and those commenters who said that ``a regular
business'' does not encompass the use of swaps to serve a person's
own business needs, as opposed to serving the business needs of the
counterparty (see letters cited in note 71, supra).
---------------------------------------------------------------------------

Other comments suggesting specific criteria to identify ``a regular
business'' also were helpful. We agree with commenters \208\ that ``a
regular business'' of entering into swaps can be characterized by
having staff and resources allocated to the types of activities in
which swap dealers must engage with their counterparties, such as those
noted above (e.g., credit analysis, confirmation generation, collateral
calls, and covenant monitoring). However, we understand that some end
users of swaps engage in some of these activities and, in certain
circumstances, may have staff and resources available for these
activities. Therefore, this element of the definition should be applied
in a reasonable manner, taking all appropriate circumstances into
account. This element does not depend on whether a specific amount or
percentage of expenses or employee time are related to these swap
activities. Instead, it is appropriate to objectively examine a
person's use of staff and resources related to swap activities. Using
staff and resources to a significant extent in conducting credit
analysis, opening and monitoring accounts and the other activities
noted above, is an indication that the person is engaged in ``a regular
business'' of entering into swaps.
---------------------------------------------------------------------------

\208\ See letters cited in note 80, supra.
---------------------------------------------------------------------------

Regarding the commenters' assertion that the activity of entering
into swaps in connection with a person's physical commodity business
cannot constitute ``a regular business'' of the person, we believe that
while in most cases this is not dealing activity,\209\ a per se
exclusion of this type is not appropriate because it is possible that
in some circumstances a person might enter into swaps that are
connected to a physical commodity business but also serve market
functions characteristic of the functions served by swap dealers. Also,
again, the statutory definition does not contain any such exclusion,
but rather includes any person who ``regularly enters into swaps with
counterparties as an ordinary course of business for its own account,''
without regard to the person's particular type of business.
---------------------------------------------------------------------------

\209\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii) (swaps entered
into for hedging physical positions as defined in the rule are not
considered in the determination of whether a person is a swap
dealer).
---------------------------------------------------------------------------

Consistent with the statutory definition, we interpret ``a regular
business'' of entering into swaps in a manner that applies equally to
all market participants that engage in the activities set forth in the
statutory definition. This will ensure that all participants in the
swap markets are regulated in a fair and consistent manner, regardless
of whether their underlying business is primarily physical or financial
in nature.\210\
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\210\ Regulation of firms engaged in an underlying physical
business is also consistent with regulatory practices outside the
U.S. For example, non-financial entities register with the Financial
Services Authority in the U.K. as ``Oil Market Participants'' and
``Energy Market Participants.'' See Financial Services Authority
Handbook EMPS and OMPS, available at http://fsahandbook.info/FSA/html/handbook.
---------------------------------------------------------------------------

Finally, as noted above, the manner in which persons negotiate,
execute and use swaps is likely to evolve in response to the
requirements of the Dodd-Frank Act and the other forces that will shape
the swap markets going forward. For this reason, it would be
inappropriate to craft per se exclusions from the swap dealer
definition at a time when the only available information about the use
of swaps relates to the period prior to implementation of the Dodd-
Frank Act.\211\
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\211\ For the same reasons, we do not believe it would be
appropriate, in determining whether a person has a ``regular
business'' of entering into swaps, to consider whether a person
engages in activities normally associated with financial
institutions, as some commenters suggested. See letters cited in
note 76, supra.
---------------------------------------------------------------------------

e. Interim Final Rule Excluding Swaps Entered Into for Hedging Physical
Positions
We note that some commenters said that swaps used to hedge or
mitigate commercial risks should not be considered in determining
whether a person is a swap dealer.\212\ We understand that swaps are
used to hedge risks in numerous and varied ways, and we expect that the
number of persons covered by the definition will be very small in
comparison to the thousands of persons that use swaps for hedging.
---------------------------------------------------------------------------

\212\ See, e.g., letters cited in note 72, supra.
---------------------------------------------------------------------------

In terms of the statutory definition of the term ``swap dealer,''
the CFTC notes as an initial matter that there is no specific provision
addressing hedging activity. Thus, the statutory definition leaves the
treatment of hedging swaps to the CFTC's discretion; it neither
precludes consideration of a swap's hedging purpose, nor does it
require an absolute exclusion of all swaps used for hedging.\213\
---------------------------------------------------------------------------

\213\ In this regard, the statutory definition of the term
``swap dealer'' stands in contrast to the statutory definition of
the term ``major swap participant'' which, as discussed further
below, explicitly provides that positions in swaps held for hedging
or mitigating commercial risk are to be excluded in certain parts of
that definition. See CEA section 1a(33)(A)(i)(1), 7 U.S.C.
1a(33)(A)(i)(1). The absence of any explicit requirement in the
``swap dealer'' definition to exclude swaps held for hedging or
mitigating commercial risk does not support the view that Congress
intended to categorically exclude all swaps that may serve as hedges
in determining whether a person is covered by the definition.
Similarly, the absence of any limitation in the statutory
definition of the term ``swap dealer'' to financial entities, when
such limitation is included elsewhere in Title VII, indicates that
no such limitation applies to the swap dealer definition. CEA
section 2(h)(7), 7 U.S.C. 2(h)(7), specifically limits the
application of the clearing mandate, in certain circumstances, to
only ``financial entities.'' That section also provides a detailed
definition of the term ``financial entity.'' See CEA section
2(h)(7)(C), 7 U.S.C. 2(h)(7)(C). That such a limitation is included
in this section, but not in the swap dealer definition, does not
support the view that the statutory definition of the term ``swap
dealer'' should encompass only financial entities.
---------------------------------------------------------------------------

In general, entering into a swap for the purpose of hedging is
inconsistent with swap dealing.\214\ The practical

[[Page 30612]]

difficulty lies in determining when a person has entered into a swap
for the purpose of hedging, as opposed to other purposes for entering
into swaps, such as accommodating demand for swaps or as part of making
a market in swaps, and in distinguishing a swap with a hedging purpose
from a swap with a hedging consequence. In view of these uncertainties,
the CFTC believes it is appropriate to adopt an interim final rule that
draws upon the principles of bona fide hedging that the CFTC has long
applied to identify when a financial instrument is used for hedging
purposes, and excludes from the swap dealer analysis swaps entered into
for the purpose of hedging physical positions that meet the
requirements of the rule.
---------------------------------------------------------------------------

\214\ For example, under the dealer-trader distinction, the
Commissions would expect persons that use security-based swaps to
hedge their business risks, absent other activity, likely would not
be dealers. See part II.A.5.b, infra. Under the CFTC's interpretive
guidance, making a market in swaps is appropriately described as
routinely standing ready to enter into swaps at the request or
demand of a counterparty, and the indicia of swap dealing as a
``regular business'' include entering into swaps to satisfy the
business or risk management needs of the counterparty. Entering into
swaps for the purpose of hedging one's own risks generally would not
be indicative of this form of swap activity. See also, e.g., joint
letter from Senator Stabenow and Representative Lucas (the final
rule should distinguish using swaps for hedging from swap dealing).
---------------------------------------------------------------------------

Specifically, the CFTC is adopting as an interim final rule CFTC
Regulation Sec. 1.3(ggg)(6)(iii), which provides that the
determination of whether a person is a swap dealer will not consider a
swap that the person enters into, if:
(i) The person enters into the swap for the purpose of offsetting
or mitigating the person's price risks that arise from the potential
change in the value of one or several (a) assets that the person owns,
produces, manufactures, processes, or merchandises or anticipates
owning, producing, manufacturing, processing, or merchandising; (b)
liabilities that the person owns or anticipates incurring; or (c)
services that the person provides, purchases, or anticipates providing
or purchasing;
(ii) the swap represents a substitute for transactions made or to
be made or positions taken or to be taken by the person at a later time
in a physical marketing channel;
(iii) the swap is economically appropriate to the reduction of the
person's risks in the conduct and management of a commercial
enterprise;
(iv) the swap is entered into in accordance with sound commercial
practices; and
(v) the person does not enter into the swap in connection with
activity structured to evade designation as a swap dealer.\215\
---------------------------------------------------------------------------

\215\ See CFTC Regulation Sec. 1.3(ggg)(6)(iii). All five
requirements set forth in the regulation must be met with respect to
the swap, in order for the swap to be excluded from the swap dealer
determination by the regulation.
---------------------------------------------------------------------------

Thus, although the CFTC is not incorporating the bona fide hedging
provisions of the CFTC's position limits rule here, the exclusion from
the swap dealer analysis draws upon language in the CFTC's definition
of bona fide hedging.\216\ For example, the exclusion expressly
includes swaps hedging price risks arising from the potential change in
value of existing or anticipated assets, liabilities, or services, if
the hedger has an exposure to physical price risk. And, as in the bona
fide hedging rule, the exclusion utilizes the word ``several'' to
reflect that there is no requirement that swaps hedge risk on a one-to-
one transactional basis in order to be excluded, but rather they may
hedge on a portfolio basis.\217\ For these reasons, swaps that qualify
as enumerated hedging transactions and positions are examples of the
types of physical commodity swaps that are excluded from the swap
dealer analysis if the rule's requirements are met.\218\
---------------------------------------------------------------------------

\216\ See CFTC Regulation Sec. 151.5(a)(1). The definition of
bona fide hedging in CFTC Regulation Sec. 1.3(z), which applies for
excluded commodities, is not relevant here, because it does not
contain the requirement that the swap represents a substitute for a
transaction made or to be made or a position taken or to be taken in
a physical marketing channel, as required by CFTC Regulation Sec.
1.3(ggg)(6)(iii)(B). We believe that this requirement is an
important aspect of how principles from the bona fide hedging
definition are useful in identifying swaps that are entered into for
the purpose of hedging as opposed to other purposes.
\217\ See CFTC, Position Limits for Futures and Swaps; Final
Rule, 76 FR 71626, 71649 (Nov. 18, 2011).
\218\ The swaps that qualify as enumerated hedging transactions
and positions are those listed in CFTC Regulation Sec. 151.5(a)(2)
and appendix B to part 151. These examples are illustrative of the
types of ``assets,'' ``liabilities,'' and ``services'' contemplated
in CFTC Regulation Sec. 1.3(ggg)(6)(iii), because the price risk
arising from changes in their value could be offset or mitigated
with a swap that represents a substitute for transactions made or to
be made or positions taken or to be taken by the person at a later
time in a physical marketing channel. To be clear, notwithstanding
that a swap does not fit precisely within such examples, it may
still satisfy CFTC Regulation Sec. 1.3(ggg)(6)(iii).
Regarding commenters' queries about dynamic hedging, which one
commenter described as the ability to modify the hedging structure
related to physical assets or positions when relevant pricing
relationships applicable to that asset change (see joint letter from
WGCEF and CMC), we note that qualification as bona fide hedging has
never been understood to require that hedges, once entered into,
must remain static. We expect that entites would move to update
their hedges periodically when pricing relationships or other market
factors applicable to the hedge change.
---------------------------------------------------------------------------

This provision in the final rule is consistent with our overall
interpretive approach to the definition of the term ``swap dealer.''
The interpretations of the statutory dealer definitions by both
Commissions focus on a person's activities in relation to its
counterparties and other market participants.\219\ As noted above, for
example, one indicator that a person enters into swaps as part of ``a
regular business'' is that the person does so to satisfy the business
or risk management needs of the counterparty. This aspect of the swap
dealer analysis turns on the accommodation of a counterparty's needs or
demands. If a person enters into swaps for the purpose of hedging a
physical position as defined in CFTC Regulation Sec. 1.3(ggg)(6)(iii),
by contrast, then the swap can be identified as not having been entered
into for the purpose of accommodating the counterparty's needs or
demands.\220\ Also, a person's activity of seeking out swap
counterparties in order to hedge a physical position as defined in the
rule generally would not warrant regulations to promote market
stability and transparency or to serve the other purposes of dealer
regulation.\221\
---------------------------------------------------------------------------

\219\ See parts II.A.4.e and II.A.5.a, infra. For example, the
conclusion that a person's relationship with its counterparties can
lead to associated obligations is consistent with the ``shingle
theory,'' which implies a duty of fair dealing when a person hangs
out its shingle to do business. See note 260, infra.
\220\ In this way, the exclusion from the swap dealer analysis
of swaps hedging physical positions as defined in CFTC Regulation
Sec. 1.3(ggg)(6)(iii) is similar to the exclusions, discussed
below, of swaps between affiliates and swaps between a cooperative
and its members. See CFTC Regulation Sec. 1.3(ggg)(6)(i)(ii); see
also part II.C, infra. However, to the extent a person engages in
dealing activities involving swaps, the presence of offsetting
positions that hedge those dealing activities would not excuse the
requirement that the person register as a swap dealer.
\221\ Thus, the CFTC's interpretation of the swap dealer
definition in this regard draws upon principles in the dealer-trader
distinction. See part II.A.4.a. Additional authority for CFTC
Regulation Sec. 1.3(ggg)(6)(iii) is provided by subparagraph (B) of
the swap dealer definition. This subparagraph provides that a person
``may be designated as a swap dealer for a single type or single
class or category of swap or activities and considered not to be a
swap dealer for other types, classes, or categories of swaps or
activities.'' CEA Section 1a(49)(B), 7 U.S.C. 1a(49)(B). It thereby
authorizes a review of a person's various activities with respect to
swaps, and a determination that some of the person's activities are
covered by a designation as a swap dealer, while other of the
person's activities are not. Thus, a person who enters into some
swaps for hedging physical positions as defined in CFTC Regulation
Sec. 1.3(ggg)(6)(iii), and also enters into other swaps in
connection with activities covered by the swap dealer definition,
could be designated as a swap dealer only for the latter activities.
---------------------------------------------------------------------------

At the same time, however, there may be circumstances where a
person's activity of entering into swaps is encompassed by the
statutory definition of the term ``swap dealer,'' notwithstanding that
the swaps have the effect of hedging or mitigating the person's
commercial risk.\222\ Although these swaps could, in theory, be
excluded from the swap dealer analysis, we believe that a broader, per
se exclusion for all swaps that hedge or mitigate commercial risk is

[[Page 30613]]

inappropriate for the swap dealer definition.
---------------------------------------------------------------------------

\222\ For example, ``pay floating/receive fixed'' swaps entered
into by a swap dealer with long exposure to the floating side of a
market would have the effect of hedging the dealer's exposure.
---------------------------------------------------------------------------

First, the hedging exclusion that we are adopting is in the nature
of a safe harbor; i.e., it describes activity that will not be
considered swap dealing activity. As such, the CFTC believes that it is
appropriate that the interim final rule not be cast broadly.\223\ This
does not mean that other types of hedging activity that do not meet the
requirements of the interim final rule are necessarily swap dealing
activity. Rather, such hedging activity is to be considered in light of
all other relevant facts and circumstances to determine whether the
person is engaging in activity (e.g., accommodating demand for swaps,
making a market for swaps, etc.) that makes the person a swap dealer.
---------------------------------------------------------------------------

\223\ While we recognize that a rule delineating the swap
activities that do not constitute swap dealing would simplify and
make more certain, at least in some contexts, the application of the
swap dealer definition, there are also reasons for caution in
incorporating a categorical exclusion for hedging.
---------------------------------------------------------------------------

Second, the usefulness of an exclusion of all swaps that hedge or
mitigate commercial risk for certain aspects of the major swap
participant definition \224\ is not a reason to use the same exclusion
in the swap dealer definition, since the swap dealer definition serves
a different function. The definition of the term ``major swap
participant,'' which applies only to persons who are not swap
dealers,\225\ is premised on the prior identification, by the swap
dealer definition, of persons who accommodate demand for swaps, make a
market in swaps, or otherwise engage in swap dealing activity. The
major swap participant definition performs the subsequent function of
identifying persons that are not swap dealers, but hold swap positions
that create an especially high level of risk that could significantly
impact the U.S. financial system.\226\ Only for this subsequent
function is it appropriate to apply the broader exclusion of swaps held
for the purpose of hedging or mitigating commercial risk.\227\
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\224\ See part IV.C, infra.
\225\ See CEA Sec. 1a(33)(A)(i), 7 U.S.C. 1a(33)(A)(i).
\226\ See CEA Sec. 1a(33)(B), 7 U.S.C. 1a(33)(B).
\227\ We do not believe that the differences between the
exclusion in the major participant definitions for swaps held for
the purpose of hedging or mitigating commercial risk and the
exclusion in the swap dealer definition for certain swaps entered
into for the purpose of hedging risks related to physical positions
mean that the Commissions, or the CFTC in particular, have
implemented two different definitions of hedging. In fact, neither
of these exclusions define the term ``hedging.'' Rather, the
differences between the two exclusions reflect differences in the
parameters that must be satisfied in order to ensure that hedging
swaps are appropriately excluded from the two different definitions.
---------------------------------------------------------------------------

The CFTC believes that since the over-the-counter swap markets have
operated largely without regulatory oversight and encompass swaps used
for a wide variety of commercial purposes, no method has yet been
developed to reliably distinguish, through a per se rule, between: (i)
Swaps that are entered into for the purpose of hedging or mitigating
commercial risk; and (ii) swaps that are entered into for the purpose
of accommodating the counterparty's needs or demands or otherwise
constitute swap dealing activity, but which also have a hedging
consequence.\228\ In contrast, the CFTC notes that it has set forth and
modified standards for bona fide hedging transactions and granted
exemptions in compliance with such standards for decades.\229\ These
historically-developed standards form the basis of the interim final
rule excluding from the swap dealer analysis certain swaps that hedge
the risks associated with a physical position.
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\228\ As noted in the preceding paragraph, it is not necessary
to make this distinction for purposes of the major swap participant
definition.
\229\ See, e.g., 42 FR 42751 (Aug. 8, 1977). Although the latest
formulation of the definition of bona fide hedging--CFTC Regulation
Sec. 151.5(a)--was recently adopted, see CFTC, Position Limits for
Futures and Swaps; Final Rule and Interim Final Rule, 76 FR 71626
(Nov. 18, 2011), the bona fide hedging test has been in use for
decades.
---------------------------------------------------------------------------

The exclusion in CFTC Regulation Sec. 1.3(ggg)(6)(iii) depends not
on the effect or consequences of the swap, but on whether the purpose
for which a person enters into a swap is to hedge a physical position
as defined in the rule. If so, then the swap is excluded from the
dealer analysis because using swaps for that purpose is inconsistent
with, and is not, dealing activity.\230\ On the other hand, if, at the
time the swap is entered into, the person's purpose for entering into
the swap is not as defined in CFTC regulation Sec. 1.3(ggg)(6)(iii),
or if it is unclear whether the swap is for such purpose, then the fact
that the swap hedges the person's exposure in some regard does not
preclude consideration of that swap in the dealer analysis.\231\ In
this latter case, all relevant facts and circumstances regarding the
swap and the person's activity with respect to the swap would be
relevant in the determination of whether the person is a swap
dealer.\232\
---------------------------------------------------------------------------

\230\ To be clear, the swaps a person enters into for hedging
physical positions as defined in CFTC Regulation Sec.
1.3(ggg)(6)(iii) are not indicative of dealing activity under any of
the prongs of the swap dealer definition.
\231\ In this regard, CFTC Regulation Sec. 1.3(ggg)(6)(iii) is
different from certain of the CFTC's rules regarding bona fide
hedging, where a person's purpose in entering into a swap may not be
relevant.
\232\ We believe that, in practice, the difficulty of
distinguishing, in applying the swap dealer definition, swaps
entered into for the purpose of hedging from other types of swaps
will be resolvable when the facts and circumstances of a person's
swap activities are taken into consideration in light of our
interpretive guidance.
---------------------------------------------------------------------------

We believe that, based on the CFTC's experience in applying bona
fide hedging principles with respect to swaps hedging risks related to
physical positions, the exclusion in CFTC Regulation Sec.
1.3(ggg)(6)(iii) at this time is the best means of providing certainty
to market participants regarding which swaps may be disregarded in the
dealer analysis. However, commenters presented a range of views as to
the exclusions from the dealer analysis that may be appropriate in this
regard.\233\ Accordingly, the CFTC is implementing this exclusion on an
interim rule basis and is seeking comments on all aspects of the
interim rule, including any adjustments that may be appropriate in the
rule or accompanying interpretive guidance.
---------------------------------------------------------------------------

\233\ See, e.g., letters cited in note 141, supra.
---------------------------------------------------------------------------

The CFTC also seeks comments on whether a different approach to
swaps entered into for the purpose of hedging risk is appropriate to
implement the statutory definition of the term ``swap dealer.''
For example, the CFTC invites commenters to address whether any
exclusion of hedging swaps from the swap dealer analysis is
appropriate, and if so, how swaps that are entered into for purposes of
hedging may be identified and distinguished from other swaps.
Commenters are encouraged to address whether it is relevant to
distinguish swaps entered into for purposes of hedging from swaps that
have a consequential result of hedging, and if so, how such swaps may
be distinguished. Also, commenters may address whether the exclusion
should be limited to swaps hedging risks related to physical positions
or extended to encompass swaps hedging financial risks or other types
of risks.
Commenters should address whether the exclusion in CFTC Regulation
Sec. 1.3(ggg)(6)(iii) should be consistent with the exclusion in CFTC
Regulation Sec. 1.3(kkk). If so, why, and if not, why not? If the two
exclusions should be consistent, does consistency require that that
exclusions be identical, or would there be variations in application of
the two exclusions? Are there market participants whose swap positions
would be classified as held for the purpose of hedging or mitigating
commercial risk under CFTC Regulation

[[Page 30614]]

Sec. 1.3(kkk) but would not qualify for the exclusion under CFTC
Regulation Sec. 1.3(ggg)(6)(iii)? If so, specifically identify the
types of market participants and swaps. If the CFTC were to apply in
the swap dealer definition the exclusion in CFTC Regulation Sec.
1.3(kkk) in lieu of the exclusion in CFTC Regulation Sec.
1.3(ggg)(6)(iii), would there be negative market impacts? If so, what
are they? Would there be positive market impacts? If so, what are they?
In particular, what type(s) of swaps that ``hedge or mitigate
commercial risk,'' but that are not excluded under the interim rule,
may constitute dealing activity in light of the rules and interpretive
guidance regarding the swap dealer definition set forth in this
Adopting Release?
Comments regarding the costs and benefits related to the interim
final rule and any alternative approaches, including in particular the
quantification of such costs and benefits, are also invited.
Commenters are encouraged, to the extent feasible, to be
comprehensive and detailed in providing their approach and rationale.
The comment period for the interim final rule will close July 23, 2012.
f. Swaps Entered Into by Persons Registered as Floor Traders
Commenters discussed whether the swap dealer definition encompasses
the activity of entering into swaps on or subject to the rules of a DCM
or SEF, and submitted for clearing to a derivatives clearing
organization (``DCO''), particularly when firms engage in that activity
using only proprietary funds.\234\ Because Title VII of the Dodd-Frank
Act amended the definition of floor trader specifically to encompass
activities involving swaps,\235\ the CFTC believes that it would lead
to potentially duplicative regulation if floor traders engaging in
swaps in their capacity as floor traders were also required to register
as swap dealers. Accordingly, the CFTC believes that it is appropriate
not to consider such swaps when determining whether a person acting as
a floor trader, as defined under CEA section 1a(23),\236\ and
registered with the CFTC under CFTC Regulation Sec. 3.11, is a swap
dealer if the floor trader meets certain conditions. Specifically, the
final rule provides that, in determining whether a person is a swap
dealer, each swap that the person enters into in its capacity as a
floor trader as defined by CEA section 1a(23) or on a SEF shall not be
considered for the purpose of determining whether the person is a swap
dealer, provided that the person:
---------------------------------------------------------------------------

\234\ See letter from Trading Coalition. One commenter
specifically discussed floor traders and floor brokers and the
regulatory regime that should apply to them following implementation
of the Dodd Frank Act. See letter from Christopher K. Hehmeyer.
We note that other commenters suggested that all swaps cleared
on an exchange should be excluded from the dealer definitions. See
letters cited in note 138, supra. However, the discussion here is
limited to persons who are registered as floor traders and meet
other conditions. Also, the final rule provision discussed here does
not exclude floor traders from the definition of the term ``swap
dealer;'' rather, it provides that if the stated conditions are met,
certain swaps entered into by floor traders are excluded from the
swap dealer analysis.
\235\ See section 721(a)(11) of the Dodd-Frank Act (amending the
definition of the term ``floor trader'' in CEA section 1a(23)). The
Exchange Act does not have an equivalent regulatory category to
floor trader under the CEA, and thus Congress did not make a similar
amendment to the Exchange Act.
\236\ The definition of the term ``floor trader'' includes a
person entering into swaps on a ``contract market.'' See CEA section
1a(23). This exclusion also encompasses swaps that a registered
floor trader enters into on or subject to the rules of a SEF, in
addition to on or subject to the rules of a DCM, so long as the swap
meets the conditions stated in the exclusion.
---------------------------------------------------------------------------

(i) Is registered with the CFTC as a floor trader pursuant to CFTC
Regulation Sec. 3.11;
(ii) enters into swaps solely with proprietary funds for that
trader's own account on or subject to the rules of a DCM or SEF, and
submits each such swap for clearing to a DCO;
(iii) is not an affiliated person of a registered swap dealer;
(iv) does not directly, or through an affiliated person, negotiate
the terms of swap agreements, other than price and quantity or to
participate in a request for quote process subject to the rules of a
DCM or SEF;
(v) does not directly or through an affiliated person offer or
provide swap clearing services to third parties;
(vi) does not directly or through an affiliated person enter into
swaps that would qualify as hedging physical positions pursuant to CFTC
Regulation Sec. 1.3(ggg)(6)(iii) or hedging or mitigating commercial
risk pursuant to CFTC Regulation Sec. 1.3(kkk), with the exception of
swaps that are executed opposite a counterparty for which the
transaction would qualify as a bona fide hedging transaction;
(vii) does not participate in any market making program offered by
a DCM or SEF; and
(viii) complies with the record keeping and risk management
requirements of CFTC Regulation Sec. Sec. 23.201, 23.202, 23.203, and
23.600 with respect to each such swap as if it were a swap dealer.\237\
---------------------------------------------------------------------------

\237\ See CFTC Regulation Sec. 1.3(ggg)(6)(iv).
---------------------------------------------------------------------------

This rule permits floor traders who might otherwise be required to
register as a swap dealer to be registered solely as floor traders with
the CFTC. Given the limitations on the scope of the rule, the
requirements for floor traders using the relief to comply with
recordkeeping and risk management rules applicable to swap dealers as a
condition of the relief, and the fact that swaps subject to the rule
are traded on a DCM or SEF and cleared through a DCO, the CFTC believes
it is not necessary to have floor traders subject to this rule register
as both floor traders and swap dealers as a result of swaps activities
covered by the rule.\238\
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\238\ The Commissions note the rule applies only to CFTC-
registered floor traders engaging in swaps on DCMs or SEFs and
cleared through DCOs. As noted above, the SEC does not have a
regulatory category under the Exchange Act equivalent to floor
trader under the CEA and none of these provisions apply in the
context of security-based swap dealers or any entity regulated under
the Exchange Act. Any person engaging in security-based swap
transactions, whether or not these activities are similar to those
engaged in by floor traders, will need to independently consider
whether they need to register as security-based swap dealers as a
result of their activities.
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g. Additional Interpretive Issues Relating to the ``Swap Dealer''
Definition
As noted above, the Commissions, in consideration of comments
received, are making certain modifications to the interpretive guidance
concerning the definition of the term ``swap dealer'' set out in the
Proposing Release. However, the Commissions are retaining certain
elements of their proposed interpretation of the term ``swap dealer,''
as discussed below.
First, with respect to the comments asserting that the proposed
interpretive approach is overly broad,\239\ we note that the statute
provides that the term ``swap dealer'' means ``any person'' who engages
in the activities described in any of the four prongs of the
definition, subject to the exceptions and qualifications set out in the
statute. In view of this statutory text, these comments effectively
assert that the statute should be interpreted to include preconditions
to swap dealer status that are not set forth in the statute. For
example, the assertion that the swap dealer definition must be limited
to persons who enter into swaps on both sides of the market would
impose a requirement that does not exist in the statute. Similarly, the
comments to the effect that swap dealers are only those persons who
seek to profit by intermediating between swap market participants adds
a requirement not set forth in the statute.
---------------------------------------------------------------------------

\239\ See letters cited at notes 83 to 84, supra.
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We believe, though, that the activities that cause a person to be
covered by the

[[Page 30615]]

swap dealer definition should be addressed in the context of the four
prongs of the statutory definition. That is, the relevant question is
whether a person engages in any of the types of activities enumerated
in the statute, and not whether the person meets any additional,
supposedly implicit preconditions to swap dealer status.
Second, the Commissions continue to believe, as stated in the
Proposing Release, that accommodating demand and facilitating interest
are appropriately used as factors in identifying swap dealers. As noted
by commenters, however, the mere fact that a person entering into a
particular swap has the effect of ``accommodating demand'' or
``facilitating interest'' in swaps does not conclusively establish that
the person is a swap dealer. Instead, the person's overall activities
in the swap market (or particular sector of the swap market if the
person is active in a variety of sectors) should be compared against
these factors. If, in the context of its overall swap activities, a
person fulfills a function of accommodating demand or facilitating
interest in swaps for other parties, then these factors would be
significant in the analysis and the person is likely to be a swap
dealer.\240\
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\240\ The language of the four statutory tests for swap dealer
status (which refer to a person who holds itself out as a dealer, is
commonly known as a dealer, makes a market in swaps or regularly
enters into swaps with counterparties) contemplate that a dealer is
a person who, through its swap activities, functions to create legal
relationships that transfer risk between independent persons. See
CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).
See also Proposing Release, 75 FR at 80177 (describing swap
dealers as those persons whose function is to serve as the points of
connection in the swap markets); letter from COPE I at 4 (``Simply
stated, dealers are in the regular business of being a point of
connection to the market for others that need access to the market
to hedge risk.''): Roundtable Transcript at 21 (remarks of Richard
Ostrander, Morgan Stanley; ``a dealer is someone who is out there
willing to enter into trades'').
---------------------------------------------------------------------------

Third, as discussed above, we have adopted some of the objective
criteria suggested by commenters with respect to the indicia of holding
oneself out as a dealer or being commonly known as a dealer, market
making, and the ``regular business'' prongs of the swap dealer
definition.\241\ For instance, allocating staff and technological
resources to swap activity, deriving revenue and profit from swap
activity, or responding to customer-initiated orders for swaps can all
be indicative of having ``a regular business'' of entering into swaps
and, therefore, indicative of being a swap dealer. In addition,
activities such as providing advice about swaps or offering oneself as
a point of connection to other parties needing access to the swap
market are indicative of a person holding itself out as a swap dealer,
if the person also enters into swaps in conjunction with such
activities.
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\241\ See part II.B.2.d.iii, supra.
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The guidance we have provided about these indicia is responsive to
concerns expressed by commenters about the application of the swap
dealer definition to energy markets. As described above, some
commenters stated that in energy markets, unlike in some other markets,
end-users often enter into swaps directly with each other, on both
sides of the market, without the involvement of a separate category of
businesses serving as intermediaries.\242\ As a result, according to
these commenters, energy swap market participants often engage in some
of the activities that are indicative of swap dealer status. Some of
these commenters contended that our activity-based interpretation of
the swap dealer definition could therefore result in the inappropriate
inclusion of energy market participants in the coverage of the
definition of the term ``swap dealer.'' \243\
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\242\ See parts II.A.2.f.ii and iii, supra.
\243\ See letters cited in note 117, supra. Comments expressing
concern that the definition of the term ``swap dealer'' could
include physical commodities businesses also were presented to
Congress during consideration of legislation leading to passage of
the Dodd-Frank Act. See Proposed Legislation by the U.S. Department
of the Treasury Regarding the Regulation of Over-The-Counter
Derivatives Markets: Hearing Before the H. Comm. On Agriculture,
111th Cong. 103 (2009) (submitted report on behalf of the Working
Group of Commercial Energy Firms). However, as noted above, there is
no exclusion in the statutory definition for such businesses.
---------------------------------------------------------------------------

We believe that the language of the statutory ``swap dealer''
definition supports our activity-based interpretation and does not
support categorical exclusions of particular types of persons from the
``swap dealer'' definition based on the general nature of their
businesses. Further evidence that such a categorical exclusion is
unwarranted is provided by the fact that a number of energy market
participants--BP Plc., Cargill, Incorporated, Centrica Energy Limited,
ConocoPhillips, EDF Trading Limited, GASELYS, Hess Energy Trading
Company, LLC, Hydro-Quebec, Koch Supply & Trading, LP, RWE Supply &
Trading GmbH, Shell Energy North America (US), L.P., STASCO, Totsa
Total Oil Trading S.A., and Vattenfall Energy Trading Netherlands
N.V.--have voluntarily joined ISDA as primary dealers.\244\ As
previously noted, any business organization that ``deals in derivatives
shall be eligible for election to membership in the Association as a
primary member, provided that no person or entity shall be eligible for
membership as a Primary Member if such person or entity participates in
derivatives transactions solely for the purpose of risk hedging or
asset or liability management.'' \245\ Hence, a categorical exclusion
from the ``swap dealer'' definition based on any particular type of
business or general market activity also would be inconsistent with
current industry structure and practice.
---------------------------------------------------------------------------

\244\ The list of ISDA Primary Members is available at http://www.isda.org/membership/isdamemberslist.pdf.
\245\ See note 188, supra.
---------------------------------------------------------------------------

At the same time, however, the fact that a person engages in some
swap activities that are indicative of swap dealer status does not, by
itself, mean that the person is covered by the definition of the term
``swap dealer.'' The ``not as part of a regular business'' exception
and our guidance about its meaning address the issue of swap market
participants that engage to some extent in the activities
characteristic of swap dealers. The guidance we have provided here
therefore provides the appropriate approach to addressing these issues
in energy markets as elsewhere.
Although several commenters attempted to articulate bright-line
tests that would differentiate swap dealers from other swap market
participants, the suggested bright-line tests generally could not be
applied across the board to all types of swap market activity. For
example, some commenters suggested that swap dealers can be identified
as those who profit from entering into swaps on both sides of the
market (and under the interpretive approach set forth in this Adopting
Release, such activity may be an indicator of swap dealing).\246\ But
other commenters said that, in certain circumstances, entering into
swaps on both sides of the market is not necessarily indicative of swap
dealing.\247\
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\246\ See letters cited in note 84, supra.
\247\ See letters cited in note 86, supra. As noted above in the
discussion of market making, a swap dealer may in some circumstances
enter into swaps on only one side of the market.
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The ways in which participants throughout the market use swaps are
simply too diverse for swap dealer status to be resolved with a single,
one-factor test. This is reflected in the statutory definition of the
term ``swap dealer'' itself. Focused as it is on types of activities,
with four prongs set forth in the alternative to cover different types
of swap dealing activity, the statutory swap dealer definition is not
susceptible to the bright-line test that

[[Page 30616]]

some commenters seek. For these reasons, we continue to believe that it
is appropriate to apply the multi-factor interpretive approach set
forth in this Adopting Release.
In closing, we emphasize that the purpose of in this part IV.A.4 is
to provide guidance as to how the rules further defining the term
``swap dealer'' will be applied in particular, complex situations where
a person's status as a swap dealer may be uncertain. Even though
bright-line tests and categorical exclusions are inappropriate, we
recognize that the large majority of market participants use swaps for
normal course hedging, financial, investment or trading purposes and
are not swap dealers.
5. Final Rules and Interpretation--Definition of ``Security-Based Swap
Dealer''
a. General Reliance on the Dealer-Trader Distinction
As discussed above, we are adopting a rule under the Exchange Act
that defines ``security-based swap dealer'' in terms of the four
statutory tests and the exclusion for security-based swap activities
that are not as part of a ``regular business.'' \248\ Also, we believe
that the dealer-trader distinction \249\--which already forms a basis
for identifying which persons fall within the longstanding Exchange Act
definition of ``dealer''--in general provides an appropriate framework
for interpreting the meaning of ``security-based swap dealer.'' \250\
While there are differences in the structure of those two statutory
definitions,\251\ we believe that their parallels--particularly both
definitions' exclusions for activities that are ``not part of a regular
business''--warrant analogous interpretive approaches for
distinguishing dealers from non-dealers.
---------------------------------------------------------------------------

\248\ See Exchange Act rule 3a71-1(a), (b).
\249\ See note 31, supra.
\250\ The principles embedded within the ``dealer-trader
distinction'' are not solely useful for distinguishing persons who
constitute dealers from active ``traders,'' but also are applicable
to distinguishing dealers from non-dealers such as hedgers or
investors. The ``dealer-trader'' nomenclature has been used for
decades. See Loss, Securities Regulation 722 (1st ed. 1951) (``One
aspect of the `business' concept is the matter of drawing the line
between a `dealer' and a trader--an ordinary investor who buys and
sells for his own account with some frequency.'').
\251\ For example, while the ``dealer'' definition encompasses
certain persons in the business of ``buying and selling''
securities, the ``security-based swap dealer'' definition does not
address either ``buying'' or ``selling.'' As we noted in the
Proposing Release, we do not believe that the lack of those terms in
the ``security-based swap dealer'' definition leads to material
interpretive distinctions, as the Dodd-Frank Act amended the
Exchange Act definitions of ``buy'' and ``purchase,'' and the
Exchange Act definitions of ``sale'' and ``sell,'' to encompass the
execution, termination (prior to its scheduled maturity date),
assignment, exchange or similar transfer or conveyance of, or
extinguishing of rights or obligations under, a security-based swap.
See Proposing Release, 75 FR at 80178 n.26 (citing Dodd-Frank Act
sections 761(a)(3), (4), which amend Exchange Act sections 3(a)(13),
(14)).
At the same time, we note that the ``dealer'' definition
requires the conjunctive ``buying and selling''--which connotes a
degree of offsetting two-sided activity. In contrast, the
``security-based swap dealer'' definition (particularly the
``regularly enters into security-based swaps'' language of the
definition's third test) lacks that conjunctive terminology.
---------------------------------------------------------------------------

As discussed above,\252\ the Commissions note that interpretations
of the applicability of the dealer-trader distinction to the ``swap
dealer'' definition under the CEA do not affect existing, or future,
interpretations of the dealer-trader distinction under the Exchange
Act--both with regard to the ``security-based swap dealer'' definition,
and with regard to the ``dealer'' definition.
---------------------------------------------------------------------------

\252\ See note 171, supra.
---------------------------------------------------------------------------

In interpreting the security-based swap dealer definition in terms
of the dealer-trader distinction, the Commissions have been mindful
that some commenters expressed the view that we instead should rely on
other interpretive factors that were identified in the Proposing
Release (e.g., accommodating demand). We believe, nonetheless, that the
dealer-trader distinction forms the basis for a framework that
appropriately distinguishes between persons who should be regulated as
security-based swap dealers and those who should not. We also believe
that the distinction affords an appropriate degree of flexibility to
the analysis, and that it would not be appropriate to seek to codify
the distinction.
At the same time, the Commissions recognize that the dealer-trader
distinction needs to be adapted to apply to security-based swap
activities in light of the special characteristics of security-based
swaps and the differences between the ``dealer'' and ``security-based
swap dealer'' definitions. Relevant differences include:
Level of activity--Security-based swap markets are marked
by less activity than markets involving certain other types of
securities (while recognizing that some debt and equity securities are
not actively traded). This suggests that in the security-based swap
context concepts of ``regularity'' should account for the level of
activity in the market.
No separate issuer--Each counterparty to a security-based
swap in essence is the ``issuer'' of that instrument; in contrast,
dealers in cash market securities generally transact in securities
issued by another party. This distinction suggests that the concept of
turnover of ``inventory'' of securities, which has been identified as a
factor in connection with the dealer-trader distinction, is inapposite
in the context of security-based swaps. Moreover, this distinction--
along with the fact that the ``security-based swap dealer'' definition
lacks the conjunctive ``buying and selling'' language of the ``dealer''
definition \253\--suggests that concepts of two-sided markets at times
would be less relevant for identifying ``security-based swap dealers''
than they would be for identifying ``dealers.'' \254\
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\253\ See note 251, supra.
\254\ The analysis also should account for the fact that a party
to a security-based swap can use other derivatives or cash market
instruments to hedge the risks associated with the security-based
swap position, meaning that two-way trading is not necessary to
maintain a flat risk book.
---------------------------------------------------------------------------

Predominance of over-the-counter and non-standardized
instruments--Security-based swaps thus far are not significantly traded
on exchanges or other trading systems, in contrast to some cash market
securities (while recognizing that many cash market securities also are
not significantly traded on those systems).\255\ These attributes--
along with the lack of ``buying and selling'' language in the security-
based swap dealer definition, as noted above--suggest that concepts of
what it means to make a market need to be construed flexibly in the
context of the security-based swap market.\256\
---------------------------------------------------------------------------

\255\ Even though we expect trading of security-based swaps on
security-based swap execution facilities or exchanges following the
implementation of Title VII, we expect there to remain a significant
amount of over-the-counter activity involving security-based swaps.
\256\ For example, the definition of ``market maker'' in
Exchange Act section 3(a)(38)--which is applicable for purposes of
the Exchange Act ``unless the context otherwise requires'' (see
Exchange Act section 3(a))--defines the term ``market maker'' to
mean ``any specialist permitted to act as a dealer, any dealer
acting in the capacity of block positioner, and any dealer who, with
respect to a security, holds himself out (by entering quotations in
an inter-dealer communications system or otherwise) as being willing
to buy and sell such security for his own account on a regular or
continuous basis.'' That definition is useful in the context of
systems in which standardized securities are regularly or
continuously bought and sold, but would not be apposite in the
context of non-standardized securities or securities that are not
regularly or continuously transacted.
---------------------------------------------------------------------------

[[Page 30617]]

transaction, the parties to a security-based swap often will have an
ongoing obligation to exchange cash flows over the life of the
agreement. In light of this attribute, some market participants have
expressed the view that they have ``counterparties'' rather than
``customers'' in the context of their swap activities.
It also is necessary to use the dealer-trader distinction to
interpret the security-based swap dealer definition so that the
statutory provisions that will govern security-based swap dealers are
applied in an effective and logical way. Those statutory provisions
added by the Dodd-Frank Act advance financial responsibility (e.g., the
ability to satisfy obligations, and the maintenance of counterparties'
funds and assets) associated with security-based swap dealers'
activities,\257\ other counterparty protections,\258\ and the promotion
of market efficiency and transparency.\259\ As a whole, the relevant
statutory provisions suggest that we should apply the dealer-trader
distinction to interpret the security-based swap dealer definition in a
way that identifies those persons for which regulation is warranted
either: (i) Due to the nature of their interactions with
counterparties; \260\ or (ii) to promote market stability and
transparency, in light of the role those persons occupy within the
security-based swap markets.\261\
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\257\ E.g., capital and margin requirements (Exchange Act
section 15F(e)), and requirements for segregation of collateral
(Exchange Act section 3E).
\258\ E.g., requirements with respect to business conduct when
transacting with special entities (Exchange Act sections 15F(h)(2),
(h)(4), (h)(5)); disclosure requirements (Exchange Act section
15F(h)(3)(B)); requirements for fair and balanced communications
(Exchange Act section 15F(h)(3)(C)); other requirements related to
the public interest and investor protection (Exchange Act section
15F(h)(3)(D)); and conflict of interest provisions (Exchange Act
section 15F(j)(5)).
\259\ E.g., reporting and recordkeeping requirements (Exchange
Act section 15F(f)); daily trading records requirements (Exchange
Act section 15F(g)); regulatory standards related to the
confirmation, processing, netting, documentation and valuation of
security-based swaps (Exchange Act section 15F(i)); position limit
monitoring requirements (Exchange Act section 15F(j)(1)); risk
management procedure requirements (Exchange Act section 15F(j)(2));
and requirements related to the disclosure of information to
regulators (Exchange Act section 15F(j)(3)).
\260\ The conclusion that a person's relationship with its
counterparties can lead to associated obligations is consistent with
the ``shingle theory,'' which implies a duty of fair dealing when a
person hangs out its shingle to do business. See Securities and
Exchange Commission, Report of the Special Study of Securities
Market Part I at 238 (1963) (``An obligation of fair dealing, based
upon the general antifraud provisions of the Federal securities
laws, rests upon the theory that even a dealer at arm's length
impliedly represents when he hangs out his shingle that he will deal
fairly with the public.''; footnote omitted); Weiss, Registration
and Regulation of Brokers and Dealers 171 (1965) (``the solicitation
and acceptance by a broker-dealer of orders from customers and the
confirmation of transactions do constitute a representation by the
broker-dealer that he will deal fairly with his customers and that
such transactions will be handled promptly in the usual manner, in
accordance with trade custom'').
\261\ The importance of regulating dealers due to the centrality
of their market role was illustrated by the Government Securities
Act of 1986. When Congress provided for the regulation of government
securities dealers, Congress specifically cited the lack of
regulation as contributing to the failures of several unregulated
government securities dealers. See S. Rep. No. 99-426 (1986), as
reprinted in 1986 U.S.C.C.A.N. 5395, 5400-04. The resulting statute
provided for a definition of ``government securities dealer'' that
in relevant part is parallel to the definitions of ``dealer'' and
``security-based swap dealer,'' particularly with regard to sharing
an exclusion for activities that are not part of a ``regular
business.'' See Exchange Act section 3(a)(44).
---------------------------------------------------------------------------

b. Principles for Applying the Dealer-Trader Distinction to Security-
Based Swap Activity
In light of the statutory security-based swap dealer definition,
statutory provisions applicable to security-based swap dealers and
market characteristics addressed above, the Commissions believe that
the factors set forth below are relevant for identifying security-based
swap dealers and for distinguishing those dealers from other market
participants. This guidance seeks to address commenter requests that we
further clarify the scope of the security-based swap dealer definition,
and the Commissions believe that these factors provide appropriate
guidance without being inflexible or allowing the opportunity for
evasion that may accompany a bright-line test. At the same time, the
determination of whether a person is acting as a security-based swap
dealer ultimately depends on the relevant facts and circumstances. In
light of the overall context in which a person's activity occurs, the
absence of one or more of these factors does not necessitate the
conclusion that a person is not a security-based swap dealer.\262\
---------------------------------------------------------------------------

\262\ Similarly, depending on the relevant facts and
circumstances, the presence of certain of the illustrative
activities described here does not necessitate the conclusion that
the entity is a dealer.
---------------------------------------------------------------------------

Providing liquidity to market professionals or other
persons in connection with security-based swaps. A market participant
might manifest this indication of dealer activity by accommodating
demand or facilitating interest expressed by other market
participants,\263\ holding itself out as willing to enter into
security-based swaps, being known in the industry as being available to
accommodate demand for security-based swaps, or maintaining a sales
force in connection with security-based swap activities.\264\
---------------------------------------------------------------------------

\263\ This is to be distinguished from an entity entering into
security-based swaps for other business purposes, such as to gain
economic exposure to a particular market.
\264\ A sales force, however, is not a prerequisite to a person
being a security-based swap dealer. For example, a person that
enters into security-based swaps in a dealing capacity can fall
within the dealer definition even if it uses an affiliated entity to
market and/or negotiate those security-based swaps (e.g., the person
is a booking entity). Depending on the applicable facts and
circumstances, the affiliate that performs the marketing and/or
negotiation functions may fall within the Exchange Act's definition
of ``broker'' (which was not revised by Title VII). See Exchange Act
section 3(a)(4)(A).
---------------------------------------------------------------------------

Seeking to profit by providing liquidity in connection
with security-based swaps. A market participant may manifest this
indication of security-based swap dealer activity--which is consistent
with the definition's ``regular business'' requirement--by seeking
compensation in connection with providing liquidity involving security-
based swaps (e.g., by seeking a spread, fees or other compensation not
attributable to changes in the value of the security-based swap).\265\
The Commissions do not believe that this necessarily requires that a
person be available to take either side of the market at any time, or
that a person continuously engage in this type of activity, to be a
security-based swap dealer. Although one commenter expressed the view
that the security-based swap dealer definition requires that a person
be consistently available to take either side of the market,\266\ in
our view such an approach would be underinclusive.\267\
---------------------------------------------------------------------------

\265\ Indicia of this objective may include, but would not be
limited to, maintaining separate profit/loss statements in
connection with this type of activity, and/or devoting staff and
resources to this type of activity.
In this regard, we believe that the issue of whether a person
tends to take the prices offered in the market, rather than helping
to set those prices (such as by providing quotes, placing limit
orders, or otherwise accommodating demand), can be relevant as a
factor for distinguishing security-based swap dealers from non-
dealers. At the same time, we are mindful that a dealer may also
accept the market price as part of its dealer activity (such as when
a person enters into a security-based swap to offset the risk it
assumes in connection with its security-based swap dealing
activity); as a result, the fact that a person regularly takes the
market price as part of its security-based swap transactions does
not foreclose the possibility that the person may be a security-
based swap dealer.
\266\ See letter from ISDA I.
\267\ It is possible for a dealer to be compensated for
providing liquidity by entering into sequential offsetting
positions, or by hedging the security-based swap position by using a
different type of security-based swap, a swap or some other
financial instrument. Accordingly, a rule of decision that permitted
a person to avoid dealer regulation by providing liquidity in
connection with security-based swaps, and laying off the associated
risk using a different type of security-based swap, a swap or a
different instrument entirely, would be susceptible to abuse.
Moreover, as noted above, the definition of ``security-based swap
dealer'' does not contain the ``buying and selling'' language found
in the general Exchange Act definition of ``dealer.'' Thus, while
being regularly willing to enter into either side of the security-
based swap market would suggest that a person is engaged in dealing
activity, the absence of such activity should not necessarily lead
to an inference that a person is not acting as a dealer.
We also note that some commenters have stated that two-way
quoting by itself should not necessarily be enough to make a person
a dealer, and some of those commenters specifically stated that a
person may use two-sided quotes as part of the price discovery
process or to elicit trading interest. See, e.g., letter from MFA I.
Here too, it is important to consider whether the activity also has
a dealing business purpose, such as seeking to profit by providing
liquidity. Moreover, all participants in the security-based swap
market, whether or not security-based swap dealers, should be
mindful of the potential application of the antifraud and anti-
manipulation provisions of the federal securities laws to such
activities. Section 10(b) of the Exchange Act and Exchange Act rule
10b-5 particularly prescribe the use of any manipulative or
fraudulent device in connection with the purchase or sale of any
security, which includes manipulative trading. See Terrance
Yoshikawa, Securities Exchange Act Release No. 53731 (Apr. 26,
2006), 87 SEC Docket 2924, 2930-31 & n.19 (citing Ernst & Ernst v.
Hochfelder, 425 U.S. 185, 199 (1976)). The SEC has characterized
manipulation as ``the creation of deceptive value or market activity
for a security, accomplished by an intentional interference with the
free forces of supply and demand.'' See Swartwood, Hesse, Inc., 50
S.E.C. 1301, 1307 (1992) (citing Hochfelder, 425 U.S. at 199;
Schreiber v. Burlington Northern, Inc., 472 U.S. 1 (1985); Feldbaum
v. Avon Products, Inc., 741 F.2d 234 (8th Cir. 1984)).

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[[Page 30618]]

Providing advice in connection with security-based swaps
or structuring security-based swaps. Advising a counterparty as to how
to use security-based swaps to meet the counterparty's hedging goals,
or structuring security-based swaps on behalf of a counterparty, also
would indicate security-based swap dealing activity. It particularly is
important that persons engaged in those activities are appropriately
regulated so that their counterparties will receive the protections
afforded by certain of the statutory business conduct rules (e.g.,
special entity requirements and communication requirements) \268\
applicable to security-based swap dealers.\269\ The Commissions
recognize commenter concerns that end-users may also develop new types
of security-based swaps,\270\ but also recognize that the activities of
end-users related to the structuring of security-based swaps for
purposes of hedging commercial risk are appreciably different than
being in the business of structuring security-based swaps on behalf of
a counterparty.
---------------------------------------------------------------------------

\268\ The SEC has proposed rules to implement Title VII
provisions relating to external business conduct standards for
security-based swap dealers (as well as major security-based swap
participants). See Exchange Act Release No. 64766 (June 29, 2011),
76 FR 42396 (July 18, 2011).
\269\ This factor would also reasonably take into account
whether a preexisting relationship involving other types of
securities or other financial instruments is present. For example,
to the extent a person has an existing broker or dealer relationship
with a counterparty in connection with other types of securities,
and also enters into a security-based swap with that counterparty, a
reasonable inference would be that the person entered into the
security-based swap in a dealer capacity. Any other approach would
invite abuse, as persons could seek to leverage existing
relationships of trust while avoiding regulation as a security-based
swap dealer.
\270\ See letter from FSR I.
---------------------------------------------------------------------------

Presence of regular clientele and actively soliciting
clients. These dealer-trader factors would reasonably appear to be
applicable in the security-based swap context, just as they are
applicable in the context of other types of securities, as indicia of a
business model that seeks to profit by providing liquidity. The
Commissions are mindful that some industry participants have
highlighted a distinction between ``counterparties'' and ``customers''
in connection with swaps, and have suggested that they have no
``customers'' in the swap context. We do not believe such points of
nomenclature are significant for purposes of identifying security-based
swap dealers, however.\271\
---------------------------------------------------------------------------

\271\ For purposes of the dealer-trader analysis, as it applies
in the context of security-based swaps or any other security, we
would not expect contractual provisions stating that the
counterparty is not relying on the person's advice to have any
significance.
---------------------------------------------------------------------------

Use of inter-dealer brokers. As with activities involving
other types of securities, the Commissions would expect that a person's
use of an inter-dealer broker in connection with security-based swap
activities to be an indication of the person's status as a dealer.
Acting as a market maker on an organized security-based
swap exchange or trading system. Acting in a market maker capacity on
an organized exchange or trading system for security-based swaps would
indicate that the person is acting as a dealer.\272\ While the
Commissions recognize that some commenters have expressed the view that
persons who solely enter into security-based swaps on an organized
security-based swap exchange or trading system should not be regulated
as security-based swap dealers,\273\ in our view such an approach would
be contrary to the express language of the definition. This is not to
say, of course, that the presence of an organized exchange or trading
system is a prerequisite to being a market maker for purposes of the
security-based swap dealer definition.\274\ Moreover, acting as a
market maker is not a prerequisite to being a security-based swap
dealer.\275\ On the other hand, being a member of an organized exchange
or trading system for purposes of trading security-based swaps does not
necessarily by itself make a person a security-based swap dealer.\276\
---------------------------------------------------------------------------

\272\ Under the proposal of the SEC, the Board, the OCC and the
FDIC to implement the provisions of section 619 of the Dodd-Frank
Act (also known as the ``Volcker Rule''), a person who claims the
benefit of the market maker exception to that section's prohibitions
and restrictions on proprietary trading in connection with security-
based swap activities would be required to register with the SEC as
a security-based swap dealer, unless the person is exempt from
registration or is engaged in a dealing business outside the U.S.,
and is subject to substantive regulation in the jurisdiction where
the business is located. See Securities Exchange Act Release No.
65545, 76 FR 68846, 68947 (Nov. 7, 2011) (proposed implementing rule
Sec. ------.4(b)(2)(iv)(C)).
\273\ See, e.g., letter from Traders Coalition.
\274\ Given the current nature of the security-based swap
market, including the present level of activity and the present lack
of significant trading of security-based swaps on exchanges or
organized trading systems, we believe that it would negate the
legislative intent to interpret the definition's use of market
making concepts to require the same use of quotation media that are
incorporated into the interpretation of market making concepts in
the context of securities that are actively traded on an organized
exchange or trading system. At the same time, we recognize that
routine activity in the security-based swap market is not
necessarily indicative of making a market in security-based swaps.
For example, persons may routinely be active in the market for
purposes of hedging, to advance their investment objectives, or to
engage in proprietary trading.
\275\ The definition of ``security-based swap dealer'' contains
four alternative tests, only two of which use market making
terminology. Moreover, the third test of the security-based swap
dealer definition--which addresses persons who regularly enter into
security-based swaps as an ordinary course of business for their own
account--appears particularly inapt as a proxy for market making
activity. Transacting with customers is not an element of this
alternative test. A person thus may be a security-based swap dealer
even if it transacts exclusively with other market professionals.
Cf. OCC, ``Risk Management of Financial Derivatives'' 3-4 (1997)
(stating that OCC has classified banks as ``Tier I'' dealers if they
act as market makers by ``providing quotes to other dealers and
brokers, and other market professionals''). Compare letter from ISDA
I (taking the view that the dealer definition should be interpreted
in the context of market-making concepts).

\276\ The analysis of the status of members of such exchanges
and trading systems in part may be influenced by the final Exchange
Act rules that govern such systems, as well as the internal rules of
such systems.
---------------------------------------------------------------------------

As with the current application of the dealer-trader distinction to the
Exchange Act ``dealer'' definition, the question of whether a person is
acting as a security-based swap dealer ultimately will turn upon the
relevant facts and circumstances, as informed by these criteria.
c. Additional Interpretive Issues
Activity by hedgers. As noted above, a number of commenters raised
concerns that an overbroad ``security-based swap dealer'' definition
would inappropriately encompass persons

[[Page 30619]]

using security-based swaps for hedging purposes.\277\ As we stated in
the Proposing Release, however, under the dealer-trader distinction the
Commissions would expect persons that use security-based swaps to hedge
their business risks, absent other activity, likely would not be
dealers.\278\ We maintain that view. In other words, to the extent that
a person engages in security-based swap activity to hedge commercial
risk, or otherwise to hedge risks unrelated to activities that
constitute dealing under the dealer-trader distinction (particularly
activities that have the business purpose of seeking to profit by
providing liquidity in connection with security-based swaps), the
Commissions would not expect those hedging transactions to lead a
person to be a security-based swap dealer.\279\ Of course, to the
extent a person engages in dealing activities involving security-based
swaps, the presence of offsetting positions that hedge those dealing
activities would not excuse the requirement that the person register as
a security-based swap dealer.\280\
---------------------------------------------------------------------------

\277\ See, e.g., letter from Church Alliance.
\278\ See Proposing Release, 75 FR at 80178 n.27. The Proposing
Release also noted that if a person's other activities satisfy the
definition of security-based swap dealer, the person must comply
with the applicable requirements with regard to all of its security-
based swap activities, absent an order to the contrary. We further
noted in the Proposing Release that we would expect end-users to use
security-based swaps for hedging purposes less commonly than they
use swaps for hedging purposes.
\279\ In addition, consistent with the exclusion from the dealer
analysis of activities involving majority-owned affiliates, see part
II.C, infra, to the extent that a person engages in activities to
hedge positions subject to the inter-affiliate exclusion, absent
other activity, the Commission would not expect those hedging
transactions to lead a person to be a security-based swap dealer.
Conversely, security-based swap activities connected with the
indicia of dealing discussed above (e.g., seeking to profit by
providing liquidity in connection with security-based swaps)
themselves would suggest security-based swap dealing activity.
\280\ For example, if a person were to use other instruments to
hedge the risks associated with its security-based swap dealing
activity, that hedging would not undermine the obligation of the
person to register as a security-based swap dealer, notwithstanding
the fact that it could be asserted that the dealing positions happen
to hedge those other positions.
---------------------------------------------------------------------------

No predominance test. As discussed in the Proposing Release, the
Commissions do not believe that the security-based swap dealer analysis
should appropriately turn upon whether a person's dealing activity
constitutes that person's sole or predominant business. The separate de
minimis exemption, however, may have the effect of excusing from dealer
regulation those persons whose security-based swap dealing activities
are relatively modest.
Presence or absence of a customer relationship. Although commenters
have expressed the view that a person that engages in security-based
swap activities on an organized market should not be deemed to be a
dealer unless it engages in those activities with customers,\281\ we do
not agree. It is true that having a customer relationship can
illustrate a business model of seeking to profit by providing
liquidity, and thus provide one basis for concluding that a person is
acting as a security-based swap dealer. Nonetheless, the presence of
market making terminology within the definition is inconsistent with
the view that a security-based swap dealer must have ``customers.''
Also, Title VII requirements applicable to security-based swap dealers
address interests apart from customer protection.\282\ Accordingly, to
the extent that a person regularly enters into security-based swaps
with a view toward profiting by providing liquidity--rather than by
taking directional positions--that person may be a security-based swap
dealer regardless of whether it views itself as maintaining a
``customer'' relationship with its counterparties.\283\
---------------------------------------------------------------------------

\281\ See letters from ISDA I and Traders Coalition.
\282\ Particularly in light of the view expressed by some market
participants that they only have ``counterparties'' in the swap
markets, and not ``customers,'' any interpretation of the
``security-based swap dealer'' definition that is predicated on the
existence of a customer relationship may lead to an overly narrow
construction of the definition.
\283\ For example, a person's activity involving entering into
security-based swaps on a SEF may cause it to be a security-based
swap dealer even in the absence of a customer relationship with any
of its counterparties.
---------------------------------------------------------------------------

Criteria associated with ``holding self out'' as a dealer or being
``commonly known in the trade'' as a security-based swap dealer. The
Proposing Release articulated a number of activities that could satisfy
the definition's tests for a person ``holding itself out'' as a dealer
or being ``commonly known in the trade'' as a dealer.\284\ Several
commenters criticized those proposed criteria, largely on the grounds
that those criteria would inappropriately encompass end-users who seek
to use security-based swaps for hedging purposes, or otherwise would be
overbroad or irrelevant.\285\ The Commissions recognize the
significance of the concerns those commenters raised, and agree that
these activities need to be considered within the context of whether a
person engages in those activities with the purpose of facilitating
dealing activity. While we do not believe that any of those activities
by themselves would necessarily indicate that a person is acting as a
security-based swap dealer, under certain circumstances they may serve
as an indicia of a business purpose of seeking to profit by providing
liquidity in connection with security-based swaps.\286\
---------------------------------------------------------------------------

\284\ As noted above, these were: contacting potential
counterparties to solicit interest; developing new types of swaps or
security-based swaps and informing potential counterparties of their
availability and of the person's willingness to enter into the swap
or security-based swap; membership in a swap association in a
category reserved for dealers; providing marketing materials
describing the type of swaps or security-based swaps the party is
willing to enter into; and generally expressing a willingness to
offer or provide a range of products or services that include swaps
or security-based swaps. See Proposing Release, 75 FR at 80178.
\285\ See part II.A.2.a, supra.
\286\ While the Proposing Release identified ``membership in a
swap association in a category reserved for dealers'' as a factor in
connection with the ``holding out'' and ``commonly known'' tests, we
recognize that, depending on the applicable facts and circumstances,
such membership may not be sufficient to cause a person to be a
security-based swap dealer if the person does nothing else to cause
it to be considered a dealer.
---------------------------------------------------------------------------

6. Requests for Exclusions From the Dealer Definitions
Certain commenters have sought to exclude entire categories of
persons from the dealer definitions, notwithstanding that some persons
in those categories may engage in the activities set forth in the
statutory definition (as further defined by the Commissions).\287\ The
final rules nonetheless do not incorporate categorical exclusions of
persons from the dealer definitions because the statutory definitions
provide that ``any person'' who engages in the activities enumerated in
the definitions is covered by the dealer definitions, unless the
person's activities fall within one of the statutory exceptions.\288\
In this regard, it is significant that the exceptions in the dealer
definitions depend on whether a person engages in certain types of swap
or security-based swap activity, not on other characteristics of the
person. That is, the exceptions apply for swaps between an insured
depository institution and its customers in connection with originating
loans,\289\ swaps or security-based swaps entered into not as a part of
a regular business,\290\ and swap or security-based swap dealing that
is below a de minimis

[[Page 30620]]

level.\291\ The Dodd-Frank Act does not exclude any category of persons
from the coverage of the dealer definitions; rather, it excludes
certain activities from the dealer analysis.
---------------------------------------------------------------------------

\287\ See part II.A.2.f, supra.
\288\ See CEA section 1a(49), 7 U.S.C. 1a(49); Exchange Act
section 3(a)(71), 15 U.S.C. 78c(a)(71).
\289\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).
\290\ See CEA section 1a(49)(C), 7 U.S.C. 1a(49)(C); Exchange
Act section 3(a)(71)(C), 15 U.S.C. 78c(a)(71)(C).
\291\ See CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange
Act section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).
---------------------------------------------------------------------------

Given that the statutory dealer definitions focus on a person's
activity, the Commissions believe that it is appropriate to determine
whether a person meets any of the tests set forth in those statutory
definitions, and thus is acting as a swap dealer or security-based swap
dealer, on a case-by-case basis reflecting the applicable facts and
circumstances.\292\ If a person's swap or security-based swap
activities are of a nature to be covered by the statutory definitions,
and those activities are not otherwise excluded, then the person is
covered by the definitions. The contrary is equally true--a person who
is not engaged in activities covered by the statutory definitions, or
whose activities are excluded from the definition, is not covered by
the definitions.\293\ The per se exclusions requested by the commenters
have no foundation in the statutory text, and have the potential to
lead to arbitrary line drawing that may result in disparate regulatory
treatment and inappropriate competitive advantages.\294\
---------------------------------------------------------------------------

\292\ The Commissions believe that a facts and circumstances
approach is particularly appropriate here, where the broad terms of
the statutory dealer definitions indicate that the Commissions
should apply their expertise and discretion to interpret the
statutory text.
\293\ For example, a manufacturer, producer, processor, or
merchant that enters into swaps to hedge its currency or interest
rate risk, absent any facts and circumstances establishing dealing
activity, is not a swap dealer.
\294\ In response to the commenters concerns, the Commissions
have adopted certain tailored exclusions of certain types of swaps
and security-based swaps in the final rule.
---------------------------------------------------------------------------

The final rules particularly do not include any exclusions for
aggregators of swaps or other persons that use swaps in connection with
the physical commodity markets, including swaps in connection with the
generation, transmission and distribution of electricity. It is likely,
though, that a significant portion of the financial instruments used
for risk management by such persons are forward contracts in
nonfinancial commodities that are excluded from the definition of the
term ``swap.'' \295\ Such forward contracts are not relevant in
determining whether a person is a swap dealer.
---------------------------------------------------------------------------

\295\ A coalition of not-for-profit power utilities and electric
cooperatives has advised that it plans to submit a request for an
exemption for transactions between entities described in section
201(f) of the Federal Power Act, as contemplated by section 722(f)
of the Dodd-Frank Act. See letter from NFPEEU. Separately, some
regional transmission organizations and independent systems
operators have expressed interest in submitting an exemption
application to the CFTC as well. See generally section 722(e) of the
Dodd-Frank Act. Such exemptions, if granted after notice and comment
pursuant to CEA section 4(c), 7 U.S.C. 6(c), could further address
commenters' concerns in this regard.
---------------------------------------------------------------------------

B. ``Swap Dealer'' Exclusion for Swaps in Connection With Originating a
Loan

1. Proposed Approach
The statutory definition of the term ``swap dealer'' excludes an
insured depository institution (``IDI'') ``to the extent it offers to
enter into a swap with a customer in connection with originating a loan
with that customer.'' \296\ This exclusion does not appear in the
definition of the term ``security-based swap dealer.''
---------------------------------------------------------------------------

\296\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).
---------------------------------------------------------------------------

Proposed CFTC Regulation Sec. 1.3(ggg)(5) would implement this
statutory exclusion by providing that an IDI's swaps with a customer in
connection with originating a loan to that customer are disregarded in
determining if the IDI is a swap dealer. In order to prevent evasion,
the proposed rule further provided that the statutory exclusion does
not apply where the purpose of the swap is not linked to the financial
terms of the loan; the IDI enters into a ``sham'' loan; or the
purported ``loan'' is actually a synthetic loan such as a loan credit
default swap or loan total return swap.
1. Commenters' Views
Nearly all the commenters on this issue were IDIs seeking a broad
interpretation of the exclusion. The commenters addressed four primary
issues: (i) The type of swaps that should be covered by the exclusion;
(ii) the time period during which parties would be required to enter
into the swap in order for the swap to be considered to be ``in
connection with originating a loan;'' (iii) which transactions should
be deemed to be ``loans'' for purposes of the exclusion; and (iv) which
entities should be included within the definition of IDI.
First, regarding the type of swap that should be covered by the
exclusion, as proposed, Sec. 1.3(ggg)(5) would require that the rate,
asset, liability or other notional item underlying the swap be, or be
directly related to, a financial term of the loan (such as the loan's
principal amount, duration, rate of interest or currency). Some
commenters agreed with the principle of limiting the exclusion to swaps
that are connected to the financial terms of the loan, stating that the
exclusion should cover any swap between a borrower and the lending IDI,
so long as the swap's notional amount is no greater than the loan
amount, the swap's duration is no longer than the loan's duration, and
the swap's index and payment dates match the index and payment dates of
the loan.\297\ Another commenter, agreeing with the proposed approach,
said that there is no basis to extend the loan origination exclusion to
swaps related to the borrower's business risks, as opposed to the
financial terms of the loan.\298\
---------------------------------------------------------------------------

\297\ See letters from Branch Banking & Trust Company (``BB&T'')
dated February 3, 2011 (``BB&T I''), B&F Capital Markets, Inc.
(``B&F Capital'') dated February 18, 2011 (``B&F Capital I''),
Capital One Financial Corporation (``Capital One'') and Capstar Bank
(``Capstar''); see also joint letter from Atlantic Capital Bank,
Cobiz Bank, Cole Taylor Bank, Commerce Bank, N.A., East West Bank,
First Business Bank, First National Bank of Pennsylvania, Heartland
Financial USA, Inc., Old National Bancorp, Peoples Bancorp of North
Carolina, Inc., Susquehanna Bank, The PrivateBank and Trust Co, The
Savannah Bank, N.A., The Washington Trust Company, Trustmark
National Bank, UMB Financial Corporation, Valley National Bank,
Webster Bank NA, WesBanco Bank (``Regional Banks'') (general support
for limitation to swaps connected to financial terms of the loan).
\298\ See letter from Better Markets I.
---------------------------------------------------------------------------

Other commenters, though, said that this limitation to swaps
connected to the financial terms of the loan was inappropriate or
inconsistent with the Dodd-Frank Act, and that any swap required by the
loan agreement or required by the IDI as a matter of prudent lending
should be covered by the exclusion.\299\ Some of the commenters arguing
for the broader exclusion emphasized that the exclusion should be
available for any swap with the lending IDI which reduces the
borrower's risks, such as a commodity swap the borrower uses for
hedging, because reduction of commodity price risks faced by the
borrower also reduces the risk that the loan will not be repaid to the
IDI.\300\ Commenters said that if the exclusion does not apply to swaps
hedging the borrower's commodity price risks, then only IDIs that are
able to create a separately capitalized affiliate will be able to offer
commodity swaps (because section 716 of the Dodd-Frank Act limits the
ability of IDIs to offer commodity swaps), thereby reducing the
availability of commodity swaps to

[[Page 30621]]

borrowers that are smaller companies.\301\
---------------------------------------------------------------------------

\299\ See letters from BOK dated February 18, 2011 (``BOK II''),
FSR I, ISDA I, Midsize Banks, OCC Staff at 6 (noting that ``[l]oan
underwriting criteria for community and mid-size banks * * * may
require, as a condition of the loan, that the borrower be hedged
against the commodity price risks incidental to its business'') and
White & Case LLP (``White & Case'') and joint letter from Senator
Stabenow and Representative Lucas.
\300\ See letters from BOK II, FSR I, OCC Staff and White &
Case.
\301\ See letters from ABA I and BOK I. Other commenters
addressed the relationship between the swap dealer definition and
section 619 of the Dodd-Frank Act (the ``Volcker Rule''). See joint
letter from Capital One, Fifth Third Bancorp and Regions Financial
Corporation.
---------------------------------------------------------------------------

Second, regarding timing, the proposed rule requested comment on
whether this exclusion should apply only to swaps that are entered into
contemporaneously with the IDI's origination of the loan (and if so,
how ``contemporaneously'' should be defined for this purpose), or
whether this exclusion also should apply to swaps entered into during
part or all of the duration of the loan. In response, commenters said
that the exclusion should apply to swaps entered into in anticipation
of a loan or at any time during the loan term.\302\ Commenters said
that application of the exclusion throughout the duration of the loan
would give IDIs and borrowers flexibility as to when to fix interest
rates in fixed/floating swaps relating to loans and would allow
borrowers to make other hedging decisions over a longer time
period.\303\ Commenters also said that loans such as construction
loans, equipment loans and committed loan facilities may allow for
draws of loan principal over an extended period of time, and that swaps
entered into by the borrower and lending IDI through the course of such
a loan should be covered by the exclusion.\304\
---------------------------------------------------------------------------

\302\ See letters from BB&T I, B&F Capital I, BOK II, Capital
One, Capstar, FSR I, Midsize Banks, Manufacturers and Traders Trust
Company (``M&T'') dated June 3, 2011 (``M&T I'') and September 28,
2011 (``M&T II''), Peoples Bank Co. (``Peoples Bank''), Regional
Banks and White & Case.
\303\ See letters from B&F Capital I, BOK II, Capital One,
Capstar and M&T I and M&T II.
\304\ See letters from FSR dated October 17, 2011 (``FSR VI''),
M&T II and Wells Fargo Bank, N.A. (``Wells Fargo'') dated August 16,
2011 (``Wells Fargo II'').
---------------------------------------------------------------------------

Third, as to which transactions should be deemed ``loans'' for
purposes of the exclusion, the proposal said that the exclusion should
be available in connection with all transactions by which an IDI is a
source of funds to a borrower, including, for example, loan
syndications, participations and refinancings. Commenters agreed that
the exclusion should be available for IDIs that are in a loan
syndicate, purchasers of a loan, assignees of a loan or participants in
a loan.\305\ On loan syndications and participations in particular, one
commenter said that the exclusion should be available even if the
notional amount of the swap is more than the amount of the loan tranche
assigned to the IDI, so long as the swap notional amount is not more
than the entire amount of the loan.\306\ Another commenter said that
the exclusion should not be available if the IDI's participation in the
loan drops below a minimum level (such as 20 percent) because such use
of the exclusion by minimally-participating IDIs would invite
abuse.\307\
---------------------------------------------------------------------------

\305\ See letters from BB&T I, Midsize Banks, Regional Banks and
White & Case; see also letter from Loan Market Association
(providing background information on loan participations).
\306\ See letter from Regional Banks.
\307\ See letter from Better Markets I.
---------------------------------------------------------------------------

Some commenters said that other types of transactions also should
be treated as ``loans'' for purposes of the exclusion. The transactions
cited by commenters in this regard include leases, letters of credit,
financings documented as sales of financial assets, bank qualified tax
exempt loans and bonds that are credit enhanced by an IDI.\308\ Other
commenters said the exclusion should apply where entities related to an
IDI provide financing, such as loans or financial asset purchases by
bank-sponsored commercial paper conduits where the IDI provides
committed liquidity,\309\ and transactions where a special purpose
entity formed by an IDI is the source of financing and enters into the
swap.\310\ Some commenters said the exclusion should encompass all
transactions where an IDI facilitates a financing,\311\ or all
extensions of credit by an IDI,\312\ or all transactions where an IDI
provides risk mitigation to a borrower.\313\
---------------------------------------------------------------------------

\308\ See letters from BB&T I, Capital One, FSR I, M&T I,
Midsize Banks and Regional Banks.
\309\ See letter from FSR I.
\310\ See letter from Midsize Banks.
\311\ See letters from Pacific Coast Bankers' Bancshares
(``PCBB'') and Regional Banks.
\312\ See letters from FSR I and Midsize Banks.
\313\ See letter from PCBB.
---------------------------------------------------------------------------

Fourth, with respect to the types of financial institutions that
are eligible for the loan origination exclusion, three commenters said
that IDIs, for purposes of this exclusion, encompass more than banks or
savings associations with federally-insured deposits. The Farm Credit
Council said the exclusion should be extended to Farm Credit System
institutions because one of these institutions enters into interest
rate swaps with borrowing customers identical in function to those
offered by commercial banks and savings associations in connection with
loans, and the institutions are subject to similar regulatory
requirements and covered by a similar insurance regime.\314\ Another
commenter said that the exclusion should be extended to other regulated
financial institutions, such as insurers, so as not to create an
unlevel playing field.\315\ And the Federal Home Loan Banks said that
the exclusion should be available to them because they are subject to
similar regulatory oversight and capital standards and engage in a
similar function of extending credit as do commercial banks and savings
associations.\316\ In addition, some commenters said the exclusion
should be broadly construed as a general matter, to encourage
competition in the swap market between smaller and larger banks and to
increase borrowers' choice among potential swap providers.\317\
---------------------------------------------------------------------------

\314\ Consequently, the Farm Credit Council argued, disallowing
these institutions from using the exclusion would give commercial
banks and savings associations a competitive advantage in
agricultural lending. See letters from Farm Credit Council I and
dated February 17, 2012 (``Farm Credit Council II''). Another
commenter argued that, to the contrary, making Farm Credit System
institutions eligible for the exclusion would confer an
inappropriate competitive advantage on those institutions. See
letter from ABA dated February 14, 2012 (``ABA II''). This commenter
said that Farm Credit System institutions have certain advantages
over other IDIs, and the commenter asserted that Farm Credit System
institutions were left out of the statutory language of the
exclusion in order that they would not receive additional
competitive advantages. See id.
\315\ See letter from NAIC.
\316\ See letter from FHLB I. The Credit Union National
Association said that the Federal Home Loan Banks should not be
covered by the swap dealer definition because they do not enter into
swaps for their own account as part of a regular business. See
letter from CUNA.
\317\ See letters from BB&T I, B&F Capital dated June 1, 2011
(``B&F Capital II''), Capital One, Capstar, M&T I and Peoples Bank.
---------------------------------------------------------------------------

Two commenters asked for clarification of the following technical
points in the proposed rule: (i) Whether a swap would be covered by the
exclusion even if it does not hedge all the risks under the loan, (ii)
whether a swap that is within the exclusion could continue to be
treated as covered by the exclusion by an IDI if the IDI transfers the
loan, and (iii) whether an IDI should count swaps covered by the
exclusion in determining if its dealing activity is above the de
minimis thresholds.\318\ Another commenter asked whether an IDI with
swaps that are covered by the exclusion could be a swap dealer based on
other dealing activity.\319\ And others asked whether the exclusion
would cover swaps used by an IDI to hedge its risks arising from a loan
(i.e., a swap which the IDI enters into with a party other than the
loan borrower).\320\
---------------------------------------------------------------------------

\318\ See letters from FSR VI and Midsize Banks.
\319\ See letter from Better Markets I.
\320\ See letters from B&F Capital I, FSR I, ISDA I, M&T I and
Midsize Banks.
---------------------------------------------------------------------------

3. Final Rule
The CFTC believes that the extent of this exclusion should be
determined by

[[Page 30622]]

the language of the statutory definition, which relates to an IDI that
``offers to enter into a swap with a customer in connection with
originating a loan with that customer.'' The expansive interpretation
of the exclusion advanced by some commenters, however, would read the
statute to exclude almost any swap that an IDI enters into with a loan
customer. That is not the exclusion that was enacted. Instead, we
interpret the statutory phrase ``enter into a swap with a customer in
connection with originating a loan with that customer'' to mean that
the swap is directly connected to the IDI's process of originating the
loan to the customer.
Because of the statute's direct reference to ``originating'' the
loan, it would be inappropriate to construe the exclusion as applying
to all swaps entered into between an IDI and a borrower at any time
during the duration of the loan. If this were the intended scope of the
statutory exclusion, there would be no reason for the text to focus on
swaps in connection with ``originating'' a loan. The CFTC recognizes
the concern expressed by commenters that: (i) there be flexibility
regarding when the IDI and borrower enter into a swap relating to a
loan, and (ii) the expectation when an IDI originates a loan with a
customer is often that the customer will enter into a swap with the IDI
when there is a subsequent advance, or a draw, of principal on the
loan. We do not believe, however, that the statutory term
``origination'' can reasonably be stretched to cover the entire term of
every loan that an IDI makes to its customers. At some point, the
temporal distance renders the link to loan origination too attenuated,
and the risk of evasion too great, to support the exclusion. In order
to balance these competing and conflicting considerations, the final
rule applies the exclusion to any swap that otherwise meets the terms
of the exclusion and is entered into no more than 90 days before or 180
days after the date of execution of the loan agreement, or no more than
90 days before or 180 days after the date of any transfer of principal
to the borrower from the IDI (e.g., a draw of principal) pursuant to
the loan, so long as the aggregate notional amount of the swaps in
connection with the financial terms of the loan at any time is no more
than the aggregate amount of the borrowings under the loan at that
time.\321\
---------------------------------------------------------------------------

\321\ We note that because the exclusion is available within the
specified time period around the execution of the loan agreement and
any draw of principal under the loan, any amendment, restructuring,
extension or other modification of the loan will, in itself, neither
preclude application of the exclusion nor expand application of the
exclusion.
---------------------------------------------------------------------------

Since a loan involves the repayment of funds to the IDI on
particular terms, a swap that relates to those terms of repayment
should be covered by the exclusion. In addition, we recognize that, as
stated by commenters, requirements in an IDI's loan underwriting
criteria relating to the borrower's financial stability are an
important part of ensuring that loans are repaid.\322\ Therefore, the
final rule modifies the proposed rule to provide that the exclusion
applies to swaps between an IDI and a loan borrower that are connected
to the financial terms of the loan, such as, for example, the loan's
duration, interest rate, currency or principal amount, or that are
required under the IDI's loan underwriting criteria to be in place as a
condition of the loan in order to hedge commodity price risks
incidental to the borrower's business.\323\ The first category of swaps
generally serve to transform the financial terms of a loan for purposes
of adjusting the borrower's exposure to certain risks directly related
to the loan itself, such as risks arising from changes in interest
rates or currency exchange rates. The second category of swaps mitigate
risks faced by both the borrower and the lender, by reducing risks that
the loan will not be repaid. Thus, both types of swaps are directly
related to repayment of the loan. Although some commenters said that
this exclusion should also apply to other types of swaps, we believe it
would be inappropriate to construe this exclusion as encompassing all
swaps that are connected to a borrower's other business activities,
even if the loan agreement requires that the borrower enter into such
swaps or otherwise refers to them.\324\ In contrast to a swap that
transforms the financial terms of a loan or is required by the IDI's
loan underwriting criteria to reduce the borrower's commodity price
risks, other types of swaps serve a more general risk management
purposes by reducing other risks related to the borrower or the loan.
If the purpose of the exclusion were to cover the broad range of swaps
cited by some commenters (such as all swaps reducing a borrower's
business risks), then the terms of the statute limiting the exclusion
to swaps that are ``in connection with originating a loan with that
customer'' would be superfluous.\325\ To give effect to the statutory
text, the exclusion is limited to a swap that is connected to the
financial terms of the loan or is required by the IDI's loan
underwriting criteria to to be in place as a condition of the loan in
order to hedge commodity price risks incidental to the borrower's
business.
---------------------------------------------------------------------------

\322\ See letter from OCC Staff.
\323\ The final rule provides that the second category of swaps
must hedge a price risk related to a commodity other than an
excluded commodity because if the price risk relates to an excluded
commodity (such as an interest rate) the swap must be connected to
the financial terms of the loan in order to be covered by the
exclusion.
\324\ On the other hand, there is no requirement that the loan
agreement reference a swap in order for the swap to be excluded, if
the swap otherwise qualifies for the exclusion.
\325\ Also, we believe that the broader range of swaps serving
general risk management purposes are more likely to involve concerns
regarding market transparency and appropriate business conduct
practices addressed by swap dealer regulation than are the narrower
range of swaps that are encompassed by the exclusion.
---------------------------------------------------------------------------

Regarding the types of transactions that will be treated as a
``loan'' for purposes of the exclusion, courts have defined the term
``loan'' in other statutory contexts based on the settled meaning of
the term under common law. This definition encompasses any contract by
which one party transfers a defined quantity of money and the other
party agrees to repay the sum transferred at a later date.\326\ Rather
than examine at this time the many particularized examples of financing
transactions cited by some commenters, the term ``loan'' for purposes
of this exclusion should be interpreted in accordance with this settled
legal meaning.\327\
---------------------------------------------------------------------------

\326\ See, e.g., In Re Renshaw, 222 F.3d 82, 88 (2d Cir. 2000)
(``Because Congress did not define the term ``loan'' for [11 U.S.C.]
Sec. 523(a)(8), we must interpret it according to its settled
meaning under common law. The classic definition of a loan [is] * *
* as follows: To constitute a loan there must be (i) a contract,
whereby (ii) one party transfers a defined quantity of money, goods,
or services, to another, and (iii) the other party agrees to pay for
the sum or items transferred at a later date.'') (citing In re Grand
Union Co., 219 F. 353, 356 (2d Cir. 1914)).
\327\ The final rule adopts provisions from the proposed rule
that, in order to prevent evasion, the statutory exclusion does not
apply where the IDI originates a ``sham'' loan; or the purported
``loan'' is actually a synthetic loan such as a loan credit default
swap or loan total return swap. See CFTC Regulation Sec.
1.3(ggg)(5)(iii).
---------------------------------------------------------------------------

As stated in the proposed rule, this exclusion is available to all
IDIs that are a source of a transfer of money to a borrower pursuant to
a loan. The final rule adopts provisions from the proposed rule that
the exclusion is available to an IDI that is a source of money by being
part of a loan syndicate, being an assignee of a loan, obtaining a
participation in a loan, or purchasing a loan.\328\ However, the
proposed rule did

[[Page 30623]]

not state explicitly how the notional amount of a swap subject to the
exclusion must relate to the amount of money provided by an IDI that is
in a loan syndicate or is an assignee of, participant in or purchaser
of a loan. In this regard, some commenters said that a borrower and the
IDIs in a lending syndicate need flexibility to allocate responsibility
for the swap(s) related to the loan as they may agree.\329\ We believe
that, to allow for this flexibility, the exclusion may apply to a swap
(which is otherwise covered by the exclusion) even if the notional
amount of the swap is different from the amount of the loan tranche
assigned to the IDI. However, we also agree with a commenter that the
IDI should have a substantial participation in the loan.\330\ The
requirement of substantial participation would prevent an IDI from
applying the exclusion where the IDI makes minimal lending commitments
in multiple loan syndicates where it offers swaps, causing its swap
activity to be far out of proportion to its loan activity.\331\
---------------------------------------------------------------------------

\328\ See CFTC Regulation Sec. 1.3(ggg)(5)(ii). As is also
stated in the Proposing Release, if an IDI were to transfer its
participation in a loan to a non-IDI, then the non-IDI would not be
able to claim this exclusion, regardless of the terms of the loan or
the manner of the transfer. Similarly, a non-IDI that is part of a
loan syndicate with IDIs would not be able to claim the exclusion.
\329\ See, e.g., letter from Regional Banks.
\330\ See letter from Better Markets I. This commenter suggested
a minimal threshold of at least 20 percent of the loan. However, we
believe that a 10 percent commitment constitutes a substantial
participation in the loan which supports offering of a swap up to
the loan's full amount.
\331\ For example, an IDI could act as a 0.1 percent participant
in one hundred different loans in order to serve as the sole swap
counterparty to the borrowers for hedging the borrowers' interest
rate risk on the loans. Thus, by lending or committing to lend $100
million, the IDI could apply the exclusion to swaps with an
aggregate notional amount of $100 billion.
---------------------------------------------------------------------------

Therefore, the final rule includes a provision that the exclusion
may apply regardless of whether the notional amount of the swap is the
same as the amount of the loan, but only if the IDI is the sole source
of funds under the loan or is committed to be, under the applicable
loan agreements, the source of at least 10 percent of the maximum
principal amount under the loan.\332\ If the IDI does not meet this 10
percent threshold, the final rule provides that the exclusion may apply
only if the aggregate notional amount of all the IDI's swaps with the
customer related to the financial terms of the loan is no more than the
amount lent by the IDI to the customer.\333\ We also note that, in all
cases, application of the exclusion requires that the aggregate
notional amount of all swaps entered into by the borrower with any
person in connection with the financial terms of the loan at any time
is not more than the aggregate principal amount outstanding under the
loan at that time.\334\
---------------------------------------------------------------------------

\332\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(D)(1) and (2).
\333\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(D)(3).
\334\ See CFTC Regulation Sec. 1.3(ggg)(5)(i)(E). Paragraphs
(D)(3) and (E) of this regulation refer to all swaps ``in connection
with the financial terms of the loan'' in order to clarify that only
such swaps are relevant in this regard. For example, if the IDI were
to enter into a swap with the customer that is not in connection
with the loan's financial terms, the swap would not be relevant
because the exclusion would not apply to the swap.
---------------------------------------------------------------------------

We also reiterate the interpretation in the Proposing Release that
the word ``offer'' in this exclusion includes scenarios where the IDI
requires the customer to enter into a swap, or where the customer asks
the IDI to enter into a swap, specifically in connection with a loan
made by that IDI.
We also continue to emphasize, as stated in the Proposing Release,
that the statutory language of the exclusion limits its availability to
only IDIs as defined in the statute. Regarding some commenters'
statements about the competitive effect of this interpretation of the
term ``insured depository institution,'' we believe that the scope of
application of the swap dealer definition to various entities should be
treated in the de minimis exception, which is available to all persons.
In order to provide clarification in response to certain technical
questions raised by commenters, we note that whether a swap hedges all
of the risk, or only some of the risk, of a loan is not relevant to
application of the exclusion. Nor is it relevant to the exclusion if
the IDI later transfers or terminates the loan in connection with which
the swap was entered into, so long as the swap otherwise qualifies for
the exclusion and the loan was originated in good faith and was not a
sham.\335\ Further, swaps that are covered by the exclusion should not
be considered in determining if an IDI exceeds the de minimis level of
swap dealing activity, because the statute provides that swaps covered
by the exclusion should not be considered in determining if an IDI is a
swap dealer, and the de minimis exception provides that it considers
the ``quantity of [a person's] swap dealing.'' \336\ The application of
the exclusion to swaps entered into by an IDI in connection with the
origination of loans, however, does not mean that the IDI could not be
a swap dealer because of other of the IDI's activities that constitute
swap dealing. Regarding swaps used by an IDI to hedge or lay off its
risks arising from a loan, we do not believe it is appropriate to treat
such swaps as covered by the exclusion, because the statute explicitly
limits the exclusion to swaps ``with a customer,'' which such hedging
swaps are not. However, a swap that an IDI enters into for the purpose
of hedging or laying off the risk of a swap that is covered by the IDI
exclusion will not be considered in the de minimis determination, or
otherwise in evaluating whether the IDI is covered by the swap dealer
definition.\337\
---------------------------------------------------------------------------

\335\ On the other hand, if the IDI were to transfer the swap
(but not the loan) to another IDI, and the IDI that is the
transferee of the swap is not a source of money to the borrower
under the loan, then the transferee IDI would not be able to apply
the exclusion to the swap.
\336\ See CEA sections 1a(49)(A) and 1a(49)(D), 7 U.S.C.
1a(49)(A) and 1a(49)(D).
\337\ An IDI that is seeking out swap counterparties to enter
into swaps in order to hedge or lay off the risk of a swap that is
subject to the IDI exclusion would generally not be accommodating
demand for swaps or facilitating interest in swaps.
---------------------------------------------------------------------------

Last, we believe it is appropriate to require that an IDI claiming
the exclusion report its swaps that are covered by the exclusion to a
swap data repository (``SDR''). This requirement is consistent with the
prevailing practice that IDIs handle the documentation of loans made to
borrowers, and will provide for consistent reporting of swaps that are
covered by the exclusion, thereby allowing the CFTC and other
regulators to monitor the use of the exclusion.
In sum, the final rule balances the need for flexibility in
response to existing lending practices, consistent with the constraints
imposed by the statutory text as enacted, against the risk of
establishing a gap in the regulatory framework enacted in Title
VII.\338\ It provides that the exclusion may be claimed by a person
that meets the following conditions: (i) The person is an IDI; (ii) the
IDI enters into a swap with the borrower that does not extend beyond
the termination of the loan; (iii) the swap is connected to the
financial terms of the loan or is required by the IDI's loan
underwriting criteria to to be in place as a condition of the loan in
order to hedge commodity price risks incidental to the borrower's
business; (iv) the loan is within the common law meaning of ``loan''
and it is not a sham or a synthetic loan; (v) the IDI is the source of
money to the borrower in connection with the loan either directly, or
(so long as the IDI is the source of at least 10 percent of the entire
amount of the loan) through syndication, participation, assignment,
purchase, refinancing or otherwise; (vi) the IDI

[[Page 30624]]

enters into the swap with the borrower within 90 days before or 180
days after the date the execution of the loan agreement, or within 90
days before or 180 days after any transfer of principal to the borrower
from the IDI pursuant to the loan; (vii) the aggregate notional amount
of all swaps entered into by the borrower with all persons in
connection with the financial terms of the loan at any time is not more
than the aggregate amount of the borrowings under the loan at that
time; and (viii) the IDI agrees to report the swap to an SDR.
---------------------------------------------------------------------------

\338\ The final rule text in CFTC Regulation Sec.
1.3(ggg)(5)(i) has been revised to conform the text of the rule to
the statutory provision which refers to ``an insured depository
institution [that] * * * enter[s] into a swap with a customer in
connection with originating a loan with that customer.'' See CEA
Sec. 1a(49)(A), 7 U.S.C. 1a(49)(A)
---------------------------------------------------------------------------

An IDI that enters into swaps that do not meet these conditions,
and thus do not qualify for the statutory exclusion, is not necessarily
required to register as a swap dealer. Rather, the IDI would apply the
statutory definition and the provisions of the rule (taking into
account the applicable interpretive guidance set forth in this Adopting
Release), solely with respect to its swaps that are not subject to the
IDI exclusion, in order to determine whether it is engaged in swap
dealing activity that exceeds the de minimis threshold.

C. Application of Dealer Definitions to Legal Persons and to Inter-
Affiliate Swaps and Security-Based Swaps

1. Proposed Approach and Commenters' Views
In the Proposing Release, the Commissions preliminarily concluded
that designation as a dealer would apply on an entity-level basis
(rather than to a trading desk or other business unit that is not
organized as a separate legal person), and that an affiliated group of
legal persons could include more than one dealer.\339\ The Proposing
Release also stated that the dealer analysis should consider the
economic reality of swaps and security-based swaps between affiliates,
and preliminarily noted that swaps or security-based swaps ``between
persons under common control may not involve the interaction with
unaffiliated persons that we believe is a hallmark of the elements of
the definitions that refer to holding oneself out as a dealer or being
commonly known as a dealer.'' \340\
---------------------------------------------------------------------------

\339\ See Proposing Release, 75 FR at 80183.
\340\ Id. The Proposing Release further noted that sections
721(c) and 761(b)(3) give the Commissions anti-evasion authority, to
the extent that an entity were to seek to use transactions between
persons under common control to avoid one of the dealer definitions.
See id. (erroneously referring to section 721(c) as section
721(b)(3).
---------------------------------------------------------------------------

Commenters supported the view that swaps and security-based swaps
among affiliates should be excluded from the dealer analysis.\341\ A
number of commenters took the view that the dealer definitions should
not apply when there is common control between counterparties, or when
common control is combined with the consolidation of financial
statements.\342\ Some commenters suggested that this interpretation
regarding the scope of the dealer definitions should incorporate
concepts of affiliation that are found in other statutory and
regulatory provisions.\343\ Several commenters also opposed the
suggestion (raised as part of the Proposing Release's request for
comments) that this interpretation be limited to transactions among
wholly owned subsidiaries.\344\
---------------------------------------------------------------------------

\341\ See, e.g., letters from API I, COPE I, ISDA I, Midsize
Banks, ONEOK, Inc. (``ONEOK'') and Peabody.
Several commenters explained the widespread use of central
hedging desks to allocate risk within affiliate groups or to gather
risk from within a group and lay that risk off on the market. See,
e.g., letters from EEI/EPSA, Kraft Foods Inc. (``Kraft''), MetLife
and Prudential Financial, Inc. (``Prudential'') dated February 17,
2011 (``Prudential I'').
Some commenters particularly stated that the use of a single
entity to face the market on behalf of an affiliate group had
several risk-reducing and efficiency-enhancing benefits, and that
those benefits would be lost if the dealer definitions were to lead
corporate groups to avoid using central trading desks and instead
require each affiliate to face the market as an independent end-
user. See letters from FSR I, Philip Morris International Inc.
(``Philip Morris''), Shell Trading dated June 3, 2011 (``Shell
Trading II'') and Utility Group, and joint letter from ABA
Securities Association, American Council of Life Insurers
(``ACLI''), FSR, Futures Industry Association (``FIA''), Institute
of International Bankers, ISDA and SIFMA (``Financial
Associations'').
Some commenters also stated that legislative history suggested
that Congress did not intend that the dealer definition capture
transactions involving the use of an affiliate to hedge commercial
risk. See letters from CDEU and Prudential I.
\342\ See letters from CDEU (common control), Financial
Associations (common control and consolidation), MetLife
(consolidation), ONEOK (common control, evaluated based on whether
the trading interests of the entities are aligned) and Prudential I
(citing CFTC letter interpretation regarding common control).
\343\ See, e.g., letters from EDF Trading (proposing definition
from regulations promulgated by the Federal Energy Regulatory
Commission) and Peabody (proposing definition of ``affiliate'' used
in federal securities laws) and joint letter from the Bank of Tokyo-
Mitsubishi UFJ, Ltd., Mizuho Corporate Bank, Ltd. and Sumitomo
Mitsui Banking Corp. (suggesting use of control definition in Bank
Holding Company Act).
\344\ See, e.g., letters from Kraft and ONEOK.
---------------------------------------------------------------------------

2. Final Interpretation and Rule
a. Application to Legal Persons
Consistent with the Proposing Release, the Commissions interpret
``person'' as used in the swap dealer and security-based swap dealer
definitions to refer to a particular legal person. Accordingly, the
dealer definitions will apply to the particular legal person performing
the dealing activity, even if that person's dealing activity is limited
to a trading desk or discrete business unit,\345\ unless the person is
able to take advantage of a limited designation as a dealer.\346\
---------------------------------------------------------------------------

\345\ Within an affiliated group of companies, however, only
those legal persons that engage in dealing activities will be
designated as dealers; that designation will not be imputed to other
non-dealer affiliates or to the group as a whole. A single affiliate
group may, however, have multiple swap or security-based swap
dealers.
\346\ Limited designation as a dealer is addressed in more
detail below in part II.E.
---------------------------------------------------------------------------

b. Application to Inter-Affiliate Swaps and Security-Based Swaps
The final rules codify exclusions from the dealer definitions for a
person's swap or security-based swap activities with certain
affiliates.\347\ These rules are consistent with the Proposing
Release's recognition of the need to consider the economic reality of
any swaps or security-based swaps that a person enters into with
affiliates. Market participants may enter into such inter-affiliate
swaps or security-based swaps for a variety of purposes, such as to
allocate risk within a corporate group or to transfer risks within a
corporate group to a central hedging or treasury entity.
---------------------------------------------------------------------------

\347\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); Exchange Act
rule 3a71-1(d). A person's market-facing swap or security-based swap
activity may still cause that person to be a dealer, even if that
market-facing activity is linked to the inter-affiliate activity, to
the extent that the market-facing activity satisfies the dealer
definition. However, a person's market-facing swap activity for
hedging purposes as defined in CFTC Regulation Sec.
1.3(ggg)(6)(iii) would not cause that person to be a dealer.
---------------------------------------------------------------------------

Under the final rules, the dealer analysis will not apply to swaps
and security-based swaps between majority-owned affiliates.\348\ When
the economic interests of those affiliates are aligned adequately--as
would be found in the case of majority-ownership--such swaps and
security-based swaps serve to allocate or transfer risks within an
affiliated group, rather than to move those risks out of the group to
an unaffiliated third party. For this reason, and as contemplated by
the Proposing Release,\349\ we do not believe that such

[[Page 30625]]

swaps and security-based swaps involve the interaction with
unaffiliated persons to which dealer regulation is intended to apply.
---------------------------------------------------------------------------

\348\ See CFTC Regulation Sec. 1.3(ggg)(6)(i); Exchange Act
rule 3a71-1(d)(1). For the purposes of these rules, the
counterparties are majority-owned affiliates if one party directly
or indirectly holds a majority ownership interest in the other, or
if a third party directly or indirectly holds a majority interest in
both, based on holding a majority of the equity securities of an
entity, or the right to receive upon dissolution or the contribution
of a majority of the capital of a partnership. See CFTC Regulation
Sec. 1.3(ggg)(6)(i); Exchange Act rule 3a71-1(d)(2).
\349\ See Proposing Release, 75 FR at 80183 (noting that swaps
or security-based swaps between affiliates ``may not involve the
interaction with unaffiliated persons that we believe is a hallmark
of the elements of the definitions that refer to holding oneself out
as a dealer or being commonly known as a dealer'').
---------------------------------------------------------------------------

The standard in the final rules differs from the standard suggested
by the Proposing Release, which alluded to affiliates as legal persons
under ``common control.'' This change is based on our further
consideration of the issue, including consideration of comments that an
inter-affiliate exclusion should be available when common control is
combined with the consolidation of financial statements. Although we
are not including a requirement that financial statements be
consolidated--as we do not believe that the scope of this exclusion
should be exposed to the risk of future changes in accounting
standards--in our view a majority ownership standard is generally
consistent with consolidation under GAAP.\350\ Absent majority
ownership, we cannot be confident that there would be an alignment of
economic interests that is sufficient to eliminate the concerns that
underpin dealer regulation.
---------------------------------------------------------------------------

\350\ See FASB ASC Section 810-10-25, Consolidation--Overall--
Recognition (stating that consolidation is appropriate if a
reporting entity has a controlling financial interest in another
entity and a specific scope exception does not apply).
---------------------------------------------------------------------------

In taking this approach, we have also considered alternatives
suggested by commenters. For example, while one commenter suggested
that we adopt a definition of ``affiliate'' as used in the securities
laws,\351\ we believe that such an approach would be too broad for the
purpose of this exclusion from dealing activity, given that common
control by itself does not ensure that two entities' economic interests
are sufficiently aligned.\352\
---------------------------------------------------------------------------

\351\ See letter from Peabody. The commenter did not specify
which definition of ``affiliate'' in the securities laws it was
proposing. For example, Rule 405 of the Securities Act of 1933
defines affiliate in terms of common control, see 17 CFR 230.405,
and Section 20(a) of the Exchange Act takes a similar approach. The
Investment Company Act of 1940 (``ICA'') defines affiliate to
include entities with a common ownership interest as low as 5
percent, ICA section 2(a)(3). Two other commenters proposed using a
common control standard, perhaps also in reference to the Rule 405
definition of ``affiliate.''
\352\ The definitions of ``affiliate'' and ``control'' found in
Rule 405 and other securities law provisions are appropriate in the
context of the prophylactic and remedial provisions in which they
are found. Rule 405, for example, uses the terms ``affiliate'' and
``control'' to identify those persons that have the power to effect
registration of an issuer's securities, and the broad definitions
ensure that the persons with that power actually fulfill their
obligation to do so. By comparison, the exclusion of inter-affiliate
swaps and security-based swaps from the dealer analysis should be
more tightly focused to address situations in which counterparties
have similar economic interests.
Another commenter noted the definition of ``affiliate'' found
in certain Federal Energy Regulation Commission regulations--which
define ``affiliate'' in terms of a ten percent or five percent
common ownership interest. See letter from EDF Trading. Those
relatively low ownership thresholds, however, are intended to
address different concerns regarding collusion and cross-
subsidization, and do not appear appropriate for an interpretation
that has the potential to reduce the counterparty and market
protections provided by Title VII. See 18 CFR sections 35.36(a)(9),
35.39, 366.2(b), 366.3.
---------------------------------------------------------------------------

c. Application to Cooperatives
Similar considerations apply, in certain situations, to cooperative
entities that enter into swaps with their members in order to allocate
risk between the members and the cooperative. Commenters identified two
general types of such cooperatives--``cooperative associations of
producers'' as defined in section 1a(14) of the CEA \353\ and
cooperative financial entities such as Farm Credit System institutions
and Federal Home Loan Banks.\354\ As is the case for affiliated groups
of corporate entities, we believe that when one of these cooperatives
enters into a swap with one of its members,\355\ the swap serves to
allocate or transfer risks within an affiliated group, rather than to
move those risks from the group to an unaffiliated third party, so long
as the cooperative adheres to certain risk management practices.
---------------------------------------------------------------------------

\353\ 7 U.S.C. 1a(14). A cooperative association of producers is
at least 75 percent owned or controlled, directly or indirectly, by
producers of agricultural products and must comply with the Capper-
Volstead Act (referred to in the CEA as the Act of February 18,
1922, 7 U.S.C. 291 and 292). See letters from Land O'Lakes II, NCFC
I and NMPF.
\354\ See letters from Farm Credit Council I and FHLB I. The NRU
CFC qualifies as a cooperative financial entity, but we understand
that it does not enter into a significant amount of swaps with its
members; rather, it enters into swaps with unaffiliated third
parties. See letter from NRU CFC I and meeting with NRU CFC on
January 13, 2011.
\355\ The term ``cooperative association of producers'' also
includes any organization acting for a group of such associations
and owned or controlled by such associations. See CEA section
1a(14), 7 U.S.C. 1a(14). For a cooperative association of producers
that is acting for and owned or controlled by such associations, we
believe that this conclusion applies to any swap between such
cooperative association of producers and any cooperative association
of producers that is a member of it, and any producer that is a
member of any such cooperative association of producers that is
itself a member of the first cooperative association of producers.
See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(C).
However, we do not believe that this conclusion applies to any
security-based swap that a cooperative association of producers may
enter into, nor does it apply to any swap related to a non-physical
commodity (such as a rate swap). For this reason, the exclusion for
cooperative associations of producers is limited to swaps that are
primarily based on a commodity that is not an excluded commodity.
See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(A)(3). The term ``excluded
commodity'' is defined in CEA section 1a(19), 7 U.S.C. 1a(19).
---------------------------------------------------------------------------

Accordingly, the final rules specifically provide that the dealer
analysis excludes swaps between a cooperative and its members, so long
as the swaps in question are reported to the relevant SDR by the
cooperative and are subject to policies and procedures of the
cooperative which ensure that it monitors and manages the risk of such
swaps.\356\ The final rules define the term ``cooperative'' to include
cooperative associations of producers and any entity chartered under
Federal law as a cooperative and predominantly engaged in activities
that are financial in nature.\357\ The cooperatives covered by this
relief are subject to provisions of Federal law providing for their
cooperative purpose. Cooperative associations of producers have been
recognized since the passage of the Capper-Volstead Act as being
permitted to engage in certain cooperative activities without violating
antitrust laws.\358\ Cooperative financial institutions such as the
Farm Credit System institutions and Federal Home Loan Banks are
chartered under Federal laws that limit their membership and require
that they serve certain public purposes.\359\
---------------------------------------------------------------------------

\356\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii). To be clear,
these cooperatives are not excluded from the dealer definitions. See
part II.A.6, supra. Rather, swaps between a cooperative and its
members (and swaps that a cooperative enters into to hedge or lay
off the risk of such swaps) are excluded from the dealer analysis.
If a cooperative were to engage in other swap activities that are
covered by, and not otherwise excluded from, the statutory
definition of the term ``swap dealer,'' then it would be required to
register as a swap dealer.
\357\ See CFTC Regulation Sec. 1.3(ggg)(6)(ii)(B).
\358\ See Capper-Volstead Act section 1, 7 U.S.C. 291.
\359\ See Farm Credit Act of 1971, 12 U.S.C. 2001 et seq. and
Federal Home Loan Bank Act, 12 U.S.C. 1421 et seq.
---------------------------------------------------------------------------

We are aware that other persons commented that their swap
activities should be excluded from the dealer analysis because they use
swaps in connection with a cooperative or non-profit purpose, or
because they aggregate demand for swaps arising from numerous small
entities.\360\ However, the key distinction drawn in granting this
relief is that cooperatives covered by the exclusion enter into swaps
with their members in order to allocate risk between the members and

[[Page 30626]]

the cooperative. By contrast, the other entities noted above enter into
swaps with unaffiliated parties in order to transfer risks between
unaffiliated parties.\361\ As noted above, the Commissions believe that
the contemplated scope of the statutory definitions does not include
instances where a person's swap activities transfer risk within an
affiliated group, but does extend to activities that create legal
relationships that transfer risk between unaffiliated parties. Thus, it
is appropriate that the dealer analysis exclude swaps between a
cooperative and its members, but such analysis should include swaps
between a cooperative or other aggregator and unaffiliated persons.
---------------------------------------------------------------------------

\360\ See letter from NFPEEU (not-for-profit power utilities,
electric cooperatives and related persons); letters from Farmers'
Associations, NGFA I and NMPF (referring to private companies that
serve as aggregators for swaps in agricultural commodities or
otherwise offer swaps for agricultural risk management); and letter
from Northland Energy (small energy firm that aggregates demand for
swaps from small energy retailers and consumers).
\361\ See, e.g., letter from NFPEEU (not-for-profit power
utilities and electric cooperatives generally enter into swaps
between themselves, with large industrial consumers, and a wide
range of other counterparties). Indeed, the Dodd-Frank Act permits
the CFTC to exempt agreements, contracts or transactions between
entities described in section 201(f) of the Federal Power Act, such
as certain not-for-profit power utilities and electric cooperatives.
See section 722(f) of the Dodd-Frank Act. As noted above, a
coalition of not-for-profit power utilities and electric
cooperatives has advised that it plans to submit a request for the
exemption contemplated by section 722(f) of the Dodd-Frank Act. See
note 295 supra.
---------------------------------------------------------------------------

D. De Minimis Exception

1. Proposed Approach
The Dodd-Frank Act's definitions of ``swap dealer'' and ``security-
based swap dealer'' require that the Commissions exempt from dealer
designation any entity ``that engages in a de minimis quantity'' of
dealing ``in connection with transactions with or on behalf of
customers.'' The statutory definitions further require the Commissions
to ``promulgate regulations to establish factors with respect to the
making of any determination to exempt.'' \362\
---------------------------------------------------------------------------

\362\ CEA section 1a(49)(D), 7 U.S.C. 1a(49)(D); Exchange Act
section 3(a)(71)(D), 15 U.S.C. 78c(a)(71)(D).
---------------------------------------------------------------------------

In the Proposing Release, we preliminarily concluded that the de
minimis exception ``should be interpreted to address amounts of dealing
activity that are sufficiently small that they do not warrant
registration to address concerns implicated by the regulations
governing swap dealers and security-based swap dealers. In other words,
the exception should apply only when an entity's dealing activity is so
minimal that applying dealer regulations to the entity would not be
warranted.'' \363\ In taking this view, we rejected the suggestion that
the de minimis exception should compare a person's swap or security-
based swap dealing activities to the person's non-dealing
activities.\364\
---------------------------------------------------------------------------

\363\ Proposing Release, 75 FR at 80179 (footnote omitted).
\364\ See id. at 80179-80.
---------------------------------------------------------------------------

At the same time, we recognized that this proposed approach did not
appear to ``readily translate into objective criteria.'' We further
recognized that a range of alternative approaches may be reasonable,
and we solicited comment as to what factors should be used to implement
the exception.\365\
---------------------------------------------------------------------------

\365\ See id. at 80180.
---------------------------------------------------------------------------

The proposed de minimis exception was comprised of three factors,
all of which a person would have had to satisfy to avail itself of the
exception.\366\ The first proposed factor would have limited the
aggregate effective amount, measured on a gross basis, of the swaps or
security-based swaps that a person entered into over the prior 12
months in connection with its dealing activities to $100 million \367\
(or $25 million with regard to counterparties that are ``special
entities'').\368\
---------------------------------------------------------------------------

\366\ Under the proposal, the factors would consider a person's
swap or security-based swap dealing activity as a whole, rather than
separately considering different types of swaps or security-based
swaps. See Proposing Release, 75 FR at 80181.
\367\ See proposed Exchange Act rule 3a71-2(a). The proposed
standard reflected our understanding that in general the notional
size of a small swap or security-based swap is $5 million or less,
and that the proposed threshold would reflect 20 instruments of that
size. The standard also sought to reflect the customer protection
issues implicated by swaps and security-based swaps. See Proposing
Release, 75 FR at 80180.
The proposed notional threshold would not consider the market
risk offsets associated with combining long and short positions. In
addition, the proposed notional threshold would not account for the
amount of collateral held or posted by the entity, or other risk
mitigating factors. See id.
\368\ See proposed Exchange Act rule 3a71-2(a). As set forth by
the statutory business conduct rules applicable to security-based
swap dealers (as set forth in Exchange Act section 15F(h)(2)(C)),
``special entity'' refers to: Federal agencies; States, State
agencies and political subdivisions (including cities, counties and
municipalities); ``employee benefit plans'' as defined under the
Employee Retirement Income Security Act of 1974 (``ERISA'');
``governmental plans'' as defined under ERISA; and endowments. Title
VII imposes additional business conduct requirements on security-
based swap dealers in connection with special entities. See CEA
sections 4s(h)(2), 4s(h)(4), 4s(h)(5); Exchange Act section
15F(h)(2), (4), (5).
---------------------------------------------------------------------------

The second proposed factor would have limited a person's swap or
security-based swap dealing activity to no more than 15 counterparties
over the prior 12 months (while counting counterparties that are
members of an affiliated group as one counterparty for these purposes).
The final proposed factor would have limited a person's dealing
activity to no more than 20 swaps or security-based swaps over the
prior 12 months (without counting certain amendments as new swaps or
security-based swaps).
2. Commenters' Views
a. Basis for the Exception
Some commenters sought to link the de minimis exception to systemic
risk criteria by taking the position that a person should have to
register as a dealer only if its dealing activities pose systemic
significance.\369\ One commenter specifically objected to the position
in the Proposing Release that the de minimis exception should take into
account customer protection principles.\370\ On the other hand, one
commenter supported the rejection of a risk-based de minimis test.\371\
---------------------------------------------------------------------------

\369\ See, e.g., letters from CDEU, MFX II, NCGA/NGSA II and
SIFMA--Regional Dealers Derivatives Committee (``SIFMA--Regional
Dealers'').
\370\ See letter from WGCEF I (arguing that basing the exception
on customer protection principles would be contrary to the statutory
framework, given that only ECPs are eligible to participate in off-
exchange swap transactions).
\371\ See letter from Better Markets I.
---------------------------------------------------------------------------

Some commenters argued that the de minimis test should account for
proportionality criteria that would excuse entities whose dealing
activity is relatively minor compared to their other activities.\372\
---------------------------------------------------------------------------

\372\ See, e.g., letters from FHLB I, IECA-Credit I, NCGA/NGSA
I, NRG Energy, Peabody and WGCEF I. One commenter said the
proportionality criteria should also consider an entity's activities
with respect to the physical commodity underlying its swaps. See
letter from NCGA/NGSA I. But see letter from Better Markets I
(supporting rejection of a proportionality test). Some commenters
suggested more than one alternative approach.
---------------------------------------------------------------------------

b. Significance of ``Customer'' Language
One commenter took the position that the language within the de
minimis exception that specifically referred to ``transactions with or
on behalf of customers'' meant that the exception should be available
only for persons who limit their swaps or security-based swaps to those
that are entered into with or on behalf of customers.\373\ Other
commenters posited the opposite view that the ``customer'' language
should be read to mean that a person's dealing activities with
counterparties other than customers may be disregarded for purposes of
the exception (i.e., non-customer transactions would not count against
the de minimis thresholds).\374\ Some commenters argued that

[[Page 30627]]

transactions entered into in a fiduciary capacity should be disregarded
for purposes of the exception.\375\ One commenter questioned the
proposal's use of the term ``counterparty'' in lieu of the statutory
term ``customer.'' \376\
---------------------------------------------------------------------------

\373\ See letter from Better Markets I. Another commenter said
that the ``customer'' language serves to emphasize that the de
minimis exception is available to entities that provide swaps to
customers. See letter from NGFA I.
\374\ See letters from ISDA I, Vitol and WGCEF I. Another
commenter said that the use of the term ``customer'' indicates that
all transactions with physical commodity customers should be
disregarded in determining if a person is a dealer. See letter from
EDF Trading.
\375\ See, e.g., letter from FSR I.
\376\ See letter from Vitol (suggesting that the proposed
language meant that dealing activity involved ``customers'' but not
``counterparties'').
---------------------------------------------------------------------------

c. Proposed Tests and Thresholds
Commenters criticized the proposed de minimis thresholds in a
variety of ways. These included arguments that the proposed thresholds
were inappropriately low,\377\ would harm end-users by reducing the
number of entities willing to enter into low-value swaps and security-
based swaps,\378\ would be unjustified on a cost-benefit basis,\379\
and were disproportionately low compared to the activities of
recognized dealers.\380\ Other commenters said the de minimis
thresholds should be set at a level to allow entities to engage in a
meaningful amount of customer-facing swaps or security-based swaps
without being required to register as dealers.\381\
---------------------------------------------------------------------------

\377\ See, e.g., letters from API I, CDEU, DFA, EDF Trading,
Farm Credit Council I, Growmark, Land O'Lakes dated January 13, 2011
(``Land O'Lakes I''), Midsize Banks, NCFC I, NCGA/NGSA II, New York
City Bar Association--Committee on Futures and Derivatives
Regulation (``NYCBA Committee''), Northland Energy, NRG Energy,
Regional Banks and SIFMA--Regional Dealers. Some commenters also
said that the thresholds, particularly those for swaps, should vary
according to the riskiness of the swap or type of commodity
underlying the swap. See letters from BG LNG I, Farm Credit Council
I, Gavilon II, ISDA I, NFPEEU, Vitol and WGCEF I.
\378\ See, e.g., letters from API I, BG LNG IFarm Credit Council
I, Midsize Banks, NCFC I, NGFA I, Regional Banks and SIFMA--Regional
Dealers and meetings with Electric Companies on April 13, 2011, the
Asset Management Group of SIFMA (``SIFMA--AMG'') on February 4, 2011
and WGCEF on April 28, 2011.
\379\ See, e.g., letters from CDEU and Vitol. Another commenter
noted that application of a cost-benefit analysis of the de minimis
threshold could be challenging. See Roundtable Transcript at 193-94
(remarks of Camille Rudge, The PrivateBank and Trust Company).
\380\ See letter from CDEU (citing statistics indicating that
the average respondent to an ISDA survey had an annual ``event
volume'' of over 297,000 OTC derivatives trade processing actions);
see also letter from Regional Banks.
\381\ See meetings with Electric Companies on April 13, 2011,
Gavilon on May 11, 2011 and WGCEF on April 28, 2011.
---------------------------------------------------------------------------

A number of commenters particularly criticized the proposed
notional threshold, with some commenters suggesting that the threshold
should be based on a percentage of the total swap market \382\ or some
other fixed value,\383\ or arguing in favor of an exposure-based
threshold in lieu of a notional threshold.\384\ Other commenters said
that the aggregate notional amount of swaps is not a meaningful measure
of an entity's dealing activity.\385\ A few commenters supported the
proposed notional threshold.\386\
---------------------------------------------------------------------------

\382\ See letter from COPE I (suggesting 0.001% of the total
U.S. swap market, amounting to approximately $3 billion); see also
letters from API dated June 3, 2011 (``API II''), EDF Trading,
Edison Int'l, EEI/EPSA, IECA-Credit I, NCGA/NGSA II, NextEra,
NFPEEU, Utility Group and WGCEF I (suggesting 0.001% of the total
U.S. swap market).
\383\ See, e.g., meeting with Land O'Lakes on January 6, 2011
(suggesting the threshold be increased by 2 to 5 times--i.e., to
$200 million to $500 million); letters from Growmark, FHLB I and MFX
II (each supporting $1 billion notional standard); Regional Banks
(supporting $2 billion notional standard); letter from NCFC dated
October 31, 2011 (``NCFC III'') (supporting alternative notional
standards of $1 billion or $3 billion depending on certain
assumptions); letter from FSR VI and joint letter from Capital One,
Fifth Third Bancorp and Regions Financial Corporation (suggesting
notional standard of at least $2 billion); letter from WGCEF dated
June 3, 2011 regarding the swap dealer definition (``WGCEF V'')
(suggesting notional standard of $3.5 billion); and letter from IPR-
GDF Suez Energy North America (suggesting notional standard of $10
billion). Some commenters suggested more than one possible
threshold.
\384\ See, e.g., letters from Farm Credit Council I, FSR VI and
Midsize Banks. Other commenters said the threshold should account
for the effect of netting. See letters from API II, Chesapeake
Energy, Land O'Lakes I and MFX II. On the other hand, one commenter
specifically supported the use of the gross notional amount. See
letter from Greenberger.
\385\ See letters from Farm Credit Council I, ISDA I, Land
O'Lakes I, Midsize Banks, NCFC I, SIFMA--Regional Dealers and Vitol.
\386\ See letters from AFR, Better Markets I, Greenberger and
NMPF. One of these commenters said that data on credit default swaps
analyzed by the SEC's Division of Risk, Strategy, and Financial
Innovation indicates that the $100 million proposed notional
thresholds are too high. See letters from Better Markets to CFTC and
SEC dated April 6, 2012 (``Better Markets III'').
---------------------------------------------------------------------------

Some commenters argued against basing the de minimis exception on
the number of a person's swaps or security-based swaps or the number of
a person's counterparties,\387\ or supported increasing those
thresholds above the proposed standard.\388\ Commenters also suggested
a variety of other alternatives to the proposed tests.\389\
---------------------------------------------------------------------------

\387\ See, e.g., letters from API II, Atmos Energy, Chesapeake
Energy, COPE I, EEI/EPSA, Gavilon II, IECA-Credit I, Land O'Lakes I,
NCGA/NGSA II, NEM, NextEra I, NMPF, NRG Energy, Peabody and Utility
Group.
\388\ See, e.g., letters from ISDA I (suggesting 25 transactions
over 12 months); FHLB I (suggesting 25 counterparties and 50
transactions over 12 months) FSR I and Midsize Banks (each
suggesting 75 counterparties and 200 transactions over 12 months);
Regional Banks (suggesting 100 counterparties and 300 transactions
over 12 months); Growmark and MFX II (suggesting thresholds should
be increased by a factor of 10) and meeting with Land O'Lakes on
January 6, 2011 (suggesting thresholds should be increased by a
factor of between 2 and 5).
One commenter said the number of transaction and number of
counterparty standards should be disjunctive--i.e., a dealer's
activity would be de minimis if it were below either standard. See
letter from Northland Energy. Other commenters raised questions
about how counterparties or transactions should be counted for
purposes of the standard. See letters from CDEU (novations should
not be counted as new transactions) and J.P. Morgan (members of an
affiliated group should be counted as one counterparty), joint
letter from BB&T, East West Bank, Fifth Third Bank, The PrivateBank
and Trust Company, Regions Bank, Sun Trust Bank, U.S. Bank National
Association and Wells Fargo Bank, N.A. (``Midmarket Banks'')
(questioning how to count multiple borrower counterparties to a loan
and swap) and meeting with Land O'Lakes on January 6, 2011 (members
of a cooperative should be counted as one counterparty).
Last, some commenters said that the number of transaction or
number of counterparty standards should be deleted because they are
not useful as tests of de minimis status. See letters from Gavilon
II (eliminate both standards) and SIFMA--Regional Dealers (eliminate
number of counterparties standard).
\389\ See letters from IECA-Credit I (suggesting that exception
exclude persons whose positions either are below a notional
threshold or are below a combined proportionality and revenue
threshold), SIFMA--Regional Dealers (supporting annual threshold of
500 customer-facing or riskless principal swaps, consistent with the
de minimis exception from the Exchange Act ``broker'' definition in
connection with bank brokerage activity, as well as SEC rules in
connection with the Exchange Act definition of ``dealer''), FHLB I
(supporting non-quantitative test accounting for relatively small
swap-related exposure compared to primary customer activity,
collateral that also provides credit support for other business done
with the customer, an existing relationship with customer and
inability of customer to obtain swaps from entities that primarily
are dealers), Gavilon II (alluding to use of non-quantitative
tests), MFX II (suggesting establishment of a separate qualitative
process by which a dealer may establish why registration is not
warranted) and DC Energy (thresholds should be set at a level
appropriate to support the capital levels to be required for swap
dealers).
---------------------------------------------------------------------------

d. Additional Issues
Some commenters emphasized the need to provide protections in
connection with ``special entities.'' \390\ Certain commenters sought
to identify problems related to the application of the proposed
thresholds in connection with particular types of businesses or
markets,\391\ or to aggregators or

[[Page 30628]]

cooperatives.\392\ Other commenters suggested that the exception should
focus dealer regulation toward ``financial'' entities.\393\ One
commenter emphasized the need for the exception to be available when
the end-user is a credit union, bank or thrift.\394\
---------------------------------------------------------------------------

\390\ See letters from Better Markets I (arguing that the de
minimis exception should not be available in connection with
transactions with special entities), AFR (similar), Greenberger
(supporting reduction of the notional threshold for transactions
with special entities to $5 million) and AFSCME. Some commenters
said the standard for swaps and security-based swaps with special
entities should be a notional value equal to 0.0001% of the total
U.S. swap market. See letters from COPE I, EDF Trading, EEI/EPSA,
IECA-Credit I, NFPEEU and Utility Group. One commenter said the
threshold for special entities should be eliminated because it is
not useful in determining de minimis status. See letter from Gavilon
II.
\391\ See letters from BG LNG I (small energy companies), COPE I
and Northland Energy (each discussing commodity markets, suggesting
that notional thresholds be based on the unit of a commodity), NCFC
I (commodity prices), NGFA I (grain elevators) and WGCEF I (energy
prices).
\392\ See, e.g., letters from Growmark and Land O'Lakes I.
\393\ See letters from NEM, NextEra I, and NGFA I.
\394\ See letter from CUNA.
---------------------------------------------------------------------------

Commenters sought clarification that the de minimis criteria would
not apply to transactions for hedging or proprietary trading
purposes,\395\ or to inter-affiliate transactions.\396\
---------------------------------------------------------------------------

\395\ See, e.g., letters from API I, EDF Trading, Gavilon II and
SIFMA--Regional Dealers.
\396\ See, e.g., letter from Atmos Energy Holdings, Inc (``Atmos
Holdings'').
---------------------------------------------------------------------------

Commenters also raised issues related to the exception's treatment
of the proposed use of a rolling annual period for calculations,\397\
the proposed use of ``effective notional amounts,'' \398\ the
possibility of adjusting the thresholds over time,\399\ how the de
minimis tests would apply in the context of affiliated positions,\400\
and how the exception would account for swaps or security-based swaps
entered into before the definition's effective date.\401\
---------------------------------------------------------------------------

\397\ See letters from NCGA/NGSA I (supporting measurement of
rolling period average over 12 months), NextEra I (supporting
evaluation as of the last day of each calendar quarter rather than
over the immediate preceding 12 months) and Northland Energy
(requesting clarification that if a monetary notional amount is
used, the evaluation periods should be fixed rather than rolling).
\398\ See letters from ISDA I (stating that the use of
``effective notional amount'' in the test introduces ambiguity and
uncertainty) and WGCEF I (notional amounts should be measured on a
``delta-equivalent'' basis).
\399\ See letters from Farm Credit Council I (supporting
automatic periodic increases to reflect changes in market size, the
size of typical contracts and inflation), Greenberger (supporting
reevaluation of the de minimis criteria on an ongoing basis), and BG
LNG I, EEI/EPSA, NCFC I and WGCEF I (each supporting inflation or
market size adjustments).
\400\ See meeting with Edison Int'l (requesting clarification
that an entity that is prohibited from coordinating its financial
derivatives activities should determine whether it qualifies for the
de minimis exception without considering financial derivatives
entered into by its affiliated entities).
\401\ See letter from Covington & Burling (urging clarification
that lookback period will not commence until all the relevant
regulations become effective).
---------------------------------------------------------------------------

Some commenters suggested that the de minimis thresholds be set
higher initially to provide for efficient use of regulatory
resources.\402\ One commenter requested clarification that the
exception would apply prospectively without regard to dealing
activities taken prior to the effectiveness of Title VII.\403\ One
commenter requested that a person that falls above the de minimis tests
be able to take advantage of application and re-evaluation periods akin
to those associated with the major participant definitions.\404\
---------------------------------------------------------------------------

\402\ See letters from BGLNG I and WGCEF V. See also Roundtable
Transcript at 50-51 (remarks of Ron Oppenheimer, WGCEF), 57 (remarks
of Richard Ostrander, Morgan Stanley) and 208-09 (remarks of Bella
Sanevich, NISA Investment Advisors).
\403\ See letter from FSR I.
\404\ See letter from WGCEF I; see also Northland Energy
(supporting grace period for registration if the de minimis
threshold is exceeded).
---------------------------------------------------------------------------

Two commenters expressed support for the proposed self-executing
approach of the exception.\405\ Some commenters requested clarification
that the de minimis exception is independent of the loan origination
exclusion in the CEA ``swap dealer'' definition.\406\
---------------------------------------------------------------------------

\405\ See letters from ISDA I and Northland Energy.
\406\ See letters from FSR VI and Midsize Banks.
---------------------------------------------------------------------------

A number of commenters also addressed the application of dealer
regulation to non-U.S. entities. While those comments did not
specifically address the de minimis exception, the exception may be
relevant to addressing these cross-border issues.\407\
---------------------------------------------------------------------------

\407\ Some commenters particularly took the view that the
application of the dealer definitions to non-U.S. persons should
solely address those persons' U.S. dealing activities. See letters
from FSR I, ISDA I and Soci[eacute]t[eacute] G[eacute]n[eacute]rale.
Some commenters also specifically identified concerns of
international comity in this context. See letters cited in note 148,
supra.
The Commissions intend to address the application of dealer
regulation to non-U.S. persons as part of separate releases that
generally will address the application of Title VII to non-U.S.
persons.
---------------------------------------------------------------------------

One commenter separately addressed the credit default swap data
analysis made available by CFTC and SEC staffs.\408\ The commenter
expressed the view that this data supported the adoption of a de
minimis threshold of $100 million or less, particularly focusing on the
number of entities that may be excluded under particular
thresholds.\409\
---------------------------------------------------------------------------

\408\ See letter from Better Markets III.
\409\ See id.
---------------------------------------------------------------------------

3. Final Rules--General Principles for Implementing the De Minimis
Exception
a. Balancing Regulatory Goals and Burdens
The Commissions recognize that implementing the de minimis
exception requires a careful balancing that considers the regulatory
interests that could be undermined by an unduly broad exception as well
as those regulatory interests that may be promoted by an appropriately
limited exception.
On the one hand, a de minimis exception, by its nature, will
eliminate key counterparty protections provided by Title VII for
particular users of swaps and security-based swaps.\410\ The broader
the exception, the greater the loss of protection.\411\ Moreover, in
determining the scope of the exception, it is important to consider not
only the current state of the swap and security-based swap markets, but
also to account for how those markets may evolve in the future. This is
particularly important because the full implementation of Title VII--
including enhancements to pricing transparency and the increased access
to central clearing--reasonably may be expected to facilitate new
entrants into the swap and security-based swap markets. To the extent
that such entrants engage in dealing activity below the de minimis
threshold--either for the long term or until their activity surpasses
the threshold--the relative amount of unregistered activity within the
market may be expected to increase. Accordingly, a higher de minimis
threshold may not only result in a certain percentage of unregistered
activity being transacted initially, consistent with the current
market, but also may result in an even greater proportion of
unregistered activity being transacted in the future.
---------------------------------------------------------------------------

\410\ A number of commenters expressed particular concerns as to
the threats that an overbroad exception would pose to special
entities. See letters from AFR (noting that Congress incorporated
special protections for special entities in reaction to news reports
about special entities losing millions of dollars ``after signing up
for derivatives deals they did not understand,'' and urging the
elimination of any de minimis exception for transactions with
special entities); Better Markets I (stating that history has shown
that special entities are vulnerable to abuse, and that they need
capital, collateral and business conduct protections as much as or
more than any other category of market participants); and AFSCME
(expressing skepticism as to the view that dealer status would
preclude firms from entering into transactions with special
entities). Some of those commenters also generally supported the
proposed $100 million de minimis threshold. See letters from AFR and
Better Markets I; see also letter from Greenberger (stating that the
dynamic nature of the derivatives sector of the financial markets
should counsel caution, and that the de minimis threshold should be
reevaluated on an ongoing basis).
\411\ Notwithstanding the reduction in protection, however, in
the case of swaps and security-based swaps the general antifraud
provisions of the CEA and the securities laws, respectively,
including rules to be adopted by the SEC pertaining specifically to
security-based swaps, will continue to apply to all transactions in
security-based swaps. See, e.g., CEA section 4b(2), 7 U.S.C. 6b(2).
---------------------------------------------------------------------------

On the other hand, the Commissions also recognize that Congress
included a statutorily mandated de minimis exception for certain swap
and security-based swap dealing activity, and that an appropriately
calibrated de minimis exception has the potential to advance other
interests. For example, the de minimis exception may further the
interest of regulatory efficiency when

[[Page 30629]]

the amount of a person's dealing activity is, in the context of the
relevant market, limited to an amount that does not warrant
registration to address the concerns implicated by government
regulation of swap dealers and security-based swap dealers. To advance
this interest, it is necessary to consider the benefits to the
marketplace associated with the regulation of dealers against the total
burdens and potential impacts on competition, capital formation and
efficiency associated with that regulation.\412\
---------------------------------------------------------------------------

\412\ While we are mindful that the Commissions have yet to
adopt all the final substantive rules applicable to swap dealers and
security-based swap dealers, we nonetheless believe that we have
sufficient understanding of those potential requirements to
reasonably balance the relevant factors to identify the initial
level of dealing activity that should be considered to be de
minimis. Moreover, finalizing the dealer definitions will help
provide for the orderly and informed finalization of those other
substantive rules governing swap dealers and security-based swap
dealers.
---------------------------------------------------------------------------

In addition, the exception can provide an objective test for
persons who engage in some swap or security-based swap activities that,
in their view, potentially raise the risk that they would be deemed to
be dealers.\413\ The exception also may permit persons that are not
registered as dealers to accommodate existing clients that have a need
for swaps or security-based swaps in conjunction with other financial
services or commercial activities, thus avoiding the need for such
clients to establish separate relationships with registered dealers,
which may have attendant costs. The exception further may promote
competition in dealing activity within the swap or security-based swap
markets, by helping to allow non-registered persons to commence
providing dealing services while avoiding the costs associated with
full-fledged dealers. More competition within the market for swaps and
security-based swaps may not only decrease the costs for participants
in the market, but also may help to decrease systemic risk by lessening
the current apparent concentration of dealing activity among a few
major market participants.\414\
---------------------------------------------------------------------------

\413\ ``Congress incorporated a de minimis exception to the Swap
Dealer definition to ensure that smaller institutions that are
responsibly managing their commercial risk are not inadvertently
pulled into additional regulation.'' See 156 Cong. Rec. S6192 (daily
ed. July 22, 2010) (letter from Senators Dodd and Lincoln to
Representatives Frank and Peterson).
\414\ See 478 through 487 and accompanying text, infra.
---------------------------------------------------------------------------

The statutory requirements that apply to swap dealers and security-
based swap dealers include requirements aimed at the protection of
customers and counterparties,\415\ as discussed above, as well as
requirements aimed at helping to promote effective operation and
transparency of the swap and security-based swap markets.\416\ The
overall economic benefits provided by these requirements in large part
will depend on the proportion of swaps and security-based swaps that
are transacted subject to these requirements. In other words, the
greater the dealing activity of a registered dealer, the more
significant the resulting increase in market efficiency,\417\ and the
greater the reduction in risks faced by the entity's customers and
counterparties.\418\ These benefits can be expected to accrue over the
long term and be distributed over the market and its participants as a
whole. This is not to say, however, that it would be insignificant for
any particular counterparty if its swaps or security-based swaps were
to fall outside of the ambit of dealer regulation. For example, a
customer or counterparty that is not protected by the business conduct
rules applicable to dealers might be more likely to suffer losses
associated with entering into an inappropriate or misunderstood swap or
security-based swap than if the instrument was transacted pursuant to
the business conduct rules applicable to registered dealers.
---------------------------------------------------------------------------

\415\ As discussed above, in part, these customer and
counterparty protections derive from the financial responsibility
requirements applicable to dealers, particularly: capital and margin
requirements (CEA section 4s(e); Exchange Act section 15F(e)), and
requirements for segregation of collateral (CEA sections 4d(f),
4s(l); Exchange Act section 3E).
These customer and counterparty protections also derive from
certain other requirements applicable to dealers, particularly:
requirements with respect to business conduct when transacting with
special entities (CEA sections 4s(h)(2), 4s(h)(4), 4s(h)(5);
Exchange Act sections 15F(h)(2), (h)(4), (h)(5)); disclosure
requirements (CEA section 4s(h)(3)(B); Exchange Act section
15F(h)(3)(B)); requirements for fair and balanced communications
(CEA section 4s(h)(3)(D); Exchange Act section 15F(h)(3)(C)); other
requirements related to the public interest and investor protection
(CEA section 4s(h)(3)(D); Exchange Act section 15F(h)(3)(D)); and
conflict of interest provisions (CEA section 4s(j)(5); Exchange Act
section 15F(j)(5)).
\416\ Relevant provisions are: reporting and recordkeeping
requirements (CEA section 4s(f); Exchange Act section 15F(f)); daily
trading records requirements (CEA section 4s(g); Exchange Act
section 15F(g)); regulatory standards related to the confirmation,
processing, netting, documentation and valuation of security-based
swaps (CEA section 4s(i); Exchange Act section 15F(i)); position
limit monitoring requirements (CEA section 4s(j)(1); Exchange Act
section 15F(j)(1)); risk management procedure requirements (CEA
section 4s(j)(2); Exchange Act section 15F(j)(2)); and requirements
related to the disclosure of information to regulators (CEA section
4s(j)(3); Exchange Act section 15F(j)(3)).
\417\ For example, the more swaps or security-based swaps a
dealer enters into, the more significant will be the efficiency
benefits associated with confirmation, processing, netting
documentation and valuation requirements applicable to dealers.
\418\ For example, the more swaps or security-based swaps a
dealer enters into, the more significant the number of
counterparties that will be protected by the disclosure and other
business conduct obligations imposed on dealers.
---------------------------------------------------------------------------

In contrast to the benefits associated with dealer regulation, many
of the burdens of dealer regulation will accrue in the short term and
will fall directly on registered dealers.\419\ Some of those burdens
may be expected to be independent of the amount of an entity's dealing
activity (i.e., entities that engage in minimal dealing activity would
still be expected to face certain burdens associated with the
registration process and the development of compliance and other
systems if they are required to register as dealers), while other
burdens (e.g., the impact of margin and capital rules applicable to
dealers) may be more directly linked to the amount of that entity's
dealing activity.
---------------------------------------------------------------------------

\419\ Certain commenters also have expressed concerns that the
prospect of regulation may deter certain entities from engaging in
limited swap or security-based swap dealing activities, see, e.g.,
letters from SIFMA--Regional Dealers and Midsize Banks, which could
reduce the availability of those instruments.
---------------------------------------------------------------------------

As discussed below, the Commissions have sought to balance the
various interests associated with a de minimis exception, as well as
the benefits and burdens associated with such an exception, in
developing the factors to implement the de minimis exceptions to the
``swap dealer'' and ``security-based swap dealer'' definitions.
However, in moving forward with implementing this balancing
approach, we recognize that the information that currently is available
regarding certain portions of the swap market is limited. Following the
full implementation of Title VII, more information will be available to
permit us to assess the effectiveness of this balancing for particular
markets and to revise the exception as appropriate.
In that context--and in light of the tools currently available to
us--we have been influenced, in particular, by comments taking the view
that the de minimis factors should take into account the size and
unique attributes of the market for swaps and security-based
swaps.\420\ We believe that factors that exclude entities whose dealing
activity is sufficiently modest in light of the total size,
concentration and other attributes of the applicable markets can be
useful in avoiding the imposition of

[[Page 30630]]

regulatory burdens on those entities for which dealer regulation would
not be expected to contribute significantly to advancing the customer
protection, market efficiency and transparency objectives of dealer
regulation. The Commissions note, however, that they are not of the
general view that the costs of extending regulation to any particular
entity must be outweighed by the quantifiable or other benefits to be
achieved with respect to that particular entity. The Commissions,
rather, analyze the overall benefits and costs of regulation, keeping
in mind, as noted above, that the benefits may be distributed, accrue
over the long-term, and be difficult to quantify or to measure as
easily as certain costs.\421\
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\420\ See, e.g., letters from CDEU (comparing proposed
thresholds with statistics regarding the activities of recognized
dealers) and EEI/EPSA (recommending that thresholds be set at an
amount equal to 0.001 percent of the aggregate size of the U.S.
swaps market, and 0.0001 percent for swaps in which the counterparty
is a special entity).
\421\ For example, it does not appear possible to demonstrate
empirically--let alone quantify--the increase or decrease in the
possibility that a financial crisis would occur at a particular
future time and with a particular intensity in the absence of
financial regulation or as a result of varying levels or types of
financial regulation. It also is difficult to demonstrate
empirically that the customer protections associated with dealer
regulation would increase or decrease the likelihood that any
particular market participant would suffer injury (or the degree to
which the participant would suffer injury) associated with entering
into an inappropriate swap or security-based swap. At the same time,
certain costs may also not be readily susceptible to quantification
or measurement, for example, the costs that might be associated with
diminished presence, if any, of new entrants. The inability to
quantify these benefits and costs does not mean that the benefits
and costs of dealer regulation are any less substantial.
---------------------------------------------------------------------------

b. Specific Factors Implementing the De Minimis Exception
i. Notional Test
Consistent with the proposal, the final rules implementing the de
minimis exception take into account the notional amount of an entity's
swap or security-based swap positions over the prior 12 months arising
from its dealing activity.\422\ While the Commissions recognize that
notional amounts do not directly measure the exposure or risk
associated with a swap or security-based swap position, such measures
do reflect the relative amount of an entity's dealing activity.\423\
Moreover, although some commenters have posited measures of risk or
exposure as alternatives to notional measures, such risk or exposure
measures could, to the extent they allow for netting or collateral
offsets, potentially allow an unregistered entity to engage in large
amounts of swap or security-based swap dealing activity while remaining
within the de minimis exception so long as that entity nets or
collateralizes its swap or security-based swap positions. Such an
outcome could undermine the customer protection and market operation
benefits associated with dealer regulation. As with the proposed rules,
the notional factor in the final rules is based on the notional
positions of an entity over a 12 month period, rather than capping the
current notional amount of a position at any time, to better reflect
the amount of an entity's current activity.
---------------------------------------------------------------------------

\422\ See CFTC Regulation Sec. 1.3(ggg)(4); Exchange Act rule
3a71-2(a)(1). Over the first year following the effective date of
the final rules implementing the statutory definition of ``swap''
and ``security-based swap'' as set forth in CEA section 1a(47) and
Exchange Act section 3(a)(68), respectively, this notional test will
be based on the person's dealing activity following that effective
date. See id. Accordingly, the analysis of whether a person may take
advantage of the de minimis exception will not encompass the
person's dealing activity prior to that effective date, given the
need for the person to know whether an instrument is a swap or
security-based swap for purposes of the analysis.
\423\ ``Changes in notional volumes are generally reasonable
reflections of business activity, and therefore can provide insight
into potential revenue and operational issues. However, the notional
amount of derivatives contracts does not provide a useful measure of
either market or credit risks.'' OCC Quarterly Report at 8.
---------------------------------------------------------------------------

The final rules, like the proposed rules, include lower notional
thresholds for dealing activities in which the counterparty is a
``special entity.'' \424\ This is consistent with the fact that Title
VII's requirements applicable to swap dealers and security-based swap
dealers provide heightened protection to those types of entities.\425\
It is important that the de minimis exception not undermine those
statutory protections.\426\ Also, consistent with the Proposing
Release, these notional standards will be based on ``effective
notional'' amounts when the stated notional amount is leveraged or
enhanced by the structure of the swap or security-based swap.\427\
---------------------------------------------------------------------------

\424\ For these purposes, ``special entity'' means: (i) A
Federal agency; (ii) a state, state agency, city, county,
municipality, or other political subdivision of a state; (iii) any
employee benefit plan, as defined in section 3 of the Employee
Retirement Income Security Act of 1974 (``ERISA''); (iv) any
governmental plan, as defined in section 3 of ERISA; or (v) any
endowment, including an endowment that is an organization described
in section 501(c)(3) of the Internal Revenue Code of 1986. See CEA
section 4s(h)(2)(C) and CFTC Regulation Sec. 23.401(c); Exchange
Act section 15F(h)(2)(C).
\425\ See CEA sections 4s(h)(2), (4), (5); see also CFTC,
Business Conduct Standards for Swap Dealers and Major Swap
Participants with Counterparties; Final Rule, 77 FR 9733 (Feb. 17,
2012); Exchange Act sections 15F(h)(2), (4), (5) (providing
additional requirements for dealers that advise special entities or
that enter into swaps or security-based swaps with special
entities).
\426\ The importance of the statutory protections for special
entities has been highlighted by the SEC's recent action in
connection with the inappropriate sale of notes linked to the
performance of synthetic collateralized debt obligations to a number
of school districts. According to a complaint filed in federal
district court, these securities were unsuitable for the investment
needs of the school districts, were sold to school districts that
lacked the requisite sophistication and experience to independently
evaluate the risks of the investment, and exposed the school
districts to a heightened risk of catastrophic loss ultimately led
to a complete loss of their investments. ``SEC Charges Stifel,
Nicolaus and Former Executive with Fraud in Sale of Investments to
Wisconsin School Districts,'' SEC Litigation Release No. 22064 (Aug.
10, 2011) (http://www.sec.gov/litigation/litreleases/2011/lr22064.htm).
\427\ For example, if an exchange of payments associated with a
$1 million notional equity swap was based on three times the return
associated with the underlying equity, the effective notional amount
of the equity swap would be $3 million.
---------------------------------------------------------------------------

ii. Other Tests From the Proposing Release
The proposed rules limited the number of swaps or security-based
swaps that an entity could enter into in a dealing capacity, and the
number of an entity's counterparties in a dealing capacity. The final
rules do not include those measures. In part, this reflects commenter
concerns that a standard based on the number of swaps or security-based
swaps or counterparties can produce arbitrary results by giving
disproportionate weight to a series of smaller transactions or
counterparties.\428\
---------------------------------------------------------------------------

\428\ See, e.g., letter from COPE I.
---------------------------------------------------------------------------

c. Significance of Statutory ``Customer'' Language
Consistent with the Proposing Release, the final rules implementing
the de minimis exception do not require the presence of any type of
defined ``customer'' relationship.
In adopting these rules the Commissions have considered alternative
approaches suggested by commenters, including one commenter's
suggestion that the de minimis exception should be available only in
connection with swaps or security-based swaps entered into as part of a
``customer'' relationship.\429\ In considering that alternative view,
however, we believe that it is significant that the statutory exception
lacks terminology such as ``existing'' or ``preexisting'' that limits
the availability of the exception or otherwise to distinguishes a
``customer'' relationship from other types of counterparty
relationship. Also, while that alternative view could still permit an
unregistered person to provide limited dealer services as an
accommodation to an existing customer or counterparty, an
interpretation that predicates the exception on the presence of a
particular type of ``customer'' relationship would not advance other
potential benefits associated with a de minimis exception, including
the

[[Page 30631]]

benefit of providing certainty in connection with the swap or security-
based swap activities of end-users.\430\ Accordingly, we do not believe
that the ``customer'' reference standing alone provides a sufficient
basis to conclude that the exception should only be available if there
is an existing relationship of some type, and the final rules neither
require that a dealer accommodate the demand of an existing customer
nor require the presence of a preexisting relationship for the
exception to apply.
---------------------------------------------------------------------------

\429\ See letter from Better Markets I.
\430\ As discussed above, see note 413, supra, there is
legislative history that suggests that an intended purpose of the
exception would be to ensure that the dealer definition does not
encompass ``smaller institutions that are responsibly managing their
commercial risk.''
---------------------------------------------------------------------------

We also are not persuaded by the different commenter suggestion
that the statutory de minimis exception's ``customer'' language means
that an unregistered dealer should be permitted to engage in unlimited
dealing activity so long as its counterparties are not customers.\431\
Such an unlimited exception would appear to be contrary to the express
language of the statutory exception. In addition, such an approach
would lead to the perverse result of discouraging entities from
entering into swaps or security-based swaps to facilitate risk
management activities of customers (while encouraging other dealing
activities), which appears contrary to Title VII's general approach of
seeking to limit undue impacts on the swap and security-based swap
activities of commercial end-users.
---------------------------------------------------------------------------

\431\ See, e.g., letter from ISDA I.
---------------------------------------------------------------------------

d. Focus on ``Dealing'' Activity
Some commenters suggested that we clarify that the limitations
associated with the de minimis exception apply only in connection with
a person's dealing activities, and not to the person's hedging or
proprietary trading activities.\432\ The Commissions agree that the de
minimis exception is intended to permit an unregistered person to
engage in a limited amount of dealing activity without regard to the
person's non-dealing activity. Thus, to the extent that a particular
swap or security-based swap position is not connected to dealing
activity under the applicable interpretation of the statutory dealer
definition, it will not count against the de minimis thresholds.
Conversely, if a swap or security-based swap position is connected to
the person's dealing activity, the position will count against those
thresholds.\433\
---------------------------------------------------------------------------

\432\ See, e.g., letters from SIFMA--Regional Dealers and EDF
Trading.
\433\ For purposes of the de minimis exception to the security-
based swap dealer definition, we note that one indicator of dealing
activity under the dealer-trader distinction is that a person profit
by providing liquidity in connection with security-based swaps.
Accordingly, for purposes of the de minimis exception to the
security-based swap dealer definition, a security-based swap
position that hedges or otherwise offsets a position that was
entered into as part of dealing activity would itself comprise part
of the person's dealing activity, and hence count against the de
minimis thresholds.
For purposes of the de minimis exception to the swap dealer
definition, we take the view that the relevant question in
determining whether swaps count as dealing activity against the de
minimis thresholds is whether the swaps fall within the swap dealer
definition under the statute and the final rules, as further
interpreted by this Adopting Release. If hedging or proprietary
trading activities did not fall within the definition, including
because of the application of CFTC Regulation Sec. 1.3(ggg)(6),
they would not count against the de minimis thresholds.
---------------------------------------------------------------------------

Commenters also requested clarification that the de minimis
thresholds do not apply to a person's inter-affiliate swaps and
security-based swaps, nor apply to swaps covered by the exclusion for
swaps entered into by insured depository institutions in connection
with the origination of loans to customers.\434\ Consistent with the
discussion above,\435\ such swaps or security-based swaps do not
constitute dealing activity and should not be counted against the de
minimis thresholds. Similarly, swaps between a cooperative and its
members, as provided in CFTC Regulation Sec. 1.3(ggg)(6)(ii), and
swaps entered into for the hedging purpose defined in CFTC Regulation
Sec. 1.3(ggg)(6)(iii) should not be counted against the de minimis
threshold.\436\
---------------------------------------------------------------------------

\434\ See, e.g., letters from Atmos Holdings and FSR I.
\435\ See parts II.B and II.C, supra.
\436\ Swaps and security-based swaps that hedge, mitigate, or
offset the types of swaps and security-based swaps discussed in the
foregoing paragraph, which do not constitute dealing activity,
similarly should not be counted against the de minimis thresholds.
---------------------------------------------------------------------------

In light of the increased notional thresholds of the final rules,
and the resulting opportunity for a person to evasively engage in large
amounts of dealing activity if it can multiply those thresholds, the
final rules provide that the notional thresholds to the de minimis
exception encompass swap and security-based swap dealing positions
entered into by an affiliate controlling, controlled by or under common
control with the person at issue.\437\ This is necessary to prevent
persons from avoiding dealer regulation by dividing up dealing activity
in excess of the notional thresholds among multiple affiliates.\438\
---------------------------------------------------------------------------

\437\ See CFTC Regulation Sec. 1.3(ggg)(4)(i); Exchange Act
rule 3a71-2(a)(1). For these purposes, we interpret control to mean
the possession, direct or indirect, of the power to direct or cause
the direction of the management and policies of a person, whether
through the ownership of voting securities, by contract or
otherwise. This is consistent with the definition of ``control'' and
``affiliate'' in connection with Exchange Act rules regarding
registration statements. See Exchange Act rule 12b-2.
The final rules use a control standard in connection with the
de minimis notional thresholds as a means reasonably designed to
prevent evasion of the limitations of that exception. This contrasts
with the majority-ownership standard used by the inter-affiliate
exclusions from the dealer and major participant definitions. See
parts II.C.2 and IV.G.2, infra. That majority-ownership standard,
which in application will not be expected to be satisfied in all
circumstances in which a control standard is satisfied, is
reasonably designed to reflect the economic alignment that
appropriately underpins those exclusions.
\438\ In other words, for example, if a parent entity controls
two subsidiaries which both engage in activities that would cause
the subsidiaries to be covered by the dealer definitions, then each
subsidiary must aggregate the swaps or security-based swaps that
result from both subsidiaries' dealing activities in determining if
either subsidiary qualifies for the de minimis exception.
The SEC expects to address the application of this principle to
the security-based swap activities of non-U.S. persons in a separate
release.
---------------------------------------------------------------------------

e. Alternative Approaches We Are Not Following
Certain commenters have suggested alternative approaches to
implementing the de minimis exception. While the Commissions have
considered those suggested alternatives, we do not believe that they
provide the optimal framework for implementing the exception.
For example, some commenters took the position that the de minimis
exception should focus dealer regulation on those entities whose
dealing activities pose systemic risk, and excuse other dealers from
having to register.\439\ Such an approach, however, would fail to
account for regulatory interests apart from the control of systemic
risk that are addressed by dealer regulation, including statutory
provisions that protect customers and counterparties in other ways, and
that promote effective market operations and transparency.\440\
---------------------------------------------------------------------------

\439\ See, e.g., letters from CDEU and SIFMA--Regional Dealers.
\440\ We also disagree with the suggestion that it would be
inconsistent with the Title VII framework to consider customer
protection issues in setting the de minimis factors. See letter from
WGCEF I. While the restrictions on the availability of swaps and
security-based swaps to non-ECPs help to mitigate certain customer
protection concerns, Title VII includes specific safeguards designed
to protect dealers' customers and counterparties regardless of
whether those are ECPs. It would not be consistent with Title VII to
ignore those interests.
---------------------------------------------------------------------------

Some commenters also have suggested that the de minimis exception
should subsume a proportionality

[[Page 30632]]

standard, whereby an entity may be excluded from dealer regulation if
its dealing activity comprises only a relatively small portion of its
overall activities (or its overall swap or security-based swap
activities), or if its dealing activity is ``tangential'' to its
principal business.\441\ We are not incorporating that type of approach
into the de minimis factors, however, because that approach would not
appear to provide a logical way to balance the benefits and burdens of
dealer regulation. A proportionality approach could permit a large
entity to engage in a significant amount of dealing activity without
being subject to dealer regulation, thus undermining the benefits of
dealer regulation. Moreover, a proportionality approach could lead to
arbitrary results by excusing a large entity from dealer regulation
while requiring the registration of a smaller entity that engages in
less total dealing activity (if that smaller amount of dealing activity
comprises a greater portion of the smaller entity's total
activity).\442\
---------------------------------------------------------------------------

\441\ See letter from FHLB I.
\442\ As discussed below, if an entity is a dealer, the
regulations applicable to dealers in general will govern all of the
entity's swap or security-based swap activities and positions.
Depending on the applicable facts and circumstances, however, the
entity may be able to avail itself of a limited purpose designation
as a dealer. See part II.E, infra.
---------------------------------------------------------------------------

Some commenters also supported the use of non-quantitative
standards in connection with the de minimis exception.\443\ Although we
recognize that such an approach may help us weigh the facts and
circumstances associated with a particular person's dealing activity,
we believe that it is more appropriate to base the exception on an
objective quantitative standard, to allow the exception to be self-
executing, and to promote predictability among market participants and
the efficient use of regulatory resources. Unlike the overall
definitions of ``swap dealer'' and ``security-based swap dealers,''
which consider the entirety of a person's activities with respect to
swaps, the de minimis exception is only relevant to persons who have
determined that they are engaged in swap or security-based swap
dealing, and are looking to determine whether the quantity of their
dealing activity is de minimis. For this more particular and focused
determination, an objective quantitative standard is more appropriate.
---------------------------------------------------------------------------

\443\ See letters from FHLB I, Gavilon II, and MFX II.
---------------------------------------------------------------------------

Commenters also made various suggestions as to the types of factors
and accompanying thresholds that should be used in connection with the
de minimis exception. Those suggestions are addressed more specifically
below in the specific context of the swap dealer and security-based
swap dealer de minimis exceptions.
4. Final Rules--De Minimis Exception to Swap Dealer Definition
a. Overview of the Final Rule
After considering commenters' views, the final rule implementing
the de minimis exception caps an entity's dealing activity involving
swaps at $3 billion over the prior 12 months.\444\ This amount is based
on input from commenters and is supported by several rationales,
including the estimated size of the domestic swap market, among others.
---------------------------------------------------------------------------

\444\ CFTC Regulation Sec. 1.3(ggg)(4). As noted above, for the
first year following the effective date of the rules implementing
the definition of ``swap'' the analysis would only address activity
following that effective date. For clarity, the final rule also has
been revised from the proposal to provide that persons taking
advantage of the exception ``shall be deemed not to be'' swap
dealers (the proposed rule used the phrasing ``shall not be deemed
to be'' swap dealers) The final rule also reflects certain
structural changes consistent with the substantive changes from the
proposed rule. In addition, as discussed above, see part II.D.3.d,
supra, the final rule has been revised to provide that the notional
thresholds to the de minimis exception encompass swap dealing
positions entered into by an affiliate controlling, controlled by or
under common control with the person at issue.
---------------------------------------------------------------------------

As noted above, commenters who suggested a fixed notional standard
proposed that the standard be set at a level between $200 million and
$3.5 billion in notional amount of swaps entered into over a period of
twelve months.\445\ In considering these comments, we are mindful of
the variety of uses of swaps in various markets and therefore it is
understandable that various commenters would reach different
conclusions regarding the appropriate standard. At the same time, we
see value in setting a single standard for all swaps so that there is a
``level playing field'' for all market participants and so that the
standard can be implemented easily without the need to categorize
swaps. Considering the written input of the commenters as well as the
discussions of the de minimis standard at the Commissions' joint
roundtable and numerous meetings with market participants, and the
benefits of the regulation of swap dealers (i.e., protection of
customers and counterparties, and promotion of the effective operation
and transparency of the swap markets), we believe a notional standard
at a level of $3 billion appropriately balances the relevant regulatory
goals.
---------------------------------------------------------------------------

\445\ One commenter suggested a threshold of $3 billion. See
letter from COPE I (suggesting 0.001% of the total U.S. swap market,
amounting to approximately $3 billion). Other commenters also
supported a threshold of 0.001% of the total U.S. swap market. See
letters cited in note 382, supra.
---------------------------------------------------------------------------

As noted above, several commenters suggested that the standard be
set at an amount equal to 0.001 percent of the overall domestic market
for swaps. The Commissions note, however, that comprehensive
information regarding the total size of the domestic swap market is
incomplete, with more information available with respect to certain
asset classes than others. The CFTC evaluated data regarding one
particular type of swap--credit default swaps (``CDS'') based on
indices of debt securities known as ``index CDS''--that was provided by
the SEC.\446\ As noted in the CFTC analysis of this data, however, the
information is not filtered to reflect activity that would constitute
swap dealing under the Dodd-Frank Act, so it is not possible to use the
data to draw conclusions regarding any specific entity's status as a
swap dealer.\447\ The data reflects only activity relating to index
CDS, which constitute a very narrow part of the overall swap market,
and, as noted in the CFTC analysis, similar data regarding other types
of swaps is not available.\448\ Subject to these limitations, the data
may help evaluate the impact of alternative approaches to implementing
the de minimis exception.
---------------------------------------------------------------------------

\446\ The CFTC analysis was made available to the public. See
memorandum to the public comment file from the CFTC Office of the
Chief Economist.
\447\ See id.
\448\ See id.
---------------------------------------------------------------------------

One often-cited measure of the market, the Quarterly Report on Bank
Trading and Derivatives Activities issued by the OCC (``OCC Quarterly
Report'') is both limited, in that it includes only data related to the
activities of U.S. bank holding companies, commercial banks and trust
companies, and over-inclusive, in that it includes activities related
to instruments that are not or may not be included in the final
definition of ``swap'' (including futures, forwards, certain foreign
exchange instruments, and certain options) and it includes both swaps
and security-based swaps. Nonetheless, the Commissions believe that the
available (imperfect) data suggests that a $3 billion notional standard
is generally consistent with the commenters' suggestion of basing the
standard on a percentage of the overall domestic market for swaps.
The total notional value of $333.1 trillion in ``derivatives''
stated in the most recent OCC Quarterly Report includes approximately
$221.1 trillion

[[Page 30633]]

in ``swaps'' and ``credit derivatives.'' \449\ Since some instruments
that are security-based swaps are included in this total,\450\ the
total notional value of swap positions at U.S. bank holding companies,
commercial banks and trust companies at the end of the second quarter
of 2011 of may be estimated to be somewhat less than $221.1 trillion.
---------------------------------------------------------------------------

\449\ See Office of the Comptroller of the Currency, ``Quarterly
Report on Bank Trading and Derivatives Activities, Second Quarter
2011'' at tables 1 and 2 (http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq211.pdf). These totals
reflect the sum of the amounts reported for the top 25 bank holding
companies reported in table 1 and for all but the top 25 commercial
banks and trust companies reported in table 2.
However, this adjustment is only approximate, because the
definitions of ``swap'' and ``credit derivative'' used in the OCC
Quarterly Report are likely to be significantly different from the
final definition of ``swap'' and ``security-based swap'' for
purposes of the Dodd-Frank Act. For the same reason, it is uncertain
how many of the notional value of $54.5 trillion in options reported
in the OCC Quarterly Report are swaps or security-based swaps.
Also, data from the CDS trade information warehouse maintained
by the Depository Trust & Clearing Corporation (``DTCC'') indicates
that total global notional CDS positions on indices amount to
approximately $10.47 trillion. See http://dtcc.com/products/derivserv/data_table_i.php?tbid=3 (data for the week ending
October 7, 2011, obtained on October 17, 2011).
\450\ See part II.D.5, infra, for a discussion of the size of
the security-based swap market.
---------------------------------------------------------------------------

This total notional value is by nature under-inclusive, because it
reflects only swap positions at U.S. bank holding companies, commercial
banks and trust companies and not the swap positions of other market
participants. However, there are also reasons that the information from
the OCC Quarterly Report may overstate the notional value of swaps that
would be relevant to estimating the size of the domestic swap market
for purposes of the de minimis standard. While we believe the data is
not sufficiently precise at this time to serve as the sole basis for
the notional standard, a standard of $3 billion seems that it is likely
generally consistent with 0.001 percent of the domestic swap market
that would be relevant to a potential dealer's de minimis swap activity
figure. First, the large majority of derivatives in the OCC Quarterly
Report (approximately $229 trillion in notional value for commercial
banks and trust companies) are derivatives between ``dealers'' (as
defined for the purposes of the report.) \451\ Thus, it is likely that
a large part of the derivatives in the OCC Quarterly Report reflect
transactions between financial institutions that will be swap dealers.
It is also notable that approximately $204.6 trillion in notional value
of the derivatives (i.e., not only swaps) reported by U.S. commercial
banks were interest rate contracts, many of which are swaps entered
into by IDIs with customers in connection with the origination of loans
which will be excluded from the determination of whether the IDIs are
swap dealers.\452\ Finally, the OCC Quarterly Report measures swap
positions held at a certain point in time, rather than the level of
swap activity over a certain time period, again indicating that the
figures are broader than those that would be subject to the de minimis
figure. Accordingly, it appears that notional amount of the overall
domestic market for swaps that actually would be relevant to
determining the notional standard, and thus the appropriate basis for
the 0.001 percent calculation, may be significantly lower than $331
trillion.
---------------------------------------------------------------------------

\451\ See OCC Quarterly Report at Graph 1.
\452\ See OCC Quarterly Report at Graph 3.
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Because there is merit in the 0.001 percent ratio suggested by
several commenters, we believe an appropriate balance of the goal of
promoting the benefits of regulation (while recognizing the
unquantifiable nature of those benefits) against the competing goal of
avoiding the imposition of burdens on those entities for which
regulation as a dealer would not be associated with achieving those
benefits in a significant way, would be reached by setting the notional
standard for swaps at a level that is near (taking into account the
uncertainties noted above) 0.001 percent of a reasonable estimate of
the overall domestic market for all swaps between all counterparties.
We believe a $3 billion notional value standard is appropriate taking
all these considerations into account.
b. Dealing Activity Involving Special Entities
For swaps in which the counterparty is a special entity, the final
rules set a notional standard consistent with the proposal of $25
million over the prior 12 months.\453\ The Commissions believe that
this notional standard is appropriate in light of the special
protections that Title VII affords to special entities. In adopting
this threshold, we recognize the serious concerns raised by commenters
stating that the de minimis exception should not permit any dealing
activities (by persons who are not registered as swap dealers)
involving special entities, in light of losses that special entities
have incurred in the financial markets.\454\ However, the final rule
does not fully exclude such dealing activity from the exception, in
light of the potential benefits that may arise from a de minimis
exception. In this way, the threshold would not completely foreclose
the availability of swaps to special entities from unregistered
dealers, but the threshold would limit the financial and other risks
associated with those positions for a special entity, which would in
turn limit the possibility of inappropriately undermining the special
protections that Title VII provides to special entities.
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\453\ CFTC Regulation Sec. 1.3(ggg)(4)(i).
\454\ See letters from AFR and Better Markets I.
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c. Phase-in Procedure
The Commissions believe that a phase-in period for the de minimis
threshold would facilitate the orderly implementation of Title VII by
permitting market participants and the Commissions to familiarize
themselves with the application of the swap dealer definition and swap
dealer requirements and to consider the information that will be
available about the swap market, including real-time public reporting
of swap data and information reported to swap data repositories. In
addition, a phase-in period would afford the Commissions additional
time to study the swap markets as they evolve in the new regulatory
framework and allow potential swap dealers that engage in smaller
amounts of activity (relative to the current size of the market)
additional time to adjust their business practices, while at the same
time preserving a focus on the regulation of the largest and most
significant swap dealers. The Commissions also recognize that the data
informing their current view of the de minimis threshold is based on
the markets as they exist today, and that the markets will evolve over
the coming years in light of the new regulatory framework and other
developments.
We have also considered that there may be some uncertainty
regarding the exact level of swap dealing activity, measured in terms
of a gross notional amount of swaps, that should be regarded as de
minimis. While some quantitative data regarding the usage of swaps is
available, there are many aspects of the swap markets for which
definitive data is not available. We have also considered comments
suggesting that the de minimis thresholds should be set higher
initially to provide for efficient use of regulatory resources,\455\ or
that implementation of the dealer requirements should be phased.\456\
For

[[Page 30634]]

all these reasons, the Commissions believe it is appropriate that the
final rules provide for a phase-in period following the effective date
during which higher de minimis thresholds would apply.
---------------------------------------------------------------------------

\455\ See letters cited in footnote 402, supra.
\456\ See, e.g., Roundtable Transcript at 35 (remarks of Ron
Filler, New York Law School) and letters from FSR dated May 12, 2011
(``FSR III'') and WGCEF V.
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In particular, during this phase-in period, a person's swap dealing
activity over the prior 12 months is capped at a gross notional value
of $8 billion.\457\ With respect to swaps with special entities, the
Commissions believe it is appropriate that the $25 million gross
notional value threshold apply during the phase-in period.\458\ In
light of the available data--and the limitations of that data in
predicting how the full implementation of Title VII will affect dealing
activity in the swap markets--the Commissions believe that the
appropriate threshold for the phase-in period is an annual gross
notional level of swap dealing activity of $8 billion or less. In
particular, the $8 billion level should still lead to the regulation of
persons responsible for the vast majority of dealing activity within
the swap markets.
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\457\ See CFTC Regulation Sec. 1.3(ggg)(4)(i).
\458\ This limitation regarding swaps with special entities
during the phase-in period is consistent with the Dodd-Frank Act's
goal of helping special entities be in a position to benefit from
the counterparty protections associated with the regulation of
registered swap dealers under Title VII.
---------------------------------------------------------------------------

Accordingly, the Commissions believe that while a $3 billion
notional threshold reflects an appropriate long-term standard based on
the available data,\459\ it also is appropriate to allow a degree of
latitude in applying the threshold over time in the event that
subsequent developments in the markets or the evaluation of new data
from swap data reporting facilities suggest that the thresholds should
be adjusted. In particular, the implementation of swap data reporting
under the Dodd-Frank Act may result in new data that would be useful in
confirming the Commissions' determination to establish the $3 billion
threshold which applies after the phase-in period.
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\459\ See, e.g., part II.D.4.a, supra.
---------------------------------------------------------------------------

For these reasons, review of the de minimis exception will comprise
an important part of the reports that the CFTC is directing its staff
to conduct with regard to the swap dealer definition during the phase-
in period. Among other topics, the report should consider market data
addressing swap dealing activity over a period of approximately two
years, and any resulting changes in swap dealing activity, by dealers
above and below the $8 billion phase-in threshold, and above and below
the $3 billion level applicable after the phase-in period. The report
is required to be completed by the CFTC staff no later than 30 months
following the date that a swap data repository first receives swap data
under the CFTC's regulations, and the report will be published for
public comment.\460\ The CFTC will take this report, in conjunction
with any public comment on it, into account in weighing further action
on the de minimis exception at the end of the phase-in period.
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\460\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(C).
---------------------------------------------------------------------------

The final rules provide that nine months after publication of its
staff report, the CFTC may, in its discretion, either promulgate an
order that the phase-in period will end as of the date set forth by the
CFTC in that order, or issue for public comment a notice of proposed
rulemaking to modify the de minimis threshold, in which case the CFTC
would also issue an order establishing the date that the phase-in
period will end.\461\ The period of nine months provided in the rule is
intended to provide the CFTC an opportunity to consider its staff
report, public comments on the staff report and any other relevant
information.
---------------------------------------------------------------------------

\461\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(C).
---------------------------------------------------------------------------

The CFTC recognizes that the determination of the appropriate de
minimis threshold is a significant issue requiring thorough
consideration of a variety of regulatory and market factors. At the
same time, the CFTC recognizes the need for predictability in how the
de minimis exception will apply. Therefore, the final rules include a
finality provision, stating that the phase-in period will end no later
than five years after the date that a swap data repository first
receives swap data under the CFTC's regulations.\462\
---------------------------------------------------------------------------

\462\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii)(D).
---------------------------------------------------------------------------

Persons who are able to avail themselves of the higher de minimis
threshold that applies during the phase-in period will not be required
to do so. In particular, a person that is engaged in dealing activity
involving swaps in excess of the $3 billion threshold may choose to
commence the process for registering as a swap dealer during the phase-
in period.\463\
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\463\ See CFTC Regulation Sec. 1.3(ggg)(4)(vi).
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d. CFTC Staff Report
As noted above, the CFTC is directing its staff to report to the
CFTC as to whether changes are warranted to the rules implementing the
swap dealer definition, including the rule implementing the de minimis
exception. We are mindful that following the full implementation of
Title VII--which itself is contingent on the implementation of the
dealer definition--more data will be available to the CFTC via swap
data repositories. We expect that this additional data will assist the
CFTC in testing the assumptions and addressing the effects of the final
rule we are adopting to implement the de minimis exception. For
example, this data should help the CFTC assess, among other things, the
nature and amount of unregulated dealing activity that occurs under the
$3 billion threshold. The CFTC will make this report available for
public comment so that it may benefit from additional input and
analysis regarding the swap dealer definition.
By making use of post-implementation data, the staff report
(together with public comment on the report) will help the CFTC better
evaluate the exception in light of potential market changes resulting
from the full implementation of Title VII--including market changes
resulting from the de minimis exception itself--as part of determining
whether revised de minimis thresholds would be appropriate. The report
and public comment thereon will also be taken into consideration by the
CFTC in determining what action, if any, to take with respect to the
phase-in period associated with the de minimis exception.
The final rules provide, moreover, that the CFTC may change the
requirements of the de minimis exception by rule or regulation.\464\
Through this mechanism, the CFTC may revisit the rule implementing the
exception and potentially change that rule, for example, if data
regarding the post-implementation swap market suggests that different
de minimis thresholds would be appropriate.\465\ In determining whether
to revisit the thresholds, the CFTC intends to pay particular attention
to whether the de minimis exception results in a swap dealer definition
that encompasses too many entities whose activities are not

[[Page 30635]]

significant enough to warrant full regulation under Title VII, or,
alternatively, whether the de minimis exception leads an undue amount
of dealing activity to fall outside of the ambit of the Title VII
regulatory framework, or leads to inappropriate reductions in
counterparty protections (including protections for special entities).
The CFTC also intends to pay particular attention to whether
alternative approaches would more effectively promote the regulatory
goals that may be associated with a de minimis exception.
---------------------------------------------------------------------------

\464\ CFTC Regulation Sec. 1.3(ggg)(4)(v). CEA section
1a(49)(D) (like Exchange Act section 3(a)(71)(D)) particularly
states that the ``Commission''--meaning the CFTC--may exempt de
minimis dealers and promulgate related regulations. We do not
interpret the joint rulemaking provisions of section 712(d) of the
Dodd-Frank Act to require joint rulemaking here, because such an
interpretation would read the term ``Commission'' out of CEA section
1a(49)(D) (and Exchange Act section 3(a)(71)(D)), which themselves
were added by the Dodd-Frank Act.
\465\ See letter from Greenberger (stating that the dynamic
nature of the derivatives sector of the financial markets should
counsel caution, and that the de minimis threshold should be
reevaluated on an ongoing basis).
---------------------------------------------------------------------------

5. Final Rules--De Minimis Exception to ``Security-Based Swap Dealer''
Definition
a. Overview of the Final Rule
The final rule implementing the de minimis exception to the
``security-based swap dealer'' definition has been revised from the
proposal in a number of ways. As discussed above, the final rule does
not incorporate proposed limits on the number of security-based swaps
that a person may enter into in a dealing capacity, or on the number of
security-based swap counterparties a person may have when acting in a
dealing capacity.\466\ Moreover, the provisions of the exception that
cap an unregistered person's annual notional dealing activity with
counterparties other than ``special entities'' have been increased from
the proposed $100 million threshold.\467\ Instead, the final rule caps
such dealing activity involving security-based swaps that are credit
default swaps--which largely would consist of single-name credit
default swaps--at $3 billion in notional amount over the prior 12
months.\468\ For other types of security-based swaps (e.g., single-name
or narrow-based equity swaps or total return swaps), the exception caps
an unregistered person's dealing activity at $150 million in notional
amount over the prior 12 months.\469\ Also, as addressed below, the
final rule provides for phase-in levels in excess of those $3 billion
and $150 million thresholds for a certain period of time.
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\466\ See part II.D.3.b, supra.
\467\ For clarity, the final rule also has been revised from the
proposal to provide that persons taking advantage of the exception
``shall be deemed not to be'' dealers (the proposed rule used the
phrasing ``shall not be deemed to be'' dealers), and to provide that
such persons ``shall not be subject to Section 15F of the Exchange
Act and the rules, regulations and interpretations issued
thereunder.'' See Exchange Act rule 3a71-2(a). The final rule also
reflects certain structural changes consistent with the substantive
changes from the proposed rule.
In addition, as discussed above, see part II.D.3.d, supra, the
final rule has been revised to provide that the notional thresholds
to the de minimis exception encompass swap and security-based swap
dealing positions entered into by an affiliate controlling,
controlled by or under common control with the person at issue.
\468\ Exchange Act rule 3a71-2(a)(1)(i). The final rule, like
the proposal, requires the analysis of de minimis levels to be based
on effective notional amounts to the extent that the stated notional
amount is leveraged or enhanced by the structure of the security-
based swap (such as, for example, if the exchange of payments
associated with an equity swap was based on a multiple of the return
associated with the underlying equity). See Exchange Act rule 3a71-
2(a)(3).
It is important to recognize that while these types of de
minimis principles are relevant to the ``security-based swap
dealer'' definition, they are not applicable to the general
definitions of ``broker'' and ``dealer'' under the Exchange Act, or
the broker-dealer registration requirements of Exchange Act section
15(a). Unlike the ``security-based swap dealer'' definition, those
other definitions, with the exception of the bank-broker definition
in section 3(a)(4)(B)(xi) of the Exchange Act, lack de minimis
exceptions.
\469\ Exchange Act rule 3a71-2(a)(1)(ii).
---------------------------------------------------------------------------

In addition, consistent with the proposal, the final rule caps an
unregistered person's security-based swap dealing activity involving
counterparties that are ``special entities'' at $25 million in notional
amount over the prior 12 months.\470\ The final rule further provides
that the SEC may establish alternative methods of determining the scope
of the de minimis exception by rule or regulation.\471\
---------------------------------------------------------------------------

\470\ Exchange Act rule 3a71-2(a)(1)(iii).
\471\ Exchange Act rule 3a71-2(d); see part II.D.5.f, infra.
---------------------------------------------------------------------------

b. Interests Associated With a De Minimis Exception
In developing this final rule, we have sought to balance the
interests advanced by the de minimis exception against the protections
that would be weakened were the exception applied in an overbroad
manner. In making this evaluation, we have taken into account data
regarding the security-based swap market and especially data regarding
the activity--including activity that may be suggestive of dealing
behavior--of participants in the single-name credit default swap
market.\472\
---------------------------------------------------------------------------

\472\ Certain data has been addressed by an analysis regarding
the market for single-name credit default swaps performed by the
SEC's Division of Risk, Strategy, and Financial Innovation. See
``Information regarding activities and positions of participants in
the single-name credit default swap market'' (Mar. 15, 2012)
(available at http://www.sec.gov/comments/s7-39-10/s73910-154.pdf)
(``CDS Data Analysis''). We believe that the data underlying this
analysis provides reasonably comprehensive information regarding the
credit default swap activities and positions of U.S. market
participants, but note that the data does not encompass those credit
default swaps that both: (i) do not involve U.S. counterparties; and
(ii) are based on non-U.S. reference entities. Our reliance on this
data, which we believe to be the best available, should not be
interpreted to indicate our views as to the nature or extent of the
application of Title VII to non-U.S. persons; instead, the SEC
anticipates that issues regarding the extraterritorial application
of Title VII will be addressed in a separate release.
As discussed below, see notes 476 and 485, infra, we also have
considered more limited publicly available data regarding equity
swaps.
The CDS Data Analysis also included an appendix of data
regarding index credit default swaps. We do not consider that data
for purposes of the analysis described in this section because the
statutory definition of ``security-based swap'' in relevant part
encompasses swaps based on single securities or on narrow-based
security indices. See Exchange Act sec. 3(a)(68)(A); see also
Exchange Act Release No. 64372, 76 FR 29818 (May 23, 2011) (proposed
rules further defining ``security-based swap'' and certain other
terms).
---------------------------------------------------------------------------

As discussed above, a de minimis exception eliminates key Title VII
protections for some market participants by regulating less dealer
activity. Conversely, an appropriately applied de minimis exception may
provide an objective test when there is doubt as to whether particular
activities may cause a person to be deemed to be a dealer; \473\ allow
non-dealers to accommodate the incidental security-based swap needs of
existing clients; and help to facilitate competition by allowing the
entry of new dealers into the market. In addition, as discussed above,
a de minimis exception may promote regulatory efficiency by providing a
framework to help focus dealer regulation upon those entities for which
such regulation is warranted, rather than upon entities that engage in
relatively limited amounts of dealing activity.\474\
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\473\ We believe that the application of the dealer-trader
distinction and the guidance we have provided that distinguishes
hedging activities from dealing activities in the security-based
swap market will also help dealers meet their obligations.
\474\ See part II.D.3.a, supra.
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i. Providing for Regulatory Coverage of the Vast Majority of Dealing
Activity
In seeking to develop a de minimis exception that preserves key
counterparty and market protections while promoting regulatory
efficiency, we have considered the comparative amount of security-based
swap dealing activity that could fall outside the ambit of dealer
regulation as a result of the exception. In doing so we have considered
not only the security-based swap market as it currently exists, but
also how the market reasonably may be expected to change after the full
implementation of Title VII.
In performing this comparative exercise we are, in part, drawing
inferences from the CDS Data Analysis, a dataset released by the SEC
staff that characterizes nearly all transactions in single-name credit
default swaps during the 2011 calendar year.\475\ Though the final
rules apply to all security-based swaps, not just single-name credit

[[Page 30636]]

default swaps, the SEC believes that these data are sufficiently
representative of the market to help inform the analysis because an
estimated 95 percent of all security-based swap transactions appear
likely to be single-name credit default swaps.\476\ The SEC also
recognizes that although the de minimis exception is applicable to
persons only with respect to their dealing activity, the CDS Data
Analysis contains transactions reflecting both dealing activity and
non-dealing activity, including transactions by persons who may engage
in no dealing activity whatsoever.\477\
---------------------------------------------------------------------------

\475\ See note 472, supra.
\476\ While recognizing that the Commissions have yet to adopt
final rules defining a ``security-based swap,'' we believe that
single-name credit default swaps will constitute roughly 95 percent
of the market, as measured on a notional basis, for instruments that
will fall within that definition, with certain equity swaps (in
other words, total return swaps based on single equities or narrow-
based indices of equities) constituting the primary example of
security-based swaps that are not credit default swaps.
In particular, according to data published by BIS, the global
notional amount outstanding in equity forwards and swaps as of June
2011 was $2.03 trillion, and the notional amount outstanding in
credit default swaps was approximately $32.4 trillion. See
Statistical Annex, BIS Quarterly Review (December 2011), at A10
(available at http://www.bis.org/publ/qtrpdf/r_qs1112.pdf).
Although the BIS data reflects the global OTC derivatives market,
and not just U.S. market, we have no reason to believe that these
ratios differ significantly in the U.S. market. In fact, OCC data
regarding U.S. entities generally confirms these ratios, in that as
of June 30, 2011, U.S. commercial banks and trust companies held
$15.23 trillion in notional outstanding credit derivative positions
and $677 billion in equity derivative positions, meaning that credit
derivatives accounted for approximately 95 percent of the total
credit and equity derivative positions held by these entities. See
OCC Quarterly Report at tables 1 and 10. Cf. letter from Greenberger
(referencing OCC data as relevant to determining size of swap
market).
\477\ A person that is engaged in security-based swap dealing
activity, for example, may also engage in proprietary trading
involving security-based swaps that would be reflected in the
transaction data. Even accounting for such possibilities, however,
the SEC believes that the data nonetheless support the broad
conclusion described below that dealing activity within the
security-based swap market is highly concentrated.
---------------------------------------------------------------------------

As described more fully in the CDS Data Analysis, to ascertain
which entities might be transacting as dealers, and which may not be,
various criteria were employed as indicia of possible dealing activity.
In each case, the results suggest the great extent to which there is
currently a high degree of concentration of potential dealing activity
in the single-name credit default swap market. For example, using the
criterion that dealers are likely to transact with many counterparties
who themselves are not dealers, analysis of 2011 transaction data show
that only 28 out of 1,084 market participants have three or more
counterparties that themselves are not recognized as dealers by
ISDA.\478\ As the data show, 15 of these 28 potential dealers exceeded
a threshold of $100 billion notional transacted in single-name credit
swaps during 2011, which accounts for over 98 percent of the 28
entities' total activity.\479\ At a lower threshold of $10 billion
notional, 21 of the 28 potential dealers are included (representing
99.7 percent of the activity of potential dealers), and at an even
lower threshold of $3 billion notional, 25 potential dealers are
included (representing 99.9 percent).\480\
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\478\ See CDS Data Analysis at table 3c. The SEC recognizes that
the analysis of this transaction data is imperfect as a tool for
identifying dealing activity, given that the presence or absence of
dealing activity ultimately turns upon the relevant facts and
circumstances of an entity's security-based swap transactions, as
informed by the dealer-trader distinction. Criteria based on the
number of an entity's counterparties that are not recognized as
dealers nonetheless appear to be useful for identifying apparent
dealing activity in the absence of full analysis of the relevant
facts and circumstances, given that engaging in security-based swap
transactions with non-dealers would be consistent with the conduct
of seeking to profit by providing liquidity to others, as
anticipated by the dealer-trader distinction. In emphasizing this
criterion for identifying dealing activity, we are not seeking to
predict with precision how many entities ultimately may register as
security-based swap dealers. The ultimate number of dealers that may
register can also be expected to reflect growth in the market, new
dealing entrants, and in some cases the registration of multiple
dealing entities within an affiliated group.
\479\ See CDS Data Analysis at table 3c. In particular, those 15
entities engaged in a total of $11.01 trillion in notional single-
name credit default swap transactions over 2011, which reflects 98.5
percent of the total $11.18 trillion in notional transactions over
2011 for the 28 total identified possible dealers.
\480\ See id. The 21 possible dealers with a 2011 notional in
excess of $10 billion account for a total of $11.15 trillion in
notional single-name credit default swap transactions in 2011, or
over 99.7 percent of the total. The 25 possible dealers in excess of
$3 billion account for almost $11.18 in notional transactions in
2011, or over 99.9 percent of the total.
---------------------------------------------------------------------------

Other criteria for identifying possible dealing activity based on
the number of an entity's non-dealer counterparties similarly suggest a
high degree of concentration of dealing activity within the current
security-based swap market.\481\ Criteria that consider the number of
an entity's total single-name security-based swap counterparties,\482\
criteria that consider alternative factors for identifying dealing
activity,\483\ and certain combined criteria \484\ further

[[Page 30637]]

suggest a high concentration of dealing activity within the security-
based swap market.
---------------------------------------------------------------------------

\481\ For example, two other criteria consider the number of an
entity's non-dealer counterparties (in those cases identifying as
dealers those persons that have seven or more, or five or more,
counterparties not recognized as dealers by ISDA) also indicate that
potential dealers with notional amounts in excess of $100 billion in
2011 account for over 98 percent of the notional transactions of all
entities meeting the applicable criteria in 2011. Potential dealers
with notional transactions above $10 billion in 2011 (let alone
those with notional transactions above $3 billion) reflect all or
virtually the entire notional amount of all dealers identified by
those criteria. See id. at tables 3a and 3b.
\482\ The CDS Data Analysis also sought to identify dealing
activity based on the total number of an entity's counterparties.
See id. at tables 2a through 2c. Those criteria similarly suggest a
high degree of concentration of dealing activity within the single-
name credit default swap market:
i. A criterion that identifies potential dealing activity based
on an entity having twenty or more counterparties in single-name
security-based swaps identified 16 possible dealers. Fourteen of
those entities had notional transactions in excess of $100 billion
in 2011, reflecting over 99 percent of the total associated with all
16. The remaining two identified entities had notional transactions
in excess of $10 billion in 2011. See id. at table 2a.
ii. A criterion that identifies potential dealing activity based
on an entity having 15 or more counterparties in single-name
security-based swaps identified 33 possible dealers. Fifteen of
those entities had notional transactions in excess of $100 billion
in 2011, reflecting over 97 percent of the total associated with all
33. A total of 27 of those entities had notional transactions in
excess of $10 billion in 2011, and a total of 32 of those entities
had notional transactions in excess of $3 billion in 2011, both
reflecting over 99 percent of the total. See id. at table 2b.
iii. A criterion that identifies potential dealing activity
based on an entity having 10 or more counterparties in single-name
security-based swaps identified 154 possible dealers. Fifteen of
those exceeded $100 billion in notional transactions in 2011,
reflecting over 90 percent of the total; 49 of those exceeded $10
billion in notional transactions in 2011, reflecting over 97 percent
of the total; and 93 exceeded $3 billion in notional transactions in
2011, reflecting over 99 percent of the total. See id. at table 2c.
In considering the data we are weighing these criteria less
heavily than we are weighing the criteria based on the number of
counterparties who are not identified by ISDA as dealers. This is
because it is reasonable to foresee a non-dealer making use of
multiple dealers to get the best possible price or to make use of
special expertise possessed by certain dealers, meaning that the
criteria discussed in this footnote are more likely to identify
entities not engaged in dealing activity.
\483\ Other criteria in the CDS Data Analysis sought to identify
dealing activity based on whether an entity maintains a relatively
flat book. Those criteria also indicated that entities with notional
transactions in excess of $100 billion in 2011 represented over 97
percent of the total for all entities identified by those criteria,
while entities with notional transactions in excess of $10 billion
in 2011 represented over 99 of the total for all entities identified
by those criteria. See id. at tables 4 and 5. We are weighing those
criteria less heavily than we are weighing the counterparty-based
criteria discussed above because an entity that engages in
directional trades could also appear to have a flat book if its
portfolio contained transactions representing various directional
bets, but of similar aggregate notional sizes on both sides of the
market. See id. at 3.
The analysis also included one criterion that considers
potential dealing activity based on a low propensity to post margin.
See id. at table 6. While we do not believe that this analysis
deserves the same degree of weight as the others, given concerns
about the completeness of the data (see id. at 4), we note that this
criterion nonetheless also indicates a high concentration of dealing
activity in the market. See id. at table 6 (indicating that of the
473 entities identified by this criterion, the 14 entities with
notional transactions in excess of $100 billion in 2011 account for
roughly 94 percent of the total notional transaction activity
associated with all 473 entities over 2011).
\484\ Finally, the CDS Data Analysis also included criteria that
identified potential dealing activity based on an entity meeting two
or three of the other criteria considered. See id. at tables 7 and
8. These criteria again indicate a high degree of concentration of
dealing activity in the market. The analysis that addressed whether
an entity met two of the other criteria identified 92 possible
dealers, with the 15 entities having notional transactions in excess
of $100 billion in 2011 representing over 96 percent of the total
activity of those 92 entities in 2011. See id. at table 7. The
analysis that addressed whether an entity met three of the other
criteria identified 41 possible dealers, with the 15 entities having
notional transactions in excess of $100 billion in 2011,
representing over 98 percent of the total activity of those 41
entities in 2011. See id. at table 8.
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While less data are available in connection with other types of
instruments constituting security-based swaps, such as equity swaps,
the available data similarly suggest a high concentration of positions
in those instruments among potential dealers.\485\
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\485\ For example, OCC data shows that, of the five largest bank
or trust companies, four have notional equity derivative positions
of above $1 billion, and that those four entities account for $630
billion in notional positions out of $677 billion for all U.S.
commercial banks or trust companies, which constitutes approximately
93 percent of the total. See OCC Quarterly Report at table 10.
Similarly, a review of the equity swaps positions of the 50 largest
U.S. bank holding companies shows that nine bank holding companies
have notional equity swap positions exceeding $1 billion, and
account for 99.5 percent of the total positions held by such
companies, and 29 have no positions in equity swaps. (Data was
compiled from each bank holding company's FR 9-YC, available at
http://www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx). Cf. letter
from WGCEF V (referencing swap position data from bank holding
companies' Forms FR Y-9C as relevant to determining size of the swap
market).
---------------------------------------------------------------------------

Though inspection of the data does not seem to suggest a single
precise de minimis threshold, the above analysis of potential dealing
activity is useful in that it reveals a range of possible thresholds
from $100 billion to $3 billion that would cover anywhere from 98
percent through 99.9 percent of the total activity of all potential
dealers in 2011. However, these thresholds--and their implied market
coverage ratios--only reflect levels of activity that exist in today's
highly concentrated market. In order to further narrow the range of
possible thresholds, and to select an appropriate level for the de
minimis exception, the analysis must consider the potential state of
the market as it might reasonably exist after the implementation of
Title VII.
ii. Avoiding Gaps Resulting From the Regulatory Changes in Conjunction
With the Exception
Although the overall portion of security-based swap activity that
would appear to be subject to dealer regulation based on current
measures of dealing concentration in the market constitutes an
important factor to consider in balancing the regulatory burdens and
benefits associated with a de minimis exception, analysis of the
current market should not serve as the sole mechanism for setting the
exception.
In particular, sole reliance on an approach that focuses on current
measures of market concentration would not adequately account for
likely changes to the market associated with the implementation of
regulation. In part, these changes may be a direct result of the full
implementation of Title VII--including enhancements to transparency and
increases in central clearing--as those changes reasonably may be
expected to reduce the concentration of dealing activity within the
market over time.\486\ Also, to the extent implementation of Title VII
permits new dealers to enter the market, the availability of a de
minimis exception would mean those new dealing entrants would fall
outside the ambit of dealer regulation, either for the long term or
until their dealing activity surpasses the applicable notional
threshold.\487\ Accordingly, de minimis thresholds that are based
solely on the current state of the market, including the current
concentration of dealing activity within the market, may reasonably be
expected to fail to account for the amount of dealing activity that in
the future could fall outside of the ambit of dealer regulation due to
the exception.\488\
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\486\ Cf. Bessembinder and Maxwell, ``Transparency and the
Corporate Bond Market,'' Journal of Economic Perspectives, Spring
2008, at 217, 226 (noting that after reporting of U.S. OTC bond
transactions through the Trade Reporting and Compliance Engine
(``TRACE'') became mandatory, the portion of trades completed by the
12 largest dealers fell from 56 percent to 44 percent).
\487\ We understand that large dealers have competitive
advantages under the current market, in light of the desire of
counterparties to engage in security-based swap transactions with
large, well capitalized and highly rated dealers. See, e.g., Craig
Pirrong, Rocket Science, Default Risk and The Organization of
Derivatives Markets, Working Paper, University of Houston (2006)
(available at http://www.cba.uh.edu/spirrong/Derivorg1.pdf). The
lower business costs associated with being unregulated may prove to
partially offset that advantage. At the same time, we reasonably may
expect that informed counterparties will take into account the lower
protections--and higher risks--associated with transactions with
unregulated dealers in determining whether to use regulated or
unregulated dealers as counterparties.
\488\ We note that there also are benefits to increased
competition and a decrease in concentration of dealer activity, as
contemplated by Title VII, including potentially lower costs for
market participants and a decrease in systemic risk.
---------------------------------------------------------------------------

For example, as discussed above, when possible dealers in single-
name credit default swaps are identified by an entity having three or
more counterparties that are not recognized by ISDA as being dealers,
entities with notional transactions in excess of $100 billion over a 12
month period represent over 98 percent of the total activity of all
such possible dealers over that period, leaving two percent of possible
dealing activity below that level.\489\ However, a de minimis threshold
of $100 billion would allow new entrants to commence engaging in
unregulated dealing in competition with persons who are regulated as
dealers pursuant to Title VII, which, depending on the number and size
of such entrants, could significantly decrease the portion of dealing
activity in the market done by registered dealers (at least until the
point that new entrants cross the de minimis threshold, if they do at
all). For example, if 15 new entrants \490\ were to engage in security-
based swap dealing activity up to a $100 billion threshold, the result
could be that nearly 15 percent of dealing activity within the single-
name credit default swap market would be left outside of the ambit of
dealer regulation.\491\
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\489\ See CDS Data Analysis at table 3c; see also note 479,
supra. As noted above, these amounts may not only reflect dealing
activity by an entity. Thus, even putting aside the possibility of
new unregulated entrants into the market, the portion of dealing
activity in the market that is represented by entities whose
trailing notional dealing activity exceeds $100 billion may in fact
be less than 98 percent.
\490\ The illustrative use of new entrants for purposes of this
discussion is intended to reflect the potential that new entrants to
the market could take advantage of a de minimis threshold in a way
that leads to a higher level of unregulated dealing activity within
the market. In using this illustration we are not seeking to
explicitly predict how many new entrants may come into the market in
response to any particular de minimis threshold, nor are we seeking
to predict how many new entrants may seek to stay under the de
minimis thresholds and how many instead would seek to use the
exception as a step on the way to eventually registering as a
security-based swap dealer. Rather, we simply are illustrating why
it is important to account for market changes in connection with
setting the de minimis threshold.
The OTC Derivatives Supervisors Group--a group chaired by the
Federal Reserve Bank of New York and consisting of the CFTC and SEC
as well as other international supervisors and major over-the-
counter derivatives market participants--currently recognizes 15
major OTC derivatives dealers. Accordingly, as an illustrative
example, we have assumed that this number of significant security-
based swap dealers would approximately double--i.e., include 15 new
dealers--in the wake of the various regulatory changes contemplated
by the Dodd-Frank Act, many of which may result in increased access
and competition in the security-based swap market (e.g., enhanced
priced transparency and increased access to central clearing).
However, we emphasize that this number has been selected as an
illustrative example, and have accordingly provided similar examples
assuming ten and five new entrants.
\491\ Fifteen new entities that each engage in $100 billion in
dealing activity would reflect $1.5 trillion in additional dealing
activity outside the ambit of dealer regulation, which could lead to
roughly 14.9 percent of total dealing activity being outside the
ambit of dealing regulation (with that $1.5 trillion being added to
the existing $168 billion reflected by entities that fall below the
$100 billion threshold, and that sum divided by $11.18 trillion,
under the assumption that the new entrants displace business from
the fifteen entities above the de minimis threshold). To further
illustrate, under the same assumptions and analysis, the implied
unregulated market share would be roughly 10.4 percent for ten new
entities and 6.0 percent for five new entities.
In certain regards these illustrations, on the one hand, may
overestimate the effect of new entrants because of the assumption
that such entrants engage in dealing activities up to, but not
surpassing, the de minimis threshold. While it is not impossible
that some entities may seek to use the de minimis exception to
conduct business as an unregulated niche dealer, it also is
plausible that entities generally may seek to use the exception to
commence engaging in dealing activity, with the goal of ultimately
becoming registered dealers that are not constrained by the de
minimis threshold.
On the other hand, these illustrations in certain respects may
underestimate the amount of dealing activity that can fall outside
of the regulatory ambit. For example, the amounts of security-based
swap activity of persons identified in the analysis as dealers may
not exclusively constitute dealing activity, meaning that persons
whose notional transactions over a 12-month period exceed a
particular threshold in fact may not be engaged in that amount of
dealing activity, and hence may still be able to take advantage of
the de minimis exception. Also, these illustrations do not seek to
reflect increased activity by existing dealers that already fall
below the assumed threshold.

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[[Page 30638]]

Similarly, a de minimis threshold of $25 billion may also lead to a
material reduction in the portion of the market covered by registered
dealers. For example, using the same assumptions as above, 15 new
entrants up to a $25 billion threshold could leave over four percent of
dealing activity in the market outside of the ambit of dealing
regulation.\492\ When other metrics are used to identify possible
dealing activity, the possibility of a significant regulatory gap
remains.\493\
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\492\ Fifteen new entities each engaged in $25 billion in
dealing activity would reflect $375 billion in additional dealing
activity outside the ambit of dealer regulation, which could lead to
4.1 percent of total dealing activity being outside the ambit of
dealing regulation (with that $375 billion being added to the
existing $80.2 billion reflected by entities that fall below the $25
billion threshold, and that sum divided by $11.18 trillion, under
the assumption that the new entrants displace business from the
seventeen entities above the de minimis threshold). To further
illustrate, under the same assumptions and analysis, the implied
unregulated market share would be 3.0 percent for 10 new entities
and 1.8 percent for 5 new entities. Obviously, these illustrations
are subject to the same limitations as are discussed above in the
context of the $100 million threshold illustration.
\493\ For example, similar results are obtained when possible
dealing activity is identified based on whether an entity passes at
least three of the other metrics discussed above. See CDS Data
Analysis at table 8. Using the same types of assumptions as are
discussed above, with fifteen new entities, a de minimis threshold
of $100 billion could lead to 15.0 percent of dealing activity
falling outside the ambit of dealer regulation, while a de minimis
threshold of $25 billion could lead to 4.2 percent of dealing
activity falling outside of regulation.
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Overall, it is reasonable to conclude that the higher the de
minimis threshold, the greater the likelihood that the exception,
combined with other changes resulting from the implementation of Title
VII that may encourage new entrants, will lead to a proportionately
larger amount of unregulated (except with respect to antifraud and
anti-manipulation prohibitions) dealing activity.\494\ We believe that
it is reasonable to interpret the statutory language of the de minimis
exception in a way that prevents a proportionately large amount of
dealing activity within the security-based swap market from falling
outside the ambit of dealer regulation. Accordingly, choosing to set a
lower de minimis threshold from among the range of potential thresholds
would limit the amount of potential future dealing activity that could
be transacted without being subject to dealer rules and
regulations.\495\
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\494\ As noted above, encouraging new entrants also has benefits
flowing from increased competition and a decrease in concentration
of dealer activity. See note 488, supra.
\495\ For example, 15 new dealer entrants engaged in up to $3
billion in dealing activity would account for up to $45 billion in
dealing activity. This result would mean approximately 0.4 percent
of total potential future dealing activity could be transacted by
unregistered dealers, as opposed to the potential for approximately
15 percent of potential future dealing activity to be transacted by
unregistered dealers if the de minimis were set to $100 billion. See
CDS Data Analysis at table 3c. As with the illustrative examples
above, these calculations assume that the new entrants displace
business from the entities above the de minimis threshold.
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iii. Promoting Statutory Counterparty Protections
Sole reliance on an approach based on overall market coverage in
balancing regulatory burdens and benefits would also threaten to unduly
discount important counterparty protection interests, as discussed
above and highlighted in the proposal.\496\ For example, in light of
data indicating that $5 million constitutes a common notional size for
a single-name credit default swap position,\497\ a de minimis notional
threshold of $25 billion annually would permit an unregistered dealer
to engage in as many as 5000 trades of that size. The counterparties to
these unregistered dealers would not receive the benefit of the
protections that Title VII affords to the counterparties of registered
dealers. These include, among others, the segregation protections
afforded to persons who post margin to dealers in connection with over-
the-counter security-based swap transactions.\498\ Accordingly, this
consideration also suggests that choosing a de minimis threshold closer
to the lower end of the range of potential thresholds would better
preserve the counterparty protections contemplated by Title VII.
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\496\ See part II.D.3.a, supra; see also Proposing Release at
80180 (highlighting ``customer protection issues raised by swaps and
security-based swaps--including risks that counterparties may not
fully appreciate when entering into swaps and security-based
swaps'').
\497\ See Federal Reserve Bank of New York staff report, ``An
Analysis of CDS Transactions: Implications for Public Reporting''
(2011) at 8 (stating that for dollar-denominated single name CDS on
corporate or sovereign reference entities, $5 million represented
the most common notional size) (available at http://www.newyorkfed.org/research/staff_reports/sr517.pdf); see also
Proposing Release at 80180 (noting ``that in general the notional
seize of a small swap or security-based swap is $5 million or
less'').
We note, by comparison, that Congress has determined that a de
minimis amount of securities broker activity by banks entails 500
trades annually. See Exchange Act section 3(a)(4)(B)(xi) (excluding
from the ``broker'' definition a bank that annually effects no more
than 500 securities transactions, other than transactions subject to
certain other exceptions, so long as the transaction is not effected
by a bank employee that also is a broker-dealer employee).
We further note that, while the number of counterparties or
transactions potentially implicated by unregistered dealing activity
is an important consideration in establishing an initial de minimis
level, it does not alter our view, described above, that a single de
minimis standard based on notional value--rather than the proposal's
framework of three distinct standards based on notional value,
number of counterparties, and number of transactions--is an
appropriate choice in light of concerns expressed by commenters that
a standard based on the number of transactions or counterparties can
produce arbitrary results. See part II.D.3.b.ii, supra.
\498\ Exchange Act section 3E, which was added by section 763(d)
of the Dodd-Frank Act, provides a series of requirements in
connection with the segregation of assets held as collateral in
security-based swap transactions. These include requirements that
security-based swap dealers and major security-based swap
participants provide their counterparties with notice that they have
the right to require segregation, and that such segregation must be
at an independent third-party custodian.
---------------------------------------------------------------------------

c. Balancing Reflected in the Final Rules--Credit Default Swaps That
Constitute Security-Based Swaps
The final thresholds that implement the de minimis exception (and
corresponding phase-in levels) address security-based swaps that are
credit default swaps separately from other types of security-based
swaps, in light of differences in the respective markets.
i. General Threshold for Credit Default Swaps That Constitute Security-
Based Swaps
We conclude that $3 billion over the prior 12 months constitutes an
appropriate notional threshold for applying the de minimis exception in
connection with dealing activity involving credit default swaps that
constitute security-based swaps.

[[Page 30639]]

In reaching this conclusion, we recognize the significance of
comments that supported the proposed $100 million threshold,\499\ and
that urged caution in raising that proposed threshold,\500\ as well as
commenters who supported increases to the threshold.\501\ We further
recognize the importance of applying the de minimis exception in a way
that promotes regulatory efficiency. We also recognize the range of
potential thresholds suggested by the data currently available. Based
on the competing factors described above, we believe that $3 billion
reflects a reasonable notional threshold--though not necessarily the
only such threshold.
---------------------------------------------------------------------------

\499\ See letters from Better Markets I and AFR.
\500\ See letter from Greenberger.
\501\ See, e.g., letter from COPE I.
---------------------------------------------------------------------------

In our view, the currently available data regarding the single-name
credit default swap market indicates that a notional threshold of $3
billion would be expected to result in the regulation, as dealers, of
persons responsible for the vast majority of dealing activity within
that market, both as of today and, as described above, in the future as
the benefits of the other Title VII rules are implemented and new
dealer entrants come to market.\502\
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\502\ Of the 28 market participants that have three or more
security-based swap counterparties that themselves are not
recognized by dealers by ISDA, 25 had notional single-name credit
default swap positions in excess of $3 billion in 2011. The
remaining three entities in total accounted for only $3.59 billion
in notional transactions in 2011, reflecting less than 0.1 percent
of the $11.18 trillion total for those 28 market participants. See
CDS Data Analysis at table 3c.
The other criteria set forth in the analysis for identifying
possible dealing activity in general similarly indicate that
entities with notional transactions in excess of $3 billion in 2011
account for more than 99 percent of the total notional transactions
of all identified entities in 2011. See id. at tables 2a-c, 3a-b, 4,
5, 7 and 8. While the criterion based on the posting of initial
margin only indicates 98 percent coverage for all of the 473
identified entities, see id. at table 6, as discussed above we
believe it is appropriate to provide less weight to that criterion,
which is based on voluntary reporting.
As noted above, see note 478, supra, we recognize that the
underlying market data encompasses all of the security-based swap
activity of persons identified as dealers, not only their dealing
activity. Because the thresholds that implement the de minimis
exception address only a person's dealing activity, this raises the
possibility that the analysis overstates the extent to which a $3
billion threshold would encompass persons responsible for dealing
activity within the single-name security-based swap market. Even
with that possibility, however, we believe that the data indicates
such a high concentration of dealing activity within the market that
it is reasonable to conclude that a $3 billion threshold likely
would encompass persons responsible for the vast majority of dealing
activity within the market.
---------------------------------------------------------------------------

In providing for a $3 billion notional threshold, we also recognize
the threshold would permit an unregistered dealer annually to engage in
up to 600 security-based swaps (as opposed to 20 transactions under the
proposed threshold, assuming a $5 million average notional size). In
this regard, we note that Congress, in another statutory de minimis
exception within the Exchange Act, determined that 500 securities
transactions annually constituted a de minimis amount of transactions
for banks under the ``broker'' definition.\503\ We further believe that
a $3 billion threshold appropriately addresses commenter concerns
regarding the de minimis exception being unduly narrow.\504\
---------------------------------------------------------------------------

\503\ See Exchange Act section 3(a)(4)(B)(xi); see also letter
from SIFMA--Regional Dealers (supporting a threshold of 500 trades
consistent with the statutory de minimis exception in connection
with bank brokerage activity).
\504\ For example, $3 billion is equal to the threshold
suggested by many commenters in the context of the swap market,
which is much larger than the security-based swap market. See letter
from COPE (supporting a 0.001 percent notional threshold based on
the overall swaps market, which would amount to $3 billion). Indeed,
this $3 billion threshold appears to reflect roughly 0.024 percent
of the overall market for single-name credit default swaps, a
percentage that is much greater than the 0.001 percent multiplier
that a number of commenters (see, e.g., letters cited in note 382,
supra) suggested in the swap market context. See CDS Data Analysis
at table 1 (indicating that participants in the single-name credit
default swap market engage in a total of $12.6 trillion in single-
name credit default swap transactions in 2011).
---------------------------------------------------------------------------

In adopting this $3 billion threshold, we have carefully considered
one commenter's view that the CDS Data Analysis suggests that the
proposed $100 million threshold in fact is too high, and that any
increase in that proposed $100 million threshold would be arbitrary and
capricious.\505\ In reaching these conclusions, the commenter focused
on the number of entities that potentially are engaged in dealing
activity but that could be excluded based on particular de minimis
thresholds. For example, the commenter indicated that pursuant to one
of the CDS Data Analysis's combined metrics for identifying dealing
activity, a de minimis threshold of $3 billion could lead to the
exclusion of up to 58 percent of all persons engaged in possible
dealing activity. The commenter further suggested that some entities
engaged in dealing activity may reduce their activities to take
advantage of the de minimis exception and hence reduce liquidity, and
argued that there would be no basis for the exception to be based on a
market participant's percentage of total security-based swap
activity.\506\
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\505\ See letter from Better Markets III.
\506\ The letter also raised issues regarding the ``customer''
language of the exception and argued that the de minimis exception
should not represent a risk-based test. We address those issues
elsewhere. See parts II.D.3.c (regarding ``customer'' language) and
II.D.3.e (regarding rejection of risk-based and proportionality
tests), infra.
In addition, the letter expressed the view that a percentage-
based formula would be difficult to implement, by requiring market
participants to repeatedly calculate the ratio of their activity to
total market activity. We concur. The $3 billion threshold we are
adopting reflects a fixed dollar amount, and does not share the
complications that would arise from an approach based on a
particular percentage of the market.
---------------------------------------------------------------------------

It is important to recognize that while the commenter focused on
the number of entities that might be excluded pursuant to the
exception, and suggested that higher notional dollar amount thresholds
could lead to the exclusion of a larger number of entities, the
statutory provision for the de minimis exception does not require the
exemption of a ``de minimis number'' of dealers. The statute instead
requires the exemption of persons engaged in a ``de minimis quantity''
of dealing activity.\507\ The statutory language therefore indicates
that the focus of the rule implementing the exception should be the
amount of an entity's dealing activity, not how many entities
ultimately may be able to take advantage of the exception.
---------------------------------------------------------------------------

\507\ See Exchange Act section 3(a)(71)(D).
---------------------------------------------------------------------------

Also, although the commenter implied that there would be no basis
for the rule implementing the exception to take into account a market
participant's security-based swap dealing activity compared to total
dealing activity in the market, for the reasons discussed in this
section we believe that such an approach can appropriately provide for
the regulatory coverage of the vast majority of dealing activity in a
way that promotes regulatory efficiency, without leading to unwarranted
regulatory gaps. In contrast, in our view the commenter did not
persuasively articulate a strong rationale for adopting the alternative
approach proposed in the letter, which would appear to lead to the
registration of a number of dealers that proportionately engage in a
very small amount of dealing activity.\508\
---------------------------------------------------------------------------

\508\ The commenter correctly pointed out that the regulatory
requirements applicable to registered dealers encompass counterparty
protection requirements, and that the de minimis exception should
not defeat those requirements. We recognize that the implementation
of the exception should take those counterparty protections into
account, and we have sought to do so. We do not believe, however,
that those important counterparty protection goals require a de
minimis approach that focuses on the number of entities that would
be excluded, in lieu of the statutory focus on whether a particular
entity engages in a de minimis quantity of dealing activity.
---------------------------------------------------------------------------

In support of its approach, the commenter emphasized data regarding
persons who meet certain combined criteria outlined in the CDS Data

[[Page 30640]]

Analysis. As discussed above, we believe that criteria based on the
number of an entity's counterparties that are not recognized as dealers
deserve special weight due to the potential consistency of those
criteria with the dealer-trader distinction.\509\ Identifying dealer
activity using those criteria does not support the view that a $3
billion threshold would lead to the exclusion of a large number of
entities engaged in dealing activity.\510\
---------------------------------------------------------------------------

\509\ See notes 478, 482, and 483, supra.
\510\ For example, the CDS Data Analysis identifies:
Three possible dealers with notional transactions below
$3 billion in 2011--out of a total of 28 possible dealers--when
possible dealing activity is based on having three or more
counterparties that themselves are not identified as dealers;
One possible dealer with notional transactions below $3
billion in 2011- out of a total of 20 possible dealers--when
possible dealing activity is based on having five or more
counterparties that themselves are not identified as dealers; and
Zero possible dealers with notional transactions below
$3 billion in 2011--out of a total of 16 possible dealers--when
possible dealing activity is based on having seven or more
counterparties that themselves are not identified as dealers.
See CDS Data analysis at tables 3c, 3b and 3a.
In addition, as described above, an approach focused on the
quantity of activity is supported by relatively consistent results
depending on which criterion from the CDS Data Analysis is applied--
i.e., each criterion shows a high amount of concentration and a
commensurately low quantity of activity below the $3 billion
threshold. By contrast, applying different criteria results in very
different numbers of entities excluded under any specified
threshold, suggesting that an approach focused on the number of
entities may be highly dependent on how the possible dealing
activity of those entities is defined.
---------------------------------------------------------------------------

Finally, we also are not persuaded by the commenter's suggestion
that a number of entities engaged in dealing activity would reduce
those activities to take advantage of a $3 billion de minimis
threshold, and hence reduce liquidity in the market by five percent. To
reach that figure, the commenter needed to exclude the vast majority of
dealing activity in the market.\511\ While we recognize that it is
possible that current market participants may adjust their dealing
activity in light of the de minimis threshold, and that this
potentially could reduce the liquidity provided by certain entities, we
also recognize that the de minimis exception has the potential to
promote liquidity by facilitating new entrants into the market.
---------------------------------------------------------------------------

\511\ In particular, in arguing that this incentive would reduce
liquidity by five percent, the commenter excluded all business done
by entities within the top two brackets (i.e., above $100 billion
notional), on the grounds that those entities ``are assumed to
transact mostly with larger entities.'' Based on the criteria on
which the commenter relied, those 15 entities are responsible for
over 96 percent of the activity of all possible dealers. See CDS
Data Analysis at tables 7 and 8. Absent that exclusion, the
estimated reduction of liquidity would amount to a small fraction of
a percent.
---------------------------------------------------------------------------

ii. Phase-in Period in Connection With Dealing Activity Involving
Credit Default Swaps That Constitute Security-Based Swaps
The final rules further provide that persons with notional dealing
activity of $8 billion or less over the prior 12 months involving
credit default swaps that constitute security-based swaps would be able
to avail themselves of a phase-in period.\512\ Those persons would not
be subject to the generally applicable compliance date that occurs no
later than 60 days following publication of these final rules in the
Federal Register.\513\
---------------------------------------------------------------------------

\512\ Exchange Act rule 3a71-2(a)(2).
\513\ Even with the general 60 day compliance period, however,
market participants will not necessarily be security-based swap
dealers at the end of 60 days. In particular, for the first year
following the effective date of the final rules implementing the
definition of ``security-based swap'' pursuant to the Exchange Act
section 3(a)(68), the de minimis analysis would only address
security-based swap dealing activity following that effective date.
See Exchange Act rule 3a71-2(a)(1). Among other things, this means
that until the rules defining ``security-based swap'' are effective,
no market participants would be deemed to be security-based swap
dealers.
---------------------------------------------------------------------------

The use of a phase-in period--in connection with a person's status
as a security-based swap dealer and in connection with the other
regulatory requirements that are appurtenant to dealer status--is
intended to facilitate the orderly implementation of Title VII. In
addition, the phase-in period will afford the SEC additional time to
study the security-based swap market as it evolves in the new
regulatory framework and will allow potential dealers that engage in
smaller amounts of activity (relative to the current size of the
market) additional time to adjust their business practices, while at
the same time preserving the focus of the regulation on the largest and
most significant dealers. The SEC also recognizes that the data
informing its current view of the de minimis threshold is based on the
market as it exists today, and that the market will evolve over the
coming years in light of the new regulatory framework and other
developments.
Accordingly, while the SEC believes that a $3 billion notional
threshold reflects an appropriate long-term standard based on the
currently available data,\514\ it also is appropriate to provide for a
phase-in period for those entities with $8 billion or less in dealing
activity, because subsequent developments in the market or the
evaluation of new data from the security-based swap reporting
facilities contemplated by the Dodd-Frank Act may suggest that the
threshold should be increased or decreased. In particular, the
implementation of security-based swap data reporting under the Dodd-
Frank Act will result in significant new data and afford an opportunity
to review the Commission's determination to establish a $3 billion
threshold.
---------------------------------------------------------------------------

\514\ See note 502, supra.
---------------------------------------------------------------------------

For these reasons, an important part of the report that the SEC is
directing its staff conduct with regard to the definitions of
``security-based swap dealer'' and ``major security-based swap
participant'' (described in detail below) will be a consideration of
the operation of the de minimis exception following the full
implementation of Section 15F under Title VII.\515\ The SEC will take
into account this report, along with public comment on the report, in
determining whether to propose any changes to the rule implementing the
de minimis exception, including any increases or decreases to the $3
billion threshold. The report will be linked to the availability of
data regarding the activity of regulated security-based swap market
participants in that it must be completed no later than three years
\516\ following a ``data collection initiation date'' that is the later
of: the last compliance date for the registration and regulatory
requirements for security-based swap dealers and major security-based
swap participants under Section 15F of the Exchange Act; or the first
date on which compliance with the trade-by-trade reporting rules for
credit-related and equity-related security-based swaps to a registered
security-based swap data repository is required.\517\
---------------------------------------------------------------------------

\515\ See Exchange Act rule 3a71-2A(a)(1); see also part V,
infra.
\516\ See Exchange Act rule 3a71-2A(b).
\517\ The SEC will announce the data collection initiation date
on its Web site and publish it in the Federal Register. See Exchange
Act rule 3a71-1(a)(2)(iii).
---------------------------------------------------------------------------

In light of the available data--and the limitations of that data in
predicting how the full implementation of Title VII will affect dealing
activity in the security-based swap market--the SEC believes that $8
billion constitutes an appropriate level for the availability of the
phase-in period. The available data indicate that such a level
generally comports with the balance of interests that informed the
determination of the appropriate long-term threshold of $3 billion
described above. In particular, the $8 billion level should still lead
to the regulation of persons responsible for the vast majority of
dealing activity

[[Page 30641]]

within the market.\518\ In addition, we do not believe that providing a
phase-in period for persons with notional dealing activity over the
prior 12 months of less than $8 billion would lead to a risk of an
undue portion of the market falling outside of the ambit of dealer
regulation, even after considering the potential entry of unregulated
new dealers into the market.\519\
---------------------------------------------------------------------------

\518\ Of the 28 market participants that have three or more
security-based swap counterparties that themselves are not
recognized by dealers by ISDA, 23 had notional single-name credit
default swap transactions in excess of $8 billion in 2011. The
remaining five entities in total accounted for only $12.3 billion in
notional transactions in 2011, reflecting roughly 0.1 percent of the
$11.18 total for the 28 market participants. See CDS Data Analysis
at table 3c. Only two of the 28 entities identified as possible
dealers by that criterion had annual notional transactions between
$3 billion and $8 billion in 2011.
Most of the other criteria set forth in the analysis for
identifying possible dealing activity in general similarly indicate
that entities with notional transactions in excess of $8 billion in
2011 account for more than 99 percent of the total notional
transactions of all identified entities that year. See id. at tables
2a-b, 3a-b, 4 and 5. While the criterion based on an entity having
10 or more counterparties only indicates 98 percent coverage for all
of the 154 identified entities at an $8 billion transaction level,
see id. at table 2c, as noted above this criterion may identify
persons who in reality are not engaged in dealing activity. See note
482, supra. Also, while the criterion based on the posting of
initial margin only indicates 97 percent coverage for all of the 473
identified entities at an $8 billion transaction level, see id. at
table 6, as discussed above that criterion is based on voluntary
reporting.
\519\ For example, 15 new dealer entrants up to $8 billion in
annual notional dealing activity would account for $120 billion in
dealing activity. This would amount to roughly 1.2 percent of the
total notional single-name security-based swap activity over 12
months of entities identified as possible dealers by virtue of
having three or more counterparties that are not recognized by
dealers by ISDA. See CDS Data Analysis at table 2c.
---------------------------------------------------------------------------

The final rule provides that the phase-in period will continue
until the ``phase-in termination date'' that the SEC will publish on
its Web site and in the Federal Register.\520\ In particular, the rule
provides that nine months following publication of that report, and
after giving due consideration of the report and associated public
comment, the SEC may either: (1) Terminate the phase-in period and by
order establish and publish the phase-in termination date; or (2)
determine that it is necessary or appropriate in the public interest to
propose an alternative de minimis threshold, in which case the SEC, by
order published in the Federal Register, will provide notice of that
determination and establish the phase-in termination date.\521\ If the
SEC does not establish the phase-in termination date in either of those
ways, the phase-in termination date shall automatically occur in any
event on what would be a date certain, which will be five years
following the data collection initiation date.\522\
---------------------------------------------------------------------------

\520\ Exchange Act rule 3a71-2(a)(2)(i).
\521\ Exchange Act rule 3a71-2(a)(2)(iii)(A).
\522\ Exchange Act rule 3a71-2(a)(2)(iii)(B).
---------------------------------------------------------------------------

These provisions should allow sufficient time for the staff to
complete its report, for the SEC to receive and review public comment
on the report, and for the SEC to draw conclusions regarding
establishing the phase-in termination date or proposing potential
changes to the rule implementing the de minimis exception, in a way
that also promotes the orderly and predictable termination of the
phase-in period.\523\
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\523\ This approach balances the fact that the SEC believes that
its $3 billion and $150 million de minimis thresholds are
appropriate in light of the currently available data and the
market's need for a degree of certainty as to the length of this
phase-in period, on the one hand, against the possibility that the
staff report and the accompanying public comment may demonstrate
that revision to these thresholds is necessary, on the other hand.
---------------------------------------------------------------------------

This phase-in period will not be available in connection with the
$25 million threshold for dealing activity involving special entities,
discussed below. In addition, the final rule provides that this phase-
in period will not be available in connection with security-based swap
dealing activities involving natural persons, other than natural
persons who qualify as ECPs by virtue of CEA section 1a(18)(A)(xi)(II),
which addresses natural persons who have $5 million or more invested on
a discretionary basis and who enter into a security-based swap to
manage the risk associated with their assets and liabilities.\524\
These limitations to the availability of the phase-in period are
consistent with the Dodd-Frank Act's goal of helping special entities
be in a position to benefit from the counterparty protections
associated with the regulation of registered security-based swap
dealers under Title VII, as well as the SEC's mandate to protect
participants in the securities markets.
---------------------------------------------------------------------------

\524\ See Exchange Act rule 3a71-2(a)(2)(i). In other words, the
phase-in period will still be available in connection with dealing
activities with natural persons who are ECPs because they have
entered into a security-based swap for hedging purposes. While we
recognize the importance of Title VII protections to natural persons
who engage in security-based swap activity, we also recognize the
benefit of facilitating such persons' use of security-based swaps as
hedges. Accordingly, persons who engage in dealing activity with
natural persons who are ECPs under other provisions of the ECP
definition will be subject to the applicable de minimis threshold
for all of their dealing activity, without the availability of the
phase-in period.
Persons who engage in dealing activity with natural persons who
are not ECPs will fall within the Exchange Act definition of
``dealer,'' which has no de minimis exception. See Exchange Act
section 3(a)(5)(A) (generally excluding dealers in security-based
swaps from the Exchange Act definition of ``dealer,'' unless the
counterparty is not an ECP).
---------------------------------------------------------------------------

Persons who are able to avail themselves of the phase-in period, of
course, will not be required to do so. Any person that chooses to
register with the SEC as a security-based swap dealer shall be deemed
to be a security-based swap dealer subject to all applicable regulatory
requirements for such registrants, regardless of whether the person
engages in security-based swap dealing activity in an amount that is
below the applicable de minimis threshold or phase-in level.\525\
---------------------------------------------------------------------------

\525\ See Exchange Act rule 3a71-2(e).
---------------------------------------------------------------------------

d. Balancing Reflected in the Final Rules--Other Types of Security-
Based Swaps
The final rule provides that the de minimis exception for dealing
activity involving security-based swaps other than credit default swaps
will be based on a threshold of $150 million notional over the prior 12
months.\526\ In addition, a phase-in period will be available in
connection with persons whose dealing activity involving those
instruments is $400 million or less in notional amount over the prior
12 months.
---------------------------------------------------------------------------

\526\ Exchange Act rule 3a71-2(a)(1)(ii). The proposal requested
comment on whether different segments of the security-based swap
market should be treated differently. See Proposing Release at 80101
(``Commenters further are requested to address * * * whether the [de
minimis] exemption's factors should vary depending on the type of
swap or security-based swap at issue.'').
---------------------------------------------------------------------------

These amounts reflect roughly one-twentieth of the corresponding
amounts associated with the exception for credit default swaps that
constitute security-based swaps. As discussed above, while less data is
available regarding other types of security-based swaps than is
available regarding single-name credit default swaps, the available
data is consistent in indicating that those other types of security-
based swaps on a notional basis currently comprise roughly one-
twentieth of the total amount of instruments that will be expected to
constitute security-based swaps.\527\ In light of this significantly
smaller market, we believe that a $3 billion notional threshold would
threaten to cause an overly large portion of dealing activity within
the market to fall outside the ambit of dealer regulation.
---------------------------------------------------------------------------

\527\ See note 476, supra.
---------------------------------------------------------------------------

In this regard, we note that it is likely that there are fewer
barriers to entry in connection with acting as a dealer in security-
based swaps such as equity swaps and total return swaps on debt than
there are in connection with acting as a dealer in single-name credit
default

[[Page 30642]]

swaps.\528\ We also note that because equity swaps and total return
swaps on debt can serve as close economic proxies for equity and debt
securities, an overly broad de minimis threshold in connection with
such instruments could threaten to undermine the Exchange Act framework
for regulating persons who act as dealers in equity and debt.
---------------------------------------------------------------------------

\528\ For example, persons registered with the SEC as broker-
dealers in connection with other types of securities would appear to
be well positioned to act as dealers in connection with equity
swaps, as such broker-dealers already would be expected to have
systems in place to enter into equity positions to hedge their
equity swap dealing positions.
---------------------------------------------------------------------------

At the same time--notwithstanding the smaller scope of this market
and the lesser availability of data regarding dealing activity within
the market--we do not believe that it is necessary to make the de
minimis exception unavailable in connection with dealing activity
involving security-based swaps that are not credit default swaps. In
this regard we particularly note that the limited available data
regarding equity swaps suggests a high degree of concentration in
dealing activity involving those instruments,\529\ which indicates that
an appropriately sized de minimis threshold can be expected to promote
regulatory efficiency.
---------------------------------------------------------------------------

\529\ As noted above, four commercial banks and trust companies
accounted for 93 percent of all equity positions held by such
companies as of June 30, 2011, and nine bank holding companies
accounted for over 99 percent of all equity positions held by the
fifty largest such companies as of December 2011. See note 485,
supra.
---------------------------------------------------------------------------

Balancing those factors, we conclude that a $150 million annual
notional threshold is appropriate to implement the de minimis exception
in connection with security-based swaps that are not credit default
swaps, consistent with our understanding of the comparative size of
that market as applied to the threshold applicable to credit default
swap dealing activity. For reasons similar to those described above, we
conclude that there should be a phase-in period available to persons
whose annual notional dealing activity in connection with security-
based swaps that are not credit default swaps is no more than $400
million in annual 12-month notional amount. This phase-in period is
subject to the same limitations regarding transactions involving
special entities and natural persons as apply to the phase-in period
for credit default swaps. It also will be subject to the same
provisions regarding the termination of the phase-in period as apply in
connection with credit default swaps.\530\ The comparative lack of data
involving these markets--in contrast to the market for single-name
credit default swaps--particularly highlights how the use of a phase-in
period that is linked to the availability of post-implementation data
is appropriate.\531\
---------------------------------------------------------------------------

\530\ See Exchange Act rule 3a71-2(a)(2); see also notes 520
through 522, supra, and accompanying text.
\531\ The SEC expects that the staff report should be especially
helpful for providing data regarding dealing activity in connection
with those other types of security-based swaps to consider the
impact of the termination of the phase-in period, as well as
potential changes to the de minimis exception in connection with
these instruments.
---------------------------------------------------------------------------

As above, a person who is eligible to take advantage of the phase-
in period in connection with these types of security-based swaps may
nonetheless register as a security-based swap dealer.
e. Dealing Activity Involving Special Entities
Consistent with the proposal, the final rules in general will cap
an entity's dealing activity involving security-based swaps at no more
than $25 million notional amount over the prior 12 months when the
counterparty to the security-based swap is a special entity.\532\ There
will be no phase-in period in connection with transactions involving
special entities. In adopting this threshold, we recognize the serious
concerns raised by commenters that stated that the de minimis exception
should not permit any dealing activities involving special entities in
light of losses that special entities have incurred in the financial
markets,\533\ as well as the special protection that Title VII affords
special entities.\534\
---------------------------------------------------------------------------

\532\ Exchange Act rule 3a71-2(a)(1)(iii).
\533\ See letters from AFR and Better Markets I.
\534\ In this regard we note that Title VII authorizes the SEC
to impose special business conduct requirements when a security-
based swap dealer is counterparty to a special entity. See Exchange
Act section 15F(h)(5). In proposing rules to implement these
requirements, the SEC requested comment regarding the scope of the
``special entity'' definition, including, for example, regarding
whether the SEC should interpret ``special entity'' to exclude a
collective investment vehicle in which one or more special entities
have invested. See Exchange Act Release No. 64766 (June 29, 2011),
76 FR 42396, 42422 (July 18, 2011). For purposes of interpreting
this special entity threshold to the de minimis exception--
particularly with regard to when a special entity would be a
counterparty to a person that is engaged in dealing activity--the
SEC believes that it will be appropriate to be guided by final
interpretations regarding when a dealer will be a counterparty to a
special entity for purposes of those business conduct requirements.
---------------------------------------------------------------------------

At this time, the final rule does not fully exclude such dealing
activity from the exception, in light of the potential benefits that
may arise from a de minimis exception. In this way, the threshold would
not completely foreclose the availability of security-based swaps to
special entities from unregistered dealers--as $25 million would
annually accommodate up to five single-name credit default swaps of a
$5 million notional size--but the threshold would limit the financial
and other risks associated with those positions for a special entity,
which would in turn limit the possibility of inappropriately
undermining the special protections that Title VII provides to special
entities.
In reaching this conclusion we recognize that special entities do
participate in the single-name credit default swap market, given that
an analysis of market data indicates that in 2011 special entities were
parties to over $40 billion in single-name credit default swap
transactions.\535\ At the same time, the impact of this $25 million
threshold--particularly concerns that the threshold may foreclose the
ability of special entities to access dealers in the market--appears to
be mitigated by the fact that the counterparties to those special
entities tend to engage in notional transactions in single-name credit
default swap well in excess of the general de minimis standards.\536\
In light of the underlying counterparty protection issues, we see no
basis to distinguish between types of security-based swaps in setting
this special entity threshold.
---------------------------------------------------------------------------

\535\ See CDS Data Analysis at table 9.
\536\ See id. at n.8 (noting that the average notional activity
of those 16 counterparties was $680 billion, with the lowest being
approximately $9 billion).
---------------------------------------------------------------------------

For similar reasons, in the future as we consider whether to amend
the de minimis exception we expect to pay particular attention to
whether the threshold for transactions involving special entities
should further be lowered.
f. Future Revisions to the Rule
As noted above and described in detail below in part V, the SEC is
directing its staff to report on whether changes are warranted to the
rules and interpretations implementing the security-based swap dealer
definition, including the rule implementing the de minimis
exception.\537\ The SEC will take the report and associated public
comment into account in determining whether to propose any changes to
the rule implementing the exception.\538\ Consistent with that
possibility, the final rule provides that the SEC may change the
requirements of the de minimis exception by rule or regulation.\539\
Through this mechanism,

[[Page 30643]]

the SEC may revisit the rule implementing the exception and potentially
change that rule, for example, if data regarding the security-based
swap market following the implementation of Section 15F under Title VII
suggests that different de minimis thresholds would be
appropriate.\540\ In determining whether to revisit the thresholds, the
SEC intends to pay particular attention to whether the de minimis
exception results in a dealer definition that encompasses too many
entities whose activities are not significant enough to warrant full
regulation under Title VII, or, alternatively, whether the de minimis
exception leads an undue amount of dealing activity to fall outside of
the ambit of the Title VII regulatory framework, or leads to
inappropriate reductions in counterparty protections (including
protections for special entities). The SEC also intends to pay
particular attention to whether alternative approaches would more
effectively promote the regulatory goals that may be associated with a
de minimis exception.
---------------------------------------------------------------------------

\537\ See Exchange Act rule 3a71-2A(a)(1).
\538\ See notes 520 through 522, supra, and accompanying text.
\539\ Exchange Act rule 3a71-2(d). Exchange Act section
3(a)(71)(D) particularly states that the ``Commission''--meaning the
SEC--may exempt de minimis dealers and promulgate related
regulations. We do not interpret the joint rulemaking provisions of
section 712(d) of the Dodd-Frank Act to require joint rulemaking
here, because such an interpretation would read the term
``Commission'' out of Exchange Act section 3(a)(71)(D), which itself
was added by the Dodd-Frank Act.
\540\ See letter from Greenberger (stating that the dynamic
nature of the derivatives sector of the financial markets should
counsel caution, and that the de minimis threshold should be
reevaluated on an ongoing basis).
---------------------------------------------------------------------------

6. Registration Period for Entities That Exceed the De Minimis Factors
The de minimis exception raises implementation issues akin to those
associated with the major participant definition, in that both
provisions use tests that have retrospective elements to determine
whether an entity must register and be subject to future regulation. As
a result, some commenters have suggested that entities that surpass the
de minimis thresholds should be able to take advantage of a grace
period to undertake the process of registering as swap dealers or
security-based swap dealers.\541\ Otherwise, absent such a ``roll-in''
period, entities whose dealing activities surpass the relevant de
minimis factors would immediately be in violation of dealer
registration requirements. In light of these concerns, and the interest
of avoiding undue market disruptions, the Commissions believe that it
is appropriate to provide entities that exceed applicable the de
minimis factors a period of time to register as dealers.
---------------------------------------------------------------------------

\541\ See letters from Northland Energy and WGCEF I.
---------------------------------------------------------------------------

Accordingly, the final rules have been revised from the proposal to
provide for a timing standard that is similar to what we are using in
connection with the major participant definition.\542\ That is, if an
entity that has relied on the de minimis exception no longer is able to
rely on the exception because its dealing activity exceeds a relevant
threshold, the entity would have two months, following the end of the
month in which it no longer is able to take advantage of the exception,
to submit a completed application to register as a swap dealer or
security-based swap dealer.\543\
---------------------------------------------------------------------------

\542\ Compare CFTC Regulation Sec. 1.3(hhh)(3); Exchange Act
rule 3a67-8(a) (providing that persons who meet the criteria to be
major participants will have two months to submit a completed
registration application).
\543\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii); Exchange Act
rule 3a71-2(b). As discussed below with regard to the implementation
period for the major participant definitions, persons will have
additional time to comply with the applicable requirements following
the submission of a completed application. See part IV.L.3, infra.
---------------------------------------------------------------------------

Also, akin to the major participant definitions,\544\ a person
registered as a swap dealer or security-based swap dealer may apply to
withdraw that registration, while continuing to engage in a limited
amount of dealing activity in reliance on the de minimis exception, if
that person has been registered as a dealer for at least 12
months.\545\ This should help ensure that persons do not rapidly move
in and out of dealer status based on short-term fluctuations in their
swap or security-based swap activities.
---------------------------------------------------------------------------

\544\ Compare CFTC Regulation Sec. 1.3(hhh)(5); Exchange Act
rule 3a67-8(c) (providing that a major participant may be deemed to
no longer be a major participant if its swap or security-based swap
positions are below the relevant thresholds for four quarters).
\545\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii); Exchange Act
rule 3a71-2(c). Consistent with this approach, moreover, the final
rule has been revised from the proposal to clarify that the de
minimis exception in general is not available to a registered swap
dealer or security-based swap dealer. See CFTC Regulation Sec.
1.3(hhh)(1)(i); Exchange Act rule 3a71-2(a)(1) (revised language
clarifying availability of exception to a person that is not a swap
dealer or security-based swap dealer).
---------------------------------------------------------------------------

The final rules implementing the de minimis exception do not
provide any reevaluation period for entities that engage in a level of
dealing activity above the de minimis thresholds, in contrast to the
major participant definitions.\546\ We do not believe that there is an
appropriate basis for such a provision, particularly given that dealer
regulation addresses customer protection and market operation and
transparency concerns apart from risk concerns.
---------------------------------------------------------------------------

\546\ Compare CFTC Regulation Sec. 1.3(hhh)(4); Exchange Act
rule 3a67-8(b) (providing for a reevaluation period in connection
with the major participant definitions when a person does not exceed
any applicable threshold by more than 20 percent in a calendar
quarter).
---------------------------------------------------------------------------

E. Limited Purpose Designation as a Dealer

1. Proposed Approach
The definitions of the terms ``swap dealer'' and ``security-based
swap dealer'' provide that the Commissions may designate a person as a
dealer for one type, class or category of swap or security-based swap,
or specified swap or security-based swap activities, without the person
being considered a dealer for other types, classes, categories or
activities.\547\
---------------------------------------------------------------------------

\547\ CEA section 1a(49)(B); Exchange Act section 3(a)(71)(B).
---------------------------------------------------------------------------

In the Proposing Release, we noted that these provisions represent
permissive grants of authority that do not require the Commissions to
provide limited designations.\548\ We further stated that a person that
is covered by the definitions of the terms ``swap dealer'' or
``security-based swap dealer'' would be considered a dealer for all
types, classes or categories of the person's swaps or security-based
swaps, or activities involving swaps or security-based swaps, in light
of the difficulty of seeking to separate a person's dealing activities
from their non-dealing activities involving swaps or security-based
swaps, unless such person sought and received designation as a dealer
for only specified categories of swaps or security-based swaps, or
specified activities.\549\ We explained that this would provide persons
the opportunity to seek a limited designation based on applicable facts
and circumstances, and that we anticipated that a dealer could seek a
limited designation at the time of its initial registration or
later.\550\
---------------------------------------------------------------------------

\548\ See Proposing Release, 75 FR at 80182.
\549\ See id.; see also proposed CFTC Regulation Sec.
1.3(ggg)(3); proposed Exchange Act rule 3a71-1(c).
\550\ See Proposing Release, 75 FR at 80182.
---------------------------------------------------------------------------

In the Proposing Release, the CFTC further noted that non-financial
entities such as physical commodity firms potentially may conduct
dealing activity through a division rather than through a separately
incorporated subsidiary, and that such an entity's swap dealing
activity would not be a core component of its overall business. The
CFTC added that if this type of entity registered as a dealer, certain
swap dealer requirements would apply to the dealing activities of the
division, but not necessarily to the swap activities of other parts of
the entity.\551\
---------------------------------------------------------------------------

\551\ See id.

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[[Page 30644]]

2. Commenters' Views
A number of commenters addressed the limited designation of dealers
in conjunction with the limited designation of major participants. Many
of the issues those commenters raised thus are relevant to both sets of
definitions.
a. Presumption of Full Designation
A number of commenters objected to the proposed presumption that an
entity would be designated as a dealer (or major participant) for all
categories of swaps or security-based swaps and all of the person's
activities connected to swaps or security-based swaps. Several
commenters argued that this approach would be contrary to Congressional
intent,\552\ conflict with the statutory language,\553\ or conflict
with underlying policy concerns.\554\ One commenter suggested that the
Commissions lack the statutory authority to apply swap dealer
requirements to an entity's non-swap dealing activities.\555\
---------------------------------------------------------------------------

\552\ See letters from Cargill Incorporated (``Cargill''), CDEU
and Investment Company Institute (``ICI'') dated February 22, 2011
(``ICI I'').
\553\ See letters from MetLife and WGCEF I.
\554\ See letter from Cargill (stating that limited designation
promotes the policy of encouraging non-financial firms that
primarily are engaged in non-dealing businesses to continue to
conduct limited dealing activities, adding that such firms ``do not
present the potential systemic risks of financial firms,'' and that
their full designation as dealers would discourage them from
providing risk management products).
\555\ See letter from EDF Trading.
---------------------------------------------------------------------------

b. Potential Types of Limited Designations
A number of commenters addressed potential types of limited
designations. One expressed support for limited swap dealer
designations for particularized business units and for particular swap
categories,\556\ while another requested that limited swap dealer
designations be available based on any reasonable commercial
groupings.\557\ Some commenters urged that limited dealer designations
should be available for the branches or business units of foreign swap
dealers and security-based swap dealers with U.S.-based customers or
U.S. business lines.\558\
---------------------------------------------------------------------------

\556\ See letter from Capital One.
\557\ See letters from NCGA/NGSA II (particularly referring to
groupings based on individual physical commodities) and WGCEF dated
June 9, 2011 (``WGCEF VII'') (limited designation should permit
firms to structure organization of limited purpose registrans as
appropriate in particular circumstances).
\558\ See letters cited in note 148, supra.
---------------------------------------------------------------------------

c. Applications for Limited Designations
A number of commenters addressed issues relating to the application
process for limited designations. Some commenters supported the ability
of a person to apply for limited designations at the time of initial
registration,\559\ while one commenter sought clarification on how and
when a person could apply for limited swap dealer status.\560\ Some
commenters suggested that entities should be considered to have a
provisional limited designation upon the filing of a completed
application for limited dealer designation.\561\
---------------------------------------------------------------------------

\559\ See letters from MFA I (specifically requesting that the
rules provide that an entity can receive a limited purpose
designation at the time of their initial registration) and FSR I.
\560\ See letter from National Futures Association (``NFA'').
\561\ See letters from Capital One, Farm Credit Council I and
FHLB I.
---------------------------------------------------------------------------

Some commenters requested further clarification as to what factors
or criteria would be considered relevant to limited designation
determinations.\562\ One commenter stated that non-financial companies
should have a presumption of limited swap dealer designation under
certain circumstances.\563\ Another commenter took the view that
commercial firms should be able to determine whether to register a
legal entity or a division as a dealer.\564\ One commenter suggested
the analysis consider the complexity of an entity's dealing and non-
dealing activities, and further suggested that limited designations
should automatically be available if an entity's dealing activities do
not exceed 50 percent of its total swap activities.\565\ Commenters
also raised issues related to how a person's status as a financial or a
non-financial entity affects a person's eligibility for limited
designations.\566\
---------------------------------------------------------------------------

\562\ See letters from BG LNG I and ISDA I.
\563\ See letter from Cargill (arguing that a firm should be
presumptively entitled to limited swap dealer status if: it is a
non-financial company; its non-dealing activities include (but need
not be limited to) production, merchandising or processing of
physical commodities; the firm's dealing activities take place in a
separately identifiable division or business unit with separate
management; and dealing revenues are less than 30 percent of the
firm's total revenues in the firm's most recent fiscal year).
\564\ See letter from WGCEF VII (stating that so long as a
registered swap dealer bears the onus of demonstrating compliance
with regulatory requirements, regulators ``should not dictate''
whether the firm registers a legal entity or a division as a dealer;
also requesting guidance as to how applicable regulatory
requirements may apply to a subdivision of a legal entity that
registers as a dealer, and requesting a safe harbor from enforcement
action when a decision to register only a particular desk or
division as a dealer is made in good faith).
\565\ See letter from Capital One.
\566\ Compare letter from Capital One (stating that all market
participants, including financial institutions, should be allowed to
apply for limited swap dealer designations) with letter from Cargill
(suggesting that an entity's status as a financial company should be
relevant to limited dealer determinations).
---------------------------------------------------------------------------

d. Application of Regulatory Requirements to Limited Dealers
Commenters also addressed issues related to the application of
regulatory requirements to limited dealers. One commenter recommended
that dealer regulatory requirements generally should apply only to a
division undertaking limited dealing activities; that commenter further
stated that capital requirements should be calculated based only on the
activities of that division, while recognizing that capital must be
held by the entity as a whole.\567\ Other commenters argued that
capital and margin requirements should only be applied to an entity on
a limited basis.\568\
---------------------------------------------------------------------------

\567\ See letter from Cargill.
\568\ See letter from FSR I (recommending that to the extent
that capital requirements are tied to swap activity or exposures,
that only activities or exposures in the designated category be
reflected in the calculation).
---------------------------------------------------------------------------

e. Miscellaneous Issues
One commenter recommended that non-financial entities that are
deemed to be limited dealers (or major participants) be permitted to be
treated as end-users for the aspects of their businesses that are not
subject to the limited designation.\569\ The commenter further
suggested that the swaps ``push-out'' rule requirements of section 716
of the Dodd-Frank Act be interpreted so that an insured depository
institution that is a limited purpose dealer would only have to push
out the dealing portion of its swap business, and be allowed to retain
the other aspects of its swaps business.\570\ One commenter requested
clarification as to whether a person that is a limited purpose dealer
in connection with one category of swap could be a major participant in
connection with another category (in light of the statutory language
excluding dealers from the major participant definitions).\571\
---------------------------------------------------------------------------

\569\ See id. (recommending that the corporate treasurer of an
entity with a limited designation as a swap dealer for ``other
commodity swaps'' as a result of its energy derivatives activity be
able to hedge the entity's interest rate and currency risk without
being subject to the business conduct, reporting, recordkeeping or
other rules applicable to dealers and major participants).
\570\ See id.
\571\ See letter from NFA. As discussed below, see 752, infra, a
person who is designated as a dealer in connection with particular
types of swaps or security-based swaps may be major participants
with regard to other types.
---------------------------------------------------------------------------

3. Final Rules and General Principles
Consistent with the proposal, the final rules retain the
presumption that a

[[Page 30645]]

person who meets one of the dealer definitions will be deemed to be a
dealer with regard to all of its swaps or security-based swaps
activities, unless the CFTC or SEC exercises its authority to limit the
person's designation as a dealer to specified categories of swaps or
security-based swaps, or specified activities.\572\ As discussed in the
Proposing Release, moreover, a person may apply for a limited
designation when it submits a registration application, or at a later
time.\573\ The final rules also contain a technical change from the
proposed rules to clarify that limited designations may be based on a
particular type, class or category of swap or security-based-swap.\574\
---------------------------------------------------------------------------

\572\ CFTC RegulationSec. 1.3(ggg)(3); Exchange Act rule 3a71-
1(c).
\573\ The SEC expects to address the process for submitting an
application for limited designation as a security-based swap dealer,
along with principles to be used by the SEC in analyzing such
applications, as part of separate rulemakings.
\574\ The rules particularly have been revised from the proposal
to add ``type'' and ``class'' language to supplement the use of the
term ``category.'' This change is consistent with the statutory
language. In addition, the final rules related to limited
designations for ``security-based swap dealers'' corrects an
erroneous reference to major participant designation.
---------------------------------------------------------------------------

a. Default Presumption of Full Designation
Consistent with the proposal, the final rules retain the standard
that a person that satisfies the ``swap dealer'' or ``security-based
swap dealer'' definition in general would be considered a dealer for
all types, classes or categories of the person's swaps or security-
based swaps, or all activities involving swaps or security-based swaps.
The Commissions are not persuaded by the suggestion that this
presumption is inconsistent with the statute, legislative intent or
underlying policy. Not only is the relevant statutory language written
as a grant of authority rather than a specific mandate to designate
certain entities as limited purpose dealers, but the presumption also
reasonably reflects the difficulty of separating a dealer's dealing
activities from its non-dealing activities, and the challenges of
applying dealer regulatory requirements to only a portion of a dealer's
swap or security-based swap activities.\575\
---------------------------------------------------------------------------

\575\ This approach also is consistent with the treatment of
dealers of other types of securities under the Exchange Act. When a
person's securities activities cause them to be a ``dealer'' for
purposes of the Exchange Act, the statutory requirements and
regulations applicable to dealers will apply to all of that person's
securities activities, regardless of whether particular activities
would not have caused the entity to fall within the ``dealer''
definition. For example, Exchange Act section 15(c)(3)(A) prohibits
brokers and dealers from engaging in certain securities-related
activity in contravention of SEC-prescribed rules with respect to
financial responsibility or related practices. This provision does
not distinguish between those activities that cause a person to fall
within the ``broker'' or ``dealer'' definitions, and other
activities that themselves do not cause that person to be a broker
or dealer. The SEC's authority extends to all securities activities
by those brokers or dealers.
---------------------------------------------------------------------------

We similarly are not persuaded by the view that the Commissions
lack the authority to apply dealer regulation to non-dealing activities
of a registered swap dealer or security-based swap dealer.\576\ Certain
of the statutory requirements applicable to swap dealers and security-
based swap dealers--such as capital requirements--simply do not
distinguish between a person's dealing activities and their non-dealing
activities.\577\ In other words, absent a limited designation, the
statutory requirements applicable to dealers address the regulation of
all of a dealer's swap or security-based swap activities.\578\
---------------------------------------------------------------------------

\576\ See letter from EDF Trading.
\577\ See, e.g., CEA section 4s(e); Exchange Act section 15F(e).
\578\ The substantive regulations applicable to dealers, of
course, can account for the nature of a dealer's particular swap or
security-based swap activities.
The SEC also intends to address limited designation issues in
the context of a separate release addressing the application of
Title VII to non-U.S. entities.
---------------------------------------------------------------------------

b. Demonstration of Compliance With Dealer Requirements
The Commissions will consider limited purpose applications on an
individual basis through analysis of the unique circumstances of each
applicant, given that the types of entities that engage in swap or
security-based swap dealing are diverse and their organization and
activities are varied.\579\
---------------------------------------------------------------------------

\579\ Consistent with this approach, applications to limit a
person's dealer designation to ``specified categories'' of swaps or
security-based swaps (see CFTC Regulation Sec. 1.3(ggg)(3);
Exchange Act rule 3a71-1(c)), would not be required to interpret the
term ``category'' consistently with the use of that term in
connection with the major participant definitions. CFTC Regulation
Sec. 1.3(iii) and Exchange Act rule 3a67-2, defining the terms
``major swap category'' and ``major security-based swap category,''
respectively, do not apply for this purpose.
---------------------------------------------------------------------------

Regardless of the type of limited designation being requested, the
Commissions will not designate a person as a limited purpose dealer
unless it can demonstrate that it can fully comply with the
requirements applicable to dealers.
Certain of the statutory requirements applicable to dealers
particularly focus on the entity's swap or security-based swap
activities and positions. These include, among other aspects,
requirements related to trading records, documentation and
confirmations.\580\ An applicant for a limited purpose designation
would have to demonstrate how it would satisfy those transaction-
specific requirements in the context of a limited designation.
---------------------------------------------------------------------------

\580\ See, e.g., CEA section 4s(h)(3), Exchange Act section
15F(h)(3) (business conduct standards, including disclosure
requirements, for dealers); CEA section 4s(g), Exchange Act section
15F(g) (daily trading record requirements for dealers); CEA section
4s(i); Exchange Act section 15F(i) (documentation requirements for
dealers).
---------------------------------------------------------------------------

Other statutory requirements applicable to dealers particularly
focus on the entity itself. These include requirements related to
registration, capital, risk management, supervision, and chief
compliance officers.\581\ Here too, an applicant for a limited purpose
designation would have to demonstrate how it would satisfy those
requirements in the context of limited designations.
---------------------------------------------------------------------------

\581\ See, e.g., CEA section 4s(a)(1), Exchange Act section
15F(a)(1) (registration requirements for dealers); CEA section
4s(e), Exchange Act section 15F(e) (capital and margin requirements
for dealers). The Dodd-Frank Act provides that in setting the
capital requirements for swap dealers and security-based swap
dealers (as well as major participants) that are subject to a
limited designation, the Commissions and the prudential regulators
must take into account the risks associated with other types,
classes, or categories of swaps or security-based swaps engaged in,
and the other swap or security-based swap activities conducted by,
that person ``that are not otherwise subject to regulation
applicable to that person by virtue of the status of the person'' as
a dealer or major participant. See CEA section 4s(e)(2)(C); Exchange
Act section 15F(e)(2)(C). In the case of a commercial agricultural
or energy company that obtains a limited purpose designation for a
particular business unit, the CFTC does not expect that this
provision will generally require the limited purpose designee to
calculate its required capital on the basis of swaps engaged in, or
activities conducted by, other business units within the company, to
the extent those swaps or activities do not generate risk beyond the
agricultural or energy company's ordinary commercial line of
business.
---------------------------------------------------------------------------

A limited purpose designation might be appropriate, for example,
where a commercial agricultural company is a dealer in swaps related to
a thinly-traded commodity, such as a particular fertilizer, but is not
a dealer in, and does not wish to be subject to the swap dealer
requirements with respect to its swaps that relate to broadly-traded
commodities like corn or wheat (or where, say, a commercial energy
company is a dealer in swaps involving a commodity to be delivered at a
particular location and does not wish to be subject to the swap dealer
requirements for its swaps involving that commodity to be delivered at
other locations, for which it is not a swap dealer). A limited
designation might also be appropriate so that the swap dealer
requirements do not apply to interest rate or currency swaps that the
agricultural or energy company enters into in managing its financial
risk.

[[Page 30646]]

A limited purpose designee could be a particular business unit
within a company. Additionally, a limited designation might be
considered to ``split the desk'' by applying the swap dealer
requirements solely to the designee's limited activities involving
swaps not entered into for the purpose of hedging a physical position
as defined in CFTC Regulation Sec. 1.3(ggg)(6)(iii). Any particular
limited purpose application will be analyzed in light of the unique
circumstances presented by the applicant.
A key challenge that any applicant to a limited dealer designation
will face is the need to demonstrate full compliance with the
requirements that apply to the type, class or category of swap or
security-based swap, or the activities involving swaps or security-
based swaps, that fall within the swap dealer designation.

III. Amendments to the Definition of Eligible Contract Participant

A. Background

The Dodd-Frank Act makes it unlawful for a person that is not an
eligible contract participant (``ECP'') to enter into a swap other than
on, or subject to the rules of, a DCM.\582\ In addition, section 763(e)
of the Dodd-Frank Act makes it unlawful for a person to effect a
transaction in a security-based swap with or for a person that is not
an ECP unless the transaction is effected on a national securities
exchange registered with the SEC.\583\ Moreover, section 768(b) of the
Dodd-Frank Act makes it unlawful for a person to offer to sell, offer
to buy or purchase, or sell a security-based swap to a person that is
not an ECP unless a registration statement under the Securities Act of
1933 (``Securities Act'') \584\ is in effect with respect to that
security-based swap.\585\ These provisions mean that persons can engage
in neither swaps nor security-based swaps transactions with persons
that are not ECPs on SEFs, on security-based SEFs, or on a bilateral,
off-exchange basis.
---------------------------------------------------------------------------

\582\ In particular, section 723(a)(2) of the Dodd-Frank Act
adds new subsection (e) to CEA section 2 (7 U.S.C. 2(e)), providing
that ``[i]t shall be unlawful for any person, other than an eligible
contract participant, to enter into a swap unless the swap is
entered into on, or subject to the rules of, a board of trade
designated as a contract market under section 5.''
\583\ In particular, section 763(e) of the Dodd-Frank Act adds
paragraph (l) to Exchange Act section 6 (15 U.S.C. 78f(l)),
providing that ``[i]t shall be unlawful for any person to effect a
transaction in a security-based swap with or for a person that is
not an eligible contract participant, unless such transaction is
effected on a national securities exchange registered pursuant to
subsection (b).''
\584\ 15 U.S.C. 77a et seq.
\585\ In particular, section 768(b) of the Dodd-Frank Act adds
paragraph (d) to Securities Act section 5 (15 U.S.C. 77e(d)),
providing that ``[n]otwithstanding the provisions of section 3 or 4,
unless a registration statement meeting the requirements of section
10(a) is in effect as to a security-based swap, it shall be unlawful
for any person, directly or indirectly, to make use of any means or
instruments of transportation or communication in interstate
commerce or of the mails to offer to sell, offer to buy or purchase
or sell a security-based swap to any person who is not an eligible
contract participant as defined in section 1a(18) of the Commodity
Exchange Act (7 U.S.C. 1a(18)).'' The Commissions note that market
participants must make the determination of ECP status with respect
to the parties to transactions in security-based swaps and mixed
swaps prior to the offer to sell or the offer to buy or purchase the
security-based swap or mixed swap.
---------------------------------------------------------------------------

The Dodd-Frank Act also amended the ECP definition by: \586\ (i)
Providing that, for purposes of CEA sections 2(c)(2)(B)(vi) and
2(c)(2)(C)(vii), the term ECP does not include a commodity pool in
which any participant is not itself an ECP; (ii) raising the monetary
threshold that governmental entities may use to qualify as ECPs, in
certain situations, from $25 million in investments owned and invested
on a discretionary basis to $50 million in investments owned and
invested on a discretionary basis; \587\ and (iii) replacing the
``total asset'' standard for individuals to qualify as ECPs with an
``amounts invested on a discretionary basis'' standard.\588\
---------------------------------------------------------------------------

\586\ See Sections 741(b)(10) and 721(a)(9) of the Dodd-Frank
Act; see also Financial Regulatory Reform, A New Foundation:
Rebuilding Financial Supervision and Regulation, available at http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf, at 48-
49 (June 17, 2009).
\587\ See CEA section 1a(18)(A)(vii), 7 U.S.C. 1a(18)(A)(vii).
\588\ See CEA section 1a(18)(A)(xi), 7 U.S.C. 1a(18)(A)(xi). The
Dodd-Frank Act did not amend the monetary thresholds for individuals
to qualify as ECPs. As such, an individual can qualify as an ECP if
such individual has amounts invested on a discretionary basis, the
aggregate of which is in excess of (i) $10,000,000, or (ii)
$5,000,000 if such individual also enters into the agreement,
contract, or transaction in order to manage the risk associated with
an asset owned or liability incurred, or reasonably likely to be
owned or incurred, by such individual.
---------------------------------------------------------------------------

Commodity pools may, among other things, enter into transactions
involving foreign currency. ECP status is important for commodity pools
that enter into the following types of foreign currency transactions
(such commodity pools, ``Forex Pools''): (i) Off-exchange foreign
currency futures; (ii) off-exchange options on foreign currency
futures; (iii) off-exchange options on foreign currency; (iv) leveraged
or margined foreign currency transactions; and (v) foreign currency
transactions that are financed by the offeror, the counterparty or a
person acting in concert with the offeror or counterparty on a similar
basis.\589\ In some cases, discussed below in detail, if a Forex Pool
does not satisfy the ECP definition applicable to commodity pools
engaging in the types of foreign currency transactions noted above
\590\ and it engages in these types of foreign currency transactions
(such transactions, ``retail forex transactions'' and such commodity
pools, ``Retail Forex Pools''), the transactions will be subject to a
regulatory regime that imposes certain requirements and restrictions on
the counterparties to the Retail Forex Pool, and, if the Retail Forex
Pool engages in retail forex transactions other than with certain
counterparties, on the commodity pool operator (``CPO'') who operates
the Retail Forex Pool. These requirements and restrictions do not apply
if the Forex Pool satisfies the ECP definition applicable to commodity
pools engaging in the types of foreign currency transactions noted
above.
---------------------------------------------------------------------------

\589\ See CEA sections 2(c)(2)(B)(vi) and 2(c)(2)(C)(vii), 7
U.S.C. 2(c)(2)(B)(vi) and 7 U.S.C. 2(c)(2)(C)(vii). In this context,
the term ``off-exchange'' means other than on or subject to the
rules of an organized exchange, as defined in CEA section 1a(37), 7
U.S.C. 1a(37).
\590\ See CEA section 1a(18)(A)(iv), 7 U.S.C. 1a(18)(A)(iv); see
also CFTC Regulation Sec. 1.3(m)(5) (exporting the look-through
language of CEA section 1a(18)(A)(iv) to CEA section 1a(18)(A)(v)).
The Dodd-Frank Act amended the ECP definition to include a provision
that specifically applies to Forex Pools engaging in these types of
foreign currency transactions. See Section 741(b)(10) of the Dodd-
Frank Act (adding a provision to CEA section 1a(18)(A)(iv), 7 U.S.C.
1a(18)(A)(iv), stating ``provided, however, that for purposes of
section 2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term
`eligible contract participant' shall not include a commodity pool
in which any participant is not otherwise an eligible contract
participant.''). See part III.B below for a discussion of this
provision. This provision applies only with respect to retail forex
transactions. This means that a Retail Forex Pool, as defined above,
that is not an ECP for retail forex transaction purposes could be an
ECP for other transactions it enters into that are not retail forex
transactions.
---------------------------------------------------------------------------

The Commissions are adopting further definitions of the term
``eligible contract participant'' in the following six respects: (i)
Generally prohibiting a Forex Pool from qualifying as an ECP if such
Forex Pool directly enters into retail forex transactions \591\ and has
one or more direct participants that are not ECPs; \592\ (ii)
clarifying that, in determining whether a direct participant in a Forex
Pool is an ECP, the indirect participants in the Forex Pool will not be
considered unless such Forex Pool, a commodity pool holding a direct or
indirect (through one or more intermediate tiers of pools) interest in

[[Page 30647]]

such Forex Pool, or any commodity pool in which such Forex Pool holds a
direct or indirect interest has been structured to evade Subtitle A of
Title VII of the Dodd-Frank Act; \593\ (iii) prohibiting a commodity
pool from qualifying as an ECP unless it has total assets exceeding $5
million and is operated by a person described in CEA section
1a(18)(A)(iv)(II);\594\ (iv) explicitly including swap dealers,
security-based swap dealers, major swap participants, and major
security-based swap participants in the definition of ECP; (v)
permitting a non-ECP to qualify as an ECP, with respect to certain
swaps, based on the collective net worth of its owners, subject to
several conditions, including that the owners are ECPs; and (vi)
permitting a Forex Pool to qualify as an ECP notwithstanding that it
has one or more direct participants that are not ECPs if the Forex Pool
(a) is not formed for the purpose of evading regulation under CEA
sections 2(c)(2)(B) or (C) or related rules, regulations or orders, (b)
has total assets exceeding $10 million and (c) is formed and operated
by a registered CPO or by a CPO who is exempt from registration as such
pursuant to Sec. 4.13(a)(3). In addition, the Commissions are issuing
interpretive guidance regarding the definition of ECP to correct an
inaccurate statutory cross-reference with respect to the ability of
government entities to qualify as ECPs under CEA section
1a(18)(A)(vii).\595\ The Commissions also are issuing interpretive
guidance with respect to the ECP status of Forex Pools whose
participants are limited solely to non-U.S. persons and which are
operated by CPOs located outside the United States, its territories or
possessions.
---------------------------------------------------------------------------

\591\ In many commodity pool structures, this is the master fund
alone.
\592\ But see note 652, infra, with respect to single level
Forex Pools using retail forex transactions solely to hedge.
\593\ Section 721(c) of the Dodd-Frank Act requires the CFTC to
adopt a rule to further define the terms ``swap,'' ``swap dealer,''
``major swap participant,'' and ``eligible contract participant,''
in order ``[t]o include transactions and entities that have been
structured to evade'' subtitle A of Title VII (or an amendment to
the CEA made by subtitle A).
\594\ 7 U.S.C. 1a(18)(A)(iv)(II).
\595\ 7 U.S.C. 1a(18)(A)(vii).
---------------------------------------------------------------------------

The Commissions note that commenters raised interpretive and other
issues related to the ECP definition that the Commissions may consider
in the future.\596\
---------------------------------------------------------------------------

\596\ These issues include: (i) The ECP status of jointly and
severally liable borrowers and counterparties, non-ECPs guaranteed
by ECPs, and non-ECP swap collateral providers; (ii) whether bond
proceeds count toward the ``owns and invests on a discretionary
basis $50,000,000 or more in investments'' element of the
governmental ECP prong (CEA section 1a(18)(A)(vii), 7 U.S.C.
1a(18)(A)(vii)); (iii) the relationship between the ECP and eligible
commercial entity definitions for purposes of CEA section
1a(18)(A)(vii), 7 U.S.C. 1a(18)(A)(vii); (iv) the scope of the
``proprietorship'' element of the entity prong of the ECP definition
in CEA section 1a(18)(A)(v), 7 U.S.C. 1a(18)(A)(v) (which the
Commissions are addressing to a limited extent in the discussion of
the new line of business ECP category in part III.F, infra, and in
Regulation Sec. 1.3(m)(7)(ii)(C) under the CEA); (v) the meaning of
the new ``amounts invested on a discretionary basis'' element of the
individual prong of the ECP definition (CEA section 1a(18)(A)(xi), 7
U.S.C. 1a(18)(A)(xi)); (vi) whether persons can be ECPs in
anticipation of receiving, but before they have, the necessary
assets; and (vii) that swap dealers are not among the entities
listed in CEA section 2(c)(2)(B)(i)(II), 7 U.S.C. 2(c)(2)(B)(i)(II),
as acceptable counterparties to non-ECPs engaging in retail forex
transactions.
---------------------------------------------------------------------------

B. Commodity Pool Look-Through for Retail Forex Transactions

1. Statutory Provisions
Prior to the Dodd-Frank Act, clause (A)(iv) of the ECP definition
provided that a commodity pool was an ECP if it had $5 million in total
assets and was operated by a person regulated under the CEA, regardless
of whether each participant in the commodity pool was itself an
ECP.\597\ Section 741(b)(10) of the Dodd-Frank Act added a proviso to
clause (A)(iv) \598\ stating that a Forex Pool will not qualify as an
ECP, solely for purposes of CEA sections 2(c)(2)(B)(vi) or
2(c)(2)(C)(vii) (i.e., retail forex transactions) if any participant in
the Forex Pool is itself not an ECP.\599\
---------------------------------------------------------------------------

\597\ Clause (A)(iv) of the pre-Dodd-Frank Act ECP definition
also included a commodity pool operated by a foreign person
performing a similar role or function as a person regulated under
the CEA and subject as such to foreign regulation (regardless of
whether the foreign person was itself an ECP).
\598\ The proviso states ``provided, however, that for purposes
of section 2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term
`eligible contract participant' shall not include a commodity pool
in which any participant is not otherwise an eligible contract
participant.'' CEA section 1a(18)(A)(iv); 7 U.S.C. 1a(18)(A)(iv).
\599\ See CEA section 1a(18)(A)(iv), 7 U.S.C. 1a(18)(A)(iv). In
other words, the proviso in section 1a(18)(A)(iv) does not reference
or implicate ECP status for purposes of (i) CEA section 2(e), 7
U.S.C. 2(e) (which, as discussed above, permits non-ECPs to trade
swaps only on or subject to the rules of a DCM); (ii) Securities Act
section 5(d) (which, as discussed above, makes it unlawful for a
person to offer to sell, offer to buy or purchase, or sell a
security-based swap to a person that is not an ECP unless a
registration statement under the Securities Act is in effect with
respect to that security-based swap); or (iii) Exchange Act section
6(l) (which as discussed above, makes it unlawful for a person to
effect a transaction in a security-based swap with or for a person
that is not an ECP unless the transaction is effected on a national
securities exchange registered with the SEC). The look-through
proviso does not expressly state that indirect participants, as well
as direct participants, in the Forex Pool must be ECPs for the Forex
Pool to be an ECP. But see notes 636 and 638, infra (discussing the
authority for such an approach).
---------------------------------------------------------------------------

Thus, for purposes of retail forex transactions, the Dodd-Frank Act
imposed a requirement to ``look through'' a Forex Pool--meaning that
ECP status would be limited to Forex Pools in which each participant is
itself an ECP. This is important for two reasons. First, a Forex Pool
that does not qualify as an ECP can enter into a retail forex
transaction described in CEA section 2(c)(2)(B)(i)(I) only with one of
the federally-regulated counterparties enumerated in CEA sections
2(c)(2)(B)(i)(II)(aa) (U.S. financial institutions),\600\ (bb) (certain
brokers, dealers and their associated persons),\601\ (cc) (certain
futures commission merchants (``FCMs'') and their affiliated
persons),\602\ (dd) (certain financial holding companies) \603\ or (ff)
(certain retail foreign exchange dealers (``RFEDs'')) \604\ (each an
``Enumerated Counterparty'' and collectively ``Enumerated
Counterparties''); the counterparty restriction does not apply to
retail forex transactions described in CEA section 2(c)(2)(C)(i)(I)(bb)
\605\ entered into by a Forex Pool that does not qualify as an ECP,
though such transactions are subject to antifraud protections and
related enforcement provisions if entered into with a

[[Page 30648]]

counterparty other than an Enumerated Counterparty described in CEA
section 2(c)(2)(B)(i)(II)(aa), (bb) or (dd).\606\ Second, the operator
of a Retail Forex Pool engaging in retail forex transactions with an
Enumerated Counterparty that is an FCM, specified affiliated person of
an FCM or RFED must register with the CFTC as a CPO,\607\ unless the
CPO also is an Enumerated Counterparty under 2(c)(2)(B)(i)(II)(aa),
(bb) or (dd) \608\ or an exemption from CPO registration applies.\609\
Moreover, CEA section 2(c)(2)(E)(ii)(I),\610\ which was added by
section 742(c)(2) of the Dodd-Frank Act, prohibits an Enumerated
Counterparty from entering into retail forex transactions described in
CEA section 2(c)(2)(B)(i)(I) with a person that is not an ECP ``except
pursuant to a rule or regulation of [the appropriate Federal regulator
of such Enumerated Counterparty allowing such transactions] under such
terms and conditions as [such regulator] shall prescribe.'' CEA section
2(c)(2)(E)(iii)(II) \611\ requires that such rules or regulations treat
similarly all agreements, contracts, and transactions in foreign
currency that are functionally or economically similar to CEA section
2(c)(2)(B)(i)(I) agreements, contracts, and transactions.
---------------------------------------------------------------------------

\600\ 7 U.S.C. 2(c)(2)(B)(i)(II)(aa). The term ``financial
institution'' is defined in CEA Section 1a(21), 7 U.S.C. 1a(21).
\601\ 7 U.S.C. 2(c)(2)(B)(i)(II)(bb). This category is comprised
of each:
(AA) [] broker or dealer registered under section 15(b) (except
paragraph (11) thereof) or 15C of the Securities Exchange Act of
1934 (15 U.S.C. 78o(b), 78o-5); [and] (BB) [ ] associated person of
a broker or dealer registered under section 15(b) (except paragraph
(11) thereof) or 15C of the Securities Exchange Act of 1934 (15
U.S.C. 78o(b), 78o-5) concerning the financial or securities
activities of which the broker or dealer makes and keeps records
under section 15C(b) or 17(h) of the Securities Exchange Act of 1934
(15 U.S.C. 78o-5(b), 78q(h)).
\602\ 7 U.S.C. 2(c)(2)(B)(i)(II)(cc). This category is comprised
of each:
(cc)(AA) []futures commission merchant that is primarily or
substantially engaged in the business activities described in
section 1a of this Act, is registered under this Act, is not a
person described in item (bb) of this subclause, and maintains
adjusted net capital equal to or in excess of the dollar amount that
applies for purposes of clause (ii) of this subparagraph; [and] (BB)
[ ] affiliated person of a futures commission merchant that is
primarily or substantially engaged in the business activities
described in section 1a of this Act, is registered under this Act,
and is not a person described in item (bb) of this subclause, if the
affiliated person maintains adjusted net capital equal to or in
excess of the dollar amount that applies for purposes of clause (ii)
of this subparagraph and is not a person described in such item
(bb), and the futures commission merchant makes and keeps records
under section 4f(c)(2)(B) of this Act concerning the futures and
other financial activities of the affiliated person.
\603\ 7 U.S.C. 2(c)(2)(B)(i)(II)(dd). The enumerated
counterparty in this category is ``a financial holding company (as
defined in section 2 of the Bank Holding Company Act of 1956).''
\604\ 7 U.S.C. 2(c)(2)(B)(i)(II)(ff). This category is comprised
of each:
retail foreign exchange dealer that maintains adjusted net
capital equal to or in excess of the dollar amount that applies for
purposes of clause (ii) of this subparagraph and is registered in
such capacity with the [CFTC], subject to such terms and conditions
as the [CFTC] shall prescribe, and is a member of a futures
association registered under section 17 [of the CEA].
\605\ 7 U.S.C. 2(c)(2)(C)(i)(I)(bb).
\606\ The counterparty limitation with respect to CEA section
2(c)(2)(B)(i)(I) retail forex transactions is a function of the fact
that the CEA's exchange-trading requirement generally applies with
respect to foreign currency futures, foreign currency options on
futures, and foreign currency options. See CEA section 4(a), 7
U.S.C. 6(a) (generally requiring futures contracts to be traded on
or subject to the rules of a DCM); CEA section 4c(b), 7 U.S.C. 6c(b)
(prohibiting trading options subject to the CEA contrary to CFTC
rules, regulations or orders permitting such trading); Part 32 of
the CFTC's rules, 17 CFR part 32 (generally prohibiting entering
into options subject to the CEA) and CFTC Regulation Sec. 33.3(a),
17 CFR 33.3(a) (prohibiting entering into options on futures other
than on or subject to the rules of a DCM). Because CEA section 4(a)
would render an off-exchange futures contract illegal but for CEA
section 2(c)(2)(B) permitting such transactions with an Enumerated
Counterparty, it would be illegal for a non-Enumerated Counterparty
to enter into a futures contract described in 2(c)(2)(B)(i)(I) with
a non-ECP. Similarly, because options can be conducted only pursuant
to CFTC authority and the CFTC has proposed to treat commodity
options within its jurisdiction as swaps, CEA section 2(e) would
prohibit such options, if on foreign exchange and entered into with
a non-ECP, but for the fact that 2(c)(2)(B) permits them if traded
with an Enumerated Counterparty.
The lack of a counterparty limitation with respect to CEA
section 2(c)(2)(C)(i)(I)(bb) retail forex transactions is a function
of the different structures of CEA sections 2(c)(2)(B) and (C).
Whereas CEA section 2(c)(2)(B)(i) covers transactions that would be
illegal but for compliance with CEA section 2(c)(2)(B) (due to such
section's incorporation of the entire CEA, including, for example,
the exchange-trading requirement discussed above), falling within
CEA section 2(c)(2)(C)(i)(I), by that section's own terms, merely
brings a covered transaction within the scope of CEA section
2(c)(2)(C), which does not include the exchange-trading requirement
of CEA section 4(a). Because CEA section 2(c)(2)(C)(i)(I) covers
transactions that may or may not also be transactions described in
section 2(c)(2)(B)(i)(I) and the far fewer requirements imposed by
CEA section 2(c)(2)(C) invite characterization of such difficult-to-
categorize transactions as falling solely within CEA section
2(c)(2)(C), the CFTC will interpret such dually characterizable
transactions as governed by CEA section 2(c)(2)(B). If such
transactions fall only within CEA section 2(c)(2)(C), however,
because they would be subject to neither the exchange-trading
requirement of CEA section 4(a) nor the CFTC's plenary options
authority under CEA section 4c(b) (while CEA section
2(c)(2)(C)(ii)(I), 7 U.S.C. 2(c)(2)(C)(ii)(I), reserves the CFTC's
section 4c(b) authority, in this scenario, the contract in question
is not an option), a person other than an Enumerated Counterparty
may act as counterparty to a non-ECP. Such contracts would, however,
be subject to two of the CEA's antifraud provisions, sections 4(b)
and 4b, 7 U.S.C 6(b) and 7 U.S.C 6b, respectively, as if they were
futures contracts. See CEA section 2(c)(2)(C)(iv), 7 U.S.C.
2(c)(2)(C)(iv). Such contracts also would be subject to related
enforcement provisions. See CEA section 2(c)(2)(C)(ii)(I), 7 U.S.C.
2(c)(2)(C)(ii)(I).
\607\ See CEA sections 2(c)(2)(B)(iv)(I) and (C)(iii)(I)
(requiring registration for CPOs of Retail Forex Pools entering into
retail forex transactions with FCMs, specified affiliated persons
thereof or RFEDs). By contrast, those sections exclude from the CPO
registration requirement CPOs of Retail Forex Pools engaging in
retail forex transactions with Enumerated Counterparties described
in CEA section 2(c)(2)(B)(i)(II)(aa), (bb), (ee) and (ff). While the
cited CEA sections refer to counterparties not described in ``any of
item (aa), (bb), (ee), or (ff)'' of subparagraph (B)(i)(II), the
CFTC Reauthorization Act of 2008 (``CRA''), included as Title XIII
of the Food, Conservation and Energy Act of 2008, Pub.L. 110-246,
122 Stat. 1651 changed item (ee) to item (dd) (a financial holding
company as defined in section 2 of the Bank Holding Company Act of
1956) and removed item (ff) (formerly an investment bank holding
company (as defined in section 17(i) of the Exchange Act (15 U.S.C.
78q(i))). Therefore, the Commissions interpret the reference in CEA
sections 2(c)(2)(B)(iv)(I)(cc) and 2(c)(2)(C)(iii)(I)(cc) to items
(aa), (bb), (ee), or (ff) to be references to items (aa), (bb) and
(dd). Cf. Retail Foreign Exchange Transactions; Conforming Changes
to Existing Regulations in Response to the Dodd-Frank Wall Street
Reform and Consumer Protection Act, 76 FR 56103 (Sept. 12, 2011)
(providing background on related incorrect internal references in
CEA sections 2(c)(2)(B) and (C)). See also CFTC Regulation Sec.
5.3(a)(2)(i), 17 CFR 5.3(a)(2)(i), which requires a CPO, as defined
in CFTC Regulation Sec. 5.1(d)(1), 17 CFR 5.1(d)(1), to register as
such. CFTC Regulation Sec. 5.1(d)(1), in turn, defines a CPO, for
purposes of Part 5 of the CFTC's Regulations, 17 CFR part 5, as
``any person who operates or solicits funds, securities or property
for a pooled investment vehicle that is not an [ECP] as defined in
section 1a(18) of the Act, and that engages in retail forex
transactions.'' The CFTC interprets the references in Regulation
Sec. 5.1(d)(1) to ECPs as defined in CEA section 1a(18) to include
the ECP definition as further defined or interpreted by the
Commissions under authority conferred by the Dodd-Frank Act or
otherwise amended or interpreted by the Commissions or a court.
While the statutory CPO definition in CEA section 1a(11)(A), 7
U.S.C. 1a(11)(A), does not include transactions described in CEA
section 2(c)(2)(B)(i), the Commissions believe this was an
oversight. In any case, CEA section 1a(11)(B), 7 U.S.C. 1a(11)(B),
grants the CFTC the authority to further define the term CPO, which
the CFTC has done in CFTC Regulation Sec. 5.1(d)(1). Therefore, a
person operating a commodity pool engaging in transactions described
in CEA section 2(c)(2)(B)(i) is a CPO.
\608\ See CEA sections 2(c)(2)(B)(iv)(II) and
2(c)(2)(C)(iii)(II). While CEA sections 2(c)(2)(B)(iv)(II) and
2(c)(2)(C)(iii)(II) refer to counterparties described in item (aa),
(bb), (ee), or (ff) of subparagraph (B)(i)(II), the CFTC
Reauthorization Act of 2008 changed item (ee) to item (dd) and
removed item (ff). Therefore, the Commissions interpret the
reference in CEA sections 2(c)(2)(B)(iv)(II) and 2(c)(2)(C)(iii)(II)
to items (aa), (bb), (ee), or (ff) to be references to items (aa),
(bb) and (dd). Cf. Retail Foreign Exchange Transactions; Conforming
Changes to Existing Regulations in Response to the Dodd-Frank Wall
Street Reform and Consumer Protection Act, 76 FR 56103 (Sept. 12,
2011) (providing background on related incorrect internal references
in 2(c)(2)(B) and (C)).
\609\ See, e.g., CFTC Regulation Sec. 4.13(a)(3) (exempting
from CPO registration operators of commodity pools engaged in a de
minimis amount of trading in CFTC-jurisdictional contracts).
\610\ 7 U.S.C. 2(c)(2)(E)(ii)(I).
\611\ 7 U.S.C. 2(c)(2)(E)(iii)(II).
---------------------------------------------------------------------------

Separately, subclause (A)(v)(III) of the ECP definition, both
before and after enactment of the Dodd-Frank Act, provides that a
corporation, partnership, proprietorship,\612\ organization, trust or
other business entity may qualify as an ECP if it has a net worth
exceeding $1 million and ``enters into an agreement, contract, or
transaction in connection with the conduct of the entity's business or
to manage the risk associated with an asset or liability owned or
incurred or reasonably likely to be owned or incurred by the entity in
the conduct of the entity's business.'' \613\
---------------------------------------------------------------------------

\612\ Individuals also are covered by a different prong of the
ECP definition. An individual can qualify as an ECP under clause
(A)(xi) of the ECP definition. See CEA section 1a(18)(A)(xi), 7
U.S.C. 1a(18)(A)(xi).
\613\ There are two other ways a person can qualify as an ECP
under clause (A)(v): (i) being an entity with total assets exceeding
$10 million; or (ii) being an entity the obligations of which under
an agreement, contract, or transaction are guaranteed or otherwise
supported by a letter of credit or keepwell, support, or other
agreement by an entity with total assets exceeding $10 million or an
entity described in clause (A)(i), (ii), (iii), (iv) or (vii), or
paragraph (C), of the ECP definition. See CEA section
1a(18)(A)(v)(I) and (II), 7 U.S.C. 1a(18)(A)(v)(I) and (II),
respectively.
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2. Proposed Approach
The Commissions stated in the Proposing Release that ``in some
cases commodity pools unable to satisfy the conditions of clause
(A)(iv) of the ECP definition may rely on clause (A)(v) to qualify as
ECPs instead for purposes of retail forex'' and that permitting such
reliance would frustrate the intent of Congress in imposing the look-
through requirement on Forex Pools in clause (A)(iv) of the ECP
definition.\614\
---------------------------------------------------------------------------

\614\ Proposing Release, 75 FR at 80185.
---------------------------------------------------------------------------

The Commissions proposed to further define the term ``eligible
contract participant'' to preclude a Forex Pool from qualifying as an
ECP for purposes of retail forex transactions in reliance on clause
(A)(v) of the ECP definition if

[[Page 30649]]

such Forex Pool has any participant that is not an ECP and, therefore,
is not an ECP due to the look-through provision added to clause
(A)(iv). Further, because commodity pools can be structured in various
ways and can have one or more feeder funds and/or pools, the
Commissions proposed to preclude a Forex Pool from being an ECP for
purposes of retail forex transactions if there was any non-ECP
participant at any level of the pool structure (e.g., the pool itself,
a direct participant that invests in the pool, or any indirect
participant that invests in that pool through other pools or vehicles).
3. Commenters' Views
One commenter supported the Commissions' efforts to close the
potential loophole of Forex Pools that are unable to qualify as ECPs
due to the new look-through provision in clause (A)(iv) of the ECP
definition instead qualifying as ECPs under clause (A)(v) of the ECP
definition.\615\ This commenter indicated that it shares the
Commissions' concern that Forex Pools that do not satisfy the amended
ECP definition due to the look-through provision for commodity pools in
clause (A)(iv) may alternatively rely upon clause (A)(v) of the ECP
definition to qualify as an ECP for purposes of retail forex
transactions.\616\ This commenter further stated that Congressional
intent in requiring a look-through for Forex Pools would be frustrated
if fraudulent pool operators could avail themselves of this
alternative.\617\
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\615\ See letter from the NFA. The NFA indicated that it
recently took separate emergency actions against two firms that did
not qualify under the NFA's requirements for retail forex
transactions. In one case, the commodity pool fell short of the $5
million total asset requirement in clause (A)(iv) of the ECP
definition; in the other case, the firm never properly formed a
commodity pool. The NFA cautioned in its letter, ``these cases
illustrate that firms will attempt to obtain ECP status to shield
themselves from the jurisdiction of regulators to the detriment of
pool participants.''
\616\ Id.
\617\ Id.
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However, several commenters recognized the importance of the
concern about a potential loophole \618\ but stated that the
Commissions should revise the proposal to mitigate the potential
adverse consequences to market participants. One commenter, for
example, commented on the expected effects of the proposed rule on
funds of funds (``FOFs'').\619\ According to this commenter, FOFs (i)
normally face as counterparties foreign subsidiaries of U.S. banks and
foreign banks, and (ii) would incur substantial counterparty,
documentation and operational costs in moving their retail forex
transactions onto DCMs or toward the Enumerated Counterparties.
---------------------------------------------------------------------------

\618\ See, e.g., letters from SIFMA--AMG dated September 15,
2011 (``SIFMA AMG IV'') (acknowledging some form of ECP look-through
is appropriate to prevent evasion where circumvention otherwise
could occur and stating that it is sympathetic to the Commissions'
implicit objective of ensuring that a person that would not qualify
as an ECP not be permitted to accomplish indirectly what it is not
permitted to do directly), Sidley Austin LLP (``Sidley'') (stating
that the commenter fully appreciates that Congress added the look-
through language to the ECP definition to prevent unscrupulous forex
market participants from avoiding the retail forex provisions of the
CEA and the CFTC's rules by ``engineering'' an ECP by pooling the
capital of a large group of retail customers, thus depriving those
investors of the protections otherwise afforded to them), AIMA I
(stating that ``we understand Congress has made a decision to try to
protect retail investors by amending the definition of ECP under
Section 1a(1[8]) of the [CEA] to include that, for a commodity pool
to qualify as an ECP under sub-section (A)(iv), the pool's
underlying participants must also qualify as ECPs under section
1a(1[8])).''
\619\ See letter from Sidley. Sidley noted that FOF managers'
retail forex transactions are largely undertaken for hedging
purposes and that most FOF managers offer investments to non-U.S.
persons, a significant number of which pay for their investments in
FOF interests using their own currency. Sidley further noted that,
because most FOFs accept investments only in U.S. dollars, FOF
managers must convert to U.S. dollars the foreign currency received
from such investors and invest those dollars in underlying funds,
and that they enter into a hedging transaction to reduce the risk of
exchange rate changes between an investor's currency and the U.S.
dollar.
---------------------------------------------------------------------------

In a similar vein, two commenters advised that a substantial number
of hedge funds, as well as publicly offered commodity pools, would,
under the Commissions' proposal, fail to qualify as ECPs for purposes
of retail forex transactions, as most such funds have at least one
direct or indirect non-ECP participant.\620\ These commenters indicated
that this would disrupt the trading strategies employed by many
commodity trading advisors (``CTAs'') on behalf of commodity
pools.\621\ One of these commenters suggested an anti-evasion approach
combining a lower level of pool assets with a requirement that the
commodity pool not be formed for the purpose of evading the regulatory
requirements applicable to retail forex transactions.\622\
---------------------------------------------------------------------------

\620\ See letters from Willkie Farr & Gallagher LLP (``Willkie
Farr'') and the NYCBA Committee.
\621\ Id.
\622\ See letter from Willkie Farr.
---------------------------------------------------------------------------

Another commenter argued that Congress did not include the look-
through provision in clause (A)(v) of the ECP definition because of its
effect on bona fide hedgers.\623\ This commenter also advised that the
primary entities affected are hedge fund and private equity fund
managers investing in securities who use retail forex transactions
solely to hedge investment portfolio currency risks, and/or because
they accept subscriptions in currencies other than U.S. dollars.\624\
---------------------------------------------------------------------------

\623\ See letter from Akin Gump Strauss Hauer & Feld LLP (``Akin
Gump'').
\624\ Id.
---------------------------------------------------------------------------

Several commenters disagreed with the Commissions' statement in the
proposal that extending the look-through provision in clause (A)(iv) of
the ECP definition to clause (A)(v) would effectuate Congressional
intent. Two commenters noted that there is no specific Dodd-Frank Act
provision requiring such a change.\625\ Two other commenters argued
that clause (v) of the ECP definition provides an independent basis for
qualification as an ECP, which should not be affected by the changes in
clause (A)(iv) of the ECP definition.\626\
---------------------------------------------------------------------------

\625\ See letters from AIMA I and Ropes & Gray LLP (``Ropes &
Gray'').
\626\ See letters from Akin Gump, Sidley and Skadden, Arps,
Slate, Meagher & Flom LLP (``Skadden''). Sidley also indicated that
there seems to be no compelling reason to treat commodity pools
worse than other sophisticated market participants with respect to
retail forex transactions with non-Enumerated Counterparties, and no
reason to treat them worse than a corporation or other entity with
only $10 million in total assets that therefore qualifies as an ECP
under clause (A)(v) of the ECP definition to trade retail forex
transactions although it may have no particular expertise in such
markets.
---------------------------------------------------------------------------

One commenter indicated that the extraterritorial application of
the proposed rules regarding the ECP definition is unclear.\627\ Among
other things, this commenter indicated it is unnecessary to extend the
scope of the look-through to protect possible retail investors outside
of the U.S., especially where a CPO has not marketed a pool in the U.S.
and does not otherwise have any U.S. investors.\628\
---------------------------------------------------------------------------

\627\ See letter from AIMA I.
\628\ Id.
---------------------------------------------------------------------------

Commenters proposed several alternative approaches that they
believed would address the Commissions' concerns. One commenter
suggested that the Commissions create a new category of ECPs for Forex
Pools comprised entirely of qualified eligible persons (``QEPs'') \629\
and operated by persons subject to regulation under the CEA.\630\ This
commenter also suggested that the Commissions create a new category of
ECPs for Forex Pools that satisfy a monetary threshold for total assets
or for the minimum initial investment of a Forex Pool to be
sufficiently large that, in general, only legitimate pools would exceed
such thresholds.\631\ Finally, this commenter suggested that the
Commissions create a category of ECPs

[[Page 30650]]

for non-U.S. persons.\632\ A second commenter suggested that the
Commissions create a category of ECPs for commodity pools that are
operated by a CPO or advised by a CTA subject to regulation by a
foreign regulator comparable to the CFTC.\633\
---------------------------------------------------------------------------

\629\ The term ``qualified eligible person'' is defined in CFTC
Regulation Sec. Sec. 4.7(a)(2) and (3).
\630\ See letter from Sidley.
\631\ Id.
\632\ Id. Sidley cited to the approach in Regulation S under the
Securities Act (17 CFR 230.901 et seq.), Sections 3(c)(1) and (7) of
the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1) and (7)),
and CFTC Regulation Sec. 4.7(a)(2)(xi).
\633\ See letter from Willkie Farr.
---------------------------------------------------------------------------

One commenter suggested (i) allowing commodity pools and their
counterparties to rely, for the duration of an investment and each time
commodity pool participants make an investment decision, on participant
ECP representations provided in connection with an initial investment,
provided that each participant covenants to update such representations
if they become inaccurate, and (ii) providing specific relief for FOFs
because they generally invest all or substantially all of their assets
in underlying portfolio funds and use retail forex transactions to
reduce foreign exchange exposure.\634\
---------------------------------------------------------------------------

\634\ See letter from Sidley.
---------------------------------------------------------------------------

4. Final Rule
After considering commenters' concerns, the Commissions are
adopting final rules that have been revised from the proposal. In
particular, consistent with the statutory text of the Dodd-Frank Act,
CFTC Regulation Sec. 1.3(m)(5)(i) further defines the term ``eligible
contract participant'' to prohibit a Forex Pool that directly enters
into a retail forex transaction (i.e., a transaction-level commodity
pool) \635\ from qualifying as an ECP under clause (A)(iv) or clause
(A)(v) of the ECP definition, solely for purposes of entering into
retail forex transactions, if the pool has one or more direct
participants that are not ECPs. In response to commenters' concerns
described above, CFTC Regulation Sec. 1.3(m)(5)(ii) is revised to
provide that, in determining whether a commodity pool that is a direct
participant in a transaction-level Forex Pool is an ECP, the indirect
participants in the transaction-level Forex Pool \636\ will not be
considered unless such Forex Pool, a commodity pool holding a direct or
indirect (through one or more intermediate tiers of pools) interest in
such Forex Pool, or any commodity pool in which such Forex Pool holds a
direct or indirect interest has been structured to evade Subtitle A of
Title VII of the Dodd-Frank Act by permitting persons that are not ECPs
to participate in agreements, contracts, or transactions described in
section 2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Commodity
Exchange Act. That is, absent evasion, the Commissions are changing the
proposed ``indefinite look-through'' to an ``evasion-based look-
through'' in the final rule.\637\
---------------------------------------------------------------------------

\635\ Commodity pool structures can take various forms. One
common commodity pool structure is a ``master-feeder'' fund
structure. In such a structure, investors purchase interests in
``feeder funds,'' which in turn purchase interests in a ``master
fund.'' Typically, the only fund in a commodity pool structure that
enters into retail forex transactions (and other transactions)
directly is the master fund; the feeder funds (and their investors)
typically would participate indirectly by receiving the profit or
loss from such retail forex transactions (and other transactions) as
distributions based on the feeder funds' interests in the master
fund. Notwithstanding that the master-feeder structure is common,
other structures exist. Thus, each fund in a commodity pool
structure that directly enters into retail forex transactions is a
transaction-level commodity pool.
\636\ A fund that does not itself engage in retail forex
transactions but that holds an interest in a transaction-level Forex
Pool that engages in retail forex transactions is itself a commodity
pool. Cf. U.S. Regulation of the International Securities and
Derivatives Markets--Greene, Beller, Rosen, Silverman, Braverman and
Sperber, Sec. 12.13[1], n.351 and related text.
\637\ The Commissions caution, however, that they will closely
monitor developments in this part of the market and will not
hesitate to revisit their decision to limit the look-through
provision pursuant to 1.3(m)(5)(ii) should they observe a pattern of
evasion or misconduct.
---------------------------------------------------------------------------

In adding the look-through provision to the commodity pool prong of
the ECP definition, Congress made a decision to protect retail foreign
exchange investors by requiring that the participants in a Forex Pool
qualify as ECPs for the Forex Pool itself to qualify as an ECP. The
Commissions believe that the intent of the look-through provision--
protecting Forex Pool participants from fraudulent and abusive
conduct--must be given effect to comply with this Congressional
mandate. Nevertheless, the Commissions acknowledge commenters' concerns
about potential unintended consequences of applying an indefinite look-
through to every direct and indirect participant of a Forex Pool, as
proposed. Accordingly, to avoid unintended consequences and related
costs for Forex Pools whose operators and managers have not
historically presented the risks that the look-through provision was
intended to address,\638\ the Commissions are replacing the proposed
indefinite look-through of every participant in a Forex Pool with a
limited, evasion-based look-through pursuant to which a transaction-
level Forex Pool will qualify as an ECP, for purposes of retail forex
transactions, if all of such Forex Pool's direct participants are ECPs,
and will look through a commodity pool participant in such Forex Pool
only if it, at any level, has been structured to evade the look-through
provision in clause (A)(iv) of the ECP definition.
---------------------------------------------------------------------------

\638\ The proposed rule was based on the CFTC's longstanding,
broad view of what constitutes a ``pool,'' a view recently codified
in the ``commodity pool'' definition by section 721(a)(5) of the
Dodd-Frank Act in CEA section 1a(10), 7 U.S.C. 1a(10), and
recognized by courts, and thus applied the look-through provision at
each level of a Forex Pool's investment structure. See CFTC,
Commodity Pool Operators and Commodity Trading Advisors: Amendments
to Compliance Obligations, 77 FR 11252 (Feb. 24, 2012) (``CPO/CTA
Compliance Release'') (advising that ``it is the position of the
[CFTC] that a fund investing in an unaffiliated commodity pool it
itself a commodity pool'' and ``[t]his interpretation is consistent
with the statutory definition of commodity pool, which draws no
distinction between direct and indirect investments in commodity
interests''); CFTC v. Equity Financial Group, 572 F.3d 150, 157-158
(July 13, 2009) (concluding, in the context of a commodity pool that
invested all of its assets with a commodity pool operated by a
different CPO, that the CFTC's commodity pool regulations ``cover
pools that invest in other pools'' and that ``the remedial purposes
of the statute would be thwarted if the operator of a fund could
avoid the regulatory scheme simply by investing in another pool
rather than trading''). The same logic applies to a master-feeder
structure operated by the same CPO: the remedial purpose of the
look-through proviso in clause (A)(iv) of the statutory ECP
definition would be thwarted if the look-through could be defeated
simply by funneling pool participants into a master fund through a
feeder fund.
The proposed rule also was borne of the CFTC's long history of
combating fraudulent practices by typically unregistered individuals
or entities that prey upon often unsophisticated retail customers
through complex and highly leveraged off-exchange transactions in
foreign currency. However, the operators and managers of commodity
pool FOFs, master-feeder structures and hedge funds for
sophisticated investors have not generally been the subject of CFTC
enforcement actions with respect to retail forex transactions. For
an in depth discussion of the history of the CFTC's authority over
retail forex transactions, the abuses giving rise to that authority,
and related enforcement actions, see CFTC, Regulation of Off-
Exchange Retail Foreign Exchange Transactions and Intermediaries, 75
FR 3282 (Jan. 20, 2010). Congress acted three times in a decade to
clarify the CFTC's authority to prosecute the rampant fraud seen in
this area--first in the Commodity Futures Modernization Act of 2000,
Public Law 106-554, 114 Stat. 2763 (Dec. 21, 2000) in 2000, then
again in the CRA, and finally in the Dodd-Frank Act in 2010.
---------------------------------------------------------------------------

The Commissions believe the final rule strikes the right balance
between implementing strong protections for non-ECP commodity pool
participants and not imposing undue burdens or costs on CPOs, CTAs and
commodity pool participants related to retail forex transactions. In
addition, the Commissions believe that replacing the indefinite look-
through with the limited, evasion-based look-through alleviates many of
the commenters' concerns. Accordingly, the Commissions believe it is
appropriate to limit the look-through provision to the level of a
commodity pool structure that enters into retail forex transactions and
to look through commodity pools to their ultimate participants only in
those

[[Page 30651]]

cases in which it is required to prevent evasion of the protections for
those persons whom Congress intended to be subject to retail forex
transactions restrictions.
At the same time, the Commissions do not believe that Forex Pools
failing to qualify as ECPs due to the look-through provision in clause
(A)(iv) of the ECP definition should, nonetheless, be permitted
unfettered access to ECP status under clause (A)(v).\639\ The look-
through provision for Forex Pools provides heightened investor
protection from forex fraud for Forex Pool participants that are not
themselves ECPs. Thus, the Commissions believe that permitting Forex
Pools with one or more non-ECP participants to achieve ECP status by
relying on clause (A)(v) of the ECP definition, which applies to
business entities generally, would serve to undermine the look-through
provision that Congress specifically imposed on Forex Pools under
clause (A)(iv).\640\
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\639\ In section 712(d)(2)(A) of the Dodd-Frank Act, Congress
granted the Commissions the authority to adopt such rules regarding
the ECP definition as the Commissions determine are necessary and
appropriate, in the public interest, and for the protection of
investors.
\640\ The Commissions note that several commenters requested
clarification regarding the relationship between the look-through
provision set forth in CFTC Regulation Sec. 1.3(m)(5) and the
prohibition on a commodity pool qualifying as an ECP under clause
(A)(v) of the ECP definition if it does not qualify as an ECP under
clause (A)(iv) of the ECP definition set forth in CFTC Regulation
Sec. 1.3(m)(6). See, e.g., meeting with SIFMA--AMG on August 2,
2011. The look-through provision is limited to determining ECP
status under clause (A)(iv) or clause (A)(v) of the ECP definition
for purposes of retail forex transactions entered into by Forex
Pools. The look-through provision does not reference or implicate
ECP status for purposes of CEA section 2(e) (which prohibits non-
ECPs from entering into swaps other than on or subject to the rules
of a DCM), Securities Act section 5(d) (which prohibits a person
from offering to sell, offering to buy or purchase, or selling a
security-based swap to a person that is a non-ECP unless a
registration statement under the Securities Act is in effect with
respect to that security-based swap), or Exchange Act section 6(l)
(which prohibits a person from effecting a transaction in a
security-based swap with or for a person that is a non-ECP unless
the transaction is effected on a national securities exchange
registered with the SEC). The prohibition in CFTC Regulation Sec.
1.3(m)(6) on a commodity pool qualifying as an ECP under clause
(A)(v) of the ECP definition if it does not qualify as an ECP under
clause (A)(iv) of the ECP definition does not involve any look-
through. Rather, in contrast with CFTC Regulation Sec. 1.3(m)(5),
CFTC Regulation Sec. 1.3(m)(6) applies for purposes of all
agreements, contracts and transactions for which ECP status is
relevant. See part III.C, infra, for a discussion of the prohibition
on a commodity pool qualifying as an ECP under clause (A)(v) of the
ECP definition if it does not qualify as an ECP under clause (A)(iv)
of the ECP definition.
---------------------------------------------------------------------------

Moreover, developments subsequent to the issuance of the Proposing
Release should ameliorate commenters' concerns that CEA section
2(c)(2)(E)(ii)(I) significantly limits the universe of possible retail
forex transaction counterparties.\641\ At the time the Commissions
issued the Proposing Release and throughout the comment period, the
CFTC was the only Federal regulatory agency that had issued final rules
governing retail forex transactions by its regulated persons and
entities.\642\ Since then, though, both the OCC and the FDIC finalized
(effective July 15, 2011) rules governing retail forex transactions by
Enumerated Counterparties regulated by those agencies.\643\ In
addition, the SEC has issued interim temporary final rules (also
effective July 15, 2011) governing retail forex transactions by
registered broker-dealers.\644\ Also, the Federal Reserve Board
proposed rules to govern retail forex transactions by its regulated
banks on August 3, 2011.\645\ As a result of these regulatory actions,
Forex Pools that are not ECPs due to the look-through provision and who
are subject to a counterparty limitation \646\ may enter into retail
forex transactions with any Enumerated Counterparty but for those
regulated by the Federal Reserve Board.\647\
---------------------------------------------------------------------------

\641\ See also part III.G, infra, discussing CFTC Regulation
Sec. 1.3(m)(8), one effect of which is to eliminate the retail
forex transaction counterparty restriction for Forex Pools
qualifying as ECPs.
\642\ See generally Part 5 of the CFTC's regulations, 17 CFR 5,
and CFTC, Regulation of Off-Exchange Retail Foreign Exchange
Transactions and Intermediaries, 75 FR 55410 (Sept. 10, 2010). See
also CFTC, Retail Foreign Exchange Transactions; Conforming Changes
to Existing Regulations in Response to the Dodd-Frank Wall Street
Reform and Consumer Protection Act 76 FR 56103 (Sept. 12, 2011).
\643\ See FDIC, Retail Foreign Exchange Transactions, 76 FR
40779 (July 12, 2011) (final FDIC retail forex rules); OCC, Retail
Foreign Exchange Transactions, 76 FR 41375 (July 14, 2011) (final
OCC retail forex rules); see also OCC, Retail Foreign Exchange
Transactions, 76 FR 56094 (Sept. 12, 2011) (interim final OCC retail
forex rules for federal savings associations and their operating
subsidiaries).
\644\ See SEC, Retail Foreign Exchange Transactions, 76 FR 41676
(July 15, 2011). In the release accompanying the rules, the SEC
requested comment on broker-dealers' involvement in retail forex
transactions to inform the SEC in developing permanent rules to
regulate these activities. See id. at 46181-83.
\645\ See Board, Retail Foreign Exchange Transactions
(Regulation NN), 76 FR 46652 (Aug. 3, 2011) (proposed Board rules
for retail forex transactions).
\646\ See part III.B.1, supra, discussing the applicability of
the counterparty limitation.
\647\ Of course, upon the Board's finalization of its retail
forex rules, U.S. financial institutions regulated by the Board also
will be acceptable counterparties.
---------------------------------------------------------------------------

The Commissions believe that the final rules reasonably address
commenters' concerns. In this regard, the Commissions note that in
applying the look-through provision, the Commissions will consider the
indirect participants in a transaction-level Forex Pool if such Forex
Pool, a commodity pool holding a direct or indirect (through one or
more intermediate tiers of pools) interest in such Forex Pool, or any
commodity pool in which such Forex Pool holds a direct or indirect
interest has been structured to evade Subtitle A of Title VII of the
Dodd-Frank Act by permitting persons that are not ECPs to participate
in agreements, contracts, or transactions described in section
2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Commodity Exchange Act.
One example of a scheme to evade would be if a commodity pool tier has
been included in the structure of the Forex Pool primarily to provide
non-ECP participants exposure to retail forex transactions rather than
to achieve any other legitimate business purpose.\648\ One example of a
``legitimate business purpose'' that would not trigger the look-through
provision is a FOF operated primarily for the purpose of investing in
underlying funds and using retail forex transactions solely to hedge
the currency risk posed by an unfavorable change in the exchange rate
between the currency in which underlying funds accept investments and
the currency in which FOF investors pay for their investments in the
FOF.\649\ Similarly, the Commissions would not consider a commodity
pool using retail forex transactions solely for bona fide hedging
purposes \650\ with

[[Page 30652]]

respect to currency risk as being structured to avoid the look-through
provision.\651\ The ``participate in agreements, contracts, or
transactions described in section 2(c)(2)(B)(i) or section
2(c)(2)(C)(i) of the Act'' language of CFTC Regulation Sec.
1.3(m)(5)(ii) is aimed at exposure to retail forex transactions as an
asset class, investment strategy, or an end in itself, not at exposure
to retail forex transactions solely designed for bona fide hedging
purposes with respect to foreign exchange exposure arising in the
course of a commodity pool's business.\652\
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\648\ Feeder funds are usually added to commodity pool
structures for purposes such as tax efficiency. A master-feeder
structure ``[permits] U.S. taxable investors to take advantage of
investing in a U.S. limited partnership feeder fund, which[,]
through certain elections made at the time the structure is
established, is tax effective for such U.S. taxable investors'' and
``[permits] [n]on-U.S. and U.S. tax-exempt investors [to] subscribe
via a separate offshore feeder company so as to avoid coming
directly within the U.S. tax regulatory net applicable to U.S.
taxable investors.'' Effie Vasilopoulos & Katherine Abrat, The
Benefits of Master-Feeder Fund Structures for Asian-based Hedge Fund
Managers, Hedge Fund Monthly (April 2004), available at http://www.eurekahedge.com/news/04apr_archive_Sidley_master_feeder.asp.
Other benefits can include efficiencies gained by the use of only a
single trading entity, avoiding the need to split trade tickets,
eliminating the need to duplicate agreements with counterparties and
greater economies of scale in administering the fund. Id.
\649\ Sidley notes that the typical FOF operates in this manner.
See generally letter from Sidley for a more detailed discussion of
these transactions.
\650\ In this context, bona fide hedging purposes means bona
fide hedging purposes within the meaning and intent of CFTC
Regulation Sec. 1.3(z)(1), except that the requirement therein that
the transaction or position be on a DCM or SEF that is a trading
facility will not be a factor in the bona fide hedging purpose
analysis. Compare CFTC Regulation Sec. 4.5(c)(2)(iii)(A) (relying
in part on the bona fide hedging concepts in CFTC Regulations
Sec. Sec. 1.3(z)(1) and 151.5 to provide relief from the CPO
definition). See also CPO/CTA Compliance Release at 11256-11257
(discussing and declining to adopt commenters' request to expand the
definition of bona fide hedging to include risk management). Where a
Forex Pool's counterparty, but not the Forex Pool, is hedging its
risks, it is not the case that the Forex Pool is entering the retail
forex transaction solely to hedge its own risk.
\651\ The examples mentioned in text should not be construed to
mean that any other fact pattern does or does not constitute
evasion, which must be determined on a case-by-case basis.
\652\ Based on the same reasoning, the Commissions do not
believe it was the intent of the look-through proviso in CEA section
1a(18)(A)(iv) to subject to a retail forex regime a single level
commodity pool engaging in retail forex transactions solely for bona
fide hedging purposes with respect to foreign exchange exposure
arising in the course of a commodity pool's operations.
Consequently, the Commissions will interpret such a commodity pool
as an ECP if it otherwise satisfies the terms of CEA section
1a(18)(A)(iv) even if such a pool has one or more non-ECP
participants.
---------------------------------------------------------------------------

In applying the limited look-through provision in the final rule,
the Commissions would consider a Forex Pool's direct participants to
include not only persons that initially hold interests in the level of
the commodity pool structure that enters into retail forex
transactions, but also persons that can acquire those interests or that
subsequently hold those interests. As applied to exchange-traded
products (``ETPs'') that are Forex Pools, any person that acquires an
interest in the ETP Forex Pool in secondary market transactions would
be a direct participant. ETPs typically issue shares only in the large
aggregations or blocks (such as 50,000 ETP shares) called ``Creation
Units.'' An authorized purchaser, usually an investment bank, broker
dealer or large institutional investor, may purchase a Creation Unit.
After purchasing a Creation Unit, the authorized purchaser may hold the
Creation Unit, or sell some or all of the ETP shares in the Creation
Unit to investors in secondary market transactions by splitting up the
Creation Unit and selling the individual ETP shares on a national
securities exchange or in off-exchange transactions. The ability to
break up the Creation Unit into ETP shares permits other investors,
such as non-ECPs, to purchase the individual ETP shares in secondary
market transactions.
All participants in an ETP Forex Pool must be ECPs when they
purchase or otherwise acquire an interest in the ETP Forex Pool. In
addition, an ETP Forex Pool will not be able to verify whether the
persons that acquire interests in the ETP Forex Pool in exchange
transactions are ECPs. The ability of non-ECPs to acquire interests in
an ETP Forex Pool and the inability of the ETP Forex Pool to verify ECP
status with respect to exchange transactions create a presumption that
ETP Forex Pools are not ECPs and, therefore, are Retail Forex Pools.
This presumption would not apply in the case of a Forex Pool that is
structured in a manner that does not involve exchange trading and in
which the Forex Pool would be able to verify the ECP status of its
participants.
One commenter suggested that the Commissions allow commodity pools
and their counterparties to rely on participant ECP representations
provided in connection with an initial investment.\653\ The Commissions
note that the obligation to determine that the parties to retail forex
transactions are ECPs is imposed on the CPOs of Forex Pools and the
counterparties looking to enter into retail forex transactions with
Forex Pools. In making that determination, the Commissions expect CPOs
and retail forex transaction counterparties to Forex Pools to be guided
by the principles for verifying the ECP status of a swap dealer's or
major swap participant's counterparty discussed in the CFTC's recently
adopted external business conduct standards, including the safe
harbor.\654\ Thus, solely for purposes of CEA section 1a(18)(A)(iv) and
CFTC Regulation Sec. 1.3(m)(5), the Commissions will permit CPOs and
retail forex transaction counterparties to rely on written
representations from, as applicable, pool participants or potential
pool participants that the person making the representation is an ECP
(or is a non-U.S. person; as discussed below in this section III.B.4.,
solely for purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation
Sec. 1.3(m)(5), the Commissions will consider Forex Pools whose
participants are limited solely to non-U.S. persons (and which are
operated by CPOs located outside of the U.S., its territories or
possessions) to be ECPs), or from Forex Pools that the Forex Pool is an
ECP, provided that the CPO or retail forex transaction counterparty has
a reasonable basis to so rely, just as swap dealers and major swap
participants are permitted to do pursuant to the safe harbor in new
CFTC Regulation Sec. 23.430(d), 17 CFR 23.430(d). Solely for purposes
of CEA section 1a(18)(A)(iv) and CFTC Regulation Sec. 1.3(m)(5), a CPO
or retail forex transaction counterparty will have a reasonable basis
to rely on such written representations if the person making the
representation specifies therein the provision(s) of, as applicable,
section 1a(18) of the CEA or CFTC Regulation Sec. 4.7(a)(1)(iv)
pursuant to which the person qualifies as an ECP or a non-U.S. person,
respectively, unless it has information that would cause a reasonable
person to question the accuracy of the representation.\655\ Solely for
purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation Sec.
1.3(m)(5), persons representing that they qualify as non-U.S. persons
based on CFTC Regulation Sec. 4.7(a)(1)(iv)(D) must represent that
they are relying on such provision as modified as discussed below
(i.e., without the 10% carve-out for U.S. persons).
---------------------------------------------------------------------------

\653\ See letter from Sidley.
\654\ See CFTC, Business Conduct Standards for Swap Dealers and
Major Swap Participants With Counterparties; Final Rule, 77 FR 9733
(Feb. 17, 2012).
\655\ Cf. CFTC Regulation Sec. Sec. 23.430(d), 23.402(d).
---------------------------------------------------------------------------

Furthermore, the CFTC recognizes that, despite a counterparty's
reasonable good faith efforts to ensure that Forex Pools do not in fact
have any U.S. participants, a situation may arise where a Forex Pool
does turn out to have U.S. participants. If a counterparty has
reasonable policies and procedures in place to verify the ECP status of
Forex Pool counterparties and, notwithstanding such reasonable good
faith efforts and following such policies and procedures, enters into
retail forex transactions with such a Forex Pool in good faith and it
was subsequently determined that U.S. participants represented no more
than a de minimis number of participants or amount of ownership of the
Forex Pool, absent other material factors, the CFTC would not expect to
bring an enforcement action against the counterparty for entering into
a retail forex transaction in contravention of the requirements of the
retail forex regime. For purposes of this analysis only, and without
this being viewed as a de minimis threshold for purposes of this rule
or otherwise, the CFTC would consider as de minimis, ownership of units
of participation of a Forex Pool held by U.S. participants of less than
10% of the beneficial interest in the Forex Pool. The fact that, absent
other material factors, the CFTC would not expect to bring an
enforcement action against a forex transaction counterparty in such
case does not

[[Page 30653]]

relieve any obligation on the part of the CPO of the Forex Pool either
to register as a CPO, claim the 4.13(a)(3) exemption therefrom or
redeem the U.S. participants as described above.
One commenter suggested that the Commissions allow commodity pools
and their counterparties to rely on participant ECP representations
provided in connection with an initial investment.\656\ The Commissions
believe that if participants make ECP representations in connection
with an initial investment in a Forex Pool, absent an additional
investment (which would require a new ECP verification, other than in
the case of automatically reinvested distributions), the subsequent
loss of a participant's ECP status would not cause the Forex Pool to
lose its own ECP status for purposes of retail forex transactions so
long as the operating agreement of the Forex Pool or the subscription
or other agreement pursuant to which the participant invested in the
Forex Pool requires the participant to advise the CPO of the Forex Pool
promptly of a loss of the participant's ECP status. In the event of the
loss of ECP status of a participant, the CPO would be required to
redeem the non-ECP from the Forex Pool at the first opportunity
following notification to avoid the Forex Pool losing its ECP status
for subsequent retail forex transactions.
---------------------------------------------------------------------------

\656\ See letter from Sidley. The Commissions note that the
obligation to determine that the parties to retail forex
transactions are ECPs is imposed on the CPOs of Forex Pools and the
persons looking to engage in retail forex transactions with Forex
Pools.
---------------------------------------------------------------------------

The Commissions are mindful that several commenters indicated that
CPOs do not customarily include a question or representation as to ECP
status in subscription agreements for pool participants, and stated
that requiring CPOs to qualify or redeem existing participants due to
the new look-through provision would be expensive, burdensome and
disruptive.\657\ In this regard, the Commissions note that the look-
through requirement for commodity pools was imposed by statute. As a
result of the Commissions adopting the limited look-through in the
final rule (as compared to the proposed indefinite look-through),
however, the number of commodity pools subject to the look-through
provision should be dramatically reduced, reducing the number of pools
subject to regulation of their retail forex transactions, and the
associated costs, accordingly.\658\
---------------------------------------------------------------------------

\657\ See, e.g., letter from SIFMA AMG IV.
\658\ The adoption of CFTC Regulation Sec. 1.3(m)(8), discussed
in part III.G, infra, also should reduce the number of pools subject
to regulation of their retail forex transactions, and the associated
costs, accordingly.
---------------------------------------------------------------------------

Also, in response to commenter concerns that the look-through
provision would be applied to entities other than commodity pools
(e.g., operating companies),\659\ the Commissions revised the text of
CFTC Regulation Sec. 1.3(m)(5)(i) to reflect their intent to apply the
look-through provision solely to commodity pools qualifying as ECPs, if
at all, under clause (A)(iv) and clause (A)(v) of the ECP
definition.\660\ This is consistent with the statutory text, which is
limited to looking through commodity pools under clause (A)(iv) of the
ECP definition, and the intent behind the look-through provision, as it
relates to clause (A)(v) thereof.
---------------------------------------------------------------------------

\659\ See, e.g., letter from Sandalwood Securities, Inc.
(expressing concern that ``the Proposed Rule extends Dodd-Frank's
limited look-through provision to all sub-sections of section
la(12)'').
\660\ Thus, for example, investment companies qualifying under
clause (A)(iii) of the ECP definition and employee benefit plans
qualifying under clause (A)(vi) of the ECP definition (and, as
stated in each clause, ``a foreign person performing a similar role
or function subject as such to foreign regulation'') would not be
covered by the look-through provision. To the extent that other
entities would otherwise be captured by the look-through as proposed
(such as collective investment trusts whose investors are ERISA
plans not excluded from the commodity pool definition by CFTC
Regulation Sec. 4.5(a)(4) and which qualify as ECPs under clause
(A)(v) of the ECP definition), the Commissions believe that focusing
on the level of the Forex Pool entering into the retail forex
transactions, and such Forex Pool's direct participants (absent
evasion), should alleviate such concerns.
---------------------------------------------------------------------------

Commenters also stated that Retail Forex Pools will no longer be
able to enter into retail forex transactions with foreign financial
institutions.\661\ As discussed in section III.B.1. above, however,
this is not the case with respect to retail forex transactions
described in CEA section 2(c)(2)(C)(i)(I)(bb). With respect to retail
forex transactions described in CEA section 2(c)(2)(B)i)(I), this is a
consequence of the express statutory text of the Dodd-Frank Act, which
removed non-U.S. financial institutions from the list of Enumerated
Counterparties eligible to enter into retail forex transactions with
non-ECPs.\662\
---------------------------------------------------------------------------

\661\ Cf. letters from Sidley and Millburn Ridgefield
Corporation (``Millburn'').
\662\ See section 742(c) of the Dodd-Frank Act, amending CEA
section 2(c)(2)(B)(i)(II)(aa), 7 U.S.C. 2(c)(2)(B)(i)(II)(aa).
---------------------------------------------------------------------------

Commenters further suggested generally that the Commissions create
additional categories of ECPs to address the Commissions' concerns
regarding the potential loophole of Retail Forex Pools that are unable
to qualify as ECPs due to the new look-through provision in clause
(A)(iv) of the ECP definition qualifying as an ECP under clause (A)(v)
of the ECP definition. While one commenter proposed adopting a new rule
clarifying that Forex Pools comprised entirely of QEPs and operated by
persons subject to regulation under the CEA are ECPs,\663\ Congress
chose to look to ECP status of Forex Pool participants, not QEP status,
as the basis for determining whether such Forex Pools are ECPs.
Therefore, it is more appropriate to rely on Retail Forex Pool
participants' ECP status than to rely on QEP status to establish ECP
status.
---------------------------------------------------------------------------

\663\ See letter from Sidley. This commenter also suggested
deeming non-U.S. persons to be ECPs by definition. The Commissions
have addressed this comment below in this section in response to the
comment regarding the extraterritorial impact of the proposed ECP
rules.
---------------------------------------------------------------------------

One commenter stated a concern regarding what it characterized as
the lack of clarity surrounding the extraterritoriality impact of the
proposed ECP rules.\664\ The Commissions recognize the potential
consequences of the broad look-through language in CEA section
1a(18)(A)(iv) \665\ and are providing guidance as to the application of
the look-through to Forex Pools whose participants are limited solely
to non-U.S. persons and which are operated by CPOs located outside the
United States, its territories or possessions.
---------------------------------------------------------------------------

\664\ See letter from AIMA I.
\665\ 7 U.S.C. 1a(18)(A)(iv).
---------------------------------------------------------------------------

As discussed below, while foreign entities are not necessarily
immune from U.S. jurisdiction for commercial activities undertaken with
U.S. counterparties or in U.S. markets, canons of statutory
construction ``assume that legislators take account of the legitimate
sovereign interests of other nations when they write American laws,''
\666\ particularly when limited U.S. interests are at stake.\667\
---------------------------------------------------------------------------

\666\ See F. Hoffman-LaRoche, Ltd. v. Empagran S.A., 542 U.S.
155, 164 (2004), citing Murray v. Schooner Charming Betsy, 2 Cranch
64, 118, 2 L.Ed. 208 (1804) (``[A]n act of congress ought never to
be construed to violate the law of nations if any other possible
construction remains''); Hartford Fire Insurance Co. v. California,
509 U.S. 764 (1993) (Scalia, J., dissenting). See also Restatement
(Third) Foreign Relations Law Sec. 403 (scope of a statutory grant
of authority must be construed in the context of international law
and comity including, as appropriate, the extent to which regulation
is consistent with the traditions of the international system).
\667\ See also CFTC, Exemption From Registration for Certain
Foreign Persons, 72 FR 63976 (Nov. 14, 2007) (where the CFTC stated
that:
Given this agency's limited resources, it is appropriate at this
time to focus [the Commission's] customer protection activities upon
domestic firms and upon firms soliciting or accepting orders from
domestic users of the futures markets and that the protection of
foreign customers of firms confining their activities to areas
outside this country, its territories, and possessions may best be
for local authorities in such areas)
(citing CFTC, Introducing Brokers and Associated Persons of
Introducing Brokers, Commodity Trading Advisors and Commodity Pool
Operators; registration and Other Regulatory Requirements, 48 FR
35248, 35261 (Aug. 3, 1983)).

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

[[Page 30654]]

The Commissions do not believe that Congress intended for Forex
Pools with no U.S. participants and operated by CPOs located outside
the United States, its territories or possessions to be subject to a
U.S. retail forex regime and, therefore, will consider Forex Pools
whose participants are limited solely to non-U.S. persons and which are
operated by CPOs located outside the United States, its territories or
possessions to be ECPs for purposes of CFTC Regulation Sec. 1.3(m)(5).
For this purpose, a Forex Pool participant is a non-U.S. person if it
satisfies the definition of ``Non-United States person'' in CFTC
Regulation 4.7(a)(1)(iv); provided, however, that, if a participant is
an entity organized principally for passive investment, such as a pool,
investment company or other similar entity, such entity will be
considered to be a Non-United States person under paragraph (D) of CFTC
Regulation 4.7(a)(1)(iv) for purposes of CFTC Regulation Sec.
1.3(m)(5) solely if all units of participation in such passive
investment vehicle participant are held by Non-United States
persons.\668\ A broader interpretation or relief is not appropriate at
this time.\669\
---------------------------------------------------------------------------

\668\ CFTC Regulation Sec. 4.7(a)(i)(iv)(D) lists the following
as one category of non-United States person:
An entity organized principally for passive investment such as a
pool, investment company or other similar entity; Provided, That
units of participation in the entity held by persons who do not
qualify as Non-United States persons or otherwise as qualified
eligible persons represent in the aggregate less than 10% of the
beneficial interest in the entity, and that such entity was not
formed principally for the purpose of facilitating investment by
persons who do not qualify as Non-United States persons in a pool
with respect to which the operator is exempt from certain
requirements of part 4 of the Commission's regulations by virtue of
its participants being Non-United States persons.
It would be inappropriate to disregard the presence of U.S.
persons constituting as much as 10% of such entities' participants
in the context of this interpretive guidance. As discussed elsewhere
herein, however, entities described in CEA section 1a(18)(A)(iii) or
(vi), 7 U.S.C. 1a(18)(A)(iii) or (vi), are not subject to the look-
through and are ECPs irrespective of the ECP status of their
participants.
\669\ Cf. CPO/CTA Compliance Release at 11264 (stating that ``it
is prudent to withhold consideration of a foreign advisor exemption
until the [CFTC] has received data regarding such firms on Forms
CPO-PQR and/or CTA-PR * * * to enable the [CFTC] to better assess
[which] firms * * * may be appropriate to include within the
exemption, should the [CFTC] decide to adopt one'').
---------------------------------------------------------------------------

C. ECP Status for Commodity Pools Under Clause (A)(v) vs. Under Clause
(A)(iv) of the ECP Definition

1. Proposed Approach
The Commissions stated in the Proposing Release that they believe
``some commodity pools unable to satisfy the total asset or regulated
status components of clause (A)(iv) of the ECP definition may rely on
clause (A)(v) to qualify as ECPs instead.'' \670\ The Commissions
further stated in the Proposing Release that ``a commodity pool that
cannot satisfy the monetary and regulatory status conditions prescribed
in clause (A)(iv) should not qualify as an ECP in reliance on clause
(A)(v) of the ECP definition.'' \671\ Based on those views, the
Commissions proposed to further define the term ``eligible contract
participant'' to prevent such a commodity pool from qualifying as an
ECP pursuant to clause (A)(v) of the ECP definition. This proposal
applied to all commodity pools, not just Forex Pools engaged in retail
forex transactions.
---------------------------------------------------------------------------

\670\ Proposing Release, 75 FR at 80185.
\671\ Id.
---------------------------------------------------------------------------

2. Commenters' Views
Two commenters argued that, had Congress wished to prevent
commodity pools from relying on the general ECP provision for business
entities in clause (A)(v), it could have expressly excluded commodity
pools from clause (A)(v).\672\ Another commenter attempted to
illustrate that clause (A)(v) of the ECP definition is an independent
basis for qualifying as an ECP by distinguishing clause (A)(v) from
clause (A)(iv).\673\
---------------------------------------------------------------------------

\672\ See letters from Sidley and Skadden.
\673\ See letter from Akin Gump. Akin Gump noted that ``[a]s
opposed to [clause] (A)(iv), [clause] (A)(v) includes as one means
of satisfying its criteria that the entity be entering into a
contract for hedging purposes.'' While correct, clause (A)(v) also
includes as another means of satisfying its criteria that an entity
enter into agreements, contracts or transactions in connection with
the conduct of the entity's business, which would be a much lower
standard.
---------------------------------------------------------------------------

One commenter expressed the view that it is unclear whether
``subject to regulation under this Act'' in CEA section
1a(18)(A)(iv)(II) \674\ means a registered CPO or something else (e.g.,
a person excluded from the definition of a CPO, a CPO exempt from
registration conditioned in part upon making a filing to claim such
relief).\675\
---------------------------------------------------------------------------

\674\ 7 U.S.C. 1a(18)(A)(iv)(II).
\675\ See letter from SIFMA AMG IV. CEA Section
1a(18)(A)(iv)(II) refers to a commodity pool that ``is formed and
operated by a person subject to regulation under this Act or a
foreign person performing a similar role or function subject as such
to foreign regulation (regardless of whether each investor in the
commodity pool or the foreign person is itself an eligible contract
participant) provided, however, that for purposes of section
2(c)(2)(B)(vi) and section 2(c)(2)(C)(vii), the term `eligible
contract participant' shall not include a commodity pool in which
any participant is not otherwise an eligible contract participant.''
---------------------------------------------------------------------------

3. Final Rule
The Commissions are adopting CFTC Regulation Sec. 1.3(m)(6) as
proposed, which states that ``[a] commodity pool that does not have
total assets exceeding $5,000,000 or that is not operated by a person
described in subclause (A)(iv)(II) of section 1a(18) of the Act is not
an eligible contract participant pursuant to clause (A)(v) of such
Section.'' \676\ As noted, the Commissions are concerned that clause
(A)(v) of the ECP definition may undermine the protections that
specifically apply to commodity pool participants pursuant to the
limitations on ECP status for commodity pools set forth in clause
(A)(iv) of the ECP definition. Allowing a commodity pool that cannot
satisfy the monetary and regulatory status conditions prescribed for
commodity pools in clause (A)(iv) to qualify as an ECP under clause
(A)(v) would undermine these protections.
---------------------------------------------------------------------------

\676\ The Commissions have made certain technical corrections to
proposed CFTC Regulation Sec. 1.3(m)(6)(i) as concerns its
citations to the CEA.
---------------------------------------------------------------------------

The Commissions acknowledge the comments stating that clause (A)(v)
of the ECP definition is an independent basis for qualifying as an ECP
and that Congress did not explicitly provide that a commodity pool that
fails to qualify as an ECP under clause (A)(iv) cannot do so under
clause (A)(v). However, when specifically legislating for commodity
pools, Congress determined that total assets of $5 million and
operation by a person subject to regulation under the CEA (or a foreign
equivalent) are necessary to assure appropriate protection for non-ECP
participants in a commodity pool. Furthermore, the commenters' view
that Congress's use of the disjunctive term ``or'' between clauses
(A)(x) and (A)(xi) of the ECP definition means that an entity can rely
on clause (A)(v) of the ECP definition, notwithstanding that such
entity cannot satisfy a prong more specific to it, would largely render
superfluous each clause under subparagraph (A) of the ECP definition
other than clause (v) and clause (xi) (for individuals).\677\ As such,
the Commissions believe that the final rule adopted in this release is
consistent with Congressional intent.
---------------------------------------------------------------------------

\677\ Interpreting statutory language as surplusage is
disfavored. Effect should be given to every clause and word of a
statute. See Negonsott v. Samuels, 507 U.S. 99 (1993).
---------------------------------------------------------------------------

The Commissions also are mindful that one commenter expressed a
concern that the Commissions' reliance on clause (A)(iv) of the ECP
definition

[[Page 30655]]

might cause commodity pools to lose their ability to claim ECP status
under clauses of the ECP definition, other than clause (v), and asked
the Commissions to clarify the meaning of the phrase ``formed and
operated by a person subject to regulation under the [CEA]'' in clause
(A)(iv).\678\ In response, the Commissions note that a commodity pool
that does not qualify for ECP status under clause (A)(iv) of the ECP
definition may still qualify as an ECP under either of the two clauses
of the ECP definition other than clause (A)(v) applicable to
subcategories of commodity pools. Thus, registered investment companies
and foreign equivalents may qualify as ECPs under clause (A)(iii) of
the ECP definition, and ERISA plans and the other entities described in
clause (A)(vi) of the ECP definition may qualify as ECPs thereunder.
The Commissions' actions in this release do not change that result.
---------------------------------------------------------------------------

\678\ See letter from SIFMA AMG IV.
---------------------------------------------------------------------------

Also, with regard to that commenter's request for clarification,
for purposes of CFTC Regulation Sec. 1.3(m)(6), the Commissions
interpret the language ``subject to regulation under the [CEA]'' in
clause (A)(iv) of the ECP definition as requiring lawful operation of
the commodity pool by a person excluded from the CPO definition, a
registered CPO, or a person properly exempt from CPO registration.\679\
Congress did not limit ECP status under clause (A)(iv) to commodity
pools operated by persons registered as CPOs; it used the more
encompassing phrase ``subject to regulation'' under the CEA.\680\ On
the other hand, to construe that phrase to include any person operating
a commodity pool would render the phrase superfluous.\681\ The
commenters' view would enable a CPO that fails to register as required
to claim that the commodity pool it operates is an ECP under clause
(A)(v) and thus is not subject to regulation of its retail forex
transactions. The Commissions believe that construing the phrase
``formed and operated by a person subject to regulation under the
[CEA]'' to refer to a person excluded from the CPO definition,
registered as a CPO or properly exempt from CPO registration
appropriately reflects Congressional intent.
---------------------------------------------------------------------------

\679\ For these purposes, the Commissions would take the same
approach to insignificant deviations from exemptive filings as the
CFTC does in CFTC Regulation Sec. 4.7(e).
\680\ If the Commissions interpreted the ``subject to regulation
under this Act'' language in CEA section 1a(18)(A)(iv)(II) to mean
that the commodity pool operator must be registered as a CPO and
limited CPOs to claiming ECP status solely under clause (iv) of the
ECP definition, then the operators of all commodity pools trading
swaps would have to register as CPOs to be ECPs. While more CPOs
will be registering with the CFTC because the CFTC has withdrawn
CFTC Regulation Sec. 4.13(a)(4), see CPO/CTA Compliance Release,
and the Dodd-Frank Act has expanded the scope of the transactions
within the CFTC's jurisdiction, thus reducing the number of CPOs who
can rely on the 5 percent threshold in CFTC Regulation Sec.
4.13(a)(3) and thus claim the CPO registration exemption, the CFTC
did not withdraw 4.13(a)(3), so some CPOs will be able to continue
to rely on it. Also, not all persons operating commodity pools will
be CPOs. See CFTC Regulation Sec. 4.5 (exclusion from the
definition of the term ``commodity pool operator''). The Commissions
do not believe Congress intended commodity pool ECP status to
require CPO registration by the commodity pools' operators in all
cases.
\681\ If the mere act of forming or operating a commodity pool
means that a person is ``subject to regulation'' under the CEA, then
the ``subject to regulation'' language would not be needed.
---------------------------------------------------------------------------

D. Dealers and Major Participants as ECPs

1. Proposed Approach
The Commissions proposed to add swap dealers, security-based swap
dealers, major swap participants and major security-based swap
participants to the ECP definition on the basis that such persons ``are
likely to be among the most active and largest users of swaps and
security-based swaps.'' \682\
---------------------------------------------------------------------------

\682\ Proposing Release, 75 FR at 80184.
---------------------------------------------------------------------------

2. Commenters' Views
Several commenters supported the proposed addition of swap dealers,
security-based swap dealers, major swap participants, and major
security-based swap participants to the ECP definition.\683\ No
commenter opposed this aspect of the proposal.
---------------------------------------------------------------------------

\683\ One representative commenter stated that ``the proposed
definition in CFTC Proposed CFTC Regulation Sec. 1.3(m)(1)-(4)
fills important gaps left by Congress by ensuring that major swap
participants, major security-based swap participants, swap dealers
and security-based swap dealers are treated as ECPs.'' See letter
from Sidley.
---------------------------------------------------------------------------

3. Final Rule
The Commissions are adopting the new ECP categories as proposed.
The rules as adopted clarify that the terms ``swap dealer,''
``security-based swap dealer,'' ``major swap participant,'' and ``major
security-based swap participant'' have their respective meanings as
defined in the CEA and the Exchange Act and as otherwise further
defined by the Commissions.\684\
---------------------------------------------------------------------------

\684\ These new ECP categories are set forth in new CFTC
Regulation Sec. 1.3(m)(1)-(4).
---------------------------------------------------------------------------

E. Government Entities: Incorrect Cross-Reference

1. Description of the Issue
Clause (A)(vii) of the ECP definition conditions the ECP status of
governmental entities, and their political subdivisions, agencies,
instrumentalities and departments (collectively, ``government
entities''), in part, on the identity of their counterparties.
Specifically, a government entity may qualify as an ECP under the
provision in clause (A)(vii) that requires the entity's counterparty to
be ``listed in any of subclauses (I) through (VI) of section
2(c)(2)(B)(ii)'' of the CEA.\685\ However, subclauses (I) through (III)
of CEA section 2(c)(2)(B)(ii) \686\ are unrelated to counterparty types
(rather, they describe the dollar amounts that apply for purposes of
retail forex transactions under CEA section 2(c)(2)(B)), and subclauses
(IV) through (VI) of CEA section 2(c)(2)(B)(ii) no longer exist in the
statute. Read literally, then, this provision of the ECP definition is
inherently a nullity and, thus, cannot enable government entities to
qualify as ECPs.\687\
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\685\ CEA section 1a(18)(A)(vii)(cc), 7 U.S.C.
1a(18)(A)(vii)(cc).
\686\ 7 U.S.C. 2(c)(2)(B)(ii)(I)-(III).
\687\ A government entity, though, can still qualify as an ECP
under the other provisions of clause (A)(vii) if it is a certain
type of ``eligible commercial entity'' as defined in CEA section
1a(17), 7 U.S.C. 1a(17), or owns and invests on a discretionary
basis $50 million or more in investments.
---------------------------------------------------------------------------

2. Commenters' Views
One commenter traced the history of the relevant provisions and
concluded that the reference to subclauses (I) through (VII) of CEA
section 2(c)(2)(B)(ii) in clause (A)(vii) of the ECP definition is
erroneous.\688\ This commenter pointed instead to CEA section
2(c)(2)(B)(i)(II) \689\ as the reference that should be included in
clause (A)(vii) of the ECP definition because it lists the entities
that are eligible to serve as counterparties in retail forex
transactions.
---------------------------------------------------------------------------

\688\ See letter from Wells Fargo dated June 3, 2011 (``Wells
Fargo I'').
\689\ 7 U.S.C. 2(c)(2)(B)(i)(II).
---------------------------------------------------------------------------

This commenter noted that the cross-reference in clause (A)(vii) of
the ECP definition was correct when it was added to the CEA as part of
the CFMA, but that it became incorrect in 2008 when an unrelated
amendment to the CEA was enacted \690\ that changed the numbering of
the CEA's provisions governing retail forex transactions but that
failed to make a conforming amendment to clause (A)(vii) of the ECP
definition. As a result of this 2008 amendment to the CEA, the list of
entities that formerly appeared in subclauses (I) through (VI) of CEA
sections 2(c)(2)(B)(ii) now appear in items (aa) through (ff) of CEA
section

[[Page 30656]]

2(c)(2)(B)(i)(II) instead.\691\ This commenter requested that ``the
Commissions correct this clearly erroneous reference in the definition
of ECP through interpretive guidance, rulemaking or Commission order.''
\692\
---------------------------------------------------------------------------

\690\ See section 13101 of the CRA.
\691\ 7 U.S.C. 2(c)(2)(B)(i)(II)(aa)-(ff).
\692\ See letter from Wells Fargo I.
---------------------------------------------------------------------------

3. Interpretive Guidance
Clause (A)(vii) of the ECP definition contains an erroneous cross-
reference to subclauses (I) through (VI) of CEA section 2(c)(2)(B)(ii).
Accordingly, the Commissions are issuing interpretive guidance by
identifying the counterparties with which a governmental entity can
enter into swaps to attain ECP status under the provision in clause
(A)(vii) that requires the entity's counterparty to be ``listed in any
of subclauses (I) through (VI) of section 2(c)(2)(B)(ii)'' of the CEA.
The Commissions consider a government entity covered by the
counterparty limitation in clause (A)(vii) to be an ECP with respect to
an agreement, contract, or transaction that is offered by, and entered
into with, a person that is listed in items (aa) through (ff) of
section 2(c)(2)(B)(i)(II) of the CEA. The limitation of ECP status
``with respect to'' a particular transaction is consistent with
Congress' determination that, for purposes of this provision of clause
(A)(vii), governmental entities may derive their ECP status from the
status of their counterparty.

F. Qualification as an ECP With Respect to Swaps Used To Hedge or
Mitigate Commercial Risk in Connection With the Conduct of an Entity's
Business

1. Proposing Release
In the Proposing Release, the Commissions requested comment on
whether any additional categories should be added to the definition of
ECP, ``such as the following categories suggested by commenters [on the
ANPRM]: Commercial real estate developers; energy or agricultural
cooperatives or their members; or firms using swaps as hedges pursuant
to the terms of the CFTC's Swap Policy Statement.'' \693\ As noted
above, the ECP definition is important because the Dodd-Frank Act
amended the CEA to prohibit a person that is not an ECP from entering
into swaps other than on or subject to the rules of a DCM.\694\
---------------------------------------------------------------------------

\693\ See Proposing Release, 75 FR at 80185. The reference to
the ``Swap Policy Statement'' is to the CFTC's Policy Statement
Concerning Swap Transactions, 54 FR 30694 (July 21, 1989). The Swap
Policy Statement ``identifie[d] those swap transactions which [were]
not * * * regulated as futures or commodity option transactions
under the [CEA] or the related regulations.'' 54 FR at 30694. One
element of the Swap Policy Statement required that the swap be
entered into in connection with each swap counterparty's line of
business. Id. at 30697. The Swap Policy Statement was applicable to
cash-settled swaps only, with foreign exchange considered to be cash
for this purpose. Id. at 30696. The Swap Policy Statement required
that the terms of the relevant swap be individually tailored,
meaning that the material terms of the swap had to be negotiated,
the parties had to make individualized credit determinations, and
the swap documentation could not be fully standardized. Id. at
30696-97. The Swap Policy Statement did not apply to swaps subject
to exchange-style offset, swaps that were cleared or subject to a
margin system, or swaps marketed to the public. Id. As noted in the
Product Definitions Proposal, the Dodd-Frank Act supersedes the Swap
Policy Statement. 76 FR at 29829, n. 74.
\694\ The discussion in this section relates only to swaps and
has no effect on the laws or regulations applicable to security-
based swaps, security-based swap agreements or mixed swaps.
As noted above, the Dodd-Frank Act also amended the Exchange Act
and the Securities Act to make it unlawful for a person to effect a
transaction in a security-based swap with or for a person that is
not an ECP unless the transaction is effected on a national
securities exchange registered with the SEC, and to make it unlawful
for a person to offer to sell, offer to buy or purchase, or sell a
security-based swap to a person that is not an ECP unless a
registration statement under the Securities Act is in effect with
respect to that security-based swap.
---------------------------------------------------------------------------

2. Commenters' Views
Several commenters supported the addition of categories to the
definition of ECP because, these commenters said, not all current swap
market participants are ECPs. Many of these commenters said that non-
ECPs have entered into swaps in reliance on the Swap Policy
Statement.\695\ Commenters highlighted, among other things, the
importance of the Swap Policy Statement to pass-through entities used
by farmers,\696\ operating companies \697\ and commercial property
developers,\698\ noting that such entities may not meet the ECP
criteria. According to these commenters, these pass-through entities
often are small and medium-sized businesses that enter into interest
rate swaps with lending financial institutions in reliance on the Swap
Policy Statement.\699\ The commenters explained that the loans usually
are guaranteed by the principals of the entity entering into the swap,
and that the borrower would qualify as an ECP if structured as a
single-level corporate entity or sole proprietorship.\700\ Commenters
said that if these non-ECP entities were limited to swaps that are
available on or subject to the rules of a DCM, many regional bank
borrowers would lose the ability to use swaps, real estate companies
would have less flexibility in risk management, and smaller lenders
would be at a competitive disadvantage.\701\ Another commenter said
that Dodd-Frank Act provisions such as the end-user clearing exception
indicate that Congress intended to preserve the availability of swaps
used for business reasons rather than for investment or
speculation.\702\
---------------------------------------------------------------------------

\695\ See letter from CDEU. One commenter estimated that swap
transactions completed by regional and community banks in reliance
on the Swap Policy Statement constituted 30-40% of all of such
banks' swaps, representing approximately 7,000 to 10,000 swaps per
year and $15 to $20 billion in related loan principal. See letter
from B&F I. Another commenter advised that it has entered 11 swaps,
with a total notional of $26 million, since its formation in 2007,
almost all of the counterparties to which ``qualified for the swap
under the [Swap Policy Statement] business purpose exemption.'' See
letter from Capstar. The CFTC stated when issuing the Swap Policy
Statement that it ``reflects the [CFTC]'s view that at this time
most swap transactions, although possessing elements of futures or
options contracts, are not appropriately regulated as such under the
[CEA] and [CFTC] regulations.'' Swap Policy Statement at 30694.
\696\ See, e.g., letter from Rabobank, N.A., Rabo AgriFinance,
Inc. and Co[ouml]peratieve Centrale Raiffeisen-Boerenleenbank B.A.
(``Rabobank, New York Branch'') (relating that ``[f]or a variety of
estate planning and regulatory purposes, farmers commonly hold their
ownership interests in land, buildings and farm equipment
indirectly, through a network of legal entities'').
\697\ See, e.g., letter from Fifth Third Bank and Union Bank,
N.A. (advising that ``[i]t is common for an operating business to
organize a separate limited liability company (for tax and legal
reasons) to acquire * * * assets * * * and to lease these assets to
the operating company[, which] becomes the borrow[er] * * * for the
loan used to acquire those assets'' and that ``[t]he limited
liability company often does not maintain sufficient capital to
qualify as an ECP'').
\698\ See, e.g., letters from Capstar, Frost National Bank, FTN
Financial Capital Markets, Midsize Banks and NAREIT.
\699\ See letters from BB&T I and B&F I. Commenters said that
these businesses may intentionally maintain less than $1 million in
equity primarily for tax and legal reasons. See letters from Capital
One and Columbia State Bank (stating that over 65% of its borrowers
are structured as limited liability companies or S corporations and
intentionally maintain less than $1 million in equity at the entity
entering into the swap).
\700\ See letter from Columbia State Bank. See also letter from
BB&T I.
\701\ See letters from BB&T I, Capital One, Capstar, Columbia
State Bank, Midsize Banks, NAREIT and Wells Fargo II.
\702\ See letter from FSR I.
---------------------------------------------------------------------------

[[Page 30657]]

ECP definition that included looking to the ECP status or
sophistication of the majority owner of an entity in determining if the
entity itself is an ECP.\705\ Other commenters suggested other
provisions to allow non-ECPs to enter into swaps other than on or
subject to the rules of a DCM, so long as the non-ECP meets various
conditions indicating that the swap is used in connection with its line
of business.\706\
---------------------------------------------------------------------------

\703\ See letters from BB&T I, Midsize Banks and Wells Fargo II.
\704\ See letters from CDEU and Regional Banks.
\705\ See letter from NAREIT.
\706\ See letters from the American Public Gas Association
(``APGA''), Capital One and Gavilon dated December 23, 2010
(``Gavilon I'').
---------------------------------------------------------------------------

Other commenters argued for per se ECP qualification based on their
status as certain types of persons, such as farmers\707\ or for ECP
status based solely on a combination of a person's status and the swap
being related to a person's line of business with no additional
conditions.\708\
---------------------------------------------------------------------------

\707\ See meeting with Ron Eliason on December 16, 2010 (in
which Mr. Eliason contended that farmers should be able to enter
into swaps, even if they do not meet the income or asset tests in
the current ECP definition and, therefore, would not be permitted to
enter into swaps other than on or subject to the rules of a DCM).
\708\ See letter from APGA (requesting that ``the [CFTC]
exercise its authority under section la(18)(C) of the Act and
determine that public natural gas distribution companies, including
member-owned co-operatives, that enter into swaps in connection with
their business of supplying customers with natural gas are ECPs
within the meaning of section la(18) of the Act'').
---------------------------------------------------------------------------

3. Final Rules and Interpretation
In response to the commenters' concerns, the CFTC is adopting CFTC
Regulation Sec. 1.3(m)(7) to permit an entity, in determining its net
worth for purposes of subclause (A)(v)(III) of the ECP definition,\709\
to include the net worth of its owners, solely for purposes of
determining its ECP status for swaps used to hedge or mitigate
commercial risk, provided that all of its owners are themselves ECPs
(disregarding shell companies). Under CFTC Regulation Sec. 1.3(m)(7)
as adopted, an entity seeking to qualify under subclause (A)(v)(III) of
the ECP definition in order to enter into a swap used to hedge or
mitigate commercial risk is permitted to count the net worth of its
owners in determining its own net worth, so long as all its owners are
ECPs. This regulation applies only to entities that are otherwise
eligible to rely on subclause (A)(v)(III) to determine ECP status; it
does not expand or change the scope of application of that
paragraph.\710\
---------------------------------------------------------------------------

\709\ CEA section 1a(18)(A)(v)(III) provides that the term
``eligible contract participant'' includes ``a corporation,
partnership, proprietorship, organization, trust, or other entity *
* * that (aa) has a net worth exceeding $1,000,000; and (bb) enters
into an agreement, contract, or transaction in connection with the
conduct of the entity's business or to manage the risk associated
with an asset or liability owned or incurred or reasonably likely to
be owned or incurred by the entity in the conduct of the entity's
business.'' 7 U.S.C. 1a(18)(A)(v)(III).
\710\ For example, if a commodity pool were precluded by CFTC
Regulation Sec. 1.3(m)(6) from relying on clause (A)(v) of the
statutory definition to qualify as an ECP, such pool would not be
able to rely on CFTC Regulation Sec. 1.3(m)(7) to qualify as an
ECP.
---------------------------------------------------------------------------

CFTC Regulation Sec. 1.3(m)(7) as adopted applies only when
determining ECP status for swaps used to hedge or mitigate commercial
risk. This new regulation does not apply when determining ECP status
for other swaps or for security-based swaps, security-based swap
agreements, mixed swaps, or agreements, contracts or transactions that
are not swaps (regardless of the purpose for which they are used).
The Commissions have considered the comments indicating that, as
currently structured, many businesses are owned by multiple legal
entities and/or individuals, and the net worth of all the owners in the
aggregate in some cases would satisfy the $1 million net worth
requirement in subclause (A)(v)(III), even though the particular legal
entity that enters into a swap does not have a net worth exceeding $1
million.\711\ While the Commissions recognize that the requirement, in
subclause (A)(v)(III)(aa) of the ECP definition, that the entity
relying on that paragraph have a net worth exceeding $1 million
evidences Congress' intent that only entities with this level of
financial resources should be eligible for ECP status under this
paragraph of the definition, the Commissions agree with commenters that
application of this requirement in these circumstances would
inappropriately limit the ability of business entities to use swaps to
hedge or mitigate commercial risk. As a result, the Commissions are
persuaded that in this limited situation, the entity should qualify as
an ECP and be eligible to enter into swaps other than on or subject to
the rules of a DCM, so long as the entity is using the swap to hedge or
mitigate commercial risk and all of the owners of the entity are ECPs
(other than shell companies).
---------------------------------------------------------------------------

\711\ See, e.g., letters from B&F I (stating that ``[i]f the
customer does not * * * [itself] meet the ECP definition, then the
transaction would have to be guaranteed by any entity or individual
who is an owner * * * [who] meets the $10,000,000 total asset test
of section 1(a)(18)(A)(v)(I) of the Act or the $1,000,000 net worth
test of section 1(a)(18)(A)(v)(III) of the Act.''), NAREIT (urging
that the Commissions impute ECP status to non-ECP entities involved
in specified real estate businesses to such entities whose
``majority owner or controlling entity'' is an ECP) and Midsize
Banks (recommending that the ECP determination be made with respect
to a non-ECP entity's owners based on criteria including qualifying
natural persons as ECPs based on a $1,000,000 net worth).
---------------------------------------------------------------------------

In response to those commenters requesting per se ECP status or the
ability to qualify as an ECP based on a combination of status and
engaging in swaps related to a line of business, without further
restriction, the Commissions do not believe it is necessary or
appropriate to further define the term ECP to such an extent in order
to address most commenters' concerns. The Commissions note that such
approaches would undermine the prohibition in CEA section 2(e) \712\ on
non-ECPs executing swaps other than on or subject to the rules of a
DCM. The Commissions also note that focusing solely on a link between a
swap and a line of business would undermine the application of the ECP
definition to swaps in that the various prongs of the ECP generally are
linked to dollar thresholds, regulated status, or a combination of the
two.
---------------------------------------------------------------------------

\712\ 7 U.S.C. 2(e).
---------------------------------------------------------------------------

The Commissions also note that it currently is considering a draft
petition for relief pursuant to CEA section 4(c)(6)(C) \713\ for
certain entities described in Federal Power Act section 201(f),\714\
which may address the concerns of some commenters. Additionally, the
Commissions are developing joint rules to further define the term
``swap,'' including the forward exclusion from the swap definition
which, in turn, may result in certain transactions not being considered
swaps. Further, the CFTC also is considering today a form of trade
option exemption, which may further address commenters' concerns.
---------------------------------------------------------------------------

\713\ 7 U.S.C. 6(c)(6)(C).
\714\ 16 U.S.C. 824(f).
---------------------------------------------------------------------------

With respect to farmers, in response to the CFTC's Commodity
Options and Agricultural Swaps rulemaking proposal,\715\ commenters
generally were of the view that the ECP definition is appropriate in
its current form.\716\ While

[[Page 30658]]

the Commissions may consider providing further relief should experience
show, after the ECP definition becomes effective, that further relief
is warranted, neither the ECP definition nor the various actions cited
in the foregoing paragraph are final, so providing further relief is
premature. The Commissions' measured approach, which builds on the
existing net worth requirement in the general entity ECP category,
provides broad relief to many of the commenters (e.g., borrowers
generally) while otherwise adhering to the existing ECP categories.
---------------------------------------------------------------------------

\715\ 76 FR 6095 (Feb. 3, 2011).
\716\ See, e.g., letters from NCFC dated April 4, 2011 (``NCFC
II'') (stating ``[o]n behalf of the more than two million farmers
and ranchers who belong to one or more farmer cooperative(s), the
[NCFC] * * * [believes] the limitation on participation [in
agricultural swaps] to [ECPs] outside of a DCM * * * should limit
[agricultural swap] participation to appropriate persons'' and that
``[t]he ECP requirement with a threshold of $1 million in net worth
to be allowed to use swaps and options, other than on a DCM, is
appropriate for the products cooperatives offer their members''), ;
letter from NGFA dated April 4, 2011 (``NGFA II'') (stating that
``[t]he use of agricultural swaps has been constrained relative to
other swaps by virtue of being subject to CFTC regulatory
requirements, while other swaps have been exempted from CFTC
oversight,'' ``the Dodd-Frank Act * * * institutes a number of
safeguards, including the limitation that only [ECPs] may engage in
swaps unless entered into on a designated contract market,'' and
``[t]he NGFA believes that these safeguards provide more-than-ample
protection in the swaps marketplace for both agricultural and non-
agricultural swaps and that there is no compelling reason to place
additional burdens on agricultural swaps.'').
---------------------------------------------------------------------------

The Commissions note that commenters said that, because of the way
some businesses are structured for tax, estate planning or other
purposes, they enter into swaps through a legal entity that does not,
by itself, qualify as an ECP even though the net worth of the business
and its owners, taken in the aggregate, would qualify as an ECP
pursuant to subclause (A)(v)(III) of the ECP definition. The
Commissions believe that the best way to address this concern is to
allow such a business to consider the net worth of all its owners in
determining whether the net worth requirement in subclause (A)(v)(III)
is satisfied.\717\
---------------------------------------------------------------------------

\717\ The Commissions note that this regulation provides an
alternative means for certain business entities to qualify as ECPs.
It neither diminishes nor qualifies in any way the requirement in
CEA section 2(e) that persons that are not ECPs enter into swaps
only on or subject to the rules of a DCM.
---------------------------------------------------------------------------

CFTC Regulation Sec. 1.3(m)(7) is available only to an entity that
seeks to qualify as an ECP under subclause (A)(v)(III) of the statutory
definition in order to enter into a swap that will be used to hedge or
mitigate commercial risk. The Commissions limited CFTC Regulation Sec.
1.3(m)(7) to subclause (A)(v)(III) because this provision of the ECP
definition is available to a business entity that uses swaps in
connection with the conduct of its business or to manage risks
associated with assets or liabilities related to the conduct of its
business.\718\
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\718\ CEA section 1a(18)(A)(v)(III)(bb), 7 U.S.C.
1a(18)(A)(v)(III)(bb). The Commissions note that an entity that
would qualify as an ECP under subclause (A)(v)(III) without
application of CFTC Regulation Sec. 1.3(m)(7) is not required to
meet the conditions stated in, this regulation.
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The purpose of CFTC Regulation Sec. 1.3(m)(7) is to maintain the
ability of business entities to enter into swaps other than on or
subject to the rules of a DCM for limited purposes. This regulation
therefore is available only with respect to a swap that is used to
hedge or mitigate commercial risk within the meaning of CFTC Regulation
Sec. 1.3(kkk).\719\ CFTC Regulation Sec. 1.3(m)(7) applies only if
all of an entity's owners qualify as ECPs under the provision of the
ECP definition applicable to such owner. Although some commenters
suggested that an entity should be able to qualify as an ECP based on
the status of its majority or controlling owners,\720\ the Commissions
believe that CFTC Regulation Sec. 1.3(m)(7) should be available only
when all of an entity's owners qualify as ECPs. The Commissions do not
believe it would be appropriate to impair the protection of non-ECPs
that flows from the requirement that non-ECPs enter into swaps only on
or subject to the rules of a DCM.\721\ In order to maintain these
protections and prevent evasion, CFTC Regulation Sec. 1.3(m)(7)
provides that any shell company will be disregarded, and in order to
determine if the underlying entity may use CFTC Regulation Sec.
1.3(m)(7), each owner of such shell company must be an ECP.\722\
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\719\ See part IV.C. The use of the phrase ``hedge or mitigate
commercial risk'' in CFTC Regulations Sec. Sec. 1.3(m)(7) and
1.3(kkk) is similar to the use of the same phrase in the exception
to the mandatory clearing requirement in CEA section 2(h)(7), 7
U.S.C. 2(h)(7).
\720\ See, e.g., letter from NAREIT.
\721\ See CEA section 2(e), 7 U.S.C. 2(e).
\722\ See CFTC Regulation Sec. 1.3(m)(7)(ii).
The term ``shell company'' means any entity that limits its
holdings to direct or indirect interests in entities that are ECPs
through reliance on CFTC Regulation Sec. 1.3(m)(7). Any entity that
holds at least one direct or indirect interest in an entity not
relying on CFTC Regulation Sec. 1.3(m)(7) would not be a shell
company. The ECP status of owners of entities that are not shell
companies is not relevant for purposes of CFTC Regulation Sec.
1.3(m)(7), which should permit wider financing of small businesses
using swaps to hedge or mitigate commercial risk.
To be clear, an individual will never be considered to be a
shell company for purposes of CFTC Regulation Sec. 1.3(m)(7).
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Correspondingly, in aggregating net worth for purposes of
determining the ECP status of an entity pursuant to CFTC Regulation
Sec. 1.3(m)(7), if the entity is owned by a shell company, then it is
the net worth of the owners of that shell company that is relevant, not
the net worth of the shell company.\723\
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\723\ This provision may apply repeatedly in a ``chain.'' For
example, if in determining whether an entity may rely on CFTC
Regulation Sec. 1.3(m)(7), an owner of that entity that is a shell
company is disregarded, then if the owner of that shell company is
also a shell company, that second shell company also is disregarded,
and so on.
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Last, also in order to prevent evasion, CFTC Regulation Sec.
1.3(m)(7)(ii)(C) specifies that an individual may rely on the
proprietorship provision of clause (A)(v) of the statutory definition
for purposes of determining its status as an ECP owner of an entity
only if the proprietorship \724\ status arises independent of the
business conducted by such entity \725\ and the individual proprietor
acquires his/her interest in such entity (i) in connection with the
conduct of the individual's proprietorship or (ii) to manage the risk
associated with an asset or liability owned or incurred or reasonably
likely to be owned or incurred by the proprietorship.\726\ The
Commissions are adopting CFTC Regulation Sec. 1.3(m)(7)(ii)(C) because
they believe that the only circumstance in which a proprietorship
should be considered an ECP for purposes of CFTC Regulation Sec.
1.3(m)(7)(i) is if it is making an investment related to the
proprietorship.\727\ The ECP status of an individual acting other than
with respect to its proprietorship is determined based on the ECP
clause applicable to individuals. The Commissions note that they have
authority to take action to prevent evasion of the provisions regarding
shell companies and proprietorships by entities relying on CFTC
Regulation Sec. 1.3(m)(7) to establish ECP status.
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\724\ A proprietorship generally is a business that a person
operates in a personal capacity and with respect to which that
person directly owns all the assets and directly is responsible for
all of the liabilities, rather than through a corporation,
partnership or other structure conveying limited liability. See
letters from Midmarket Banks and Wells Fargo II (stating that
``proprietors . . . typically are not separate legal entities'');
see also State of California Franchise Tax Board Web site (advising
that ``[t]he business and the owner are one. There is no separate
legal entity and thus no separate legal person''), at https://www.ftb.ca.gov/businesses/bus_structures/soleprop.shtml. A
proprietorship is not a separate taxable entity but reports the
income or loss of the business, which is taxed along with a sole
proprietor's other income, on a separate schedule attached to his or
her individual federal income tax return. See letter from Midmarket
Banks. See also 2011 Form1040 Schedule C: Profit or Loss from
Business (Sole Proprietorship), available at http://www.irs.gov/pub/irs-pdf/f1040sc.pdf; 2011 Instructions for Schedule C, available at
http://www.irs.gov/pub/irs-pdf/i1040sc.pdf.
\725\ CFTC Regulation Sec. 1.3(m)(7)(ii)(C)(I) is designed to
ensure that the individual qualifies as a proprietorship, if at all,
other than due to its interest in either an entity seeking to
qualify as an ECP under CFTC Regulation Sec. 1.3(m)(7)(i) or in any
other entity.
\726\ See CFTC Regulation Sec. 1.3(m)(7)(ii)(C)(IV). This
language is modeled on the language in 7 U.S.C.
1a(18)(A)(v)(III)(bb).
\727\ The Commissions note that this guidance regarding
proprietorships applies only when an entity is relying on CFTC
Regulation Sec. 1.3(m)(7). The Commissions do not intend that this
guidance would expand or limit the circumstances when a
proprietorship may otherwise rely on clause (A)(v) of the statutory
definition in establishing its ECP status.

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[[Page 30659]]

G. ECP Status for Forex Pools Operated by Registered CPOs or CPOs
Exempt From Registration Under Certain Conditions

1. Description of the Issue and Commenters' Views
Notwithstanding the modifications to the look-through provisions
for Forex Pools discussed above in section III.B., the Commissions
acknowledge commenters' concerns about the potential for unintended
consequences arising from the look-through provisions of the Dodd-Frank
Act. Several commenters asserted that many Forex Pools are operated by
sophisticated, professional managers that do not need the protections
of a retail forex regime designed to protect non-ECPs that are engaging
in retail forex transactions.\728\ More specifically, some commenters,
based on CFTC enforcement actions involving Forex Pools, suggested that
commodity pools of a sufficient size, and/or operated by a registered
or exempt CPO, do not pose the risks of fraud and abuse of non-ECP
customers that the statutory look-through provision is intended to
address.\729\
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\728\ See, e.g., letters from Millburn (characterizing the
proposed rules as ``greatly limit[ing] the ability of entities
managed by sophisticated money managers that are subject to
registration and examination by regulators to qualify as ECPs'') and
Sidley (describing ``[a] commodity pool, like a registered
investment company or an employee benefit plan, [a]s a pool of
assets from investors of varying (and, in some cases, undetermined)
levels of sophistication that are advised by a sophisticated
adviser'').
\729\ See joint letter from the Global Foreign Exchange Division
(``GXFD'') and MFA dated January 19, 2011 (``GFXD II'') (describing
35 CFTC Forex Pool enforcement cases from 2010 and 2011 and noting
that in 80% of these cases, the amount at issue in the misconduct
was less than $10 million, and that only one case involved a
registered CPO where the amount at issue in the misconduct was more
than $10 million; two additional cases involved misconduct involving
CPOs exempt from registration as such under CFTC Regulation Sec.
4.13(a). While the commenter did not characterize these amounts as
``total assets'' (instead, the commenter used terms such as
``fraudulently obtained'' or ``sustained losses of'' to modify the
cited dollar amounts) in most cases, it is clear that these amounts
are equivalent to, or subsets of, total assets. For instance, for a
CPO to have fraudulently obtained $10 million from commodity pool
participants, the CPO must have taken in $10 million from them,
resulting in the commodity pool at one time having $10 million in
total assets. See also letter from Sidley (providing 26 examples of
CFTC Forex Pool-related enforcement cases, all but one of which
involved Forex Pools with less than $50 million in total assets). A
number of the cases cited by GXFD and Sidley overlap; in the
aggregate, these commenters appear to have presented data on 45
different cases rather than 61.
---------------------------------------------------------------------------

As a result, commenters suggested that the look-through provision
should not apply in determining ECP status of commodity pools that meet
certain conditions. For example, commenters suggested that the look-
through not be applied to a commodity pool with $10 million in total
assets paired with another or other factors, such as not being
structured to evade,\730\ being subject to regulation under the
CEA\731\ or the CPO being registered as such.\732\ Another commenter
suggested requiring the total assets or minimum initial investment of a
Forex Pool to be sufficiently large that, in general, only legitimate
pools would exceed such thresholds.\733\ This commenter suggested a
total asset threshold of $50 million.\734\
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\730\ See letter from GFXD II.
\731\ See letters from GXFD II and Skadden.
\732\ See meeting with SIFMA on January 20, 2012 (in which
representatives of SIFMA proposed a new non-exclusive set of
criteria for a Forex Pool to qualify as an ECP, which included, as
one of several alternatives in one element of the proposed criteria,
that a Forex Pool be operated by a registered CPO). See also letter
from Willkie Farr (observing that ``[i]t may be time to regulate
certain previously unregulated transactions and traders, so that
more CPOs are registered'' and that ``many commodity pools are
operated and advised by registered professionals'').
\733\ See letter from Sidley.
\734\ See id.
---------------------------------------------------------------------------

Separately, one commenter also claimed that the statutory look-
through, if strictly implemented, might inappropriately preclude Forex
Pools and their CPOs, many of whom are registered, from engaging in
retail forex transactions with swap dealers because swap dealers are
not Enumerated Counterparties (and some swap dealers also may not be
Enumerated Counterparties in a different capacity, such as being a U.S.
financial institution).\735\ This commenter stated that such a result
could reduce close out netting opportunities in the event of the
insolvency of a counterparty.
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\735\ See joint letter from the GFXD and MFA dated January 10,
2012 (``GFXD I''). These commenters indicated that, while
[s]ome swap dealers may be dually licensed as a bank or a
broker-dealer [and therefore] eligible to transact in OTC foreign
exchange with retail investors as well as swaps with institutional
investors * * * as an operational matter, it is not clear that firms
will be able to and find it efficient to structure their business so
that the retail foreign exchange platform is conducted from the same
entity as the institutional swaps business.
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2. Final Rule
In response to commenters, the CFTC is adopting CFTC Regulation
Sec. 1.3(m)(8), pursuant to which certain Forex Pools may qualify as
ECPs notwithstanding the look-through requirement. As adopted, CFTC
Regulation Sec. 1.3(m)(8) enables a Forex Pool that enters into a
retail forex transaction to qualify as an ECP with respect thereto,
irrespective of whether each participant in the Forex Pool is an ECP,
if the Forex Pool satisfies the following conditions:
It is not formed for the purpose of evading CFTC
regulation under Section 2(c)(2)(B) or Section 2(c)(2)(C) of the CEA or
related CFTC rules, regulations or orders governing Retail Forex Pools
and retail forex transactions);
It has total assets exceeding $10 million; and
It is formed and operated by a registered CPO or by a CPO
who is exempt from registration as such pursuant to CFTC Regulation
Sec. 4.13(a)(3).
CFTC Regulation Sec. 1.3(m)(8) as adopted requires that the Forex
Pool not be formed for the purpose of evading CFTC regulation of Retail
Forex Pools and retail forex transactions under CEA Section 2(c)(2)(B)
or (C). A Forex Pool that is formed for that purpose would not be an
ECP under new CFTC Regulation Sec. 1.3(m)(8).
CFTC Regulation Sec. 1.3(m)(8) as adopted also requires that the
Forex Pool have total assets exceeding $10 million to qualify as an
ECP. The $10 million threshold is twice the current total asset
threshold for a commodity pool to qualify as an ECP under CEA section
1a(18)(A)(iv). The Commissions believe the $10,000,000 threshold is
appropriate in light of the potential regulatory burdens a higher
threshold might impose on smaller commodity pools. The Commissions
believe that such a threshold, coupled with the other conditions of the
rule, is sufficiently high to assure that the protections provided to
retail forex transactions are not needed for these types of commodity
pools. The Commissions will vigilantly monitor developments with
respect to Forex Pools, including enforcement activity, and revisit
this total asset threshold if warranted by subsequent events.
Finally, CFTC Regulation Sec. 1.3(m)(8) as adopted requires that
Forex Pool be formed \736\ and operated by a CPO registered as such
with the CFTC or by a CPO who is exempt from registration as such
pursuant to CFTC Regulation Sec. 4.13(a)(3). The Commissions believe
that the registered CPO aspect of this condition is appropriate for
several reasons, including that it will ensure

[[Page 30660]]

that the NFA oversees compliance by those registered CPOs relying on
this new regulation.\737\ CPO registration also provides a clear means
of addressing wrongful conduct.\738\ Although some commenters suggested
that a CPO need only be ``subject to regulation under the CEA'' in
order for a Forex Pool operated by that CPO to qualify as an ECP
notwithstanding the look-through requirements, CFTC Regulation Sec.
1.3(m)(8) instead requires that the CPO of a Forex Pool be registered
as a CPO or be a CPO who is exempt from registration as such pursuant
to CFTC Regulation Sec. 4.13(a)(3), alternative conditions supported
by other commenters. The Commissions are requiring operation by a
registered CPO, or by a CPO who is exempt from registration as such
pursuant to CFTC Regulation Sec. 4.13(a)(3), as a condition for a
Forex Pool to qualify for ECP status under CFTC Regulation Sec.
1.3(m)(8) because, based on the data presented by commenters, CFTC
enforcement actions involving Forex Pools rarely involve registered
CPOs or CPOs exempt from registration as such.\739\
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\736\ Given that (i) many CPOs will be registering as such for
the first time due to the CFTC's recent rescission of the exemption
from CPO registration set forth in CFTC Regulation Sec. 4.13(a)(4)
or its modification of the criteria for claiming the exclusion from
the CPO definition in CFTC Regulation Sec. 4.5 and (ii) such pools
were formed prior to their CPOs' registration as such, commodity
pools formed prior to December 31, 2012 need not have been
``formed'' by a registered CPO or by a CPO exempt from registration
as such pursuant to CFTC Regulation Sec. 4.13(a)(3) in order to be
qualified as ECPs under the new prong, so long as they are operated
by a registered CPO on or before such date.
\737\ See CPO/CTA Compliance Release at 11254 (noting that
``registration allows the Commission to ensure that all entities
operating collective investment vehicles participating in the
derivatives markets meet minimum standards of fitness and
competency''). See http://www.nfa.futures.org/NFA-registration/cpo/index.html for an overview of registration and related requirements
for CPOs, their principals and their associated persons and http://www.nfa.futures.org/NFA-compliance/NFA-commodity-pool-operators/index.html for an overview of the compliance regime for registered
CPOs overseen by the NFA. The CFTC anticipates that more CPOs will
register in the coming months now that it has withdrawn the CFTC
Regulation Sec. 4.13(a)(4) exemption from CPO registration,
increasing the number of registered CPOs, in turn increasing the
number of CPOs who can satisfy the registered CPO alternative under
CFTC Regulation Sec. 1.3(m)(8)(iii).
\738\ See CPO/CTA Compliance Release at 11254 (stating that
``the [CFTC] has clear authority to take punitive and/or remedial
action against registered entities for violations of the CEA or of
the [CFTC''s regulations * * * [and] to deny or revoke registration,
thereby expelling an individual or entity from serving as an
intermediary in the industry'' and that the CFTC's reparations
program and the NFA's arbitration program also are available avenues
``to seek redress for wrongful conduct by a [CFTC] registrant'').
\739\ As discussed above in note 729, only one of the 45 unique
cases presented by commenters involved a pool with more than $10
million in total assets and a registered CPO. Only two of those
cases involved a pool operated by CPOs exempt from registration: in
both of those cases, however, the CPO raised less than $10 million.
In addition, one of those CPOs relied on the CFTC Regulation Sec.
4.13(a)(4) CPO registration exemption. As discussed above, the CFTC
has withdrawn that exemption.
---------------------------------------------------------------------------

While NFA oversight of CPOs operating Retail Forex Pools is a
useful criterion to determine whether an exclusion from the look-
through provisions of CEA section 1a(8)(A)(iv) and CFTC Regulation
Sec. 1.3(m)(5) is warranted, the Commissions believe that Retail Forex
Pools operated by CPOs exempt from registration as such pursuant to
CFTC Regulation Sec. 4.13(a)(3) also merit relief from those look-
through provisions. On September 10, 2010, the CFTC published in the
Federal Register a final rule revising the CPO registration exemption
in CFTC Regulation Sec. 4.13(a)(3) to incorporate retail forex
transactions into the transactions subject to the alternative caps on
the use of commodity interests \740\ by CPOs claiming the
exemption.\741\ The CFTC explained in the related Federal Register
proposing release that the proposed change to CFTC Regulation Sec.
4.13(a)(3) was part of a proposal to adopt a comprehensive regulatory
scheme to implement the CRA with respect to retail forex transactions
(``CRA-Related Forex Proposal'').\742\ The CFTC also explained that
``the NFA-specified minimum security deposit for off-exchange retail
forex transactions would be included among the amounts that cannot
exceed 5 percent of the liquidation value of the pool's portfolio in
order for the operator to claim the exemption from registration under
Regulation 4.13(a)(3)''\743\ and that ``such amounts are roughly
equivalent to initial margin and option premiums).'' \744\ The CFTC
also described the CRA-Related Forex Proposal as ``amend[ing] existing
regulations as needed to clarify their application to, and inclusion
in, the new regulatory scheme for retail forex.'' \745\ More recently,
notwithstanding the Dodd-Frank Act's addition of the look-through
provision in CEA section 1a(8)(A)(iv), the CFTC determined to retain
the exemption from CPO registration under Regulation 4.13(a)(3),
reasoning that ``overseeing entities with less than five percent
exposure to commodity interests is not the best use of the Commission's
resources.'' \746\
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\740\ The term ``commodity interest'' is defined in CFTC
Regulation Sec. 1.3(yy), and includes ``[a]ny contract, agreement
or transaction subject to [CFTC] jurisdiction under section 2(c)(2)
of the [CEA].'' CFTC Regulation Sec. 1.3(yy)(3).
\741\ See CFTC, Regulation of Off-Exchange Retail Foreign
Exchange Transactions and Intermediaries; Final Rules, 75 FR 55410
(Sept. 10, 2010).
\742\ CFTC, Regulation of Off-Exchange Retail Foreign Exchange
Transactions and Intermediaries; Proposed Rules, 75 FR 3282 (Jan.
10, 2010).
\743\ Section 12 of the NFA's Financial Requirements impose the
following minimum security deposit requirements for retail forex
transactions: (i) 2% of the notional value of transactions in the
British pound, the Swiss franc, the Canadian dollar, the Japanese
yen, the Euro, the Australian dollar, the New Zealand dollar, the
Swedish krona, the Norwegian krone, and the Danish krone; (ii) 5% of
the notional value of other transactions; (iii) for short options,
the above amount plus the premium received; and (iv) for long
options, the entire premium. See NFA Manual, available at http://www.nfa.futures.org/nfamanual/NFAManual.aspx?RuleID=SECTION%2012&Section=7.
\744\ CFTC, Regulation of Off-Exchange Retail Foreign Exchange
Transactions and Intermediaries; Proposed Rules, 75 FR 3282, 3287
(Jan. 10, 2010).
\745\ Id. at 3282.
\746\ CPO/CTA Compliance Release at 11261. The CFTC also stated
that:
[t]he Commission believes that trading exceeding five percent of
the liquidation value of a portfolio, or a net notional value of
commodity interest positions exceeding 100 percent of the
liquidation value of a portfolio, evidences a significant exposure
to the derivatives markets, and that such exposure should subject an
entity to the Commission's oversight.
Id. at 11263.
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Given that, shortly before the adoption of the Dodd-Frank Act, the
CFTC proposed to add retail forex transactions to those that can be
entered into by CPOs claiming relief from registration as such under
CFTC Regulation Sec. 4.13(a)(3), that it finalized that action shortly
after the Dodd-Frank Act was adopted and that it recently left CFTC
Regulation Sec. 4.13(a)(3) in place despite having proposed to
withdraw that CPO registration exemption, and for the reasons described
above, the Commissions believe CPOs exempt from registration as such
pursuant to CFTC Regulation 4.13(a)(3) and operating Retail Forex Pools
should be able to continue to do so outside the retail forex regime.
Section 712(d)(2)(A) of the Dodd-Frank Act grants the Commissions
the authority to adopt such rules related to the ECP definition as the
Commissions determine are necessary and appropriate, in the public
interest, and for the protection of investors. Based on commenters'
views, the Commissions have determined that CFTC Regulation Sec.
1.3(m)(8) as adopted is necessary and appropriate because the statutory
look-through provision, if strictly implemented, would subject Forex
Pools operated by CPOs that are sophisticated, professional asset
managers to an array of additional compliance costs and deprive them of
access to swap dealers as counterparties when engaging in retail forex
transactions.\747\ The Commissions also have determined that it is
appropriate to limit the availability of ECP status under CFTC
Regulation Sec. 1.3(m)(8) to Forex

[[Page 30661]]

Pools operated by registered CPOs or by CPOs exempt from registration
as such pursuant to CFTC Regulation Sec. 4.13(a)(3).\748\ The
conditions in CFTC Regulation Sec. 1.3(m)(8) also are appropriate in
that they require Forex Pools seeking ECP status thereunder to have
total assets exceeding $10 million. Historically, CFTC enforcement
actions have involved fewer instances of misconduct by CPOs of Forex
Pools with total assets above this threshold.\749\
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\747\ The nature of a swap dealer's business activities and
assets may detract from what is considered regulatory capital for an
FCM or RFED engaging in retail forex transactions, thereby making it
difficult for some swap dealers to dually register both as such and
as an FCM or RFED in order to do retail forex business. As an ECP, a
Forex Pool's choice of retail forex transaction counterparties will
not be limited to Enumerated Counterparties, and thus may include
swap dealers.
\748\ The Commissions note that the statistics presented by
commenters indicate that Forex Pool misconduct by registered CPOs
and those exempt from CPO registration is significantly rarer than
Forex Pool misconduct by otherwise unregistered CPOs. See letter
from the GFXD II.
\749\ See letter from Sidley (showing that 6 of the 27 cases
presented involved more than $10 million).
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The Commissions have determined that CFTC Regulation Sec.
1.3(m)(8) is in the public interest in that it will make available a
category of counterparty (i.e., swap dealers) that likely would not
otherwise be available, and help to assure that sophisticated,
professional managers operating qualifying Forex Pools can continue to
engage in retail forex transactions. The Commissions have determined
that the conditions of CFTC Regulation Sec. 1.3(m)(8) are sufficient
for the protection of investors for the reasons discussed above, such
as a significant reduction in the incidence of Forex Pool misconduct
among CPOs, whether registered as such or exempt therefrom, operating
Forex Pools with more than $10 million in total assets. The Commissions
intend to monitor developments in the Forex Pool area and will revisit
the conditions of this regulation as warranted by subsequent events.

IV. Definitions of ``Major Swap Participant'' and ``Major Security-
Based Swap Participant''

The statutory definitions of ``major swap participant''\750\ and
``major security-based swap participant''\751\ (collectively, ``major
participant'') encompass any person that is not a swap dealer or
security-based swap dealer \752\ and that satisfy any one of three
alternative statutory tests that encompass a person: (i) That maintains
a ``substantial position'' in swaps or security-based swaps for any of
the major swap categories as determined by the Commissions; (ii) whose
outstanding swaps or security-based swaps create substantial
counterparty exposure that could have serious adverse effects on the
financial stability of the U.S. banking system or financial
markets;\753\ or (iii) that is a ``financial entity'' that is ``highly
leveraged'' relative to the amount of capital it holds (and that is not
subject to capital requirements established by an appropriate Federal
banking agency) and maintains a ``substantial position'' in outstanding
swaps or security-based swaps in any major category as determined by
the Commissions.\754\ The first--and only the first--of those three
statutory tests explicitly excludes: (i) Positions held for ``hedging
or mitigating commercial risk,'' and (ii) positions maintained by any
employee benefit plan as defined in sections 3(3) and (32) of ERISA for
the ``primary purpose of hedging or mitigating any risk directly
associated with the operation of the plan.''\755\
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\750\ CEA section 1a(33).
\751\ Exchange Act section 3(a)(67).
\752\ As discussed above, a person may be designated as a dealer
for particular activities involving swaps or security-based swaps,
or particular swap or security-based swap activities, without being
deemed to be a dealer with regard to other categories or activities.
See part II.E, supra. To the extent that a person is subject to that
type of limited designation as a swap dealer or security-based swap
dealer, the person may be subject to being a major swap participant
or a major security-based swap participant in connection with
positions that fall outside of that limited dealer designation.
\753\ See CEA section 1a(33)(A)(ii); Exchange Act section
3(a)(67)(A)(ii)(II).
\754\ See CEA section 1a(33)(A)(iii); Exchange Act section
3(a)(67)(A)(ii)(III).
\755\ See CEA section 1a(33)(A)(i); Exchange Act section
3(a)(67)(A)(ii)(I).
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The statutory definitions require the Commissions to define the
term ``substantial position'' at the threshold determined to be prudent
for the effective monitoring, management, and oversight of entities
that are systematically important or can significantly impact the
financial system of the U.S. In setting these thresholds, the
Commissions are required to consider the person's relative position in
uncleared as opposed to cleared swaps and may take into consideration
the value and quality of collateral held against counterparty
exposures.\756\
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\756\ See CEA section 1a(33)(B) and Exchange Act section
3(a)(67)(B).
---------------------------------------------------------------------------

The statutory definitions further permit the Commissions to limit
the scope of the major participant designations so that a person may be
designated as a major participant in certain categories of swaps or
security-based swaps, but not all categories.\757\
---------------------------------------------------------------------------

\757\ See CEA section 1a(33)(C); Exchange Act section
3(a)(67)(C).
---------------------------------------------------------------------------

In addition, the ``major swap participant'' definition excludes
certain entities whose primary business is providing financing and that
use derivatives for the purpose of hedging underlying commercial risks
related to interest rate and foreign currency exposures, 90 percent or
more of which arise from financing that facilitates the purchase or
lease of products, 90 percent or more of which are manufactured by the
parent company or another subsidiary of the parent company.\758\ The
``major security-based swap participant'' definition does not contain
this type of exclusion.
---------------------------------------------------------------------------

\758\ See CEA section 1a(33)(D).
---------------------------------------------------------------------------

As detailed in the Proposing Release, the major participant
definitions focus on the market impacts and risks associated with a
person's swap and security-based swap positions.\759\ This is in
contrast to the definitions of ``swap dealer'' and ``security-based
swap dealer,'' which focus on a person's activities and account for the
amount or significance of those activities only in the context of the
de minimis exception. However, persons that meet the major participant
definitions in large part must follow the same statutory requirements
that will apply to swap dealers and security-based swap dealers.\760\
In this way, the statute applies comprehensive regulation to entities
whose swap or security-based swap activities do not cause them to be
dealers, but nonetheless could pose a high degree of risk to the U.S.
financial system generally.\761\
---------------------------------------------------------------------------

\759\ See Proposing Release, 75 FR at 80185.
\760\ In particular, under CEA section 4s and Exchange Act
section 15F, dealers and major participants in swaps or security-
based swaps generally are subject to the same types of margin,
capital, business conduct and certain other requirements, unless an
exclusion applies. See CEA section 4s(h)(4), (5); Exchange Act
section 15F(h)(4), (5). See also CFTC, Business Conduct Standards
for Swap Dealers and Major Swap Participants with Counterparties;
Final Rule, 77 FR 9733 (Feb. 17, 2012); Notice of Proposed
Rulemaking: Capital requirements of swap dealers and major swap
participants, 76 FR 27802 (May 12, 2011); and SEC, Notice of
Proposed Rulemaking: Business Conduct Standards for Security-Based
Swap Dealers and Major Security-Based Swap Participants, Securities
Exchange Act Release No. 64766, 76 FR 42396 (July 18, 2011).
\761\ As discussed below, the tests of the major participant
definitions use terms--particularly ``systemically important,''
``significantly impact the financial system'' or ``create
substantial counterparty exposure''--that denote a focus on entities
that pose a high degree of risk through their swap and security-
based swap activities. In addition, the link between the major
participant definitions and risk was highlighted during the
Congressional debate on the statute. See 156 Cong. Rec. S5907 (daily
ed. July 15, 2010) (colloquy between Senators Hagen and Lincoln,
discussing how the goal of the major participant definitions was to
``focus on risk factors that contributed to the recent financial
crisis, such as excessive leverage, under-collateralization of swap
positions, and a lack of information about the aggregate size of
positions'').
---------------------------------------------------------------------------

Although the two major participant definitions are similar, they
address instruments that reflect different types of risks and that can
be used by end-users and other market participants for

[[Page 30662]]

different purposes. Interpretation of the definitions must account for
those differences as appropriate.
The Commissions in the Proposing Release proposed to further define
the ``major swap participant'' and ``major security-based swap
participant'' definitions, by specifically addressing: (i) The
``major'' categories of swaps or security-based swaps; (ii) the meaning
of ``substantial position''; (iii) the meaning of ``hedging or
mitigating commercial risk''; (iv) the meaning of ``substantial
counterparty exposure that could have serious adverse effects on the
financial stability of the United States banking system or financial
markets''; and (v) the meanings of ``financial entity'' and ``highly
leveraged.'' The proposal also addressed the period of time that a
major participant would have to register (as well as the minimum length
of time for being a major participant), the limited purpose
designations of major participants, the exclusion for ERISA plan
hedging positions, and certain additional interpretive issues.
After considering commenters' views, the Commissions are adopting
final rules further defining the meaning of major participant.
As discussed below, the Commissions also are directing their
respective staffs to report separately as to whether changes are
warranted to any of the rules implementing the major participant
definitions. These staff reports will help the Commissions evaluate the
``major swap participant and ``major security-based swap participant''
definitions, including whether new or revised tests or approaches would
be appropriate for identifying major participants.\762\
---------------------------------------------------------------------------

\762\ See part V, infra.
---------------------------------------------------------------------------

A. ``Major'' Categories of Swaps and Security-Based Swaps

1. Proposed Approach
The first and third tests of the statutory major participant
definitions encompass entities that maintain a substantial position in
a ``major'' category of swaps or security-based swaps.\763\
---------------------------------------------------------------------------

\763\ See CEA section 1a(33)(A)(i), (iii); Exchange Act section
3(a)(67)(a)(2)(i), (iii).
---------------------------------------------------------------------------

In the Proposing Release, the Commissions proposed to designate
four ``major'' categories of swaps and two ``major'' categories of
security-based swaps. These categories sought to reflect the risk
profiles of the various types of swaps and security-based swaps, and
the different purposes for which end-users use those instruments. The
Proposing Release also noted the importance of not parsing the
``major'' categories so finely as to base the ``substantial position''
thresholds on unduly narrow risks and reduce those thresholds'
effectiveness as risk measures.\764\
---------------------------------------------------------------------------

\764\ See Proposing Release, 75 FR at 80186-87.
---------------------------------------------------------------------------

The proposed four ``major'' categories of swaps were rate swaps,
credit swaps, equity swaps and other commodity swaps.\765\ Rate swaps
would encompass any swap which is primarily based on one or more
reference rates, such as swaps of payments determined by fixed and
floating interest rates, currency exchange rates, or other monetary
rates. Credit swaps would encompass any swap that is primarily based on
default, bankruptcy and other credit-related risks related to, or the
total returns on, instruments of indebtedness (including loans),
including but not limited to any swap primarily based on one or more
broad-based indices related to debt instruments, and any swap that is a
broad-based index credit default swap or total return swap. Equity
swaps would encompass any swap that is primarily based on equity
securities, such as any swap primarily based on one or more broad-based
indices of equity securities, including any total return swap on one or
more broad-based equity indices. Other commodity swaps would encompass
any swap not included in any of the first three categories, and would
generally include, for example and not by way of limitation, any swap
for which the primary underlying item is a physical commodity or the
price or any other aspect of a physical commodity. The four categories
were intended to cover all swaps, and each swap would be in the
category that most closely describes the primary item underlying the
swap.\766\
---------------------------------------------------------------------------

\765\ See proposed CFTC Regulation Sec. 1.3(iii).
\766\ The statutory definition of ``swap'' lists 22 different
types of swaps.
---------------------------------------------------------------------------

The Commissions proposed to designate two ``major'' categories of
security-based swaps.\767\ The first category would encompass any
security-based swap that is based, in whole or in part, on one or more
instruments of indebtedness (including loans), or a credit event
relating to one or more issuers or securities, including but not
limited to any security-based swap that is a credit default swap, total
return swap on one or more debt instruments, debt swaps, or debt index
swaps. The second category would encompass any other security-based
swaps not included in the first category, including for example, swaps
on equity securities or narrow-based security indices comprised of
equity securities.\768\ These proposed categories were based on the
different uses of these types of security-based swaps, and were
consistent with market statistics and infrastructures that distinguish
between those types of security-based swaps.\769\
---------------------------------------------------------------------------

\767\ See proposed Exchange Act rule 3a67-2.
\768\ The second category also encompasses all security-based
swaps on narrow based indices that are comprised of both debt and
equity components.
\769\ See Proposing Release, 75 FR at 80187.
---------------------------------------------------------------------------

2. Commenters' Views
Certain commenters requested clarification regarding how the major
categories would be applied. One commenter particularly requested
additional clarity as to how the proposed categories will apply to
mixed swaps and to swaps that are based on debt that is convertible to
equity,\770\ while another commenter requested additional clarity as to
the status of certain mortgage-related transactions.\771\
---------------------------------------------------------------------------

\770\ See letter from ISDA I.
\771\ See letter from Freddie Mac.
---------------------------------------------------------------------------

One commenter suggested that the final rules should include a
catch-all provision to allow the Commissions to review large positions
that appear to be structured to evade proper categorization, and that
market participants should suggest the protocols for categorization of
swaps or security-based swaps.\772\
---------------------------------------------------------------------------

\772\ See meeting with Professor Darrell Duffie, Stanford
University Graduate School of Business (``Duffie'') on February 2,
2011.
---------------------------------------------------------------------------

One commenter suggested that the rate swap category should be
divided between interest rates and currencies, and that energy,
agriculture and metals swaps should be separate categories.\773\
Another commenter expressed the view that creation of a separate
category for cross currency swaps could lead to confusion among market
participants who may feel obligated to bifurcate cross currency swaps
between two categories.\774\ Some commenters expressed general support
for the major categories as proposed.\775\
---------------------------------------------------------------------------

\773\ See letter from Better Markets I.
\774\ See letter from ACLI.
\775\ See letters from Barnard, ISDA I and MetLife; see also
letter from American Insurance Association (``AIA'') (agreeing that
the defined major categories would cover substantially all
significant swaps and security-based swaps).
---------------------------------------------------------------------------

3. Final Rules
After considering the issue in light of comments received, the
Commissions are adopting final rules designating ``major'' categories
of swaps and security-based swaps consistent with the proposal.
Accordingly, the final rules provide that the four ``major'' categories
of swaps are rate swaps,

[[Page 30663]]

credit swaps, equity swaps and other commodity swaps.\776\ The two
``major'' categories of security-based swaps are debt security-based
swaps \777\ and other security-based swaps.\778\
---------------------------------------------------------------------------

\776\ See CFTC Regulation Sec. 1.3(iii). The four major
categories of swaps are the same as the asset classes used in the
CFTC Regulations relating to SDRs and reporting, except that the
asset classes for interest rate swaps and foreign exchange
transactions are combined into the single rate swap major category
of swaps. See CFTC, Swap Data Repositories: Registration Standards,
Duties and Core Principles; Final Rule, 76 FR 54538 (Sept. 1, 2011)
and Swap Data Recordkeeping and Reporting Requirements; Final Rule,
77 FR 2136 (Jan. 13, 2012).
\777\ The name of the first major category of security-based
swaps has been changed to ``debt security-based swaps'' in this
Adopting Release from ``security-based credit derivatives'' in the
Proposing Release. This change more accurately reflects the products
encompassed by this category, particularly total return swaps on
debt instruments. See Exchange Act rule 3a67-2(a).
In addition, the final rules defining the major categories for
purposes of the major participant definitions remove a cross-
reference to the corresponding dealer definitions under the CEA or
the Exchange Act to clarify that the rules apply only in the context
of the major participant definitions, and not the dealer
definitions. See CFTC Regulation Sec. 1.3(iii); Exchange Act rule
3a67-2.
\778\ See Exchange Act rule 3a67-2(b).
---------------------------------------------------------------------------

The Commissions believe that it is not necessary to further divide
the proposed categories or add new categories for swaps and security-
based swaps for purposes of the major participant definitions. We
believe that maintaining a large number of narrow categories of swaps
and security-based swaps would increase the possibility of confusion by
market participants with regard to categorizing the swaps and security-
based swaps in which they transact. The Commissions also continue to
believe that it is important not to parse the ``major'' categories so
finely as to base the ``substantial position'' thresholds on unduly
narrow groupings that would reduce those thresholds' effectiveness as
risk measures. Categories that are broad and clearly delineated further
should help prevent action to evade designation as a major participant
in a particular ``major'' category.
While we believe that these rules in general are sufficiently clear
to allow each swap and security-based swap to be placed in the
appropriate category, we are mindful of the commenters' request for
guidance with regard to certain circumstances. In the case of mixed
swaps, we would expect that the instrument would be placed in the
``swap'' and ``security-based swap'' categories that are consistent
with the underlying attributes that cause such instrument to be a mixed
swap.\779\ Also, swaps or security-based swaps that are based on more
than one item, instrument or risk, should be placed in the category
that most closely describes the primary item, instrument or risk
underlying the swap or security-based swap.\780\
---------------------------------------------------------------------------

\779\ The Commissions have proposed rules regarding the
regulation of mixed swaps. See Product Definitions Proposal, note 3,
supra.
\780\ In the case of instruments on debt securities that are
convertible into equity, in general we would expect the instrument
to be categorized based on its status (as debt or equity) at the
time of evaluation.
---------------------------------------------------------------------------

B. ``Substantial Position''

1. Proposed Approach
The major participant definitions require that the Commissions
define a ``substantial position'' in swaps or security-based swaps at a
threshold that we determine to be ``prudent for the effective
monitoring, management, and oversight'' of entities that are
systemically important or can significantly impact the U.S. financial
system. The definitions further require that we consider a person's
relative position in uncleared and cleared swaps or security-based
swaps, and permit us to consider the value and quality of collateral
held against counterparty exposure.\781\
---------------------------------------------------------------------------

\781\ See CEA section 1a(33)(B); Exchange Act section
3(a)(67)(B).
---------------------------------------------------------------------------

The proposed rules provided that a person would have a
``substantial position'' in swaps or security-based swaps if the daily
average current uncollateralized exposure associated with its swap or
security-based swap positions in a major category in a calendar quarter
amounted to $1 billion or more (or $3 billion in the case of rate
swaps).\782\ A person also would have a ``substantial position'' if the
daily average of the sum of the current uncollateralized exposure plus
the potential future exposure associated with its positions in a major
category in a calendar quarter amounted to $2 billion or more (or $6
billion for the rate swap category).\783\
---------------------------------------------------------------------------

\782\ See proposed CFTC Regulation Sec. 1.3(jjj)(1); proposed
Exchange Act rule 3a67-3(a)(1), (d).
\783\ See proposed CFTC Regulation Sec. 1.3(jjj)(1); proposed
Exchange Act rule 3a67-3(a)(2), (d).
---------------------------------------------------------------------------

The proposed rules did not prescribe any particular methodology for
measuring current exposure or valuing collateral posted, and instead
provided that the method used should be consistent with counterparty
practices and industry practices generally.\784\ The proposed rules
also provided that an entity could calculate its current
uncollateralized exposure by accounting for netting agreements on a
counterparty-by-counterparty basis,\785\ and the Proposing Release set
forth a method for allocating any residual uncollateralized exposure to
a counterparty that remains following netting.\786\
---------------------------------------------------------------------------

\784\ See proposed CFTC Regulation Sec. 1.3(jjj)(2)(ii);
proposed Exchange Act rule 3a67-3(a)(2)(i).
\785\ See proposed CFTC Regulation Sec. 1.3(jjj)(2)(iii);
proposed Exchange Act rule 3a67-3(b)(3).
\786\ See Proposing Release, 75 FR at 80190.
---------------------------------------------------------------------------

The proposed potential future exposure test was based on the risk-
adjusted notional amount of the entity's swap and security-based swap
positions, consistent with a test used by bank regulators for purposes
of setting capital standards.\787\ The test also excluded or lowered
the potential exposure associated with certain lower-risk
positions.\788\ In addition, the measures of potential future exposure
would be discounted by up to 60 percent to reflect the risk mitigation
provided by netting agreements,\789\ and would further be decreased by
80 percent for positions subject to central clearing or daily mark-to-
market margining.\790\
---------------------------------------------------------------------------

\787\ See id. at 80191-92.
\788\ See proposed CFTC Regulation Sec. 1.3(jjj)(3)(iii);
proposed Exchange Act rule 3a67-3(c)(2)(i)(C), (D).
\789\ See proposed CFTC Regulation Sec. 1.3(jjj)(3)(ii)(B);
proposed Exchange Act rule 3a67-3(c)(2)(ii).
\790\ See proposed CFTC Regulation Sec. 1.3 (jjj)(3)(iii)(A);
proposed Exchange Act rule 3a67-3(c)(3)(i). This discount for daily
margining would be available even in the presence of a threshold or
a minimum transfer amount, so long as the threshold and the minimum
transfer amount (if the latter exceeds $1 million) are separately
added to the entity's current exposure for purposes of the current
exposure plus potential future exposure test. See proposed CFTC
Regulation Sec. 1.3(jjj)(3)(iii)(B); proposed Exchange Act rule
3a67-3(c)(3)(ii).
---------------------------------------------------------------------------

2. Commenters' Views
a. Basis for Regulating Major Participants and Alternative Approaches
for Identifying ``Substantial Positions''
Several commenters expressed the view that the major participant
definition is intended to address entities whose swap or security-based
swap positions pose systemic risk,\791\ while one commenter took the
contrary view that the definition also is intended to address the
significance of an entity's swap or security-based swap positions (as
well as the risk those positions pose).\792\
---------------------------------------------------------------------------

\791\ E.g., letters from BlackRock I and MFA I.
\792\ See letter from Better Markets I.
---------------------------------------------------------------------------

One commenter stated that the proposal inappropriately sought to
account for the risk posed by the potential default of multiple
entities, rather than a single entity.\793\ Some commenters suggested
that the analysis should account for the concentration of the risk
posed by an entity's

[[Page 30664]]

positions,\794\ and one commenter suggested that the analysis should
not account for individual categories of swaps or security-based
swaps.\795\
---------------------------------------------------------------------------

\793\ See letter from BlackRock I.
\794\ See letters from Black Rock I (suggesting a two-step
process that accounts for the reduced risk associated with entities
whose positions are distributed among several counterparties); CCMR
I and APG Algemene Pensioen Groep NV (``APG'').
\795\ See letter from NYCBA Committee.
---------------------------------------------------------------------------

b. Levels of Proposed ``Substantial Position'' Thresholds
A number of commenters expressed the view that the proposed
thresholds are inappropriately low.\796\ Some commenters stated the
thresholds initially should be high, with later revisions based on
market data.\797\
---------------------------------------------------------------------------

\796\ See letters from ABC/CIEBA (indirectly referring to AIG
Financial Products, and noting that it had $400 billion in notional
positions and defaulted when it was required to post approximately
$100 billion in collateral); BG LNG I (alluding to lack of systemic
impact associated with Enron's failure, and suggesting that the
Commissions convene an advisory committee to develop thresholds);
NCGA/NGSA I (alluding to corporate financial losses involving
derivatives that have exceeded the proposed thresholds without
significantly impacting the U.S. financial system); ACLI (supporting
increase in proposed thresholds under the CEA to $4 billion current
uncollateralized exposure and $8 billion current uncollateralized
exposure plus potential future exposure); and Chesapeake Energy.
\797\ See letters from MFA dated February 25, 2011 (``MFA II'')
(stating that thresholds initially should be set higher, while later
survey-based thresholds should be based on potential systemic risk
impact and the cost of performing the calculations); CCMR I (stating
that the Commissions presently have insufficient data to determine
appropriate thresholds, and that thresholds initially should be
high); BlackRock I (stating that the Commissions should refrain from
establishing thresholds if sufficient information is not available);
and Freddie Mac. Two commenters particularly addressed the proposed
thresholds applicable to rate swaps. See letters from ACLI and
MetLife.
---------------------------------------------------------------------------

Some commenters did not oppose the proposed thresholds or expressed
support for the thresholds (though many of those commenters separately
raised issues about the underlying tests),\798\ while two commenters
supported lowering the proposed thresholds.\799\ Some commenters took
the position that the thresholds should be adjusted over time to
reflect factors such as inflation or market characteristics.\800\
---------------------------------------------------------------------------

\798\ See, e.g., letters from ACLI, Fidelity, SIFMA AMG dated
Feb. 22, 2011 (``SIFMA AMG II'') and Vanguard (supporting proposed
limits for credit swaps, equity swaps and other commodity swaps, but
not rate swaps).
\799\ See letters from AFR (supporting use of a $500 million
uncollateralized exposure threshold, or a $1 billion current
exposure plus potential future exposure threshold, with higher
thresholds for rate swaps) and Greenberger.
\800\ See, e.g., letters from MFA I (referring to inflation and
measures such as the amount of equity in the U.S. banking system)
and ISDA I (referring to evolution of the size and fundamental
characteristics of the markets, and changes to valuation
methodologies and economic conditions).
---------------------------------------------------------------------------

c. Current Uncollateralized Exposure Test
Measures of exposure and valuation of collateral--A number of
commenters supported the Proposing Release's position that the current
exposure analysis not prescribe any methodology for measuring exposure
or valuing collateral.\801\ On the other hand, some commenters
requested explicit approval of particular methodologies,\802\ a good
faith safe harbor,\803\ or regulator-prescribed measurement
standards.\804\ Some commenters emphasized the need to be able to post
non-cash collateral in connection with positions.\805\ Two commenters
requested codification of the proposal's position that operational
delays associated with the daily exchange of collateral would not lead
to current uncollateralized exposure for purposes of the analysis.\806\
---------------------------------------------------------------------------

\801\ See letters from Fidelity, ICI I, ISDA I and MFA I.
\802\ See letter from BlackRock I. Consistent with the proposal,
the final rules contemplate the use of industry standard practices
in the calculation of current exposure and potential future
exposure. As with other rules adopted by the Commissions, a market
participant may raise questions with the Commissions about the
participant's approach to addressing the final rules--including its
use of particular methodologies--for further guidance as may be
necessary or appropriate.
\803\ See letter from FSR I (particularly noting difficulty of
valuing illiquid or bespoke positions).
\804\ See letter from Better Markets I.
\805\ See, e.g., letters from ACLI, CDEU and MetLife.
\806\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

Netting issues--Some commenters stated that the proposed netting
provisions should be expanded to encompass additional products that may
be netted for bankruptcy purposes.\807\ One commenter took the view
that these provisions should be expanded across multiple netting
agreements to the extent that offsets are permitted.\808\ One commenter
asked for clarification as to the scope of the netting provisions,\809\
and one commenter expressed general support for the proposed netting
provisions.\810\
---------------------------------------------------------------------------

\807\ See letters from ISDA I (specifically addressing
securities contracts and forward contracts); NRG Energy
(specifically addressing forwards); and APG (specifically addressing
securities options and forwards).
\808\ See letter from FSR I.
\809\ See letter from Fidelity (seeking confirmation that
``master netting agreement'' can include an ISDA Master Agreement).
\810\ See letter from ACLI.
---------------------------------------------------------------------------

Allocation of uncollateralized exposure--Some commenters requested
that the final rules incorporate the principles, articulated in the
Proposing Release, for allocating any uncollateralized exposure that
remains following netting.\811\ Other commenters raised concerns that
those principles were based on an unwarranted assumption that
collateral is specifically earmarked to particular transactions.\812\
---------------------------------------------------------------------------

\811\ See letters from SIFMA AMG II and Vanguard.
\812\ See letters from FSR I and ISDA I; see also letter from
MetLife (suggesting pro rata allocation of uncollateralized current
exposure among each major category with current exposure).
---------------------------------------------------------------------------

d. Potential Future Exposure Test
General concerns and suggested alternative approaches--Some
commenters disagreed with the Proposing Release's statement that the
potential future exposure analysis would evaluate potential changes in
the value of a swap or security-based swap over the remaining life of
the contract; those commenters stated that the test instead should
focus on potential volatility during the time it would take for a non-
defaulting party to close out a defaulting party's positions.\813\
---------------------------------------------------------------------------

\813\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

Some commenters criticized the tables setting forth the risk
adjustments used to calculate potential future exposure.\814\
Commenters further suggested using, as alternatives, value-at-risk
measures or other models,\815\ or the ``standardized method'' under
Basel II.\816\ Commenters also argued that risk adjustments should
provide a greater discount to credit swaps on ``investment grade''
instruments than to other credit swaps, that index CDS should be
subject to a greater discount than single name CDS, and that there
should be a lower discount factor for CDS of shorter maturity.\817\ One
commenter generally supported the proposed conversion factors and
adjustments.\818\
---------------------------------------------------------------------------

\814\ See letters from Riverside Risk Advisors LLC (``Riverside
Risk Advisors'') (criticizing, among other aspects, discontinuities
in table, a failure to account for how far a swap is in or out of
the money, the use of a single discount factor for credit default
swaps, the fact that the risk factor for short-term equity swaps is
lower than the risk factor for credit swaps, and the fact that
equity swaps do not distinguish between high-volatility and low-
volatility stocks, as well as the failure to address portfolio
effects of diversification and correlation, and ``wrong-way'' risk
in the form of ``an adverse correlation between counterparty default
risk and the value of its derivatives contracts''); and ISDA I
(noting that the conversion factors were calibrated more than 15
years ago and were not designed for later instruments such as credit
products).
\815\ See letters from Riverside Risk Advisors (supporting
giving end-users the option to use a model-based approach); and
Better Markets I (supporting use of a value-at-risk calculation).
\816\ See letter from ISDA I.
\817\ See letters from AIMA I and MFA I.
\818\ See letter from MetLife.
---------------------------------------------------------------------------

Some commenters expressed the view that measures of potential
future exposure should be superseded by negotiated independent amounts
or regulator-required initial margin.\819\ Some commenters also argued
that

[[Page 30665]]

excess posted collateral or net in-the-money positions should be offset
against potential future exposure.\820\
---------------------------------------------------------------------------

\819\ See letters from SIFMA AMG II and Vanguard.
\820\ See, e.g., letters from AIMA I, Fidelity, MFA I, SIFMA AMG
II and Vanguard.
---------------------------------------------------------------------------

Potential future exposure measures for lower-risk positions--Some
commenters stated that the proposal to cap potential future exposure
when a person buys credit protection using a credit default swap should
be expanded to apply to any position with a fixed downside risk.\821\
Commenters also suggested that the potential future exposure associated
with purchases of credit protection be further discounted,\822\ while
one commenter took the position that purchases of credit default swaps
should be excluded from the potential future exposure test.\823\
Commenters also addressed the appropriate discount rate for calculating
the net present value of unpaid premiums.\824\
---------------------------------------------------------------------------

\821\ See letters from MFA I (citing fixed portions of interest
rate swaps), MetLife (citing purchased options as well as CDS), ACLI
and Ropes & Gray.
\822\ See letters from MFA I (arguing that the tightening of
credit spreads would imply a healthy credit environment) and AIMA;
see also meeting with MFA on February 14, 2011.
\823\ See letter from Vanguard.
\824\ See letter from MFA I (suggesting the possible use of the
LIBOR/Swap rate) and AIMA I.
---------------------------------------------------------------------------

Netting issues--One commenter stated that the proposal's netting
provisions did not adequately account for the risk mitigation
associated with hedged positions,\825\ while another commenter asked
that the proposed netting provisions be clarified and simplified.\826\
One commenter supported the proposed netting approach.\827\
---------------------------------------------------------------------------

\825\ See letter from ISDA I.
\826\ See letter from SIFMA AMG II.
\827\ See letters from ACLI.
---------------------------------------------------------------------------

Discount for cleared or margined positions--Several commenters took
the view that cleared positions should be excluded entirely from the
potential future exposure analysis, rather than only being subject to
an 80 percent discount,\828\ and some commenters also supported a
complete exclusion for positions subject to daily mark-to-market
margining.\829\ One commenter suggested a minimum 98 percent reduction
for positions subject to central clearing or mark-to-market
margining,\830\ while one commenter suggested that there be a higher
discount for positions subject to the posting of initial margin.\831\
---------------------------------------------------------------------------

\828\ See, e.g., letters from MFA I, SIFMA AMG II and Vanguard.
\829\ See letters from BG LNG I, Fidelity and ICI I.
\830\ See letter from ISDA I.
\831\ See letter from FHLB I (suggesting 90 percent discount for
cleared swaps and for uncleared swaps for which initial margin has
been posted; alternatively suggesting that posted initial margin be
subtracted from the calculated amount).
---------------------------------------------------------------------------

Some commenters also stated that there should be a partial discount
provided in connection with positions for which mark-to-market
margining is done less than daily,\832\ and that there should be a
discount for positions that are margined using security interests or
liens.\833\ On the other hand, one commenter stated that there is no
basis for providing any discount for marked-to-market positions.\834\
---------------------------------------------------------------------------

\832\ See letters from Fidelity and Canadian Master Asset
Vehicle I and Master Asset Vehicle II (``Canadian MAVs'').
\833\ See letter from FHLB I (giving as an example swaps
collateralized by security interests in real estate, oil or gas
interests, or by first liens on financial assets).
\834\ See letter from Better Markets I; see also letter from AFR
(generally opposing use of risk adjustments, but suggesting that any
such discounts should be larger for cleared positions).
---------------------------------------------------------------------------

One commenter requested that the rule language codify language in
the Proposing Release as to when a position is subject to daily mark-
to-market margining.\835\ A number of commenters addressed proposed
rule language that was intended to clarify that the discount for daily
mark-to-market margining would be available even in the presence of
thresholds and minimum transfer amounts.\836\
---------------------------------------------------------------------------

\835\ See letter from SIFMA AMG II.
\836\ See letter from CDEU (stating that the proposal could
overstate an entity's future exposure, and favoring use of the lower
of the calculated potential future exposure or the CSA threshold);
see also letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

Two commenters supported the proposed approach in general.\837\ One
commenter specifically supported the proposed 80 percent reduction for
positions subject to daily mark-to-market margining,\838\ and one
commenter specifically supported a reduction for cleared
positions.\839\
---------------------------------------------------------------------------

\837\ See letters from ACLI and MetLife.
\838\ See letter from Vanguard.
\839\ See letter from Better Markets I.
---------------------------------------------------------------------------

Additional issues regarding the potential future exposure test--
Some commenters argued that the Commissions should clarify how the
categories in the proposed potential future exposure tables would be
applied, given how those differ from the proposed ``major'' categories
of swaps and security-based swaps.\840\
---------------------------------------------------------------------------

\840\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

Some commenters raised concerns that the proposed use of an
instrument's ``effective notional'' amount is ambiguous.\841\
Commenters also took the position that for purposes of the potential
future exposure calculation, notional amounts should be adjusted to
reflect delta weighting,\842\ that the measure of duration for options
on swaps should consider whether the underlying swap is cash-
settled,\843\ and that the adopting release should set forth examples
of potential future exposure calculations.\844\
---------------------------------------------------------------------------

\841\ See letters from FSR I, SIFMA AMG II and Vanguard.
\842\ See letters from MFA I and Ropes & Gray.
\843\ See letter from MFA I.
\844\ See id.
---------------------------------------------------------------------------

e. Cost Concerns
Some commenters emphasized the need to avoid an overbroad major
participant definition, \845\ and highlighted concerns about being
subject to unnecessary regulation.\846\
---------------------------------------------------------------------------

\845\ See joint letter from Representatives Bachus and Lucas.
\846\ See, e.g., letters from SIFMA AMG II (stating that the
commenter's suggested changes in connection with the substantial
position analysis would reduce burdens and costs to market
participants, and more closely align the tests with the objectives
they are meant to achieve) and ABC/CIEBA; see also letter from
NFPEEU (reserving the right to dispute the cost-benefit analysis
associated with the proposed dealer and major participant rules
until all relevant Dodd-Frank Act releases could be analyzed as a
whole).
---------------------------------------------------------------------------

f. Additional Issues
One commenter suggested there be an explicit presumption against
imposing major participant (or dealer) regulation on end-users.\847\
Some commenters requested that the current uncollateralized exposure
test explicitly exclude cleared positions, net in-the-money positions,
and fully collateralized out-of-the-money positions,\848\ and one
commenter also supported excluding those positions from the potential
future exposure analysis.\849\ That commenter also supported excluding
swaps on government securities from the substantial position
analysis.\850\
---------------------------------------------------------------------------

\847\ See letter from CDEU.
\848\ See letters from ICI I, SIFMA AMG II and Vanguard.
\849\ See letter from ICI I.
\850\ See letter from ICI I (noting size of government security
market and Federal Reserve control over supply and demand, and
stating that the proposed thresholds are ill-suited to address the
``vast'' government securities market).
---------------------------------------------------------------------------

One commenter requested confirmation that dealers and major
participants would not be required to compute, assist with, or verify
computations for counterparties that may be major participants, and
also that market participants can enlist third-party services to assist
in performing the calculations.\851\ One commenter requested
clarification that the proposed focus on uncollateralized exposure does
not mean that end-users themselves

[[Page 30666]]

should not demand collateral from dealers.\852\
---------------------------------------------------------------------------

\851\ See letter from ISDA I.
\852\ See letter from FHLB I.
---------------------------------------------------------------------------

3. Final Rules
a. Guiding Principles
The final rules defining ``substantial position'' focus on
identifying persons whose large swap and security-based swap positions
pose market risks that are significant enough that it would be
``prudent'' to regulate those persons. In developing these rules we
have been mindful of the costs associated with regulating major
participants, and have considered cost and benefit principles as part
of the analysis of what level of swap and security-based swap positions
reasonably form the lower bounds for identifying when it would be
``prudent'' that particular entities be subject to monitoring,
management and oversight of entities that may be systemically important
or may significantly impact the U.S. financial system.\853\
---------------------------------------------------------------------------

\853\ At the same time, as discussed above in the context of the
de minimis exception to the dealer definitions, we are mindful that
the benefits of financial regulation cannot be quantified. For
example, while the regulation of major participants will comprise
one component of Title VII's comprehensive regulatory framework that
should be expected to help lessen the amount and frequency of
financial crises, we cannot place a dollar figure on the
contribution of major participant regulation to those benefits. In
light of those factors, we believe that it would be ``prudent'' to
regulate, as major participants, those persons whose swap or
security-based swap positions are large enough to pose a material
potential of causing significant counterparty impacts, consistent
with the levels set forth in the final rules. The Commissions will
further address the comparative costs and benefits associated with
regulating major participants in the context of the substantive
rules applicable to major participants.
---------------------------------------------------------------------------

The final rules implementing the ``substantial position''
definition follow the basic approach that the Commissions proposed,
including the combined use of current exposure and potential future
exposure tests.\854\ While we have carefully considered the views of
commenters who suggested alternative approaches, we have concluded that
it is appropriate to adopt the basic approach that was proposed, as
described below.
---------------------------------------------------------------------------

\854\ As with the proposal, the final rules apply these tests to
swap and security-based swap positions in a ``major'' category. See
CFTC Regulation Sec. 1.3(jjj)(1); Exchange Act rule 3a67-3(a). The
final rules have been modified from the proposal, however, by
removing a reference to ``positions excluded from consideration.''
We have concluded that this reference is unnecessary because the
first statutory major participant test explicitly provides that
positions that are subject to the commercial risk hedging and the
ERISA hedging exclusions of the first major participant test need
not be considered for purposes of that test.
---------------------------------------------------------------------------

Focus on default-related credit risks. The final rules
implement tests that seek to reflect the credit risk that a person's
swap or security-based swap positions would pose in the event of
default. In arguing that the analysis should consider factors in
addition to default-related risks, commenters have noted that certain
regulations applicable to major participants address business conduct
issues that are distinct from systemic risk issues.\855\ We nonetheless
believe that the statutory definition of ``substantial position''
indicates that the analysis should focus on default-related credit
risks, because a default-related approach is more closely linked to the
statutory criteria that the definition focus on entities that are
``systemically important'' or can ``significantly impact'' the U.S.
financial system than would be an approach that focuses on the
potential for disruptive market movements.\856\
---------------------------------------------------------------------------

\855\ See, e.g., letter from Better Markets I.
\856\ We also believe that the statutory definition should focus
on all default-related credit risks associated with swap or
security-based swap positions. We do not see a basis for excluding
any class of risks (e.g., risks associated with swaps based on
government securities) from the analysis.
---------------------------------------------------------------------------

Failure of multiple entities close in time. The final
rules that implement the ``substantial position'' definition seek to
reflect the risks that would be posed by the default of multiple
entities close in time. Although one commenter took the view that the
purpose of major participant regulation is to prevent the credit
exposure of a single person from having a systemic impact,\857\ we do
not believe that the major participant definitions should be construed
so narrowly. The events of recent years demonstrate that market stress
may lead to the failure and near-failure of multiple entities with
large financial positions over a relatively short time period. We do
not believe that it would be prudent or well-reasoned to presume that
recent history cannot repeat itself, and to assume that future failures
of entities with large financial positions will be isolated events.
---------------------------------------------------------------------------

\857\ See letter from BlackRock I.
---------------------------------------------------------------------------

Aggregate risk. The final rules address the aggregate risk
posed by an entity's swap or security-based swap positions, rather than
seeking to focus on principles of concentration (such as by using a
threshold that addresses an entity's largest exposure to an individual
counterparty) or on converse principles of interconnection. The
statutory ``substantial position'' definition is specifically written
in terms of market risk concerns (i.e., ``systemically important'' and
``can significantly impact the financial system of the United
States''), and measures of aggregate risk appear to be best geared to
reflect this standard.\858\
---------------------------------------------------------------------------

\858\ Moreover, a test that focuses on the concentration of an
entity's swap or security-based swap exposure toward one or a few
individual parties potentially poses a tension with the view that
interconnections of exposure among multiple parties are important to
establishing systemic risk.
---------------------------------------------------------------------------

Use of objective, quantitative criteria. The final rules
provide for a ``substantial position'' analysis that is based on
objective, quantitative criteria that would permit a market participant
to determine which level of swap or security-based swap positions would
cause it to be a major participant. Although one commenter has
suggested the use of a two-step approach that uses thresholds as a safe
harbor and that would be accompanied by a second-level
determination,\859\ we do not believe that such an approach would be
consistent with the statutory language or with principles of regulatory
efficiency.\860\ Accordingly, a person whose swap or security-based
swap positions satisfy the applicable thresholds will be a major
participant, with no further layer of review provided.\861\
---------------------------------------------------------------------------

\859\ See letter from BlackRock I.
\860\ The major participant definitions specifically require
that the term ``substantial position'' be defined ``by rule or
regulation'' via a ``threshold.'' That language would not appear to
anticipate the use of a multi-tier approach that accounts for
subjective criteria.
In this respect, the major participant definitions may be
compared with section 113 of the Dodd-Frank Act, which authorizes
the Financial Stability Oversight Council (``FSOC'') to provide for
a non-bank financial company to be supervised by the Board if the
FSOC ``determines that material financial distress at the U.S.
nonbank financial company, or the nature, scope, size, scale,
concentration, interconnectedness, or mix of the activities of the
U.S. nonbank financial company, could pose a threat to the financial
stability of the United States.'' Section 113 further provides that
these designations will result from a vote of the FSOC based on a
variety of factors. The ``major participant'' definition does not
provide for this type of entity-specific determination, and we
believe that the ``major participant'' definition more appropriately
is implemented by objective factors that allow market participants
to determine whether they will fall within the definition.
\861\ In addition, the final rules provide that the
``substantial position'' analysis that implements the first (and
third) major participant test will be based on the ``major''
categories of swaps and security-based swaps. Notwithstanding
commenter concerns that this approach will require market
participants to analyze their swaps and security-based swaps in new
ways and will result in additional costs, this focus on ``major''
categories is dictated by the plain language of the statute.
---------------------------------------------------------------------------

b. Current Uncollateralized Exposure Test
Consistent with the proposal, the final rules implementing the
``substantial position'' definition include a test that accounts for
the current uncollateralized exposure posed by an entity's swap or
security-based swap positions in a major

[[Page 30667]]

category.\862\ This provides a measure of the amount of potential risk
that an entity would pose to its counterparties if the entity currently
were to default.\863\
---------------------------------------------------------------------------

\862\ CFTC Regulation Sec. 1.3(jjj)(1); Exchange Act rule 3a67-
3(b)(2). The final rules contain technical changes from the proposal
to clarify the steps entailed by this calculation.
\863\ See Proposing Release, 75 FR at 80188.
---------------------------------------------------------------------------

As with the proposal, a person would apply this test by examining
the positions it maintains with each of its counterparties in a
particular major category of swaps or security-based swaps. For each
counterparty, the person would determine the dollar value of the
aggregate current exposure arising from each of its swap or security-
based swap positions with negative value in that major category by
marking-to-market using industry standard practices, and deduct from
that amount the aggregate value of the collateral the entity has posted
with respect to the swap or security-based swap positions.\864\ The
``aggregate uncollateralized outward exposure'' would be the sum of
those uncollateralized amounts over all counterparties with which the
person has entered into swaps or security-based swaps in that major
category.\865\
---------------------------------------------------------------------------

\864\ As we noted in the Proposing Release, we recognize that
there may be operational delays between changes in exposure and the
resulting exchanges of collateral, and in general we would not
expect that operational delays associated with the daily exchange of
collateral would be considered to lead to uncollateralized exposure
for these purposes. See Proposing Release, 75 FR at 80189 n.92.
Although we are not codifying this principle within the final rules,
we will be mindful of the principle when enforcing those rules.
\865\ CFTC Regulation Sec. 1.3(jjj)(2); Exchange Act rule 3a67-
3(b)(2).
---------------------------------------------------------------------------

The final rules implementing this test largely are the same as the
rules the Commissions proposed, but with certain modifications to
address issues raised by commenters.
i. Measure of Exposure and Valuation of Collateral
Consistent with the proposal, the final rules do not prescribe any
particular methodology for measuring current exposure or for valuing
collateral posted, but instead require the use of industry standard
practices.\866\ In this regard we do not concur with commenter requests
that we approve or prescribe particular methodologies, or provide a
safe harbor for measures or valuations made in good faith.\867\
Instead, it is appropriate that the final rules provide market
participants with the flexibility to use the same methodologies that
they use in connection with their business activities. Accordingly, we
would expect entities to value current uncollateralized exposure based
on the amounts that would be payable if the transaction were
terminated.
---------------------------------------------------------------------------

\866\ CFTC Regulation Sec. 1.3(jjj)(2); Exchange Act rule 3a67-
3(b)(1). As we noted in the Proposing Release, collateral may be
posted to a third-party custodian, directly to the counterparty, or
in accordance with the rules of a derivatives clearing organization
or clearing agency. See Proposing Release, 75 FR at 80189 n.94.
\867\ See letters from BlackRock I, Better Markets I and FSR I.
---------------------------------------------------------------------------

To the extent the measure of exposure or the valuation of
collateral is subject to other rules or regulations, we also would
expect those measures and valuations for purposes of the major
participant calculations to be consistent with those other applicable
rules.\868\ In addition, the ``substantial position'' analysis may take
into account the posting of non-cash collateral to the extent that the
posting of such collateral, and the valuation of that collateral, is
consistent with industry standard practices or applicable
regulation.\869\
---------------------------------------------------------------------------

\868\ These principles should apply even in the case of valuing
illiquid or bespoke positions. Market participants have the
flexibility to use commercially reasonable approaches that are
consistent with their financial statements, tax calculations and
compliance with other regulations.
\869\ For non-cash collateral to be considered for purposes of
these calculations, the collateral must be available for the
counterparty's use if the entity posting the collateral were to
default. At a minimum, this would require that the counterparty
possess a perfected security interest in that collateral. As we
noted in the Proposing Release, while we expect that other
regulatory requirements applicable to the valuation of swap or
security-based swap positions and collateral would be relevant to
certain calculations relating to major participant status, these
rules would not necessarily be relevant for other purposes, such as
in the context of capital and margin requirements. See Proposing
Release, 75 FR at 80189 n.95.
---------------------------------------------------------------------------

ii. Netting
The final rules build upon the proposal with regard to the measure
of uncollateralized current exposure in the presence of netting
arrangements. In particular, to address commenter concerns these
provisions have been modified from the proposal to account for the fact
that two counterparties may have multiple netting agreements for which
offsets are permitted, and to extend the netting principles to any
financial instruments that may be netted for purposes of applicable
bankruptcy law (rather than limiting those instruments to swaps,
security-based swaps and securities financing transactions).
Accordingly, the final rules provide that an entity may calculate
its exposure on a net basis by applying the terms of one or more master
netting agreements with a counterparty. The entity may account for
offsetting positions entered into with that particular counterparty
involving swaps or security-based swaps as well as securities financing
transactions (consisting of securities lending and borrowing,
securities margin lending and repurchase and reverse repurchase
agreements), and other financial instruments and agreements that are
subject to netting offsets for purposes of applicable bankruptcy law,
to the extent consistent with the offsets provided by those master
netting agreements.\870\ These revisions should permit the current
uncollateralized exposure test to more accurately reflect the degree of
credit risk that an entity poses to its counterparty in the event of
default.
---------------------------------------------------------------------------

\870\ CFTC Regulation Sec. 1.3(jjj)(2)(iii); Exchange Act rule
3a67-3(b)(3)(i). This provision provides for netting under the
master netting agreement of any instruments, contracts or agreements
(including contracts on physical commodities), that would qualify
for netting under applicable bankruptcy law. As we noted in the
Proposing Release, the proposed rules regarding possible offsets of
various positions are for purposes of determining major participant
status only. Other rules proposed by the Commissions may address the
extent to which, if any, persons such as dealers and major
participants may offset positions for other purposes. See Proposing
Release, 75 FR at 80189 n.98. As proposed, Exchange Act rule 3a67-
3(b)(3)(i) referred to ``security-based swaps (in any swap
category)''; this reference has been revised in the final rule to
``security-based swaps (in any security-based category).''
---------------------------------------------------------------------------

As discussed in the proposal, these netting provisions apply only
to offsetting positions with a single counterparty.\871\ The provisions
do not extend to the market risk offsets associated with an entity's
positions with multiple counterparties, because such offsets would not
directly mitigate the risks that an individual counterparty would face
in the event of the entity's default.\872\
---------------------------------------------------------------------------

\871\ CFTC Regulation Sec. 1.3(jjj)(2)(iii); Exchange Act rule
3a67-3(b)(3)(ii).
\872\ The fact that positions with third parties do not offset
exposure to a particular counterparty was recently highlighted by a
decision finding that the Bankruptcy Code does not permit excess
collateral held by one creditor to offset amounts that the debtor
owed to the creditor's affiliates. See In re Lehman Brothers Inc.,
Case No. 08-01420 (JMP) (SIPA), slip op. (Bankr. S.D.N.Y Oct. 4,
2011).
---------------------------------------------------------------------------

iii. Allocation of Uncollateralized Exposure Following Netting
The final rules build upon the proposal by codifying the method,
discussed in the Proposing Release, related to the allocation of any
uncollateralized exposure that remains following netting and the
posting of collateral. This type of allocation can be necessary
because, with netting, it otherwise may not be possible to directly
attribute residual uncollateralized exposure to a particular major
category of swap or security-based

[[Page 30668]]

swap.\873\ Some commenters have requested that the final rules codify
this method to provide more certainty to market participants.\874\
---------------------------------------------------------------------------

\873\ Such allocation would not be necessary, of course, to the
extent that an entity has no current uncollateralized exposure to a
counterparty following netting and the posting of collateral.
\874\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

Accordingly, the final rules incorporate a formula which, for
purposes of the substantial position analysis, provides that the amount
of net uncollateralized exposure that is attributable to a particular
major category of swap or security-based swap would be allocated pro
rata in a manner that compares the amount of the entity's out-of-the-
money positions in that major category to its total out-of-the-money
positions in all categories that are subject to the netting
arrangements with that counterparty.\875\ This approach does not
require that any collateral be specifically earmarked to particular
swaps or security-based swaps, and can be followed so long as
collateral is posted based on the net exposure associated with all
instruments subject to the applicable netting agreements with that
particular counterparty.\876\
---------------------------------------------------------------------------

\875\ CFTC Regulation Sec. 1.3(jjj)(2)(iii)(A); Exchange Act
rule 3a67-3(b)(4). Under this formula, for example, if an entity's
exposure to a particular counterparty is $120 million after
accounting for netting and the posting of collateral, and, subject
to netting, the entity has $40 million in out-of-the-money positions
in security-based credit derivatives, $90 million in out-of-the-
money positions in other security-based swaps, and $120 million in
out-of-the money positions in swaps and other instruments subject to
the netting agreements, then $19.2 million in net uncollateralized
exposure would be attributed to the ``security-based credit
derivatives'' category (equal to $120 million [middot] ($40 million/
($40 million + $90 million + $120 million)), and $43.2 million in
net uncollateralized exposure would be attributed to the ``other
security-based swaps'' category (equal to $120 million [middot] ($90
million/($40 million + $90 million + $120 million)).
\876\ Although one commenter suggested that the analysis should
further consider whether there are collateral posting requirements
that are specific to a particular position, we believe that the test
we are adopting is flexible enough to address that possibility. To
the extent that the parties' collateral arrangements provide that
collateral be earmarked to particular swap or security-based swap
positions, an entity may calculate its potential future exposure
with respect to that counterparty with regard to the applicable
major category of swaps or security-based swaps, without accounting
for netting across categories or instruments.
---------------------------------------------------------------------------

iv. Application of Current Exposure Test to Cleared, Fully
Collateralized or Net In-the-Money Positions
Although certain commenters have requested that the current
uncollateralized exposure test explicitly exclude swap or security-
based swap positions that are cleared, fully collateralized or net in-
the-money,\877\ the final rules do not provide such exclusions. As we
recognized in the Proposing Release, centrally cleared swaps and
security-based swaps are subject to mark-to-market margining that would
largely eliminate the uncollateralized exposure associated with a
position, effectively resulting in the cleared position being excluded
from the analysis.\878\ Also, by definition, fully collateralized
positions are not associated with current uncollateralized exposure,
and thus would be excluded from the analysis. As such, we do not
believe that it would be necessary to explicitly exclude such positions
from the analysis.\879\
---------------------------------------------------------------------------

\877\ See letters from ICI I, SIFMA AMG II and Vanguard.
\878\ See Proposing Release, 75 FR at 80189 n.92.
\879\ Moreover, to the extent that such positions are associated
with uncollateralized amounts, such as those that arise from
thresholds or minimum transfer amounts pursuant to the applicable
credit support annex, then those amounts present counterparty risk
that should be considered as part of the major participant analysis.
---------------------------------------------------------------------------

Similarly, we do not believe that it is necessary for the rules to
explicitly exclude net in-the-money swap or security-based swap
positions. If an entity does not have any current uncollateralized
exposure to a particular counterparty--after accounting for the
entity's netting agreement with that counterparty and the posting of
collateral--then the entity may disregard its positions with that
counterparty for purposes of calculating current uncollateralized
exposure. Otherwise, it is appropriate to consider the contribution of
all swaps or security-based swaps to current uncollateralized exposure,
as determined by the allocation methodology discussed above.\880\
---------------------------------------------------------------------------

\880\ Under that allocation approach, if none of the entity's
swap or security-based swap positions in a major category with that
counterparty are out-of-the-money, then none of the current exposure
resulting from the netting agreement would be attributed to that
major category.
---------------------------------------------------------------------------

c. Potential Future Exposure Analysis
The ``substantial position'' analysis also will consider an
entity's ``aggregate potential outward exposure,'' which would reflect
the potential exposure of the entity's swap or security-based swap
positions in the applicable ``major'' category of swap or security-
based swaps, subject to certain adjustments.\881\ The final rules
implementing this test in general follow the proposed approach, but
have been revised to address commenter concerns.
---------------------------------------------------------------------------

\881\ CFTC Regulation Sec. 1.3(jjj)(3); Exchange Act rule 3a67-
3(c).
---------------------------------------------------------------------------

i. Purpose Underlying the Potential Future Exposure Test
As discussed in the proposal, a potential future exposure test
addresses the fact that a sole focus on current uncollateralized
exposure could fail to identify risky entities until some time after
they begin to pose the level of risk that should subject them to
regulation as major participants.\882\ A potential future exposure test
would allow the substantial position analysis to account for this risk
by addressing how the value of an entity's swap or security-based swap
positions may move against the entity over time.\883\
---------------------------------------------------------------------------

\882\ See Proposing Release, 75 FR at 80188.
\883\ See id. at 80191.
---------------------------------------------------------------------------

Accordingly, consistent with the proposal, the final rules
incorporate a potential future exposure test that seeks to estimate how
much the value of swaps or security-based swaps might change against an
entity over the remaining life of the contract. Although some
commenters took the view that this test should only address potential
volatility during the period of time it would take for a non-defaulting
party to close out positions and liquidate collateral,\884\ we believe
that it is more appropriate for the analysis to consider the risks that
swaps or security-based swap positions pose over the lives of those
positions. An exclusive focus on short-term risks would fail to account
for the possibility that an entity's large swap or security-based swap
positions can readily produce large losses in adverse market
circumstances, potentially leading either to large uncollateralized
exposure (if the posting of collateral is not required), or to large
collateral calls that may lead to the entity's default (or to calls for
extraordinary action) and that can threaten non-defaulting parties with
significant costs and challenges in connection with liquidating and
replacing those positions. The analysis should give appropriate weight
to those risks.
---------------------------------------------------------------------------

\884\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

ii. Risk Multipliers
Subject to modifications addressed below, the final rules
implementing the ``substantial position'' analysis incorporate a
potential future exposure test based on the proposal's general approach
of adjusting notional positions using risk multipliers.\885\ This
approach incorporates and builds upon tests used by bank regulators for
the purposes of setting prudential capital.\886\ Through

[[Page 30669]]

this methodology, the final rules implement an objective approach that
readily can be replicated by market participants.
---------------------------------------------------------------------------

\885\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(1); Exchange
Act rule 3a67-3(c)(2)(i).
\886\ See 12 CFR part 3, app. C, section 32 (Office of the
Comptroller of the Currency capital adequacy guidelines for banks);
12 CFR part 325, app. D, section 32 (Federal Deposit Insurance Corp.
capital adequacy guidelines for banks); 12 CFR part 208, app. F,
section 32 (Federal Reserve System capital adequacy guidelines for
banks); 12 CFR part 225, app. G, section 32 (Federal Reserve System
capital adequacy guidelines for bank holding companies).
---------------------------------------------------------------------------

Although some commenters have suggested the use of value-at-risk
measures or internal models to evaluate potential future exposure,\887\
we do not believe that such approaches would be well tailored to be
implemented by a range of market participants, or would lead to
comparable results across market participants with identical swap or
security-based swap portfolios.
---------------------------------------------------------------------------

\887\ See letters from Riverside Risk Advisors and Better
Markets I.
---------------------------------------------------------------------------

In adopting this approach, we are mindful of the significance of
commenter concerns about the adequacy of the tables that set forth the
risk multipliers that would be applied to notional positions. These
comments address, among other issues: discontinuities in the tables;
the failure to account for whether, and how much, a swap or security-
based swap is in-the-money or out-of-the money; the failure of the
multipliers applicable to interest rate swaps to distinguish between
counterparties who pay floating rates and counterparties who pay fixed
rates; the failure of the multipliers in the credit category to account
for the volatility of the underlying instrument or the duration of the
swap or security-based swap; the failure of the multipliers for equity
and commodity swaps to distinguish between high-volatility and low-
volatility stocks and commodities; the adequacy of how the test
addresses diversification and correlation; the fact that the approach
does not provide for delta weighting of options positions; and the fact
that the factors do not distinguish between index and single-name
credit default swaps.\888\ While we acknowledge that it may be possible
to develop revised risk multipliers that are more finely tuned to
reflect relevant risk factors, at this time we believe that it would be
most appropriate to implement the ``substantial position'' analysis by
building upon an existing regulatory approach that is comparatively
simpler to implement and leads to reproducible results, rather than
seeking to develop a brand new approach.\889\
---------------------------------------------------------------------------

\888\ See, e.g., letters from Riverside Risk Advisors and MFA I.
\889\ We also are not following a commenter suggestion to
incorporate the ``standardized method'' prescribed as part of the
``Basel II'' bank capital methodology. See letter from ISDA I. The
standardized method relies on counterparty credit ratings provided
by external credit rating agencies for purposes of calculating risk-
weighted capital measurements. See ``International Convergence of
Capital Measurement and Capital Standards, A Revised Framework,
Comprehensive Version,'' the Basel Committee on Banking Supervision,
June 2006. Incorporating this reliance on credit ratings provided by
external credit rating agencies into these final rules would be
inconsistent with Section 939A of the Dodd-Frank Act, which required
all Federal agencies to review and modify existing regulations ``to
remove any reference to or requirement of reliance on credit ratings
and to substitute in such regulations such standard of credit-
worthiness as each respective agency shall determine as appropriate
for such regulations.''
---------------------------------------------------------------------------

The final rules implementing the ``major security-based swap
participant'' definition, however, modify the proposed risk multipliers
in response to commenter concerns about how the ``major'' categories of
security-based swaps should be applied to the risk multiplier
categories. In particular, the final risk multiplier category for
security-based swaps in the ``equity and other'' category encompasses
all security-based swaps that are not credit derivatives, and the final
rules eliminate the proposed category for ``other'' types of security-
based swaps.\890\
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\890\ See Exchange Act rule 3a67-3(c)(2)(i). Aside from making
the risk multipliers consistent with the ``major'' categories of
security-based swaps, this change also should allow total return
swaps on debt to be subject to the same risk multipliers as total
return swaps on equity, rather than causing the debt swaps to be
subject to higher multipliers (which may not accurately reflect the
comparative risks of those instruments).
---------------------------------------------------------------------------

iii. Potential Future Exposure Measures for Certain Lower-Risk
Positions
Consistent with the proposal, the potential future exposure
calculation will exclude purchases of options and other positions for
which a person has prepaid or otherwise satisfied its payment
obligations.\891\ Also, in response to commenter concerns, the final
rules expand on the proposal with regard to capping the potential
future exposure associated with certain lower-risk swap and security-
based swap positions. The final rules particularly cap--at the net
present value of the unpaid premiums--the potential future exposure
associated with positions by which a person buys credit protection
using a credit default swap, and positions by which a person purchases
an option for which the person retains additional payment obligations
under the position.\892\ This reflects the reduced risk associated with
such positions. The final rules do not prescribe a particular discount
rate for purposes of this analysis, and market participants instead
should use a commercially appropriate discount rate.
---------------------------------------------------------------------------

\891\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(3)(ii);
Exchange Act rule 3a67-3(c)(2)(i)(C).
\892\ See CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(4); Exchange
Act rule 3a67-3(c)(2)(i)(D). The proposed rules would have applied
this net present value caps only to the purchase of credit
protection. The final rules expand this provision by also capping
the potential future exposure associated with the purchases of
options in which an entity retains payment obligations, to reflect
the reduced risk associated with those positions.
---------------------------------------------------------------------------

In addition, to better align the results of the potential future
exposure analysis with the risks that a person presents, the final
rules have been modified from the proposal to also exclude swap or
security-based swap positions for which, pursuant to regulatory
requirement, a person has placed in reserve an amount of cash or
Treasury securities that is sufficient to pay the person's maximum
possible liability under the position, when the person is prohibited
from using that cash or those securities without also liquidating the
swap or security-based swap position.\893\
---------------------------------------------------------------------------

\893\ CFTC Regulation Sec. 1.3(jjj)(3)(ii)(A)(3)(iii); Exchange
Act rule 3a67-3(c)(2)(i)(C)(3). This exclusion of such positions
from the major participant analysis may apply, for example, to
certain swap or security-based swap positions of insurers where
applicable law requires an amount equal to the maximum possible
exposure of the insurer be segregated.
---------------------------------------------------------------------------

iv. Adjustments for Netting
Consistent with the proposal, and with the bank regulator standards
that form the basis for these potential future exposure measures, the
final rules provide that an entity may reduce the measure of its
potential future exposure in a major category by up to 60 percent to
reflect the risk mitigation effects of master netting agreements. We
believe that this approach appropriately reflects the risk mitigating
attributes of netting on potential future exposure. Moreover, in light
of commenter requests for clarification of how these netting provisions
would be applied,\894\ the final rules have been revised from the
proposal to provide that the risk reduction associated with netting
should be estimated using the same pro rata allocation methodology that
will be used to measure current exposure.\895\
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\894\ See letter from SIFMA AMG II.
\895\ Consistent with the proposal, the effects of netting are
to be estimated using the formula: P Net = 0.4 x P Gross + 0.6 x NGR
x P Gross. Under that equation, P Net is the potential exposure
adjusted for bilateral netting; P Gross is that potential outward
exposure without adjustment for bilateral netting; and NGR is the
net to gross ratio. The final rule has been revised from the
proposal to clarify that the net to gross ratio equals the current
exposure associated with the major category as calculated using the
pro rata methodology discussed above, divided by what the measure of
current exposure in connection with those out-of-the-money positions
would be in the absence of that methodology.
Accordingly, for the example set forth in note 875, supra, the
NGR for ``security-based credit derivatives'' and ``other security-
based swaps'' both would equal 0.48 (equal to $19.2 million net
exposure divided by $40 million in out-of-the-money positions in the
case of ``security-based credit derivatives,'' or $43.2 million net
exposure divided by $90 million in out-of-the-money positions in the
case of ``other security-based swaps''). If an entity has no current
exposure to a counterparty following the application of netting
arrangements and collateralization, the NGR for those positions
would equal zero, and the potential exposure would equal 40 percent
of what it would equal otherwise.

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[[Page 30670]]

v. Adjustments for Cleared and Margined Positions
The final rules also provide for the measure of potential future
exposure to be adjusted in the case of swap and security-based swap
positions that are centrally cleared or that are subject to daily mark-
to-market margining. This is consistent with the purpose of the
potential future exposure test, which is to account for the extent to
which the current outward exposure of positions (though possibly low or
even zero at the time of measurement) might grow to levels that can
lead to high counterparty risk to counterparties or to the markets
generally. The practice of the periodic exchange of mark-to-market
margin between counterparties helps to mitigate the potential for large
future increases in current exposure.
Consistent with the proposal, the final rules reflect this ability
to mitigate risk by providing that the potential future exposure
associated with positions that are subject to daily mark-to-market
margining will equal 0.2 times the amount that otherwise would be
calculated. However, in response to commenters' opinions about the
risk-mitigating effects of central clearing, and the additional level
of rigor that clearing agencies may have with regards to the process
and procedures for collecting daily margin, the final rules further
provide that the potential future exposure associated with positions
that are subject to central clearing will equal 0.1 (rather than the
proposed 0.2) times the potential future exposure that would otherwise
be calculated.\896\
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\896\ See CFTC Regulation Sec. 1.3(jjj)(3)(iii)(A); Exchange
Act rule 3a67-3(c)(3)(i). The final rules further have been revised
to clarify that the 0.1 factor applies to positions cleared by a
registered clearing agency or by a clearing agency that has been
exempted from registration.
---------------------------------------------------------------------------

Although some commenters supported the complete exclusion of
cleared positions from the potential future exposure analysis,\897\ and
we are mindful of the risk mitigating attributes of central clearing,
we also recognize that central clearing cannot reasonably be expected
to entirely eliminate counterparty risk.\898\ We conclude, however,
that the use of a 0.1 factor (in lieu of the proposed 0.2) would be
appropriate for cleared positions, reflecting the strong risk
mitigation features associated with central clearing, particularly the
procedures regarding the collection of daily margin and the use of
counterparty risk limits, while recognizing the presence of some
remaining counterparty risk.
---------------------------------------------------------------------------

\897\ See, e.g., letters from MFA I and SIFMA AMG II.
\898\ Central clearing helps to mitigate counterparty credit
risk by improving risk management and, among other things,
mutualizing the risk of counterparty failure. If multiple members of
a central counterparty fail beyond the level to which such risk is
managed, however, the central counterparty would also be at risk of
failure. Cf. Basel Committee on Banking Supervision, Consultative
Document, ``Capitalisation of bank exposures to central
counterparties,'' Nov. 25, 2011 (available at: http://www.bis.org/publ/bcbs206.pdf) (proposing that the capital charge for trade
exposures to a qualifying central counterparty should carry a low
risk weight, reflecting the relatively low risk of default of the
qualifying central counterparty). In addition, as we discussed in
the Proposing Release, see 75 FR at 80192 n.115, for example,
central counterparties that clear credit default swaps do not
necessarily become the counterparties of their members' customers
(although even absent direct privity those central counterparties
benefit customers by providing for protection of collateral they
post as margin, and by providing procedures for the portability of
customer positions in the event of a member's default). As a result,
central clearing may not eliminate the counterparty risk that the
customer poses to the member, although required mark-to-market
margining should help control that risk, and central clearing would
be expected to reduce the likelihood that an entity's default would
lead to broader market impacts.
---------------------------------------------------------------------------

Moreover, although some commenters opposed any deduction from the
measure of potential future exposure for uncleared positions that are
margined on a daily basis,\899\ we believe that the risk-mitigating
attributes of daily margining warrant an adjustment given that the goal
of the potential future exposure test is to account for price movements
over the remaining life of the contract.\900\ The use of a 0.2 factor
also reflects our expectation that the risk mitigation associated with
uncleared but margined positions would be less than the risk mitigation
associated with cleared positions.
---------------------------------------------------------------------------

\899\ See letter from Better Markets I; see also letter from
AFR.
\900\ We do not believe that it is appropriate to have this type
of discount when mark-to-market margining is done less than daily,
however.
---------------------------------------------------------------------------

While higher or lower alternatives to the 0.1 and 0.2 factors may
also be reasonable for positions that are cleared or margined on a
daily basis, we believe that the factors of the final rules reasonably
reflects the risk mitigating (but not risk eliminating) features of
those practices. The final rules also retain and clarify provisions
addressing when daily mark-to-market margining occurs for purposes of
this discount.\901\
---------------------------------------------------------------------------

\901\ We recognize that at times, market participants whose
agreements provide for the daily exchange of variation margin in
connection with swaps or security-based swaps in practice may not
exchange collateral daily, if the amounts at issue are relatively
small (such as through the use of collateral thresholds and minimum
transfer amounts). We do not believe that such practices would be
inconsistent with providing a discount for daily margining
practices. The proposed rules sought to accommodate those practices
by providing that positions would be considered to be subject to
daily mark-to-market margining for purposes of the
``uncollateralized outward exposure'' plus ``potential outward
exposure'' analysis, so long as the total of such thresholds, and
the total of such minimum transfer amounts above $1 million are
deemed to be ``uncollateralized outward exposure'' for those
purposes.
In light of commenter concerns, which indicated that the
proposal was not fully clear about the mechanics and purpose of this
approach, the relevant rule language has been revised to clarify
that this attribution of thresholds and minimum transfer amounts is
solely for the purpose of determining whether certain positions are
subject to daily mark-to-market margining for purposes of the
analysis. In addition, the final rules have been revised from the
proposal to provide that the attribution of thresholds as
``uncollateralized outward exposure'' for these purposes will be
reduced by initial margin posted, up to the amount of the threshold.
See CFTC Regulation Sec. 1.3(jjj)(iii)(B); Exchange Act rule 3a67-
3(c)(3)(ii).
---------------------------------------------------------------------------

vi. Application of ``Effective Notional'' Amounts
Consistent with the proposal (as well as the rules implementing the
de minimis exception to the dealer definitions), the potential future
exposure test is based on the ``effective notional'' amount of the swap
or security-based swap when the stated notional is leveraged or
enhanced by the structure of the swap or security-based swap.\902\
---------------------------------------------------------------------------

\902\ As discussed above, this may occur, for example, if the
exchange of payments associated with an equity swap is based on a
multiple of the return associated with the underlying equity. As is
the case for measuring current exposure, the final rules do not
prescribe any particular methodology for calculating the notional
amount or effective notional amount used in the calculation of
potential future exposure, but instead contemplate the use of
industry standard practices.
---------------------------------------------------------------------------

Moreover, as discussed in the Proposing Release,\903\ in the case
of positions that represent the sale of an option on a swap or
security-based swap (other than the sale of an option permitting the
person exercising the option to purchase a credit default swap), we
would view the effective notional amount of the option as being equal
to the effective notional amount of the underlying swap or security-
based swap, and in general we would view the duration used for purposes
of the formula as being equal to the sum of the duration of the option
and the duration of the underlying swap or security-based swap.\904\
---------------------------------------------------------------------------

\903\ See Proposing Release, 75 FR 80192 n.110.
\904\ The effective notional amount of the underlying instrument
is used for these purposes because that amount fairly reflects the
basis for measuring the potential counterparty risk associated with
the instrument. The sum of the duration of the option and the
underlying instrument is used for these purposes because that sum
reflects the length of time of the potential counterparty risk
associated with the instrument.
At the same time, we agree with a commenter's view that if the
underlying swap or security-based swap is cash settled, the
calculation of duration will only include the duration of the
option, and not the duration of the swap, because counterparty
exposure would exist only until the option expiration date. See
letter from MFA I.

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

[[Page 30671]]

vii. Treatment of Initial Margin or Overcollateralization
The final rules retain the proposed approach of not modifying the
measure of potential future exposure to reflect collateral that a
person has posted to its counterparty in excess of current exposure.
Although we recognize that the posting of excess collateral may
mitigate the future credit risk that the potential future exposure
measure is intended to estimate, that mitigating effect is not certain,
and any such mitigation may not reflect the full value of the excess
collateral. Moreover, while we believe that the measure of potential
future exposure associated with swap or security-based swap positions
reasonably estimates the credit risk that may be posed by those
positions for purposes of the substantial position analysis, we also
recognize that particular positions may prove to pose a far higher
amount of credit risk.\905\ Given how the credit risk associated with a
swap or security-based swap position can far exceed the associated
measure of potential future exposure, we do not believe that it would
be appropriate to offset that measure to account for
overcollateralization.\906\
---------------------------------------------------------------------------

\905\ For example, if a person writes a CDS that provides $10
billion in protection on a reference entity, with the CDS being
subject to daily mark-to-market margining, then for purposes of the
substantial position analysis that CDS would be associated with a
potential future exposure measure of no more than $200 million
(reflecting the 0.1 conversion factor and the additional 0.2
multiplier for margined positions), even before accounting for
netting. Yet if the reference entity were to default, the writer of
the CDS could pose up to $10 billion in credit risk to its
counterparty.
\906\ However, as discussed above, see note 901, supra, initial
margin may be considered when determining if a collateral threshold
is to be attributed to current uncollateralized exposure for
purposes of determining whether certain positions are subject to
daily mark-to-market margining for purposes of the substantial
position analysis.
---------------------------------------------------------------------------

d. Thresholds
The final rules retain the proposed thresholds for the amount of
current uncollateralized exposure and potential future exposure that
will cause an entity to be deemed to be a major participant.
Accordingly, for a person to have a ``substantial position'' in a major
category of swaps, it would be necessary for that person to have a
daily average current uncollateralized exposure of at least $1 billion
(or $3 billion for the rate swap category), or a daily average current
uncollateralized exposure plus potential future exposure of $2 billion
(or $6 billion for the rate swap category).\907\ To have a
``substantial position'' in a major category of security-based swaps,
it would be necessary for the person to have a daily average current
uncollateralized exposure of at least $1 billion, or a daily average
current uncollateralized exposure plus potential future exposure of at
least $2 billion.\908\
---------------------------------------------------------------------------

\907\ CFTC Regulation Sec. 1.3(jjj)(1).
\908\ Exchange Act rule 3a67-3(a).
---------------------------------------------------------------------------

As the Proposing Release noted, the proposed thresholds sought to
reflect: (i) The financial system's ability to absorb losses of a
particular size; (ii) the recognition that it would not be appropriate
for the substantial position test to encompass entities only after they
pose significant risks to the market through their swap or security-
based swap activity; and (iii) the need to account for the possibility
that multiple market participants may fail close in time.\909\ While
some commenters took the position that the proposed thresholds were
inappropriately low, those commenters did not present empirical data or
analysis in support of that view. Moreover, the Commissions do not
concur with the suggestion \910\ that the major participant definitions
can reasonably be read to require that we defer this rulemaking until
we have gathered additional data. Instead, the definitions direct us to
set a standard that is ``prudent,'' which is what we have sought to do.
---------------------------------------------------------------------------

\909\ As discussed above, we do not believe it would be prudent
to presume that entity failures will be separated in time during
periods of financial stress.
\910\ See letters from BlackRock I and CCMR I.
---------------------------------------------------------------------------

Some commenters who supported an increase in the proposed
thresholds attempted to support their positions via analogy to past
events, with the most significant of these being an analogy to AIG
Financial Products (``AIG FP'').\911\ The analogy to AIG FP \912\
actually argues against an increase in these thresholds, however,
particularly given that the credit derivative portfolio that
significantly contributed to the liquidity problems that AIG FP faced
amounted to $72 billion in notional amount.\913\ Under the final rules,
in the presence of central clearing or daily marking to market it would
take a credit derivative portfolio in excess of that amount to trigger
the potential future exposure threshold under the ``substantial
position'' analysis.\914\ This indicates that the thresholds are not
inappropriately low, particularly given our view that the major
participant definition is intended to encompass entities before their
swap or security-based swap positions pose significant market
threats.\915\ Conversely, while

[[Page 30672]]

additional data and analysis may warrant a reduction of these
thresholds in the future, commenters who supported a reduction in those
thresholds have not persuaded us that the proposed thresholds should be
lowered.
---------------------------------------------------------------------------

\911\ See letter from ABC/CIEBA. One commenter's analogy to
Enron also is unpersuasive. See letter from BG LNG I. In particular,
the $18.7 billion in Enron derivatives exposure cited by that
commenter does not account for collateral posted in connection with
those positions. Also, the market impact of Enron's bankruptcy was
substantially mitigated by the sale of Enron's derivatives trading
arm to a third party.
Moreover, although one commenter generally alluded to corporate
financial losses in the derivatives markets that exceeded the
proposed $1 billion and $2 billion thresholds, see letter from NCGA/
NGSA II, the relevant question does not focus on losses that market
participants have incurred, but instead focuses on what degree of
credit risk to counterparties in the swap and security-based swap
markets presents such a potential to cause significant market impact
that it would be prudent to regulate persons who pose that degree of
credit risk in connection with their swap or security-based swap
positions.
\912\ Our discussion of how the major participant analysis may
apply to an entity that has a portfolio of a size equivalent to that
of AIG FP should not be read to imply that a person may engage in
swap and security-based swap activities akin to those of AIG FP
without registering as a swap dealer or security-based swap dealer.
\913\ See, e.g., Congressional Oversight Panel, The AIG Rescue,
Its Impact on Markets, and the Government's Exit Strategy 22-24
(2010) (discussing how the risk in AIG's CDS business largely was
the result of a ``multi-sector'' CDO book that amounted to $72
billion notional as of September 2008, and how the losses to AIG
were driven by 125 of the roughly 44,000 contracts entered into by
AIG FP).
\914\ For cleared security-based credit default swaps (in which
we assume daily margining requirements result in no current
uncollateralized exposure) achieving $2 billion of potential future
exposure would require writing $200 billion notional of credit
default swap protection (reflecting the 0.10 multiplier in the risk
adjustment tables, and the additional 0.10 multiplier for positions
that are cleared). Similarly, it would take a $100 billion notional
portfolio of uncleared but marked-to-market security-based credit
default swaps to meet that same threshold (reflecting the 0.20
multiplier for positions that are subject to daily mark-to-market
margining). The total might be even higher if such instruments were
subject to counterparty netting agreements.
Even in the absence of clearing or daily mark-to-market
margining, it would take a minimum $20 billion notional portfolio of
written protection on credit (reflecting the 0.10 multiplier in the
risk adjustment tables) to meet the $2 billion potential future
exposure threshold. Accounting for netting (which can reduce
potential future exposure measures by up to 60 percent) could
materially increase that required amount.
\915\ The case of Long-Term Capital Management (``LTCM'') also
is instructive in connection with the current exposure thresholds of
the major participant analysis. Had LTCM failed, its top 17
counterparties would have suffered estimated total losses of between
$3 and $5 billion. See President's Working Group on Financial
Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital
Management (April 1999) at 17 (http://www.treasury.gov/resource-center/fin-mkts/Documents/hedgfund.pdf). The government acted in
connection with LTCM because the rushed close-out of LTCM's
positions would have affected other market participants, and the
spread of losses would have led to market uncertainty, likely
causing a number of credit and interest rate markets to experience
extreme price moves and possibly not function for a period of time.
See Statement by William J. McDonough, President Federal Reserve
Bank of New York before the Committee on Banking and Financial
Services U.S. House of Representatives (October 1, 1998) (http://www.newyorkfed.org/newsevents/speeches_archive/1998/mcd981001.html).
---------------------------------------------------------------------------

e. Additional Issues
The final rules applying the ``substantial position'' analysis and
the major participant definitions generally apply to all types of swaps
or security-based swaps that a person maintains. Although one commenter
suggested that swaps on government securities should be excluded from
the analysis, the rules will not provide such an exclusion. To the
extent that a person presents credit risk as a result of swaps
referencing government securities, there is no basis for disregarding
that risk when determining whether the person is a major participant.
In addition, in light of one commenter's concern,\916\ the
Commissions believe that it is important to emphasize that these rules
should not be interpreted to deter end-users from requesting margin
from dealers or major participants who are their counterparties to
swaps or security-based swaps.
---------------------------------------------------------------------------

\916\ See letter from FHLB I.
---------------------------------------------------------------------------

Also, in light of a point raised by another commenter,\917\ the
Commissions note that these rules implementing the major participant
definitions do not place any independent calculation or other
obligations upon counterparties to potential major participants, and
that the rules do not preclude a potential major participant from
seeking the assistance of a third party to perform the relevant
calculation.
---------------------------------------------------------------------------

\917\ See letter from ISDA I.
---------------------------------------------------------------------------

C. ``Hedging or Mitigating Commercial Risk''

1. Proposed Approach
a. General Availability of the Proposed Exclusion
The first test of the major participant definitions excludes
positions held for ``hedging or mitigating commercial risk'' from the
substantial position analysis.\918\ In the Proposing Release, we
preliminarily concluded that positions that hedge or mitigate a
person's commercial risk may qualify for this exclusion regardless of
whether the entity is financial or non-financial in nature.\919\ That
conclusion in part was prompted by the fact that the statutory major
participant definitions do not explicitly make the exclusion
unavailable to financial entities; in contrast to the Title VII
exceptions from mandatory clearing requirements in connection with
hedging commercial risk,\920\ which explicitly are unavailable to
financial entities.\921\ The conclusion also was prompted by the
presence of the third major participant test--which specifically
applies the substantial position analysis to certain non-bank financial
entities but (unlike the first test) does not exclude commercial risk
hedging positions from the analysis.\922\
---------------------------------------------------------------------------

\918\ See CEA section 1a(33)(A)(i)(I); Exchange Act section
3(a)(67)(A)(i)(I).
\919\ See Proposing Release, 75 FR at 80194.
\920\ See CEA section 2(h)(7)(A); Exchange Act section
3C(g)(1)(B).
\921\ As we discussed in the Proposing Release, had the Dodd-
Frank Act intended the phrase ``hedge or mitigate commercial risk''
to apply only to activities of, or positions held by, non-financial
entities, it would not have been necessary for the mandatory
clearing exceptions to include additional provisions generally
restricting the availability of the exceptions to non-financial
entities. See Proposing Release, 75 FR at 80194.
\922\ As we discussed in the Proposing Release, the third
statutory major participant test would be redundant if the hedging
exclusion in the first major participant test were entirely
unavailable to financial entities. See Proposing Release, 75 FR at
80194 n.125.
---------------------------------------------------------------------------

In the Proposing Release, we also preliminarily concluded that the
question of whether an activity is commercial in nature should not be
determined solely by a person's organizational status as a for-profit,
non-profit or governmental entity, but instead should depend on whether
the underlying activity is commercial in nature.\923\
---------------------------------------------------------------------------

\923\ See Proposing Release, 75 FR at 80194.
---------------------------------------------------------------------------

The proposal did not preclude the exclusion from being available in
connection with hedges of a person's ``financial'' or ``balance sheet''
risks. In addition, the proposal solicited comment as to whether the
exclusion should extend to activities in which a person hedges an
affiliate's risk.
b. Proposed Definition Under the CEA Exception
The proposed interpretation of ``hedging or mitigating commercial
risk'' for purposes of the CEA's definition of ``major swap
participant'' premised the exclusion on the principle that swaps
necessary to the conduct or management of a person's commercial
activities should not be included in the calculation of the entity's
substantial position.\924\
---------------------------------------------------------------------------

\924\ The scope of the proposed exclusion is based on our
understanding that when a swap or security-based swap is used to
hedge a person's commercial activities, the gains or losses
associated with the swap or security-based swap itself will
generally be offset by losses or gains in the person's commercial
activities, and hence the risks posed by the swap or security-based
swap to counterparties or the industry will generally be mitigated.
---------------------------------------------------------------------------

The CFTC noted first that the phrase ``hedging or mitigating
commercial risk'' as used with respect to the major swap participant
definition is virtually identical to Dodd-Frank provisions granting an
exception from the mandatory clearing requirement to non-financial
entities that are using swaps to hedge or mitigate commercial
risk.\925\ Also noted was that although only non-financial entities
that use swaps or security-based swaps to hedge or mitigate commercial
risk generally may qualify for the clearing exemption, no such
statutory restriction applies with respect to the exclusion for hedging
positions in the first test of a major participant. We therefore
concluded that positions established to hedge or mitigate commercial
risk may qualify for the exclusion, regardless of the nature of the
entity--i.e., whether or not the entity is financial (including a bank)
or non-financial.\926\
---------------------------------------------------------------------------

\925\ See CEA section 2(h)(7)(A); Exchange Act section
3C(g)(1)(B) (exception from mandatory clearing requirements when one
or more counterparties are not ``financial entities'' and are using
swaps or security-based swaps to ``hedge or mitigate commercial
risk'').
\926\ The presence of the third major participant test suggests
that financial entities generally may not be precluded from taking
advantage of the hedging exclusion in the first test. The third
test, which does not account for hedging, specifically applies to
non-bank financial entities that are highly leveraged and have a
substantial position in a major category of swaps or security-based
swaps. That test would be redundant if the hedging exclusion in the
first major participant test were entirely unavailable to financial
entities.
---------------------------------------------------------------------------

The CFTC preliminarily believed that whether a position hedges or
mitigates commercial risk should be determined by the facts and
circumstances at the time the swap is entered into, and should take
into account the entity's overall hedging and risk mitigation
strategies. However, the swap could not be held for a purpose that is
in the nature of speculation, investing or trading. We anticipated that
a person's overall hedging and risk management strategies would help
inform whether or not a particular position is properly considered to
hedge or mitigate commercial risk. Further, the exclusion under the
Proposing Release included swaps hedging or mitigating any of a
person's business risks, regardless of the

[[Page 30673]]

swap's status under accounting guidelines or the bona fide hedging
exemption.
c. Proposed Definition Under the Exchange Act Exception
For purposes of the Exchange Act's ``major security-based swap
participant'' definition, the proposed rule defining ``hedging or
mitigating commercial risk'' would require that a security-based swap
position be ``economically appropriate'' to the reduction of risks in
the conduct and management of a commercial enterprise, where those
risks arise from the potential change in the value of assets,
liabilities and services connected with the ordinary course of business
of the enterprise.\927\ The Proposing Release stated that the SEC
preliminarily planned to interpret the concept of ``economically
appropriate'' based on whether a reasonably prudent person would
consider the security-based swap to be appropriate for managing the
identified commercial risk. It further stated that the SEC also
preliminarily believed that for a security-based swap to be deemed
``economically appropriate'' in this context, it should not introduce
any new material quantum of risks (i.e., it could not reflect over-
hedging that could reasonably have a speculative effect) and it should
not introduce any basis risk or other new types of risk (other than the
counterparty risk that is attendant to all security-based swaps) more
than reasonably necessary to manage the identified risk.\928\
---------------------------------------------------------------------------

\927\ See proposed Exchange Act rule 3a67-4(a).
\928\ See Proposing Release, 75 FR at 80195 n.129.
---------------------------------------------------------------------------

The proposed rules further provided that the security-based swap
position could not be held for a purpose that is in the nature of
speculation or trading--a limitation that would make the exclusion
unavailable to security-based swap positions that are held
intentionally for the short term and/or with the intent of benefiting
from actual or expected short-term price movements or to lock in
arbitrage profits, including security-based swap positions that hedge
other positions that themselves are held for the purpose of speculation
or trading.\929\ The proposal also provided that a security-based swap
position could not be held to hedge or mitigate the risk of another
security-based swap position or swap position unless that other
position itself is held for the purpose of hedging or mitigating
commercial risk.\930\ Finally, the proposal would have conditioned the
entity's ability to exclude these security-based swap positions on the
entity engaging in certain specified activities related to documenting
the underlying risks and assessing the effectiveness of the hedge in
connection with the security-based swap positions.\931\
---------------------------------------------------------------------------

\929\ See proposed Exchange Act rule 3a67-4(b)(1), and Proposing
Release, 75 FR at 80195 n.131.
\930\ See proposed Exchange Act rule 3a67-4(b)(2).
\931\ See proposed Exchange Act rule 3a67-4(c).
---------------------------------------------------------------------------

2. Commenters' Views
a. In General
Several commenters generally supported the broad concepts
underlying the proposed rules for identifying hedges of commercial
risk, and particularly supported the proposed use of an ``economically
appropriate'' standard instead of the ``highly effective'' standard
that is used to identify hedges for accounting purposes.\932\ On the
other hand, one commenter stated that the definition should incorporate
all manner of risks associated with commercial operations, including
interest rate and currency risks, risks from incidental activities to
commercial activities and risks from financial commodities.\933\ One
commenter further stated that the definition should encompass positions
that facilitate asset optimization and dynamic hedging.\934\
---------------------------------------------------------------------------

\932\ See letters from ACLI, Barnard, CDEU, COPE I, EEI/EPSA,
FSR I, ISDA I, Kraft, MetLife, NAIC, Philip Morris International
Inc. (``Philip Morris'') and Utility Group.
\933\ See letter from CDEU.
\934\ See letter from Peabody.
---------------------------------------------------------------------------

Commenters further stated that the exception should include any
position taken as part of a bona fide risk mitigation strategy,\935\
and that Congress included ``mitigation'' in the exception for the
purpose of covering risk reduction strategies that may not clearly be
hedges but mitigate risk.\936\ Some commenters also criticized the
Proposing Release's position equating the terms ``hedging'' and
``mitigating.'' \937\ One commenter also expressed concern that
entities would find it difficult to analyze their positions with
respect to the Proposing Release's statement, in the context of the
Exchange Act definition, that ``economically appropriate'' security-
based swaps would not add a new quantum of risk.\938\
---------------------------------------------------------------------------

\935\ See letter from ISDA I.
\936\ See letter from CDEU.
\937\ See letters from APG, CDEU and ISDA I.
\938\ See letter from SIFMA AMG II.
---------------------------------------------------------------------------

Conversely, some commenters suggested that the proposed
interpretation was too broad,\939\ and that a broad interpretation
could allow evasion,\940\ or permit corporate end users to accumulate
very large positions without becoming major swap participants.\941\ One
commenter stated that to include ``financial risks'' within the
exclusion's scope would be improper because a ``commercial risk'' is
one that is inherent in a person's commercial activities, while
interest rate and currency risks arise from choices about how a person
structures and finances its operations.\942\ Some commenters stated
that the rule should not include hedging of financial risks because
Congress deleted the reference in an earlier version of the Dodd-Frank
Act to hedging of ``balance sheet risk.'' \943\ One commenter urged
that we consider using accounting hedge treatment or the bona fide
hedging exemption as guideposts for determining the availability of the
exclusion.\944\ Commenters also raised concerns about differences
between the proposed approaches under the CEA and Exchange Act
definitions of the terms.\945\
---------------------------------------------------------------------------

\939\ See letters from AFR and AFSCME. The CFTC also received
submissions of a substantially identical letter from approximately
193 individuals and small businesses urging the CFTC to define
commercial risk narrowly to include only risks arising from physical
commodity price fluctuations, and not financial risks, and to
construe the exception for captive finance companies narrowly. See,
e.g., letter from Needham Oil & Air, LLC. In addition, the CFTC
received submissions from approximately 535 individuals of a
different letter, which also urged the CFTC to define commercial
risk narrowly. See, e.g., letter from Christie Hakim.
\940\ See letters from Sen. Carl Levin (``Senator Levin''),
Commodity Markets Oversight Coalition (``CMOC'') and Greenberger and
meeting with MFA on February 14, 2011.
\941\ See meeting with SIFMA AMG on February 4, 2011.
\942\ See meeting with AFR and Better Markets on March 17, 2011.
\943\ See letters from AFR and CMOC, and meeting with Duffie on
February 2, 2011.
\944\ See letter from Senator Levin.
\945\ See letters from Senator Levin, NAIC and SIFMA AMG II.
---------------------------------------------------------------------------

One commenter suggested that the definition should be expanded to
include as commercial risks the risks faced by government entities
because their need to manage risk is no different than the need of
commercial firms.\946\ Additional commenters suggested that commercial
risk be interpreted to include risks faced by non-profit firms.\947\
---------------------------------------------------------------------------

\946\ See letter from Milbank, Tweed, Hadley & McCloy LLP
(``Milbank'').
\947\ See letters from CDEU and NFPEEU.
---------------------------------------------------------------------------

Some commenters also supported modification of the rule text for
specific purposes such as including risks from ``transmitting'' to
cover activities of electricity companies,\948\ to encompass risks
``arising from'' an asset rather than just risks arising from changes
in value

[[Page 30674]]

of the asset,\949\ and to encompass the use of swaps by structured
finance special purpose vehicles to hedge interest rate risk in
structured financing.\950\
---------------------------------------------------------------------------

\948\ See letter from Edison Int'l.
\949\ See letter from Milbank.
\950\ See letter from American Securitization Forum (``ASR'').
---------------------------------------------------------------------------

b. Availability of Exclusion to Financial Entities
Several commenters supported making the exclusion available to
financial companies.\951\ Some commenters further stated that there
should be no special limits on financial entities with regard to the
exclusion,\952\ and that commercial risk should be defined broadly to
include all of the commercial activities of a person, whether or not
those activities relate to financial or non-financial commodities.\953\
Two commenters discussing the use of swaps by insurance companies
stated that making the exclusion available to financial companies is
consistent with CFTC practice in the futures markets, that there is no
fundamental difference in how an insurance company or a commercial
enterprise uses swaps to reduce its risk, and that commercial risk
encompasses financial risk.\954\ In addition, these commenters noted
that insurance regulators allow insurance companies to use swaps to
hedge risk.\955\
---------------------------------------------------------------------------

\951\ See letters from ACLI, American Express Company
(``Amex''), California State Teachers' Retirement System
(``CalSTRS'') dated Feb. 28, 2011 (``CalSTRS I''), ISDA I, MetLife,
NAIC and Peabody.
\952\ See letters from Amex, CalSTRS I and Peabody.
\953\ See letter from Amex.
\954\ See letters from ACLI and MetLife.
\955\ Id.
---------------------------------------------------------------------------

On the other hand, some commenters opposed allowing financial
entities to avail themselves of the exclusion, arguing that there is no
benefit from allowing a financial firm to avoid major participant
regulation through the hedging exclusion,\956\ that the exclusion would
allow financial companies to engage in risky trades,\957\ and that the
exclusion should be narrowly interpreted to cover hedging of only risks
related to products.\958\
---------------------------------------------------------------------------

\956\ See letter from Senator Levin (further highlighting the
need to add strict standards and controls to prevent evasion).
\957\ See letters cited in note 939, supra.
\958\ See letter from AFR.
---------------------------------------------------------------------------

c. Hedging Risks of Affiliates and Third Parties
Some commenters expressed support for allowing persons to take
advantage of the hedging exclusion when they use swaps to hedge the
commercial risks of affiliates or third parties. Some commenters
suggested that a person that aggregates and hedges risk within a
corporate group should be allowed to use the exclusion despite the fact
that it is the affiliates' risks that are hedged.\959\ One commenter
further stated that providers of risk management services should be
allowed to take advantage of the exclusion because they are hedging
commercial risk on behalf of their clients.\960\
---------------------------------------------------------------------------

\959\ See letters from CDEU, EDF Trading, Kraft, Metlife and
Philip Morris.
\960\ See letter from EDF Trading.
---------------------------------------------------------------------------

One commenter, on the other hand, stated that the exclusion should
be read narrowly for captive finance companies because the hedging
entity may have to liquidate positions rapidly without access to
affiliate's funds.\961\
---------------------------------------------------------------------------

\961\ See meeting with Duffie on February 2, 2011.
---------------------------------------------------------------------------

d. Hedge Effectiveness and Documentation
Many commenters suggested that the rule should not test hedge
effectiveness, explaining that requiring demonstration of hedge
effectiveness would impose a subjective standard and would not reduce
systemic risk.\962\ In this regard, some commenters that addressed the
proposed procedural requirements in the Exchange Act definition argued
that these procedures would place unnecessary regulatory burdens on
entities not regulated under the Dodd-Frank Act.\963\ Conversely, one
commenter that supported testing hedge effectiveness stated that the
subdivided parts of a hedge should line up exactly with the subdivided
parts of the risk.\964\
---------------------------------------------------------------------------

\962\ See letters from EEI/EPSA and EDF Trading; see also
letters from CDEU, Kraft Metlife, NRG Energy and Philip Morris (that
such a test would be overly prescriptive).
\963\ See letters from FSR I and SIFMA AMG I.
\964\ See letter from Better Markets I.
---------------------------------------------------------------------------

Some commenters agreed that the relationship between hedging and
risk should be documented. One commenter expressed the view that
documentation would facilitate audits.\965\ Others took the view that a
person should be required to demonstrate that the hedge does not create
additional risk, that the risk may be hedged by swaps, and that there
is a link between the swap and the risk.\966\
---------------------------------------------------------------------------

\965\ See letter from Metlife (but opposing ongoing evaluation
of hedge effectiveness).
\966\ See letters from AFR and Senator Levin.
---------------------------------------------------------------------------

Several commenters suggested that once initiated, a hedge should
not be retested over time, regardless of whether the position continues
to serve a hedging purpose.\967\ Other commenters disagreed, stating
that a position that is no longer a hedge should not be covered by the
exclusion.\968\
---------------------------------------------------------------------------

\967\ See letters from CDEU, EDF Trading, EEI/EPSA, Kraft,
Metlife, NRG Energy and Philip Morris.
\968\ See letters from Better Markets I and Senator Levin.
---------------------------------------------------------------------------

e. Swaps That Hedge Positions Held for Speculative, Investment or
Trading Purposes
Many commenters took the view that swaps or security-based swaps
used to hedge positions held for speculative, investment or trading
purposes should qualify as hedges of commercial risk.\969\ A few
commenters stated that speculation, investment and trading are
fundamental to commercial activity, and thus cannot be differentiated
from other types of commercial activity.\970\ Other commenters
suggested the exclusion should cover swap positions that hedge other
swap or security-based swap positions that are not themselves hedging
positions.\971\ Some commenters asserted that trading is different from
speculating (taking an outright view on market direction) and investing
(entering into a swap for appreciation in value of the swap position),
and that swaps held for ``trading'' should be able to qualify for the
exclusion.\972\
---------------------------------------------------------------------------

\969\ See letters from BG LNG II, COPE I, EPSA, FSR I, Metlife,
Peabody, Vitol and WGCEF dated February 22, 2011 regarding the major
swap participant definition (``WGECF II''), and meeting with Bunge;
see also letter from ISDA I (taking the view that swaps and
security-based swaps used to hedge speculative positions should
qualify as hedges and stating that failure to treat them as hedges
would ``invariably result in there being more unhedged speculative
risk in the market'').
\970\ See letters from Vitol and WGCEF II and meeting with
Bunge.
\971\ See letters from BG LNG II, FSR I, ISDA I and Metlife.
\972\ See letters from COPE I, EPSA and Peabody.
---------------------------------------------------------------------------

Some commenters requested that the definition under the CEA clarify
how swaps that qualify as bona fide hedges are treated for the major
swap participant definition if the underlying position had a
speculative, investment or trading purpose,\973\ and clarify that while
the hedging exclusion would not apply to swap positions that hedge
other swap positions that are held for speculation or trading, the
hedging provision would apply to swap positions that hedge other non-
swap positions held for speculation or trading.\974\ Commenters also
requested that the final rules provide that the hedging exclusion be
available for physical positions in exempt or agricultural commodities
and arbitrage positions relating to price differences between physical
commodities at

[[Page 30675]]

different locations.\975\ One commenter, on the other hand, suggested
that even swap positions that hedge other swap positions which are not
hedging positions should be treated as hedging commercial risk because
they are risk reducing.\976\
---------------------------------------------------------------------------

\973\ See letters from Vitol and WGCEF dated June 3, 2011
regarding the major swap participant definition (``WGECF VI'').
\974\ See letter from BG LNG II.
\975\ See letters from BGLNG II and WGCEF VI.
\976\ See letters from MetLife.
---------------------------------------------------------------------------

Four commenters took the position that swaps held for a purpose
that is in the nature of speculation, investing or trading should not
qualify as hedges of commercial risk.\977\ One commenter pointed out
that experience has shown that market participants sometimes
inaccurately characterize positions as hedges (e.g., the inaccurate
characterization occurs because the nature of positions change over
time), and that excluding swap positions that hedge speculative,
investment or trading positions would be especially inappropriate for
financial firms that frequently use swaps to speculate, invest or
trade.\978\ One commenter stated that any swap position hedging another
swap position could never be considered to be hedging commercial risk
because the second swap is only adjusting the first swap position,
meaning that neither swap would be congruent with risk reduction.\979\
Another commenter stated that the hedging exclusion should not cover
any swap hedging a speculative position.\980\
---------------------------------------------------------------------------

\977\ See letters from AFR, Better Markets I and Senator Levin
and meeting with Duffie on February 2, 2011.
\978\ See letter from Senator Levin.
\979\ See letter from Better Markets I.
\980\ See meeting with Duffie on February 2, 2011.
---------------------------------------------------------------------------

3. Final Rules--General Availability of the Exclusions
As with the proposed rules, the final CEA and Exchange Act rules
implementing this exclusion are different in certain regards to reflect
the different ways that swaps and security-based swaps may be expected
to be used to hedge commercial risk, as well as differences in existing
regulations under the CEA and the Exchange Act. Notwithstanding these
differences, the two rules follow parallel approaches and address
certain key issues in similar ways.
a. Availability to Financial Entities
Consistent with the position we took in the Proposing Release, the
final rules with regard to both major participant definitions do not
foreclose financial entities from being able to take advantage of the
commercial risk hedging exclusion in the first major participant test.
This conclusion in part is guided by the fact that the statutory text
implementing this hedging exclusion does not explicitly foreclose
financial entities from taking advantage of the exclusion--in contrast
to Title VII's exceptions from mandatory clearing requirements for
commercial risk hedging activities. The conclusion also results from
the need to avoid an interpretation that would cause the third major
participant test to be redundant.\981\
---------------------------------------------------------------------------

\981\ While we recognize that commenters have identified policy
reasons as to why financial entities should be entirely excluded
from being able to take advantage of the hedging exclusion, we
continue to believe the language of the major participant
definitions dictates a contrary approach.
---------------------------------------------------------------------------

In reaching this conclusion, we recognize that some commenters
stated that there would be no benefit from allowing financial firms to
avoid regulation as a major swap participant through the hedging
exclusion, and that the exclusion should cover only risks related to
non-financial commercial activities, or else the exclusion would allow
financial companies to engage in risky transactions.\982\ We believe
that not allowing the exclusion to cover swaps or security-based swaps
used for speculation or trading (or investments, in the case of swaps)
will be sufficient to limit financial entities' ability to engage in
risky transactions. We also are not persuaded that ``commercial risk''
should be limited to only risks related to non-financial activities.
---------------------------------------------------------------------------

\982\ See letters from AFR and Senator Levin.
---------------------------------------------------------------------------

We nonetheless recognize the significance of concerns that
financial entities may seek to depict speculative positions as hedges
to take advantage of the exclusion. We also are mindful of the need to
give appropriate meaning to the term ``commercial risk'' within the
exclusion. We believe that the standard set forth in the final rules,
including the provisions that make the exclusions unavailable to swap
or security-based swap positions of a speculative or trading nature (or
investment purposes, in the case of swaps), apply the statutory test in
a manner that appropriately addresses those other concerns. As
discussed below, those standards limit the ability of financial
entities to take advantage of the exclusion.\983\
---------------------------------------------------------------------------

\983\ We also do not believe that the size of an entity or an
entity's position is determinative of whether a position hedges
commercial risk. Moreover, given that the major participant
definitions implicitly require large swap or security-based swap
positions as triggers, a rule that made the hedging exclusion
unavailable to entities with large positions could negate the
statutory hedging exclusion.
---------------------------------------------------------------------------

b. Availability to Non-Profit and Governmental Entities
Under the final rules, a person's organizational status will not
determine the availability of this hedging exclusion. The exclusion
thus may be available to non-profit or governmental entities, as well
as to for-profit entities, if the underlying activity to which the swap
or security-based swap relates is commercial in nature.
c. Hedges of ``Financial'' or ``Balance Sheet'' Risks
Under the final rules, the exclusion is available to positions that
hedge ``financial'' or ``balance sheet'' risks. While we recognize that
some commenters oppose the exclusion of those positions,\984\ we
nonetheless believe that the exclusion would be impermissibly narrow if
it failed to extend to the ``financial'' or ``balance sheet'' risks
that entities may face as part of their commercial operations, given
that those types of risks (e.g., interest rate and foreign exchange
risks) may be expected to arise from the commercial operations of non-
financial end-users of swaps and security-based swaps. We do not
believe the exclusion was intended to address those risks differently
from other commercial risks, such as risks associated with the cost of
physical inputs or the price received for selling products.\985\
---------------------------------------------------------------------------

\984\ See notes 942 and 943, supra.
\985\ Moreover, it is questionable as to what types of security-
based swap positions--if any--would fall within the exclusion for
purposes of the ``major security-based swap participant'' definition
if the exclusion did not extend to hedges of ``financial'' or
``balance sheet'' risks. Security-based swaps such as single-name
credit default swaps and equity swaps would not appear amenable to
hedging a commercial entity's non-financial risks, such as price
risks associated with non-financial inputs or sales. We do not
believe that it would be appropriate to interpret the exclusion in
such a way as to make it a nullity in the context of the ``major
security-based swap participant'' definition.
---------------------------------------------------------------------------

d. Hedging on Behalf of an Affiliate
The final rules further provide that the exclusion is not limited
to the hedging of a person's own risks, but also would extend to the
hedging of the risks of a person's majority-owned affiliate.\986\

[[Page 30676]]

This approach reflects the fact that a corporate group may use a single
entity to face the market to engage in hedging activities on behalf of
entities within the group. In our view, it would not be appropriate for
the swap or security-based swap positions of the market-facing entity
to be encompassed within the first major participant test if those same
positions could have been excluded from the analysis if entered into
directly by the affiliate.\987\ Of course, the exclusion will only be
available to the market-facing entity if the position would have been
subject to the exclusion--e.g., not for a speculative or trading
purpose--had the affiliate directly entered into the position.
---------------------------------------------------------------------------

\986\ See CFTC Regulation Sec. 1.3(kkk)(1)(i); Exchange Act
rule 3a67-4(a)(1). For these purposes--consistent with the standards
regarding the application of the dealer and major participant
definitions to inter-affiliate swaps and security based swaps, see
parts II.C and IV.G--we would view the counterparties to be
majority-owned affiliates if one party directly or indirectly holds
a majority ownership interest in the other, or if a third party
directly or indirectly holds a majority interest in both, based on
holding a majority of the equity securities of an entity, or the
right to receive upon dissolution or the contribution of a majority
of the capital of a partnership. See note 348, supra.
\987\ The exclusion, however, would not be available to the
extent that a person enters into swaps or security-based swaps in
connection with the hedging activities of an unaffiliated third
party. Such activities, moreover, may indicate that the person is
acting as a swap dealer or security-based swap dealer.
---------------------------------------------------------------------------

4. Final Rules--``Major Swap Participant'' Definition Under the CEA
a. In General
The general scope of the rule regarding ``hedging or mitigating
risk'' will be adopted substantially as proposed.\988\ The CFTC,
however, is adopting CFTC Regulation Sec. 1.3(kkk) with a modification
to paragraph (1)(iii) to include a reference to qualified hedging
treatment for positions meeting Government Accounting Standards Board
(``GASB'') Statement 53, Accounting and Financial Reporting for
Derivative Instruments. The CFTC believes that this minor modification
to CFTC Regulation Sec. 1.3(kkk) is necessary in order to include
swaps that qualify for hedging treatment issued by GASB.\989\
---------------------------------------------------------------------------

\988\ The final rule text of CFTC Regulation Sec. 1.3(kkk)(2)
has been revised to include the conjunction ``and'' between clauses
(i) and (ii). In the proposed text of this rule, there was no
conjunction between these two clauses, while the conjunction ``and''
was used in the parallel rule, Sec. 240.3a67-4(b), under the
Exchange Act. Thus, the revision of the final rule text conforms the
CEA rule to the Exchange Act rule.
Also, the final rule text of CFTC Regulation Sec.
1.3(kkk)(1)(E) has been revised to include interest and currency
rates to be consistent with Sec. 1.3(kkk)(1)(F). Both provisions
address similar financial risks arising from rate ``movements'' and
``exposures,'' respectively.
\989\ Local government entities that use GASB accounting
standards may not be able to use comparable FASB hedge accounting as
a demonstration that a swap is a hedge. Although the two standards
are not the same, they are similar in effect and degree in respect
of determining whether a swap hedges a risk.
---------------------------------------------------------------------------

As noted above, the CFTC will not prohibit financial companies from
using the hedging exclusion because the exclusion for positions held
for hedging or mitigating commercial risk set forth in CEA section
1a(33)(A)(i)(1) does not limit its application based on the
characterization or status of the person or entity. Unlike the end-user
clearing exemption of section 2(h)(7), the major swap participant
hedging exclusion is not foreclosed to financial entities.\990\ In
addition, the hedging exclusion will extend to entities hedging the
risks of affiliates in a corporate group, but not to third parties
outside of a corporate group.
---------------------------------------------------------------------------

\990\ Although CEA section 1a(33)(A)(iii), 7 U.S.C.
1a(33)(A)(iii) provides that financial entities that are highly
leveraged and not subject to capital requirements established by a
Federal banking agency are effectively precluded from applying the
hedging exclusion, other financial entities are not so precluded.
Thus, availability of the hedging exclusion to some financial
entities for purposes of the major swap participant definition is
contemplated in the statutory text.
---------------------------------------------------------------------------

Like the proposed rule, the final rule under the CEA does not
require a demonstration of hedge effectiveness, periodic retesting or
specific documentation in order to apply the hedging exclusion from the
definition of major swap participant.
b. Swaps That Hedge Positions Held for Speculation, Investment, or
Trading
Swaps that hedge positions held for speculation, investment or
trading will not qualify for the exclusion. In the Proposing Release,
the CFTC explained that swap positions held for the purpose of
speculation, investment or trading are those held primarily to take an
outright view on market direction, including positions held for short
term resale, or to obtain arbitrage profits.\991\ Additionally, the
Proposing Release stated that swap positions that hedge other positions
that themselves are held for the purpose of speculation, investment or
trading are also speculative, investment or trading positions.\992\
---------------------------------------------------------------------------

\991\ See 75 FR at 80195 n.128.
\992\ Id.
---------------------------------------------------------------------------

We note that some commenters suggested that swaps that hedge
speculative, investment or trading positions should qualify for the
exclusion because speculation, investment or trading are fundamental to
commercial activity and cannot be differentiated from other types of
commercial activity. Similarly, commenters that support allowing
speculative, investment or trading positions to qualify for the
exception stated that a swap hedging the risk of another swap
(regardless of that swap's nature) is risk reducing and therefore
hedges commercial risk. We believe that these commenters'
interpretation of ``commercial'' is not consistent with congressional
intent or the meaning of ``commercial'' in the Dodd-Frank Act with
respect to the first test of the major participant definition or the
end-user exception to the clearing mandate. We are unconvinced that
allowing swap positions to qualify for the exception would be
appropriate when used to hedge speculative, investment or trading
positions because the swap would not hedge or mitigate the risks
associated with the underlying position, or at least not in the manner
intended by Congress. In addition, we believe that doing so would
undermine the effectiveness of the major participant definition in that
entities would be able to characterize positions for speculative,
investment or trading purposes as hedges and therefore evade regulation
as major participants.
Under CFTC Regulation Sec. 1.3(kkk)(2)(i), swap positions executed
for the purpose of speculating, investing, or trading are those
positions executed primarily to take an outright view on market
direction or to obtain an appreciation in value of the swap position
itself, and not primarily for hedging or mitigating underlying
commercial risks.\993\ For example, swaps positions held primarily for
the purpose of generating profits directly upon closeout of the swap,
and not to hedge or mitigate underlying commercial risk, are
speculative or serve as investments. Further, as an alternative
example, swaps executed for the purpose of offsetting potential future
increases in the price of inputs that the entity reasonably expects to
purchase for its commercial activities serve to hedge a commercial
risk.
---------------------------------------------------------------------------

\993\ The Commissions note that the SEC interprets the
availability of the hedging exclusion differently in the context of
the ``major security-based swap participant'' definition, and that
the SEC's guidance in this area controls for purposes of that
definition.
---------------------------------------------------------------------------

The CFTC notes that the use of ``trading'' in this context is not
used to mean simply buying and selling. Rather, a party is using a swap
for the purpose of trading under the rule when the party is entering
and exiting swap positions for purposes that have little or no
connection to hedging or mitigating commercial risks incurred in the
ordinary course of business. ``Trading,'' as used in CFTC Regulation
Sec. 1.3(kkk)(2)(i), therefore would not include simply the act of
entering into or exiting swaps if the swaps are used for the purpose of
hedging or mitigating commercial risks incurred in the ordinary course
of business.\994\
---------------------------------------------------------------------------

\994\ The CFTC further clarifies that merchandising activity in
the physical marketing channel qualifies as commercial activity,
consistent with the Commission's longstanding bona fide hedging
exemption to speculative position limits. See Sec. 1.3(kkk)(1)(ii).

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

[[Page 30677]]

The CFTC acknowledges that some swaps that may be characterized as
``arbitrage'' transactions in certain contexts may also reduce
commercial risks enumerated in CFTC Regulation Sec. 1.3(kkk)(1). The
discussion in footnote 128 of the Proposing Release was intended to
focus on clarifying that swaps are speculative for purposes of the rule
if entered into principally and directly for profit and not principally
to hedge or mitigate commercial risk. The reference to ``arbitrage
profits'' in footnote 128 was intended to provide an example of what is
commonly a speculative swap, not to characterize all arbitrage swaps as
speculative.
c. ``Economically Appropriate'' Standard
The CFTC has determined to adopt the ``economically appropriate''
standard as proposed. We believe that this standard will help the CFTC
and market participants distinguish which swaps are, or are not,
commercial hedges thereby reducing regulatory uncertainty and helping
prevent abuse of the hedging exclusion. CFTC Regulation 1.3(kkk)(1)(i)
of the final rules enumerates specific risk shifting practices that are
deemed to qualify for purposes of the hedging exclusion.\995\ Whether a
swap is economically appropriate to the reduction of risks will be
determined by the facts and circumstances applicable to the swap at the
time a swap is entered into. While we acknowledge that this standard
leaves room for judgment in its application, we believe this
flexibility is needed given the wide variety of swaps and hedging
strategies the rule applies to. We believe the economically appropriate
standard together with the identification of the six different
categories of permissible commercial risks listed in final CFTC
Regulation Sec. 1.3(kkk)(1)(i) is specific enough, when reasonably
applied, to distinguish whether a swap is being used to hedge or
mitigate commercial risk.
---------------------------------------------------------------------------

\995\ In the alternative to meeting the requirements of CFTC
Regulation Sec. 1.3(kkk)(1)(i), a swap may also be eligible for the
hedging exclusion if the swap qualifies as a bona fide hedge for
purposes of an exception from position limits under the CEA as
provided in CFTC Regulation Sec. 1.3(kkk)(1)(ii), or if it
qualifies for hedging treatment under FASB Accounting Standards
Codification Topic 815 or under GASB Statement 53 as provided in
CFTC Regulation Sec. 1.3(kkk)(1) (iii). Consequently, the universe
of swaps that can qualify for the hedging exclusion is broader than
the universe of swaps that qualify as bona fide hedges for purposes
of an exception from position limits under the CEA as provided in
CFTC Regulation Sec. 1.3(kkk)(1)(ii).
---------------------------------------------------------------------------

The Commission has determined not to adopt a ``congruence''
standard because that standard may be too restrictive and difficult to
use given the range of potential types of swaps and hedging strategies
available.
5. Final Rules--``Major Security-Based Swap Participant'' Definition
Under the Exchange Act
a. ``Economically Appropriate'' Standard
The final rules retain the proposed ``economically appropriate''
standard, by which a security-based swap position that is used for
hedging purposes \996\ would be eligible for exclusion from the first
major participant analysis if the position is economically appropriate
to the reduction of risks in the conduct and management of a commercial
enterprise, when those risks arise from the potential change in the
value of assets, liabilities and services in connection with the
ordinary course of business of the enterprise.\997\
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\996\ In the Proposing Release we stated that we did not believe
the use of the term ``mitigating'' in the exclusion to mean
something significantly more than ``hedging.'' See Proposing
Release, 75 FR 80194 n.127. As noted above, some commenters
disagreed, and argued that ``mitigating'' should be interpreted more
broadly to encompass general risk mitigation strategies. See, e.g.,
letters from ISDA and CDEU. In our view, the final rules we are
adopting--including the use of ``economically appropriate''
standards and the exclusions for certain positions--encompass
positions that may reasonably be described as ``hedging'' or
``mitigating'' commercial risk.
\997\ Exchange Act rule 3a67-4(a)(1). Under this standard, the
first major participant analysis need not account for security-based
swap positions that pose limited risk to the market and to
counterparties because the positions are substantially related to
offsetting risks from a person's commercial operations. These
hedging positions would include activities, such as the management
of receivables, that arise out of the ordinary course of a person's
commercial operations, including activities that are incidental to
those operations. See Proposing Release, 75 FR at 80195.
In addition, the security-based swap positions included within
the rule would not be limited to those recognized as hedges for
accounting purposes. See id.
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Consistent with the Proposing Release, we interpret the concept of
``economically appropriate'' to mean that the security-based swap
position cannot materially over-hedge the underlying risk such that it
could reasonably have a speculative effect,\998\ and that the position
cannot introduce any new basis risk or other type of risk (other than
counterparty risk that is attendant to all security-based swaps) more
than reasonably is necessary to manage the identified risks.
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\998\ In the Proposing Release, we described the ``economically
appropriate'' standard as excluding positions that introduce ``any
new material quantum of risks.'' See Proposing Release, 75 FR 80194
n. 129. The interpretation in this release is consistent with that
approach, but does not make use of the same ``quantum of risks''
terminology.
---------------------------------------------------------------------------

For example, a manufacturer that wishes to hedge the risk
associated with a customer's long-term lease of a product may purchase
credit protection using a single-name credit default swap on which the
customer is the reference entity. The credit default swap may be
excluded from the first major participant analysis even if it is for a
shorter term than the anticipated duration of the lease so long as the
use of such a shorter-term instrument is reasonable as a hedge, such as
due to cost or liquidity reasons.\999\ Also, the credit default swap
may be excluded from the first major participant test if it hedges an
amount of risk that is lower than the total amount of risk associated
with the long-term contract.\1000\
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\999\ In other words, the entity may determine that the use of a
credit default swap for a term that is shorter than the lease is
justified if that shorter-term instrument costs less or is more
liquid than a bespoke instrument that matches the duration of the
contract. While the shorter-term credit default swap does not
eliminate the underlying commercial risk, the instrument's use may
be commercially reasonable for hedging purposes, and hence
appropriately excluded from the first major participant test.
\1000\ The use of a credit default swap for an amount that is
smaller than the underlying risk may be justified as part of an
entity's risk management strategy. For example, an entity may choose
to engage in a partial hedge because a credit default swap for a
smaller amount than the underlying risk may cost less or be more
liquid than a bespoke instrument that more closely matches the
amount of the risk.
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In adopting this rule, we have considered commenter views that we
should consider limiting the exclusion to positions that are recognized
as hedges for accounting purposes.\1001\ We nonetheless do not believe
that the requirements that are appropriate to identifying hedging for
accounting purposes are needed to limit the availability of the hedging
exclusion. Moreover, linking the availability of the exclusion to
accounting standards--which themselves may evolve over time--may lead
the availability of the exclusion to evolve over time in unforeseen
ways. We accordingly believe that the exclusion should be available if
a security-based swap position is economically appropriate for hedging
purposes (and not otherwise precluded from taking advantage of the
exclusion).
---------------------------------------------------------------------------

\1001\ See letter from Senator Levin.
---------------------------------------------------------------------------

We also have considered commenter concerns that the ``economically
appropriate'' standard is too broad,\1002\ and the additional
suggestion that the exclusion instead should be limited to
circumstances in which the hedge is ``congruent'' to the underlying
risk.\1003\
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\1002\ See letters from AFR and AFSCME.
\1003\ See letter from Better Markets I. We nonetheless do not
believe that such a requirement would be consistent with the
exclusion's ``commercial risk'' terminology or underlying intent. A
congruence standard particularly would not appear to adequately
reflect the fact that commercially reasonable hedging activities can
leave residual basis risk.

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[[Page 30678]]

We recognize the significance of commenters' concerns as to the
practical application of the ``economically appropriate'' standard,
particularly with regard to hedges that are not perfectly correlated
with the underlying risk.\1004\ The standard embeds principles of
commercial reasonableness that should assuage those implementation
concerns, however. These principles necessarily account for the fact
that the reasonable use of security-based swaps to hedge a person's
commercial risk may result in residual basis risk, and that the mere
presence of this basis risk should not preclude the availability of the
exclusion. Moreover, the mere presence of residual basis risk need not
run afoul of the restriction against materially over-hedging the
underlying risk, which is instead intended to prevent the hedging
exclusion from applying to positions that are entered into for
speculative purposes or that have speculative effect (such as by being
based on a notional amount that is disproportionate to the underlying
risk).\1005\
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\1004\ See letter from SIFMA AMG II.
\1005\ For example, non-material basis risk or a non-material
over-hedge may occur due to the use of a standardized instrument. A
commercial entity may reasonably determine that it is cost effective
to use a standardized security-based swap to hedge the underlying
risk, even if use of the standardized instrument introduces non-
material basis risk or reflects a non-material amount of over-
hedging compared to what would be the result of using a bespoke
security-based swap to hedge that risk.
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We also acknowledge that an ``economically appropriate'' standard
does not provide the compliance assurance that would accompany
quantitative tests or safe harbors. Nonetheless, grounding the hedging
exclusion in principles of commercial reasonableness permits the
standard to be sufficiently flexible to appropriately address an end-
user's particular circumstances and hedging needs. Use of an
``economically appropriate'' standard also is consistent with the fact
that entities should be expected to use their reasonable business
judgment when hedging their commercial risks.
To provide additional guidance to entities hedging commercial risk,
moreover, the final rule incorporates examples of security-based swap
positions that, depending on the applicable facts and circumstances,
may satisfy the ``economically appropriate'' standard.\1006\ These are:
---------------------------------------------------------------------------

\1006\ Exchange Act rule 3a67-4(a)(2). We previously noted that
the proposed definition would facilitate those types of security-
based swap positions. See Proposing Release, 75 FR at 80196.
---------------------------------------------------------------------------

Positions established to manage the risk posed by a
customer's, supplier's or counterparty's potential default in
connection with: financing provided to a customer in connection with
the sale of real property or a good, product or service; a customer's
lease of real property or a good, product or service; a customer's
agreement to purchase real property or a good, product or service in
the future; or a supplier's commitment to provide or sell a good,
product or service in the future.\1007\
---------------------------------------------------------------------------

\1007\ As discussed in the Proposing Release, see 75 FR at 80196
n.135, the references here to customers and counterparties do not
include swap or security-based swap counterparties.
---------------------------------------------------------------------------

Positions established to manage the default risk posed by
a financial counterparty (different from the counterparty to the
hedging position at issue) in connection with a separate transaction
(including a position involving a credit derivative, equity swap, other
security-based swap, interest rate swap, commodity swap, foreign
exchange swap or other swap, option, or future that itself is for the
purpose of hedging or mitigating commercial risk pursuant to the rule
or the counterpart rule under the Commodity Exchange Act);
Positions established to manage equity or market risk
associated with certain employee compensation plans, including the risk
associated with market price variations in connection with stock-based
compensation plans, such as deferred compensation plans and stock
appreciation rights;
Positions established to manage equity market price risks
connected with certain business combinations, such as a corporate
merger or consolidation or similar plan or acquisition in which
securities of a person are exchanged for securities of any other person
(unless the sole purpose of the transaction is to change an issuer's
domicile solely within the United States), or a transfer of assets of a
person to another person in consideration of the issuance of securities
of such other person or any of its affiliates;
Positions established by a bank to manage counterparty
risks in connection with loans the bank has made; and
Positions to close out or reduce any of the positions
addressed above.
b. Treatment of Speculative or Trading Positions
The final rule, consistent with the proposal, provides that this
hedging exclusion does not extend to security-based swap positions that
are in the nature of speculation or trading.\1008\ The exclusion thus
does not extend to security-based swap positions that are held for
short-term resale and/or with the intent of benefiting from actual or
expected short-term price movements or to lock in arbitrage profits, or
to security-based swap positions that hedge other positions that
themselves are held for the purpose of speculation or trading.\1009\
---------------------------------------------------------------------------

\1008\ Exchange Act rule 3a67-4(b)(1). The commercial risk
hedging exclusion for the purposes of the ``major security-based
swap participant'' definition (in contrast to the commercial risk
hedging exclusion in connection with the ``security-based swap
dealer'' definition) does not turn upon whether a position is
``primarily'' for speculative or trading purposes. For the ``major
security-based swap participant'' definition, a security-based swap
position with any speculative or trading purpose cannot take
advantage of the commercial risk hedging exclusion regardless of
whether speculation or trading constitutes the ``primary'' purpose
of the position.
\1009\ See generally Basel Committee on Banking Supervision,
``International Convergence of Capital Measurement and Capital
Standards, A Revised Framework, Comprehensive Version'' (June 2006)
at ]] 685-689(iii) (defining the term ``trading book'' for purposes
of international bank capital standards, and stating that positions
that are held for short-term resale and/or with the intent of
benefiting from actual or expected short-term price movements or to
lock in arbitrage profits are typically considered part of an
entity's trading book).
In contrast to the CEA rule implementing the commercial risk
hedging definition in the context of the ``major swap participant''
definition, the Exchange Act rule does not explicitly exclude
security-based swaps held for the purpose of investing. We note,
however, that security-based swaps held for the purpose of investing
(i.e., held primarily to obtain an appreciation in value of the
security-based swap position) would not meet the ``economically
appropriate'' standard set forth above, and hence would not be
eligible for the exclusion.
---------------------------------------------------------------------------

The Commissions recognize that some commenters take the position
that the exclusion should extend to security-based swap positions that
hedge speculative or trading positions.\1010\ In support, these
commenters have stated that the proposed approach would lead to more
unhedged risk in the market, and that the proposed approach could lead
entities that use security-based swaps to hedge speculative positions
to be major participants, in contrast to unhedged (and presumably
riskier) entities. Commenters further requested clarification regarding
how entities may distinguish speculative or trading positions from
other security-based swap positions.\1011\
---------------------------------------------------------------------------

\1010\ See, e.g., letters from FSR I and ISDA I.
\1011\ See, e.g., letter from CDEU.
---------------------------------------------------------------------------

The Commissions nonetheless do not believe that it would be
appropriate to extend the hedging exclusion to speculative or trading
positions, including security-based swap positions that themselves
hedge other positions that are for speculative or trading

[[Page 30679]]

purposes. Those limitations are appropriate to help give meaning to the
concept of ``commercial'' risk, and to reflect the legislative intent
to limit the impact of Title VII on commercial end-users of security-
based swaps.\1012\ Indeed, the use of security-based swap positions in
connection with speculative and trading activity often may be expected
either to have the purpose of locking-in arbitrage profits associated
with those activities or producing an adjusted risk profile in
connection with perceptions of future market behavior--neither of which
would eliminate the speculative or trading purpose of the
activity.\1013\ We do not believe that it would be appropriate, or
consistent with the Dodd-Frank Act, to interpret the term ``commercial
risk'' to accord the same regulatory treatment to security-based swap
positions for speculative or trading purposes as is accorded to the use
of security-based swap positions in connection with commercial
activities such as producing goods or providing services to
customers.\1014\
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\1012\ In addition, this limitation is consistent with the
exclusion from the first major participant test in connection with
ERISA plans. That exclusion particularly addresses security-based
swap positions with the primary purpose of ``hedging or mitigating
any risk directly associated with the operation of the plan.'' It is
not clear why that scope of the ERISA exclusion would need to be
incorporated into the first major participant test if the
``commercial risk'' exclusion already were broad enough to encompass
hedges of trading or speculative positions.
\1013\ As an example, one speculative/trading strategy involving
security-based swaps can be to purchase short-dated credit
protection in conjunction with a long-dated bond, to reflect a view
that a particular company is likely to fail in the current credit
environment. Combined, those positions can produce losses if the
current credit environment did not change or if spreads were to
widen, but could produce profits either if the company were to
default or if spreads were to narrow and funding costs were to
decrease. See Morgan Stanley, Credit Derivatives Insights 156-58
(4th ed., 2008). In other words, under that strategy the purchase of
the credit protection would offset a portion of the risks associated
with the ownership of the bond, but for the purpose of taking a
directional view of the market with the hope for profit if the
purchaser's view of future market dynamics is correct (and the
reality of losses if the purchaser's view of the market is wrong).
It would require an extraordinarily liberal construction of
``commercial risk'' to subsume this type of speculative security-
based swap activity.
At the same time, we recognize that an entity hedging a
commercial risk (in contrast to a risk arising from a speculative or
trading strategy) reasonably may choose to use a security-based swap
that is shorter-dated than the underlying risk, with the security-
based swap appropriately excluded from the first major participant
definition.
\1014\ This approach does not reflect any value judgment about
the role of speculation in the market for security-based swaps, or
about the relative market benefits or risks associated with
speculation. This position simply represents an attempt to give
meaning to the statutory use of the term ``commercial risk'' in a
way that reflects Title VII's special treatment of commercial end-
users, and (as discussed below) avoid an interpretation that
effectively undermines the first major participant test.
---------------------------------------------------------------------------

Moreover, the Commissions believe that it would undermine the major
participant definition to attribute a non-speculative or non-trading
purpose to security-based swap positions that hedge speculative or
trading positions. When a person uses a security-based swap position to
help lock in profits or otherwise control the volatility associated
with speculative or trading activity, or to cause that speculative or
trading activity to reflect a particular market outlook or risk
profile, the security-based swap position serves as an integral part of
that speculative or trading activity. It thus would not appear
appropriate or consistent with economic reality to seek to distinguish
the security-based swap component from the other speculative or trading
aspects of that activity. In fact, if ``hedges'' of speculative or
trading positions were excluded from the first major participant test,
entities could readily label a wide range of security-based swap
positions entered into for speculative or trading purposes as being
excluded hedges.\1015\ Taken to its natural conclusion, such an
approach largely may exclude security-based swap positions from the
first major participant test, effectively writing that test out of the
statutory definition.
---------------------------------------------------------------------------

\1015\ As noted by one participant to the roundtable on these
definitions: ``[B]eing a hedge fund manager, there's nothing in my
portfolio I can't claim to be hedging a risk. There's nothing.
There's not a trade I do ever that I can't claim it to be a hedge
against interest rates, or inflation, or against equity. You know,
the fact of the matter is, if you're a capital market participant,
your business is taking risks.'' Roundtable Transcript at 325
(remarks of Michael Masters, Better Markets).
---------------------------------------------------------------------------

We are aware of commenters' views that regulation of major
participants has the potential to create a disincentive against certain
entities' use of security-based swaps to manage risk in connection with
their speculative or trading activities.\1016\ Under this view,
regulation potentially could result in those entities electing not to
reduce the risks that they otherwise would seek to hedge, to avoid
being regulated as major participants.\1017\ That potential result,
however, is an unavoidable consequence of the legislative decision to
regulate persons whose security-based swap positions cause them to be
major participants. It would not be appropriate to use the hedging
exclusion to negate part of the underlying statutory definition simply
to avoid disincentives that are an unavoidable consequence of the
legislative decision to regulate major participants.
---------------------------------------------------------------------------

\1016\ See letter from ISDA I.
\1017\ Of course, this would only be the case where the entity's
hedging and speculative activities combined were at a level in
excess of the major participant thresholds.
---------------------------------------------------------------------------

At the same time, we are mindful that market participants have
requested further guidance as to how to distinguish between hedging
positions that are subject to this exclusion, and speculative or
trading positions that fall outside the exclusion. In our view,
analysis of this issue is simplified by the nature of security-based
swaps, and by the limited circumstances in which a person may be
expected to have a commercial risk such that the use of a security-
based swap may be economically appropriate for managing that commercial
risk (rather than being for speculation or trading purposes).
In the case of security-based swaps that are credit derivatives,
the final rule provides examples of the use of credit default swaps to
purchase credit protection that, depending on the applicable facts and
circumstances, may appropriately be excluded from the first major
participant test (e.g., the use of a credit default swap to purchase
credit protection in connection with the potential default of a
customer, supplier or counterparty, or in connection with loans made by
a bank). Certain other purchases of credit protection using credit
default swaps--such as the purchase of credit protection to manage the
risks associated with securities that a non-financial company holds in
a corporate treasury and that are not held for speculative or trading
purposes--may also meet the standard under these rules.\1018\ The sale
of offsetting credit protection may also reasonably be expected to fall
within the exclusion to the extent that this sale is reasonably
necessary to address changes (particularly reductions) in the amount of
underlying commercial risk hedged by the initial security-based swap
position.\1019\
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\1018\ This is not to say that the purchase of credit protection
on a security that a person owns would necessarily be entitled to
the hedging exclusion. If the underlying security itself is held for
speculative or trading purposes, the credit protection would not be
excluded from the first major participant analysis, and in any event
would not reasonably be construed as hedging ``commercial risk.''
\1019\ Apart from that example, it is more difficult to foresee
circumstances in which the sale of credit protection using a credit
default swap would be expected to fall within the exclusion. We
recognize, for example, that a person that has a short position in a
security of a reference entity may have an incentive to sell credit
protection on that reference entity to offset movements in the price
or value of that short position (and/or lock in arbitrage profits in
connection with that short position). While that sale of credit
protection may mitigate the risks associated with that short
position, or produce an arbitrage profit in connection with that
short position, that security-based swap position would not appear
to constitute the hedging of ``commercial risk'' for purposes of the
exclusion.

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[[Page 30680]]

As for security-based swaps that are not credit derivatives--such
as equity swaps and total return swaps--the final rule provides
examples of how the use of those security-based swaps in connection
with certain business combinations may, depending on the applicable
facts and circumstances, appropriately be excluded from the first major
participant test. The use of equity swaps or total return swaps to
manage the risks associated with securities that are held in a
corporate treasury (and that are not held for speculative or trading
purposes) may also appropriately be subject to the exclusion. Other
uses of equity swaps or total return swaps to offset risks associated
with long or short positions in securities, however, may not
appropriately be excluded from the first major participant test,
because such positions would be expected to have an arbitrage purpose
or other speculative or trading purpose, and would be inconsistent with
the ``commercial risk'' limitation to the hedging exclusion.
c. Treatment of Positions That Hedge Other Swap or Security-Based Swap
Positions
The final rule, consistent with the proposal, provides that the
hedging exclusion does not extend to a security-based swap position
that hedges another swap or security-based swap position, unless that
other position itself is held for the purposing of hedging or
mitigating commercial risk.\1020\ This provision allows the first major
participant analysis to exclude a person's purchase of credit
protection to help address the risk of default by a counterparty in
connection with an interest rate swap, foreign exchange swap or other
swap or security-based swap that the person has entered into for the
purpose of hedging or mitigating commercial risk.
---------------------------------------------------------------------------

\1020\ Exchange Act rule 3a67-4(b)(2).
---------------------------------------------------------------------------

d. Procedural Conditions
In contrast to the proposal, the final rule does not incorporate
procedural requirements in connection with the hedging exclusion from
the first test of the major security-based swap participant
definition.\1021\ In making this change, we have been mindful of
concerns that have been expressed that such procedural requirements
would lead to undue costs in connection with hedging activity.\1022\
---------------------------------------------------------------------------

\1021\ Those proposed provisions would have conditioned the
exclusion on the person identifying and documenting the underlying
risks, establishing and documenting a method of assessing the hedge
effectiveness, and regularly assessing the effectiveness of the
security-based swap as a hedge. See proposed Exchange Act rule 3a67-
4(c).
\1022\ See, e.g., letter from FSR I.
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We understand, however, that many entities engaging in legitimate
hedging of commercial risks do, as a matter of business practice,
identify and document those risks and evaluate the effectiveness of the
hedge from time to time. The presence of supporting documentation
consistent with such procedures would help support a person's assertion
that a security-based swap position should be excluded from the first
major participant analysis, should the legitimacy of the exclusion
become an issue.
Also, although we are not requiring the entity to monitor the
effectiveness of the hedge over time, that absence of this requirement
does not change the underlying need for a security-based swap position
to be economically appropriate for the commercial risks facing the
entity to be excluded from the first major participant definition.
Thus, for example, if a person's underlying commercial risk materially
diminishes or is eliminated over time, a security-based swap position
that may have been economically appropriate to the reduction of risk at
inception at a certain point in time may, depending on the facts and
circumstances, no longer be reasonably included within the
exclusion.\1023\ As part of the reports required in connection with
possible future changes to the major participant definitions,\1024\ the
staffs are directed to address whether the continued availability of
the hedging exclusion should be conditioned on assessment of hedging
effectiveness and related documentation.
---------------------------------------------------------------------------

\1023\ Factors that may be relevant to determining whether a
security-based swap position is economically appropriate to the
reduction of risk may include the costs associated with terminating
or reducing that position.
\1024\ See part V, infra.
---------------------------------------------------------------------------

D. Exclusion for Positions Held by Certain Plans Defined Under ERISA

1. Proposed Approach
The first statutory test of the major participant definitions
excludes swap and security-based swap positions that are ``maintained''
by any employee benefit plan as defined in sections 3(3) \1025\ and
3(32) \1026\ of ERISA ``for the primary purpose of hedging or
mitigating any risk directly associated with the operation of the
plan.'' \1027\
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\1025\ Section 3(3) of Title I of ERISA defines the term
``employee benefit plan'' to include ``an employee welfare benefit
plan or an employee pension benefit plan or a plan which is both an
employee welfare benefit plan and an employee pension benefit
plan.'' See 29 U.S.C. 1002(3). The terms ``employee welfare benefit
plan'' and ``employee pension benefit plan'' are further defined in
Sections 3(1) and (2) of ERISA. See 29 U.S.C. 1002(1) and (2).
\1026\ Section 3(32) of Title I of ERISA defines the term
``governmental plan'' to mean a plan that the U.S. government, state
or political subdivision, or agencies and instrumentalities
establish or maintain for its employees, as well as plans governed
by the Railroad Retirement Acts of 1935 and 1937, plans of
international organizations that are exempt from taxation pursuant
to the International Organizations Immunities Act, and certain plans
established and maintained by tribal governments or their
subdivisions, agencies or instrumentalities. See 29 U.S.C. 1002(32).
\1027\ CEA section 1a(33)(A)(i)(I); Exchange Act section
3(a)(67)(A)(ii)(I).
---------------------------------------------------------------------------

The proposed rules incorporated that statutory exclusion without
additional interpretation or refinement.\1028\ In the Proposing
Release, moreover, the Commissions expressed the preliminary view that
we did not ``believe that it is necessary to propose a rule to further
define the scope of this exclusion.'' We further noted that the
exclusion for those plans identified in the statutory definition is not
strictly limited to ``commercial'' risk, and that this may be construed
to mean that hedging by those ERISA plans should be broadly excluded.
The Commissions also solicited comment as to whether this exclusion
should be made available to additional types of entities.\1029\
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\1028\ See proposed CFTC Regulation Sec. 1.3(hhh)(1)(ii)(A);
proposed Exchange Act rule 3a67-1(a)(2)(i).
\1029\ See Proposing Release, 75 FR at 80201, supra.
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2. Commenters' Views
Some commenters requested clarification that the ERISA hedging
exclusion is broader than the commercial risk hedging exclusion, and
that the ERISA hedging exclusion can encompass positions that are not
solely for hedging purposes.\1030\ One

[[Page 30681]]

commenter cautioned against interpreting the ERISA hedging exclusion
broadly.\1031\
---------------------------------------------------------------------------

\1030\ See letters from BlackRock I (noting that the ERISA
hedging exclusion applies to positions with the ``primary purpose''
of hedging, ``which suggests plans may exclude swap positions even
if they serve a purpose in addition to hedging or mitigating''), the
ERISA Industry Committee (``ERISA Industry Committee'') (stating
that if ERISA Title I plans are not excluded from the major
participant definition, the rules should clarify that the ERISA
hedging exclusion is broader than the commercial hedging exclusion
and encompasses a variety of risks associated with the value of a
plan's assets or the measures of its liabilities; also stating that
the ERISA exclusion should not omit positions in the nature of
investing, and particularly discussing the use of swaps to provide
diversification), ABC/CIEBA (expressing the view that the ERISA
hedging exclusion extends beyond ``traditional'' hedges, and stating
that the exclusion should encompass swaps with purposes in addition
to hedging, and that the exclusion should encompass positions for
the purpose of rebalancing, diversification and gaining asset class
exposure) and CalSTRS I (requesting that regulations provide for an
ERISA hedging exclusion that is broader than the commercial risk
hedging exclusion, and that encompasses positions for the purpose of
investing).
One commenter alluded to the incorporation of efficient
portfolio theory principles within the exception. See letter from
Russell Investments.
\1031\ See letter from AFSCME (stating that while the statutory
exclusion may encompass swaps to mitigate currency risk of cash
market investments, the exclusion should not encompass swaps used
for investment purposes such as to gain asset class exposure or
avoid transaction costs associated with a direct investment).
---------------------------------------------------------------------------

Commenters also requested that the Commissions clarify that the
ERISA hedging exclusion applies to positions maintained by trusts that
hold plan assets,\1032\ or by pooled funds.\1033\ One commenter, in
contrast, stated that the exclusion should not be available to trusts
holding plan assets.\1034\
---------------------------------------------------------------------------

\1032\ See letters from ERISA Industry Committee (stating that
the rules should provide that the exclusion applies to positions
maintained by any trust holding plan assets) and ABC/CIEBA (stating
that the rules should provide the relevant entity for purposes of
the exclusion is the counterparty to the swap, further stating that
if a trust enters into a swap as a counterparty, it is the trust
that should be tested as a possible major participant, even if the
trust also holds non-ERISA assets).
\1033\ See letters from BlackRock I (discussing how plan
fiduciaries may invest plan assets ``in pooled investment vehicles
such as registered investment companies, private funds and bank
maintained collective trust funds,'' and stating that not including
pooled funds within the exclusion would limit plans' ability to
avail themselves of the efficiencies associated with pooling), ERISA
Industry Committee (stating that there is ``no reason'' why the
exception should not also extend to position held by a pooled
investment trust on behalf of multiple employee benefit plans) and
ABC/CIEBA (stating that if a pool within a trust is the
counterparty, it is that pool that should be tested as a possible
major participant, and noting Department of Labor regulations
providing that a collective investment vehicle would be viewed as
holding plan assets if the vehicle is not a registered investment
company, and plans hold at least 25 percent of the interests in the
vehicle).
\1034\ See letter from AFSCME (stating that ``it is important to
limit the exemption to plans themselves, not to entities holding
`plan assets' '').
---------------------------------------------------------------------------

One commenter stated that the exception should be extended to all
public pension plans,\1035\ and one commenter particularly took the
view that the exclusion should be available to church plans.\1036\ Some
commenters stated that the exclusion should be available to non-U.S.
plans.\1037\
---------------------------------------------------------------------------

\1035\ See letter from Russell Investments.
\1036\ See letter from Church Alliance (stating that the
exclusion also should encompass church plans defined in paragraph
3(33) of ERISA, on the grounds that Congress would not have intended
to discriminate against church plans, and that church plans are
considered ``special entities'' that should be the beneficiaries of
extra protection).
\1037\ See letters from ABC/CIEBA, APG and BTPS.
The Commissions intend to issue separate releases that address
the application of the major participant definitions, and Title VII
generally, to non-U.S. entities.
---------------------------------------------------------------------------

3. Final Rules
Consistent with the position expressed in the Proposing Release,
the Commissions interpret the ERISA hedging exclusion in the first
statutory major participant test to be broader than that test's
commercial risk hedging exclusion. This reflects the facts that the
ERISA hedging exclusion is not limited to ``commercial'' risk, and that
the ERISA hedging exclusion addresses positions that have a ``primary''
hedging purpose (which suggests that those positions may have a
secondary non-hedging purpose).
a. Types of Excluded Hedging Activities
The Commissions are mindful of commenters' request for additional
clarity regarding the scope of the ERISA hedging exclusion. In that
regard, we note that we generally would expect swap or security-based
swap positions to have a primary purpose of hedging or mitigating risks
directly associated with the operation of the types of plans identified
in the statutory definition--and hence eligible for the exclusion--when
those positions are intended to reduce disruptions or costs in
connection with, among others, the anticipated inflows or outflows of
plan assets, interest rate risk, and changes in portfolio management or
strategies.
Conversely, we believe that certain other types of positions would
less likely have the primary purpose of hedging or mitigating risks
directly associated with the operation of the plan, as anticipated by
the statutory definition.\1038\
---------------------------------------------------------------------------

\1038\ For example, we do not foresee that the use of a swap or
security-based swap position to replicate exposure to a foreign
market or to a particular asset class to be for the primary purpose
of hedging risks directly associated with the operation of these
types of plans. While we recognize that an asset manager may
perceive benefits in using swaps or security-based swaps in that
manner, it also is necessary to give effect to the statutory
language limiting the exclusion to positions that have a ``primary
purpose'' of hedging risks ``directly associated'' with the
``operations'' of a plan. We recognize that lack of diversification
may be viewed as a risk, but it is not an ``operations'' risk.
---------------------------------------------------------------------------

b. Availability of Exclusion
The Commissions recognize the significance of comments that these
plans may use separate entities such as trusts or pooled vehicles to
hold plan assets, and that the exclusion should not be interpreted in a
way that deters the use of those vehicles. We believe that the same
principles that underpin the exclusion for hedging positions directly
entered into by the types of plans identified in the statutory
definition also warrant making the exclusion applicable to plan hedging
positions that are entered into by those other parties that hold assets
of those types of plans. Otherwise, the major participant analysis
would have the effect of deterring efficiencies in plan operations for
no apparent regulatory purpose.
Accordingly, the Commissions interpret the meaning of the term
``maintain''--in the context of the statutory provision that the swap
or security-based swap position be ``maintained by'' an employee
benefit plan--not only to include positions in which the plan is a
counterparty, but also to include positions in which the counterparty
is a trust or pooled vehicle that holds plan assets. Thus, for example,
the exclusion would be available to trusts or pooled vehicles that
solely hold assets of the types of plans identified in the statutory
definition.\1039\ The exclusion further may be available to entities
that hold such plan assets in conjunction with other assets, but only
to the extent that the entity enters into swap or security-based swap
positions for the purpose of hedging risks associated with the plan
assets. The exclusion does not extend to positions that hedge risks of
other assets, even if those are managed in conjunction with plan
assets.\1040\
---------------------------------------------------------------------------

\1039\ This interpretive guidance is intended solely in the
context of the interpretation of the first test of the statutory
major participant definitions. The guidance is not based on or
relevant to the interpretation of other regulations relating to
ERISA.
\1040\ As appropriate, for purposes of the first major
participant analysis an entity may need to allocate the exposure
associated with swap or security-based swap positions between the
amount that is attributable to plan assets (and hence eligible for
exclusion) and the amount that is attributable to other assets.
---------------------------------------------------------------------------

The Commissions also are mindful of commenter concerns that the
exclusion should explicitly be made available to other plans, such as
church plans and non-U.S. plans.\1041\ In this regard, the Commissions
believe that the boundaries of the exclusion are set by the explicit
statutory language, which states that it applies to any employee
benefit plan as defined in paragraphs (3) and (32) of section 3 of
ERISA. This reference is disjunctive--that is, a plan is eligible for
the exclusion if it is within the scope of paragraph (3) (which refers
to employee benefit plans)

[[Page 30682]]

or of paragraph (32) (which applies to government plans). Accordingly,
the scope of the cited definitions in paragraphs (3) and (32) should be
determined in accordance with all law that applies in the
interpretation of ERISA.\1042\
---------------------------------------------------------------------------

\1041\ As previously noted, the Commissions intend to issue
separate releases that address the application of the major
participant definitions, and Title VII generally, to non-U.S.
entities.
\1042\ We are not taking a view as to whether church plans or
non-U.S. plans constitute employee benefit plans as defined by
section 3(3) of ERISA.
---------------------------------------------------------------------------

E. ``Substantial Counterparty Exposure''

1. Proposed Approach
The major participant definitions' second statutory test
encompasses persons whose outstanding swaps or security-based swaps
``create substantial counterparty exposure that could have serious
adverse effects on the financial stability of the U.S. banking system
or financial markets.'' \1043\ In contrast to those definitions' first
statutory test, which relates to persons with a ``substantial
position'' in swaps or security-based swaps in a ``major''
category,\1044\ this second test is not limited to positions in a
single category. Also, unlike the first test, the second statutory test
does not explicitly exclude certain commercial risk hedging positions
or ERISA hedging positions.
---------------------------------------------------------------------------

\1043\ CEA section 1a(33)(A)(ii); Exchange Act section
3(a)(67)(A)(ii)(II).
\1044\ CEA section 1a(33)(A)(i); Exchange Act section
3(a)(67)(A)(ii)(I).
---------------------------------------------------------------------------

For the ``major swap participant'' definition, the Proposing
Release provided that a person's swap positions pose ``substantial
counterparty exposure'' if those positions present a daily average
current uncollateralized exposure of $5 billion or more, or present
daily average current uncollateralized exposure plus potential future
exposure of $8 billion or more.\1045\ For the ``major security-based
swap'' definition, the proposal provided that a person's security-based
swap positions pose ``substantial counterparty exposure'' if those
positions present daily average current uncollateralized exposure of $2
billion or more, or present daily average current uncollateralized
exposure plus potential future exposure of $4 billion or more.\1046\
---------------------------------------------------------------------------

\1045\ See proposed CFTC Regulation Sec. 1.3(lll).
\1046\ See proposed Exchange Act rule 3a67-5.
---------------------------------------------------------------------------

Under the proposal, those measures would be calculated in the same
manner as would be used for the first major participant test, except
that the ``substantial counterparty exposure'' analysis would consider
all of a person's swap or security-based swap positions rather than
solely considering positions in a particular ``major'' category, and
that the ``substantial counterparty exposure'' analysis would not
exclude positions to hedge commercial risks or ERISA plan risks.
The proposed ``substantial counterparty exposure'' thresholds were
set higher than the proposed ``substantial position'' thresholds in
part to reflect the fact that the former test accounts for a person's
positions across four major swap categories or two major security-based
swap categories.\1047\ The proposed ``substantial counterparty
exposure'' thresholds also reflected the fact that this second test
(unlike the first major participant test) encompasses certain hedging
positions that, in general, we would expect to pose a lesser degree of
risk to counterparties and the markets.
---------------------------------------------------------------------------

\1047\ Thus, these proposed thresholds in part would account for
a person that has large positions in more than one major category of
swaps or security-based swaps, but that does not meet the
substantial position threshold for any single category of swaps or
security-based swaps.
---------------------------------------------------------------------------

2. Commenters' Views

a. General Comments
In light of the similarity between the proposed tests, a number of
the concerns that commenters expressed with regard to the proposed
``substantial position'' definition also apply to the proposed
``substantial counterparty exposure'' definition. In addition, some
commenters took the view that the proposed ``substantial counterparty
exposure'' thresholds were too low,\1048\ with several of those
commenters stating that the thresholds should be raised to a level that
reflects systemic risk.\1049\ A few commenters took the view that the
proposed thresholds were too high.\1050\ Some commenters generally
supported the approach to the definition of ``substantial counterparty
exposure'' proposed by the Commissions.\1051\
---------------------------------------------------------------------------

\1048\ See, e.g., letters from ATAA (supporting higher
thresholds to measure substantial counterparty exposure), CCMR I
(suggesting that the thresholds be set high initially, capturing
only a few entities until the Commissions are able to collect and
analyze data that supports lowering the thresholds), BG LNG I
(stating that proposed threshold should be increased substantially),
WGCEF II (stating that the Commissions should adopt substantial
position and substantial counterparty exposure tests that account
for current conditions in swap markets), ABC/CIEBA (requesting that
the Commissions raise the thresholds to better target persons
creating or causing systemic risk as set forth in the a major swap
participant and major security-based swap participant definitions),
BlackRock I (stating that proposed thresholds for the substantial
counterparty exposure test are too low so that they could encompass
market participants that do not have systemically important swap
positions) and ACLI (supporting increasing the thresholds under the
CEA definition to $7 billion in daily average aggregate
uncollateralized outward exposure or $14 billion in daily average
aggregate uncollateralized outward exposure plus daily average
aggregate potential outward exposure), and meeting with MFA on
February 14, 2011 (requesting that the Commissions raise the
thresholds for measuring substantial counterparty exposure until the
Commissions conduct a market survey to determine how many entities
would need to perform the calculations regularly and whether those
entities have characteristics capable of causing systemic risk).
\1049\ See letters from ABC/CIEBA, BlackRock I, ISDA I, WGCEF
II, and meeting with MFA on February 14, 2011.
\1050\ See letters from Greenberger (in connection with
thresholds relating to substantial position) and AFR (Commissions
should define a major swap participant or major security-based swap
participant as any person that maintains $500 million in daily
average, uncollateralized exposure for any category of swaps other
than rate swaps, for which the daily average could be up to $1.5
billion).
\1051\ See, e.g., letters from ATAA (supporting the proposed
definitions of ``substantial position'' and ``substantial
counterparty exposure,'' with the caveat that higher thresholds be
used to measure ``substantial counterparty exposure''), Dominion
Resources (supporting the Commissions proposed definitions of
``substantial position'' and ``substantial counterparty exposure''),
Fidelity (threshold levels set at appropriate levels but should be
periodically reviewed for adjustment), and Kraft (thresholds as
proposed are appropriate).
---------------------------------------------------------------------------

Some commenters took the view that the ``substantial counterparty
exposure'' test should focus on the size of an entity's exposure to
specific counterparties.\1052\ Several commenters suggested that the
thresholds should be adjusted over time for inflation and changes in
the swap and security-based swap markets.\1053\ One commenter urged
that the analysis consider the interconnectedness of the entity.\1054\
---------------------------------------------------------------------------

\1052\ See letters from MFA (stating that the calculation of
substantial counterparty exposure should measure the exposure that a
person has to each individual counterparty that is a systemically
important financial institution excluding cleared swap transactions)
and CCMR I (stating that the ``substantial counterparty exposure''
and ``substantial position'' thresholds should apply to the largest
exposure that a person has to another market participant, with any
aggregate test being set at a higher level).
\1053\ See letters from CDEU, COPE I, Fidelity, ISDA I, and MFA
I.
\1054\ See letter from CDEU.
---------------------------------------------------------------------------

One commenter addressed the application of the second major
participant test to insurance companies, arguing that substantial
counterparty exposure should be decided by the FSOC in consultation
with the relevant state insurance commissioner, and that hedges should
be excluded from the calculation for insurers.\1055\
---------------------------------------------------------------------------

\1055\ See letter from NAIC (stating that the Commissions should
defer to FSOC when considering the designation of insurers under the
second test, and should exclude from the analysis swaps and
security-based swap positions used for hedging provided that such
positions are subject to state investment laws and ongoing
monitoring by a state insurance regulatory authority).
---------------------------------------------------------------------------

b. Lack of Exclusion for Hedging Positions
A number of commenters took the view that the second major
participant

[[Page 30683]]

test should exclude commercial risk hedging positions from the
analysis.\1056\ Some commenters also supported excluding ERISA hedging
positions from the analysis.\1057\ One commenter opposed any such
exclusions for hedging positions.\1058\
---------------------------------------------------------------------------

\1056\ See letters from SIFMA AMG II (noting that the
Commissions have suggested that hedging positions may not raise the
same degree of risk as other swap positions), NAIC (supporting
exclusion of commercial risk hedging positions subject to state
investment laws and ongoing monitoring by state insurance
regulators), AIA (supporting hedging exclusion to avoid capturing
entities such as property-casualty insurers), CDEU (suggesting that
inclusion of hedging positions is inconsistent with goal of
mitigating systemic risk), APG (supporting exclusion of positions
held by regulated foreign pension plans), and NRG Energy (suggesting
that a lack of an exclusion would cause end-users to curtail hedging
activities and increase systemic risk); see also letter from AIMA I
(supporting an exemption or discount if the swap transaction is
cleared, an off-set for the value and quality of any collateral, and
consideration of the directional moves of particular swap
contracts).
\1057\ See letters from ABC/CIEBA and SIFMA AMG II. One
commenter further requested that ERISA Title I plans be explicitly
excluded from the second test. See letter from ERISA Industry
Committee. Another commenter requested an exclusion for ERISA plans
generally. See letter from CalSTRS I.
\1058\ See letter from Better Markets I (stating that excluding
hedging positions would be inappropriate because the Dodd-Frank Act
did not provide for any such exclusion in the second test, hedge
positions may still contribute to counterparty exposure, and the
thresholds already reflect the lower level of risk posed by hedge
positions).
---------------------------------------------------------------------------

3. Final Rules
Consistent with the Proposing Release, the final rules defining the
term ``substantial counterparty exposure'' generally are based on the
same current uncollateralized exposure and potential future exposure
tests that are used to identify a ``substantial position.'' \1059\ As
with the Proposing Release, moreover, the ``substantial counterparty
exposure'' analysis addresses all of a person's swap or security-based
swap positions (rather than being limited to positions in a ``major''
category), and does not exclude hedging positions.\1060\ The final
rules also incorporate the quantitative thresholds that were proposed
for those tests.\1061\
---------------------------------------------------------------------------

\1059\ Accordingly, changes that the final rules made to the
proposal with regard to the ``substantial position'' definition, see
part IV.B.3, supra, also are carried over to the definition of
``substantial counterparty exposure.''
\1060\ See CFTC Regulation Sec. 1.3(lll); Exchange Act rule
3a67-5.
\1061\ Accordingly, consistent with the proposal, the threshold
for the ``major swap participant'' definition is $5 billion or more
in daily average current uncollateralized exposure, or $8 billion or
more in daily average uncollateralized exposure plus potential
future exposure. The threshold for the ``major security-based swap
participant'' is $2 billion or more in daily average current
uncollateralized exposure, or $4 billion or more in daily average
uncollateralized exposure plus potential future exposure.
---------------------------------------------------------------------------

In adopting these final rules we have considered commenter views
that the ``substantial counterparty exposure'' analysis should exclude
certain commercial risk and ERISA hedging positions. We nonetheless
believe that the structure of the major participant definitions--
particularly the fact that those definitions specifically exclude
hedging positions from the first statutory test but not from the second
test--necessitates the conclusion that the second test not exclude
those hedging positions.
We also have considered commenter views that the ``substantial
counterparty exposure'' analysis should account for the maximum
exposure that a person poses to any single counterparty. We nonetheless
believe that the statutory test--particularly its focus on serious
adverse effects on financial stability or financial markets--more
appropriately is addressed by measures of the aggregate counterparty
risk that an entity poses through its swap or security-based swap
positions. Also, consistent with our views regarding the ``substantial
position'' definition, we believe that the ``substantial counterparty
exposure'' analysis appropriately is addressed via objective and
quantitative criteria (rather than a multi-tier approach), and
appropriately takes into account current uncollateralized exposure and
potential future exposure.
Consistent with the Proposing Release, the thresholds to implement
the second major participant test are higher than the corresponding
thresholds for the first major participant test. These differences
reflect the fact that the second test encompasses four ``major''
categories of swaps or two ``major'' categories of security-based
swaps, as well as the fact that this second test does not exclude
hedging positions that would appear to pose a lesser degree of
counterparty risk than non-hedging positions.
While we are mindful of commenter views that the proposed
``substantial counterparty exposure'' thresholds were too low,\1062\ we
believe that the same principles that support the proposed standards in
the context of the ``substantial position'' definition also support the
proposed standards for this second test. As with the ``substantial
position'' analysis, the ``substantial counterparty exposure'' analysis
seeks to reflect a standard that encompasses large market participants
before the counterparty risk posed by their swap and security-based
swap positions present too large a problem, as well as the financial
system's ability to absorb losses of a particular size, and the need to
account for the possibility that multiple market participants may fail
close in time.\1063\ Commenters have not presented empirical or
analytical evidence in support of a different standard. In the future,
the Commissions may review and potentially adjust these thresholds to
reflect evolving market structures and additional data.
---------------------------------------------------------------------------

\1062\ See notes 1051 and 1052, supra.
\1063\ As with the ``substantial position'' analysis, our
decision to adopt these thresholds is informed by events related to
AIG Financial Products and LTCM. See part IV.B.3.d, supra.
---------------------------------------------------------------------------

F. ``Highly Leveraged'' and ``Financial Entity''

1. Proposed Approach
The third statutory test of the major participant definitions
encompasses any non-dealer that: (i) Is a ``financial entity'' (other
than one that is ``subject to capital requirements established by an
appropriate Federal banking agency''), (ii) is ``highly leveraged
relative to the amount of capital it holds,'' and (iii) maintains a
``substantial position'' in any ``major'' category of swaps or
security-based swaps.\1064\ In contrast to the first statutory test--
which also encompasses persons with a ``substantial position'' in swaps
or security-based swaps in a ``major'' category--this third test does
not exclude positions that hedge commercial risk or ERISA risks.
---------------------------------------------------------------------------

\1064\ CEA section 1a(33); Exchange Act section 3(a)(67).
---------------------------------------------------------------------------

a. ``Financial Entity''
The Proposing Release defined the term ``financial entity'' for
purposes of the major participant definition in the same general manner
as Title VII defines that term for purposes of the end-user exemption
from mandatory clearing,\1065\ but with certain technical changes to
avoid circularity.\1066\
---------------------------------------------------------------------------

\1065\ CEA section 2(h)(7); Exchange Act section 3C(g)(3)(A).
\1066\ See proposed CFTC Regulation Sec. 1.3(mmm)(1); proposed
Exchange Act rule 3a67-6(a). For both sets of rules, the ``financial
entity'' definition would include any: commodity pool (as defined in
section 1a(10) of the CEA); private fund (as defined in section
202(a) of the Investment Advisers Act of 1940); employee benefit
plan as defined in paragraphs (3) and (32) of section 3 of ERISA;
and person predominantly engaged in activities that are in the
business of banking or financial in nature (as defined in section
4(k) of the Bank Holding Company Act of 1956).
To avoid circularity, the use of the term ``financial entity''
in the context of the ``major swap participant'' definition also
would encompass any ``security-based swap dealer'' and ``major
security-based swap participant,'' but would not include any ``swap
dealer'' or ``major swap participant'' (even though the latter terms
also are found in the ``financial entity'' definition used for
purposes of the end-user clearing exception). See proposed CFTC
Regulation Sec. 1.3(mmm)(1). In the context of the ``major
security-based swap participant'' definition, the term ``financial
entity'' also would encompass any ``swap dealer'' or ``major swap
participant,'' but would not include any ``security-based swap
dealer'' and ``major security-based swap participant.'' See proposed
Exchange Act rule 3a67-6(a).

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

[[Page 30684]]

b. ``Highly Leveraged''
The Proposing Release set forth two alternative approaches for
determining whether a particular entity would be deemed ``highly
leveraged.'' \1067\ Under one approach, an entity would be ``highly
leveraged'' if the ratio of its liabilities to equity exceeded 8 to 1;
this proposed alternative reflected the fact that the third statutory
major participant test excludes certain types of entities.\1068\ Under
the alternative approach, an entity would be ``highly leveraged'' if
the ratio of its liabilities to equity exceeded 15 to 1; this proposed
alternative reflected standards for maximum leverage in certain
circumstances found in Title I of the Dodd-Frank Act.\1069\ The
proposal further provided that leverage would be measured at the close
of business on the last business day of the applicable fiscal quarter,
and that liabilities and equity would be determined in accordance with
U.S. generally accepted accounting principles (``GAAP'').\1070\
---------------------------------------------------------------------------

\1067\ See proposed CFTC Regulation Sec. 1.3(mmm)(2); proposed
Exchange Act rule 3a67-6(b).
\1068\ The Proposing Release particularly noted that the third
statutory major participant test excludes financial institutions
subject to capital requirements set by Federal banking agencies, and
recognized the possibility those entities were excluded based on the
presumption that they generally are highly leveraged. The Proposing
Release noted, based on analysis of financial statements, that it
appears that those institutions generally have a leverage ratio of
10 to 1, and that this suggested that the ``highly leveraged''
threshold would have to be lower for those institutions to
potentially be subject to the third test. See Proposing Release, 75
FR at 80199.
\1069\ The Proposing Release noted that Title I provides that
the Board must require a bank holding company with total
consolidated assets equal to or greater than $50 billion, or a
nonbank financial company supervised by the Board, to maintain a
debt to equity ratio of no more than 15 to 1 if the FSOC determines
``that such company poses a grave threat to the financial stability
of the United States and that the imposition of such requirement is
necessary to mitigate the risk that such company poses to the
financial stability of the United States.'' See Dodd-Frank Act
section 165(j)(1). The Proposing Release further noted that this 15
to 1 ratio may represent an upper limit to acceptable leverage and
that the major participant analysis should use a lower threshold,
or, alternatively, that the 15 to 1 ratio provides an appropriate
test of whether an entity poses the systemic risk concerns
implicated by the major participant definitions. See Proposing
Release, 75 FR at 80199.
\1070\ The Proposing Release also stated that entities that file
quarterly reports on Form 10-Q and annual reports on Form 10-K with
the SEC would determine their total liabilities and equity based on
the financial statements included with such filings while all other
entities would calculate the value of total liabilities and equity
consistent with the proper application of U.S. GAAP. See id.
---------------------------------------------------------------------------

In proposing these alternative standards for identifying ``highly
leveraged'' entities, the Commissions recognized that traditional
balance sheet measures of leverage are limited as tools for evaluating
an entity's ability to meet its obligations--in part because such
measures do not directly account for potential risks posed by specific
instruments held on the balance sheet, or for financial instruments
held off of the balance sheet. At the same time, the Commissions
preliminarily concluded that it was not necessary to use more complex
measures of risk-adjusted leverage for these purposes, in part because
the third test's ``substantial position'' analysis already accounts for
such risks. The Commissions also noted the costs that would be
associated with causing entities to engage in complex calculations of
risk-adjusted leverage.\1071\
---------------------------------------------------------------------------

\1071\ See id. at 80198-99.
---------------------------------------------------------------------------

The Proposing Release solicited comment on a variety of issues
related to the proposed leverage ratios, including the relative merits
of the alternative 8 to 1 and 15 to 1 standards, and potential
alternative standards.\1072\
---------------------------------------------------------------------------

\1072\ See id. at 80199-200.
---------------------------------------------------------------------------

2. Commenters' Views
a. ``Financial Entity''
Some commenters recommended that certain types of entities should
be excluded from the definition of ``financial entity,'' on the grounds
that those types of entities are more appropriately treated as non-
financial end users of swaps for purposes of the Dodd-Frank Act.\1073\
Commenters specifically suggested that the ``financial entity''
definition exclude: (i) Centralized hedging and treasury subsidiaries
in corporate groups; \1074\ (ii) employee benefit plans; \1075\ and
(iii) cooperative structures.\1076\ Commenters also requested
clarification as to which entities would not be ``subject to capital
requirements established by an appropriate Federal banking agency,''
and hence not subject to the third statutory test.\1077\ In addition,
commenters addressed the application of the ``financial entity''
definition to non-U.S. persons.\1078\
---------------------------------------------------------------------------

\1073\ See, e.g., letters from CalSTRS dated June 15, 2011
(``CalSTRS II''), Kraft, Newedge, NRU CFC I and Philip Morris.
\1074\ See letters from Kraft and Philip Morris.
\1075\ See letter from CalSTRS II (asserting that there is not a
basis to treat ERISA plans as ``financial entities'' for purposes of
the major participant definitions solely to maintain consistency
with an ``anomalous'' statutory provision).
\1076\ See letter from NRU CFC I.
\1077\ See letters from ACLI (requesting confirmation that the
exclusion from the third statutory test extends to entities subject
to bank or financial holding companies, entities deemed systemically
important under Title I of the Dodd-Frank Act, and any other persons
subject to capital regulation established by a Federal banking
regulator) and MetLife (requesting clarification that the exclusion
extends to persons subject to regulation and capital requirements on
a consolidated basis under federal banking law, and persons that are
individually or systemically important financial institutions under
Title I).
\1078\ One commenter took the view that non-U.S. governments and
their agencies should be excluded from the ``financial entity''
definition for purposes of the major participant definition and the
Title VII end-user exemption from mandatory clearing. See letter
from Milbank. On the other hand, one commenter favored the inclusion
of non-U.S. governments in the ``financial entity'' definition. See
meeting with Duffie on February 2, 2011 (suggesting that foreign
governments and other foreign jurisdictions, such as municipalities,
should be treated as ``financial entities'' for purposes of the
major swap participant definition and other requirements under the
Dodd-Frank Act on the grounds that such entities could become
sources of systemic risk).
The Commissions intend to issue separate releases addressing the
application of Title VII to non-U.S. persons.
---------------------------------------------------------------------------

b. ``Highly Leveraged''
A number of commenters supported the proposed 15 to 1 alternative
leverage ratio over the 8 to 1 alternative, with some commenters
further suggesting that the final rule should set a leverage ratio
higher than 15 to 1, or that the ratio should be reconsidered when more
information is available regarding leverage among swap users.\1079\ One
commenter supported the proposed 8 to 1 alternative,\1080\ and one
commenter

[[Page 30685]]

suggested that the final rule should set a leverage ratio lower than 8
to 1.\1081\ One commenter suggested a ratio of 12 to 1, consistent with
certain capital requirements.\1082\
---------------------------------------------------------------------------

\1079\ See letters from ISDA I (suggesting that the wide use of
leverage by financial institutions means that the definition should
capture only entities with the ``very highest'' leverage ratios, and
that the 15 to 1 ratio should be viewed as a floor for identifying
highly leveraged entities given that it is used in Title I to
address entities that have already been determined to pose a ``grave
threat'' to the stability of the U.S. financial system), MFA I
(stating that 15 to 1 is the more appropriate of the two choices,
and that the Commissions could subsequently adjust the ratio after
receiving market data on the use of leverage), AIMA I (encouraging
the Commissions to adopt the 15 to 1 leverage threshold until an
assessment of the impact of the major participant definitions can be
completed); Amex (supporting the use of the 15 to 1 ratio, noting
that it is consistent with the maximum leverage allowed to entities
designated as a grave threat to financial stability under Title I of
the Dodd-Frank Act) and CDEU (recommending use of the 15 to 1
standard, based on its consistency with the leverage limit in Title
I of the Dodd-Frank Act for entities posing a grave threat to the
United States financial system and that ``it would be unreasonable
to propose a stricter leverage threshold under the major participant
test for nonbank financial end-users,'' and expressing concern that
entities comfortably falling under the 8 to 1 ratio could
unexpectedly exceed this threshold during periods of market stress
and that sudden designation as a major participant ``could seriously
hinder a company from meeting its obligations'').
\1080\ See letter from Better Markets I (stating that the 8 to 1
threshold would better serve the purposes of the Dodd-Frank Act by
``ensuring that more, rather than fewer, financial entities are
covered by the risk mitigation and business conduct standards that
Congress established'' for major participants, and that use of the
15 to 1 leverage ratio from Title I of the Dodd-Frank Act is
inappropriate because the Title I ratio is used for the ``relatively
draconian'' purpose of imposing leverage limits, while this ratio
would be used for ``the more modest purpose of imposing registration
requirements'').
\1081\ See letter from Greenberger (suggesting that the leverage
test should be set at a ratio that is lower than either of the two
proposed levels).
\1082\ See meeting with MFA on February 14, 2011 (MFA
representatives making point that ``highly leveraged'' should be
defined in coordination with other regulations under the Dodd-Frank
Act, and for example, a requirement that banks hold 8% capital
implies a leverage ratio of approximately 12:1).
---------------------------------------------------------------------------

Commenters also suggested a variety of methods and adjustments for
calculating leverage ratios.\1083\
---------------------------------------------------------------------------

\1083\ The suggested adjustments were: to measure the ratio of
net current credit exposure to Tier I capital, in a manner similar
to that used by bank regulators (see letter from Greenberger); to
include as liabilities all unfunded exposures on swaps, both current
and potential (see letter from Better Markets I); and to account for
the different risk levels of various classes of assets and
liabilities and for other factors affecting a person's riskiness
(see letters from CCMR I and MFA I).
---------------------------------------------------------------------------

Some commenters further suggested that specific leverage tests be
applied to particular types of financial entities. For employee benefit
plans, commenters particularly stated that a plan's obligations to pay
benefits should not be considered a liability for purposes of the
analysis, and the value of the plan's assets should be used as the
denominator for the ratio in lieu of using the non-applicable term
``equity.'' \1084\ Another commenter--which obtains a substantial
amount of funding by issuing subordinated debt, rather than equity--
expressed the view that the leverage calculation should allow it to
treat subordinated debt as equity.\1085\
---------------------------------------------------------------------------

\1084\ See letters from CalSTRS I (also stating that for
purposes of determining leverage ratios, the value of the plan's
assets should be determined as of most recent annual valuation
rather than quarterly) and APG (stating that only investment-related
liabilities, rather than anticipated shortfalls in benefit
obligations, should be considered in the leverage calculation, and
the test should be adjusted to take into account legally binding
investment restrictions and other constraints that could be just as
effective, or more effective, at reducing insolvency risk as capital
requirements that would limit leverage).
\1085\ See letter from NRU CFC I (stating that this application
of the leverage test would be consistent with its financial
statements).
---------------------------------------------------------------------------

Several commenters addressed the application of the leverage ratio
to insurance companies in light of the applicable regulatory regimes
and their use of statutorily required accounting methods rather than
GAAP.\1086\ Those commenters took the view that an insurance company's
leverage should be tested based on its risk-based capital ratio or on
its statutory accounting statements, with certain adjustments to
account for different types of liabilities,\1087\ or based on whether
its insurance regulator believes that it is adequately
capitalized.\1088\ One commenter said that the leverage ratio test
should not apply to insurance companies,\1089\ and another said that
application of the leverage ratio test to insurance companies should be
coordinated with the FSOC.\1090\
---------------------------------------------------------------------------

\1086\ See letters from ACLI, FSR I, MetLife and NAIC.
\1087\ See letters from ACLI, FSR I and NAIC.
\1088\ See letter from MetLife.
\1089\ See letter from FSR I.
\1090\ See letter from NAIC.
---------------------------------------------------------------------------

3. Final Rules
a. ``Financial Entity''
Consistent with the Proposing Release, the final rules defining
``financial entity'' for purposes of the third major participant test
are based on the corresponding ``financial entity'' definition used in
the Title VII exception from mandatory clearing for end users, with
certain adjustments to avoid circularity.\1091\ In this regard, while
we are mindful of one commenter's views that the differences between
the major participant definitions and the end-user clearing exception
necessitate different ``financial entity'' definitions,\1092\ we do not
concur with the view that the term ``financial entity'' should be
interpreted independently in these two contexts. Both sets of
provisions distinguish between financial and non-financial entities in
a way that limits the impact of Title VII on the latter set of
entities, and we believe that the definitions should be consistent in
light of those parallel purposes.
---------------------------------------------------------------------------

\1091\ See CFTC Regulation Sec. 1.3(mmm)(1); Exchange Act rule
3a67-6(a). Accordingly, this general definition encompasses
commodity pools, private funds, ERISA plans, and persons
predominately engaged in activities that are in the business of
banking or financial in nature, as well as certain dealers or major
participants. See note 1066, supra.
\1092\ See letter from CalSTRS II (ERISA plans should not be
included in the definition of ``financial entity'' for purposes of
the major participant definitions).
---------------------------------------------------------------------------

The Commissions are aware, however, that the major participant
definitions differ from the mandatory clearing requirements in how they
address affiliates. The mandatory clearing requirements include a
provision that specifically addresses affiliates of persons that
qualify for the exception from mandatory clearing for end users,\1093\
while no such specific provision is included in the major participant
definitions. Given this absence, the Commissions believe it is
appropriate to modify the final rules defining ``financial entity'' for
purposes of the major participant definitions from the proposal to
exclude certain centralized hedging and treasury entities.\1094\ The
Commissions understand that a primary function of such centralized
hedging and treasury entities is to assist in hedging or mitigating the
commercial risks of other entities within their corporate groups.
Although those entities' activities could constitute being ``in the
business of banking or financial in nature,'' we do not believe that it
would be appropriate to treat a person as a ``financial entity'' for
the purposes of the major participant definitions if the person would
fall within that definition solely because it facilitates hedging
activities involving swaps or security-based swaps by majority-owned
affiliates that themselves are not ``financial entities.'' \1095\
Absent this change, the major participant analysis would exclude
hedging positions that do not use centralized hedging facilities, but
would not exclude identical hedging positions that make use of a
centralized hedging facility.\1096\ Such a result would inappropriately
discourage the use of centralized hedging and treasury entities.
---------------------------------------------------------------------------

\1093\ See CEA section 2(h)(7)(D); Exchange Act section
3C(g)(4).
\1094\ See CFTC Regulation Sec. 1.3(mmm)(2); Exchange Act rule
3a67-6(b).
\1095\ Consistent with the general inter-affiliate exceptions
from the dealer and major participant definitions, see parts II.C
and IV.G, for purposes of these rules, the counterparties are
majority-owned affiliates if one party directly or indirectly holds
a majority ownership interest in the other, or if a third party
directly or indirectly holds a majority interest in both, based on
holding a majority of the equity securities of an entity, or the
right to receive upon dissolution or the contribution of a majority
of the capital of a partnership. See CFTC Regulation Sec.
1.3(mmm)(1); Exchange Act rule 3a71-6(b)(2).
\1096\ We also note that this result is parallel to the Title
VII end-user exception from mandatory clearing, which extends to
hedging activities of financial entities on behalf of non-financial
affiliates. See CEA section 2(h)(7)(D); Exchange Act section
3C(g)(4).
---------------------------------------------------------------------------

While the Commissions also have considered the views of commenters
that the ``financial entity'' definition should exclude certain other
types of entities--such as employee benefit plans, and cooperatives--
the final rules do not provide any such exclusions. As a general
matter, the Commissions believe that the ``financial entity''
definition should be the same for purposes of the major participant

[[Page 30686]]

definition as it is for purposes of the end-user exception from
mandatory clearing.\1097\
---------------------------------------------------------------------------

\1097\ Similarly, the Commissions in general are not adopting
categorical requests for exclusions from the major participant
definitions. See part IV.J, infra.
---------------------------------------------------------------------------

We also have considered the views of some commenters that
subsidiaries of bank holding companies, financial holding companies or
systemically important financial institutions should be considered to
be ``subject to capital requirements established by an appropriate
Federal banking agency,'' and hence not subject to the third statutory
major participant test. We nonetheless interpret the term ``subject to
capital requirements established by an appropriate Federal banking
agency'' to specifically apply to persons for whom a Federal banking
agency directly sets capital requirements. We do not believe that the
term should be interpreted to apply to other persons by virtue of their
being part of a holding company that is subject to those capital
requirements, or otherwise being affiliated with persons subject to
those capital requirements, because we do not believe that the mere
fact of that relationship is sufficient to control or mitigate the
credit risk that those persons pose to their counterparties.
b. ``Highly Leveraged''
i. Leverage Ratio Level
After considering commenters' views, the Commissions are adopting
final rules that define ``highly leveraged'' to generally mean a ratio
of liabilities to equity in excess of 12 to 1.\1098\ Our adoption of
this 12 to 1 standard, rather than the proposed 8 to 1 or 15 to 1
alternatives, takes into account commenters' views on the alternatives,
as well as one commenter's support for a 12 to 1 ratio.\1099\
---------------------------------------------------------------------------

\1098\ See CFTC Regulation Sec. 1.3(mmm)(2); Exchange Act rule
3a67-7(a). The final rules defining ``highly leveraged'' have been
renumbered from the proposal for the sake of clarity.
\1099\ See note 1082, supra, and accompanying text.
---------------------------------------------------------------------------

In general, we believe that the structure of the third statutory
major participant test--which, unlike the first statutory test, does
not permit the exclusion of certain hedging positions--reasonably may
be interpreted as reflecting the determination that: (a) higher
leverage indicates that an entity poses a heightened risk of being
unable to meet its obligations; and (b) such entities should not be
permitted to exclude hedging positions from the ``substantial
position'' analysis in light of the counterparty risks those positions
pose (even recognizing that these may be lower than counterparty risks
posed by comparable non-hedging positions).
Commenters who addressed the proposed leverage ratio raised diverse
points of view in support of the 8 to 1 and 15 to 1 alternatives, or
other standards. A number of those commenters, however, appeared to
focus on the outcome of particular leverage ratios--i.e., that a lower
leverage ratio likely would lead to more major participants, and that a
higher leverage ratio likely would lead to fewer major participants--
and to base their conclusions on their views of that outcome. In
general, the comments did not reflect an attempt to identify typical
leverage ratios for financial entities, or to address the link between
leverage and risk.
Some commenters specifically supported the use of a 15 to 1
leverage ratio in light of Title I's use of that ratio.\1100\ While
considering this perspective, we believe it also is appropriate to
consider the different purposes for which leverage is addressed in the
Title I and major participant contexts. The 15 to 1 leverage provision
in Title I reflects a maximum allowable threshold of leverage for
certain bank holding companies and nonbank financial companies when a
determination has been made that such entities pose a ``grave threat to
the financial stability of the United States'' and that the imposition
of this limitation is necessary to mitigate the risks posed by such
entities--in essence serving as a hard leverage cap for certain
entities that have been deemed risky to the U.S. financial
system.\1101\ In contrast, leverage serves a type of gatekeeper
function in the major participant definitions by identifying the amount
of leverage that will require a non-bank financial entity to engage in
the ``substantial position'' analysis without excluding hedging
positions, rather than seeking to limit the maximum leverage available
to those entities. Just as concepts of ``maximum leverage'' are
distinct from concepts of ``high leverage,'' the use of a 15 to 1
maximum leverage ratio in Title I does not mandate the conclusion that
the same 15 to 1 ratio must be used for interpreting the meaning of
``highly leveraged'' in the major participant definitions.\1102\
---------------------------------------------------------------------------

\1100\ See, e.g., letters from Amex and CDEU.
\1101\ See Dodd-Frank Act section 165(j)(1).
\1102\ We also note that the use of the 15 to 1 ratio of Title I
in this context could lead to potentially incongruous results. In
particular, if the Commissions were to use the 15 to 1 leverage
ratio for the ``highly leveraged'' definition, then an entity that
is deemed to be such a threat to the United States financial system
that its leverage has been capped pursuant to Title I also would
effectively be excepted from the third statutory test of the major
participant definitions due to that cap. The 12 to 1 leverage ratio
that we are adopting today does not give rise to the same result and
therefore does not present the same question of interpretation as to
whether this result would be appropriate.
---------------------------------------------------------------------------

In considering the definition of the term ``highly leveraged''
based on the reasoning outlined above, we also are mindful that, as the
Proposing Release noted,\1103\ broker-dealer capital regulations
include special provisions that apply when a broker-dealer's leverage
exceeds 12 to 1.\1104\ While we recognize that these capital
regulations have limitations as tools for defining ``highly leveraged''
for purposes of the major participant definitions due to differences in
how leverage would be calculated,\1105\ we also believe that these
regulations are informative regarding the use of leverage in the major
participant context given that they highlight an existing link between
increased regulatory oversight and the amount of leverage an entity
maintains.
---------------------------------------------------------------------------

\1103\ See Proposing Release, 75 FR at 80199 n.152.
\1104\ Exchange Act rule 15c3-1 provides that a broker-dealer
may determine its required minimum net capital, among other ways, by
applying a financial ratio that provides that its aggregate
indebtedness shall not exceed 1500 percent of its net capital (i.e.,
a 15 to 1 aggregate indebtedness to net capital ratio). In addition,
Exchange Act rule 17a-11 further requires that broker-dealers that
use such method to establish their required minimum net capital must
provide notice to regulators if their aggregate indebtedness exceeds
1200 percent of their net capital (i.e., a 12 to 1 aggregate
indebtedness to net capital ratio).
\1105\ The measure of aggregate indebtedness in rule 15c3-1
excludes certain secured liabilities, and the measure of net capital
excludes certain illiquid assets but includes certain subordinated
debt. As a result, the ratios discussed above would not necessarily
be equivalent to 15:1 or 12:1 ratios when converted to a balance
sheet ratio of liabilities to equity.
---------------------------------------------------------------------------

In light of the reasons noted above for using a leverage ratio
below 15 to 1, commenter concerns that a ratio of 8 to 1 would be too
low, one commenter's suggestion of a 12 to 1 leverage ratio, and
leverage tests found in broker-dealer capital regulations, the
Commissions have determined that a 12 to 1 leverage ratio reflects an
appropriate basis for identifying ``highly leveraged'' financial
entities. In making this determination we recognize that other
approaches also may be reasonable (e.g., lower thresholds based on the
analysis of the leverage of certain financial entities also may be
reasonable, as may higher thresholds based on Title I and on other
aspects of broker-dealer capital rules). We also recognize, however,
that the need to implement the major participant definitions requires
that we draw a line. In our view, a 12 to 1 ratio reflects a

[[Page 30687]]

reasonable location for this line that is appropriate for purposes of
the third major participant test, and that reasonably accounts for
commenter concerns and the other considerations discussed above.
ii. Leverage Ratio Calculation
Consistent with the proposal, the final rules defining ``highly
leveraged'' generally measure leverage as a ratio of a person's
liabilities to equity, as determined in accordance with GAAP.\1106\
Also, consistent with the proposal, these leverage ratios should be
calculated as of the close of business on the last business day of the
applicable fiscal quarter, as we do not believe there is any relevant
difference among financial entities that would require timing
variations.
---------------------------------------------------------------------------

\1106\ See CFTC Regulation Sec. 1.3(mmm)(2); Exchange Act rule
3a67-7(b). The accounting standard setters are currently working on
a number of projects that may impact how leverage would be
calculated using GAAP. The Commissions will review and potentially
adjust their rules in the future to reflect changes in GAAP.
---------------------------------------------------------------------------

In general, moreover, the Commissions believe that all types of
financial entities should be subject to the same methods of measuring
leverage, to facilitate the even application of the leverage test. At
the same time, we are mindful of the significance of commenter concerns
that calculating leverage as a ratio of liabilities to equity
consistent with GAAP would lead to inappropriate results for certain
types of financial instruments or financial entities.
We believe that these concerns are significant enough to warrant
one modification of the proposed approach to measuring leverage. In
particular, the final rules provide that certain employee benefit plans
may: (i) Exclude obligations to pay benefits to plan participants from
their measure of liabilities for purposes of the leverage calculation;
and (ii) substitute the total value of plan assets for equity for
purposes of the leverage calculation.\1107\ We believe that this change
will allow the measure of leverage to more appropriately reflect the
risk that those entities pose.
---------------------------------------------------------------------------

\1107\ See CFTC Regulation Sec. 1.3(mmm)(2)(ii); Exchange Act
rule 3a67-7(b). These provisions specifically apply to employee
benefit plans as defined by paragraph (3) and (32) of section 3 of
ERISA, consistent with the ERISA exclusion from the first statutory
major participant test.
---------------------------------------------------------------------------

Otherwise, we do not believe that it would be appropriate to depart
from GAAP measures of equity and liabilities for purposes of
identifying highly leveraged entities.\1108\
---------------------------------------------------------------------------

\1108\ Although commenters raised issues with regard to the
application of leverage ratios to insurers, see, e.g., letter from
FSR I, we do not believe that it would be appropriate to create a
special leverage test for insurers. We note that insurers that are
publicly traded companies already file financial statements
consistent with GAAP. Also, smaller insurers that do not file GAAP-
based financial statements would be able to take advantage of the
safe harbor from the major participant calculations. See part IV.M,
infra.
---------------------------------------------------------------------------

G. Application to Inter-Affiliate Swaps and Security-Based Swaps

1. Proposed Approach and Commenters' Views
In the Proposing Release, we stated that the major participant
analysis should consider the economic reality of swaps and security-
based swaps between affiliates, and preliminarily concluded that swaps
or security-based swaps among wholly owned affiliates ``may not pose
the exceptional risks to the U.S. financial system that are the basis
for the major participant definitions.''\1109\
---------------------------------------------------------------------------

\1109\ See Proposing Release, 75 FR at 80202.
---------------------------------------------------------------------------

A number of commenters concurred that swaps among affiliates should
be excluded from the major participant analysis.\1110\ At the same
time, no commenters expressed support for the Proposing Release's
suggestion that this interpretation be limited to transactions among
wholly owned subsidiaries. Instead, several commenters expressed the
view that the swaps or security-based swaps should not be counted for
purposes of the major participant analysis when the counterparties are
under common control,\1111\ or otherwise are affiliates.\1112\ One
commenter suggested that the analysis exclude swaps or security-based
swaps between entities that are under common control and whose
financial statements are consolidated.\1113\
---------------------------------------------------------------------------

\1110\ See, e.g., letters from COPE I, FSR I and Encana
Marketing (USA) Inc. dated February 22, 2011 (``Encana I'').
Some commenters explained the widespread use of central hedging
desks to allocate risk within affiliate groups or to gather risk
from within a group and lay off that risk on the market. See, e.g.,
letters from CDEU, EEI/EPSA, Encana I and FSR I. Also, some
commenters noted that including these inter-affiliate transactions
within the major participant analysis would result in many cases in
double-counting of an entity's swap or security-based swap activity.
See letters from CDEU and FSR I.
\1111\ See letter from Amex and CDEU. One commenter specifically
suggested that we adopt the definition of ``control'' found in the
Bank Holding Company Act. See joint letter from The Bank of Tokyo-
Mitsubishi UFJ, Ltd., Mizuho Corporate Bank, Ltd. and Sumitomo
Mitsui Banking Corporation.
\1112\ See, e.g., letters from COPE I, EEI/EPSA, FSR I, Encana I
and Utility Group.
\1113\ See joint letter from ABA Securities Association, ACLI,
FSR, FIA, Institute of International Bankers, ISDA and SIFMA.
---------------------------------------------------------------------------

2. Final Rule
After considering commenters' views, we have concluded that the
major participant definitions should not encompass a person's swaps or
security-based swaps for which the counterparty is a majority-owned
affiliate. As noted in our discussion of inter-affiliate activities in
the context of the dealer definitions, market participants may enter
into such inter-affiliate swaps or security-based swaps for a variety
of purposes. When swaps and security-based swaps are entered into to
allocate risk within a corporate group and do not pose a high
likelihood of risk to the broader market--as we believe would be the
case with majority ownership--we do not believe that their swaps and
security-based swaps raise the systemic risk and other concerns that
major participant regulation is intended to address. For this reason,
we do not believe that this interpretation needs to be limited to swaps
or security-based swaps among wholly owned affiliates, as the Proposing
Release had indicated.
Accordingly, the final rules provide that a person may exclude
particular swaps or security-based swaps from the analysis of whether
the person is a major participant, so long as the counterparties to
those swaps or security-based swaps are majority-owned
affiliates.\1114\
---------------------------------------------------------------------------

\1114\ See CFTC Regulation Sec. 1.3(hhh)(4); Exchange Act rule
3a67-3(e). A person's market-facing swap or security-based swap
positions, including those taken to lay off risk assumed from a
majority-owned affiliate, must still be included in the person's
substantial position and counterparty exposure calculations.
For the purposes of this rule, and consistent with the general
inter-affiliate exception from the dealer definitions, see part
II.C, supra, counterparties are majority-owned affiliates if one
party directly or indirectly owns a majority interest in the other,
or if a third party directly or indirectly owns a majority interest
in both, based on the right to vote or direct the vote of a majority
of a class of voting securities of an entity, the power to sell or
direct the sale of a majority of a class of voting securities of an
entity, or the right to receive upon dissolution or the contribution
of a majority of the capital of a partnership.
---------------------------------------------------------------------------

In taking this approach, we have also considered alternatives
suggested by commenters. For example, while one commenter suggested
that we allow the exclusion of all swaps or security-based swaps
between entities under common control, we believe that such an approach
would be overly inclusive for the purpose of identifying transactions
that should be excluded from the major participant analysis, given that
common control by itself does not ensure that two entities' economic
interests are sufficiently aligned.\1115\ Also, one commenter suggested
that the inter-affiliate exclusion should apply to swaps and security-
based swaps between affiliates whose financial statements are
consolidated, but, as we

[[Page 30688]]

addressed in the context of the dealer definitions, we do not believe
that the scope of this exclusion should be exposed to the risk of
future changes in accounting standards.\1116\
---------------------------------------------------------------------------

\1115\ See part II.C.2, supra.
\1116\ See text accompanying note 350, supra.
---------------------------------------------------------------------------

H. Application to Positions of Affiliated Entities and to Guarantees

1. Proposed Approach
The Proposing Release expressed the preliminary view that when a
parent is the majority owner of a subsidiary entity, the subsidiary's
swap or security-based swap positions may be aggregated at the parent
for purposes of the major participant analysis, on the grounds that the
parent effectively is the beneficiary of the transaction. At the same
time, the Proposing Release acknowledged that there could remain
questions as to whether the requirements applicable to major
participants--such as capital, margin and business conduct
requirements--should be placed upon the parent or the subsidiary.\1117\
---------------------------------------------------------------------------

\1117\ The Proposing Release further recognized that it may be
appropriate at times to place the requirements upon the subsidiary
to the extent the subsidiary is acting on behalf of the parent. See
Proposing Release, 75 FR at 80202.
---------------------------------------------------------------------------

The Proposing Release solicited comment on a number of aspects of
these issues, including whether attribution would be appropriate when
there is less than majority ownership, or when a parent provides
guarantees on behalf of its subsidiaries. The Proposing Release also
solicited comment with regard to implementation issues.\1118\
---------------------------------------------------------------------------

\1118\ See id.
---------------------------------------------------------------------------

2. Commenters' Views
A number of commenters expressed the view that the Commissions
should not aggregate the positions of affiliates to the parent, arguing
that legal separation should be respected unless there is some evidence
that separate affiliates are being used to evade regulation.\1119\
Other commenters took the view that aggregation of affiliates'
positions may be appropriate in some circumstances, such as when
aggregation would accurately reflect the structure of a corporate group
or its participation in the derivatives market.\1120\ One commenter
recommended that if the Commissions choose to require the aggregation
of affiliate positions for purposes of the major participant test, the
Commissions also should provide a mechanism for entities to receive
``disaggregation'' relief upon a showing that the affiliates are acting
autonomously.\1121\
---------------------------------------------------------------------------

\1119\ See letters from FSR I, ISDA, MetLife and Newedge.
Certain of those commenters also warned of problems that could arise
if the positions of international affiliates were aggregated, due to
conflicting regulations potentially applicable to such entities. See
letters from ISDA I, MetLife and Newedge. The Commissions are
addressing issues related to the application of the major
participant definitions to non-U.S. persons in separate releases.
\1120\ See letters from CDEU (suggesting that control should be
interpreted narrowly for purposes of the major participant test such
that affiliated positions would only be aggregated if there is whole
ownership or consolidation for accounting purposes, and exercise of
actual control in terms of ownership and management) and ACLI
(suggesting flexibility such that an entity with independent credit
and no guarantee or credit support from a parent could be treated
separately, but a corporate group could consolidate its affiliates'
positions if that would accurately reflect its participation in the
derivatives market).
\1121\ See letter from Newedge.
---------------------------------------------------------------------------

Some commenters argued that positions should not be consolidated
for purposes of the major participant analysis even when a parent
guarantees the obligations of a subsidiary.\1122\ Other commenters,
however, expressed less opposition to aggregation in the presence of a
guarantee or credit support.\1123\
---------------------------------------------------------------------------

\1122\ See letters from APG (stating that the aggregation of
inter-affiliate guaranteed transactions would raise costs without
providing a corresponding benefit to the financial system, and that
principal obligors and guarantors pose separate credit risks, which
are already priced into the positions, and that guarantees are not
traditionally regulated as swaps), CDEU (objecting to attributing
the positions of an end-user affiliate that relies on a parent for
credit support, primarily out of concern that an end-user that might
otherwise avail itself of the end-user clearing exception might be
forced to clear its transactions if they were attributed to the
major participant parent), ISDA I and Twelve Firms (stating that the
statutory major participant definitions do not indicate that they
encompass contingent credit support arrangements, and that credit
exposures of subsidiaries already will be addressed through
regulation of the subsidiary).
\1123\ See letters from FSR I (suggesting that there may be some
situations in which the positions of different entities in a
corporate group should be aggregated, such as when ``a parent entity
guarantees the obligations of its subsidiaries that are engaging in
swaps'') and MetLife (stating that ``it is not appropriate to
require aggregation of subsidiaries' swaps at the parent level
unless the parent is providing a guarantee or credit support for the
subsidiaries' obligations''); see also letter from ACLI (stating
that the positions of entities that do not have a guarantee or
credit support from a parent are entitled to an individualized
determination of their status under the major participant test).
---------------------------------------------------------------------------

Commenters also addressed the application of these principles to
particular types of entities. Some commenters took the view that
positions guaranteed by financial guarantors should not be attributed
to those entities for purposes of the major participant analysis.\1124\
Other commenters stated that the positions of a special purpose vehicle
should not be aggregated with its sponsor where there is no recourse to
the sponsor for the vehicle's obligations.\1125\ One commenter
requested clarification that positions of joint ventures would not be
aggregated with those of another entity if the positions are not
consolidated on the other entity's balance sheet.\1126\ Commenters
further took the view that ERISA plans should not be aggregated with
those of plan sponsors for purposes of the major participant tests,
noting that plans and sponsors are separate legal entities, file
separate financial statements, are subject to separate regulatory
schemes, and that plan sponsors are prohibited from providing credit
support or guarantees to ERISA Title I plans.\1127\
---------------------------------------------------------------------------

\1124\ See letters from AFGI (arguing against attribution on the
grounds that the guarantors are typically not exposed to a
fluctuating termination value of interest rate swaps for these types
of transactions due to the fact that they do not guarantee that
amount, but rather only guarantee continued payments of these
policies, and also that they are subject to the standard
underwriting process and thus are subject to comprehensive
regulation) and joint letter from MBIA Inc., MBIA Insurance Corp.
and National Public Finance Guarantee Corp. (``MBIA'') (arguing
against attribution on the grounds that the economic exposure to the
financial guarantor is the equivalent of having underwritten a fixed
rate bond issued by the particular municipal entity, and such
exposures are subject to the normal underwriting process and
significant risk management and regulatory oversight).
\1125\ See letters from American Securitization Forum
(suggesting that aggregation is not appropriate when the risk is
contained within the special purpose vehicle, and noting that
special purpose vehicles often bear the entire economic risk of a
security-based swap transaction and are bankruptcy remote, so the
failure of a special purpose vehicle to meet its obligations would
not have a rippling effect onto its sponsor) and FSR I (stating that
the major participant determination should focus on a special
purpose entity itself, and not its sponsor or transferor, in
circumstances where securitization vehicles have been consolidated
with sponsors or transferors for financial accounting purposes but a
counterparty would have to conduct a separate credit analysis on the
special purpose entity, and its obligations are nonrecourse to the
sponsor or transferor).
\1126\ See letter from CDEU (noting that non-consolidated joint
ventures typically enter into their own swaps and these transactions
are not included on the balance sheet of a minority holder in a
joint venture).
\1127\ See letters from CDEU and ERISA Industry Committee.
---------------------------------------------------------------------------

Two commenters addressed operational compliance issues that would
be raised if positions are aggregated for purposes of the major
participant analysis. One commenter suggested that a corporate group
that falls within the major participant definition due to its aggregate
positions should be able to designate a single entity to undertake
compliance on behalf of the other affiliates.\1128\ Another commenter
stated that when the aggregated positions of a corporate group results
in major participant designation, the Commissions should

[[Page 30689]]

exempt from major participant regulation all affiliates in the
corporate group that otherwise would qualify for the end-user clearing
exception.\1129\
---------------------------------------------------------------------------

\1128\ See letter from FSR I (suggesting that a corporate group
should be permitted to designate a single entity or a small number
of entities as the registered major participant, with other entities
in the group relying on that entity for compliance).
\1129\ See letter from CDEU.
---------------------------------------------------------------------------

3. Final Interpretation
After considering commenter concerns and the underlying issues, we
are revising certain of the preliminary views we expressed in the
Proposing Release. In particular, we no longer take the position that a
subsidiary's swap or security-based swap position as a matter of course
should be attributed to the subsidiary's majority-owner parent.
Instead, consistent with the approach discussed below with regard to
managed accounts,\1130\ an entity's swap or security-based swap
positions in general would be attributed to a parent, other affiliate
or guarantor for purposes of the major participant analysis to the
extent that the counterparties to those positions would have recourse
to that other entity in connection with the position. Positions would
not be attributed in the absence of recourse.\1131\ We believe this
approach in general appropriately reflects the risk focus of the major
participant definitions by providing that entities will be regulated as
major participants when they pose a high level of risk in connection
with the swap and security-based swap positions they guarantee.\1132\
Indeed, the events surrounding the failure of AIG FP highlights how the
guarantees can cause major risks to flow to the guarantor.\1133\
---------------------------------------------------------------------------

\1130\ See part IV.I, infra.
\1131\ In taking this position, we are not suggesting that the
presence of a guarantee would be determinative of other issues
arising under Title VII. For example, the fact that a parent that is
a ``financial entity'' guarantees a subsidiary's swap or security-
based swap positions would not foreclose the subsidiary from taking
advantage of the exception from mandatory clearing that is available
to commercial end-users.
\1132\ In reaching this conclusion, we have been mindful of
views expressed by some commenters that the mere fact of a guarantee
should not be enough to require the attribution of a position to a
guarantor. We believe, however, that this approach is best suited to
address the risk focus of the major participant definitions. We
further believe that the statutory definition's language that
addresses persons who ``maintain'' substantial positions or
``whose'' positions create substantial counterparty exposure is
consistent with this approach.
We also have considered arguments that the major participant
definition should not extend to financial guarantee insurers. We
nonetheless believe that when an insurer guarantees the performance
of other parties' swap or security-based swap positions, in an
amount that is greater than the applicable major participant
thresholds, it would be appropriate to regulate that entity as a
major participant. When the guaranteed positions are large enough,
the risks associated with those positions and the repercussions of
the guarantor's default would appear to be within the ambit of the
risks that that the major participant definitions were intended to
capture. In reaching this conclusion, the Commissions are not
expressing a view regarding whether financial guarantee insurance is
a swap or security-based swap. See Product Definitions Proposal,
note 3, supra.
\1133\ ``AIGFP's obligations were guaranteed by its highly-rated
parent company * * * an arrangement that facilitated easy money via
much lower interest rates from the public markets, but ultimately
made it difficult to isolate AIGFP from its parent, with disastrous
consequences.'' The AIG Rescue, Its Impact on Markets, and the
Government's Exit Strategy, note 913, supra, at 20.
---------------------------------------------------------------------------

Even in the presence of a guarantee, however, we do not believe
that it is necessary to attribute a person's swap or security-based
swap positions to a parent or other guarantor if the person already is
subject to capital regulation by the CFTC or SEC (i.e., swap dealers,
security-based swap dealers, major swap participants, major security-
based swap participants, FCMs and broker-dealers) or if the person is a
U.S. entity regulated as a bank in the United States. Positions of
those regulated entities already will be subject to capital and other
requirements, making it unnecessary to separately address, via major
participant regulations, the risks associated with guarantees of those
positions.\1134\
---------------------------------------------------------------------------

\1134\ As a result of this interpretation, holding companies
will not be deemed to be major participants as a result of
guarantees to certain U.S. entities that already are subject to
capital regulation. The Commissions intend to address guarantees
provided to non-U.S. entities, and guarantees by non-U.S. holding
companies, in separate releases.
---------------------------------------------------------------------------

We recognize that attribution of swap or security-based swap
positions to a parent or guarantor for purposes of the major
participant analysis can raise special issues with regard to
operational compliance. These include, for example, issues as to the
application of the transaction-focused requirements applicable to
registered major participants (e.g., certain requirements related to
trading records and transaction confirmations), given that the entity
that directly is the party to the swap or security-based swap may be
better positioned to comply with those requirements. For those
transaction-focused requirements, we believe that an entity that
becomes a major participant by virtue of swaps or security-based swaps
directly entered into by others must be responsible for compliance with
all applicable major participant requirements with respect to those
swaps or security-based swaps (and must be liable for failures to
comply), but may delegate operational compliance with transaction-
focused requirements to entities that directly are party to the
transactions. The entity that is the major participant, however, cannot
delegate compliance duties with the entity-level requirements
applicable to major participants (e.g., requirements related to
registration and capital).\1135\
---------------------------------------------------------------------------

\1135\ This type of attribution may also be expected to raise
special issues of application in the context of guarantees involving
swap or security-based swap positions of non-U.S. entities. The
Commissions intend to address those issues in separate releases.
---------------------------------------------------------------------------

I. Application to Managed Accounts

1. Proposed Approach
The Proposing Release expressed the preliminary view that the major
participant definitions should not be interpreted to cause asset
managers or investment advisers to be major participants by virtue of
the swap and security-based swap positions of the accounts that they
manage.\1136\ In addition, the Proposing Release expressed the
preliminary view that the managed positions for which a person is a
beneficial owner should be aggregated with the person's other positions
for the purpose of determining whether the beneficial owner is a major
participant.\1137\
---------------------------------------------------------------------------

\1136\ In reaching this preliminary conclusion, we considered
the text of the major participant definitions, as well as a colloquy
on the Senate floor that addressed the status of managed accounts
for purposes of the major participant definitions. See Proposing
Release, 75 FR at 80201 & n.162.
The Proposing Release also noted that the Commissions have anti-
evasion authority to the extent that persons seek to allocate swaps
or security-based swaps among different accounts to seek to evade
the regulations applicable to major participants. See id. at 80201.
\1137\ See id.
---------------------------------------------------------------------------

2. Commenters' Views
Numerous commenters supported the view that the major participant
definitions should not be construed to aggregate the accounts managed
by asset managers or investment advisers when determining whether a
manager or adviser itself is a major participant.\1138\ One commenter
requested that the final rules codify this principle.\1139\
---------------------------------------------------------------------------

\1138\ See, e.g., letters from BlackRock I and Fidelity.
\1139\ See letter from Fidelity (particularly addressing fund
managers).
---------------------------------------------------------------------------

Some commenters opposed the possibility that the swap or security-
based swap positions of mutual funds would be attributed to fund
investors for purposes of the major participant analysis, emphasizing
that the fund is the entity that bears the credit exposure.\1140\ Some
commenters also opposed the possibility that a swap or security-based
swap position of a managed account may be attributed to the account's
beneficial owner when the counterparty to the position does not

[[Page 30690]]

have recourse to the beneficial owner's assets.\1141\
---------------------------------------------------------------------------

\1140\ See letter from BlackRock and joint letter from ICI and
SIFMA AMG.
\1141\ See letters from SIFMA AMG II (stating that ISDA Master
Agreements commonly provide that the counterparty to the transaction
does not have recourse to the accountholder's other assets held in
different accounts) and Fidelity (stating that when counterparties
look solely to the credit and assets of an individual account, the
actual risks to the counterparty are tied to and limited by the
activities of the account; also stating that requiring aggregation
of separate accounts based on beneficial ownership would be
complicated, costly, and present substantial operational and legal
complexities); see also letter from BlackRock I (stating the
understanding that the Proposing Release's reference to beneficial
ownership to require that separate account positions be attributed
to the owner of the separate account, and stating that this result
would be consistent with the definitions' focus on the persons whose
positions create credit risk).
Commenters also emphasized potential impracticalities of
requiring asset managers to be responsible for making major
participant determinations on behalf of beneficial owners. See,
e.g., letter from SIFMA AMG II.
---------------------------------------------------------------------------

One commenter encouraged the Commissions to consider developing
anti-evasion measures if necessary, but cautioned that the rules should
recognize that there are legitimate business reasons to structure
separate, individually managed funds.\1142\ Another commenter dismissed
concerns that entities may spread assets among many asset managers or
use separate trading agreements to avoid regulation.\1143\
---------------------------------------------------------------------------

\1142\ See letter from AIMA I.
\1143\ See letter from SIFMA AMG II (arguing that it would be
unlikely for this sort of evasion to actually occur since such
tactics would be prohibitively expensive and operationally
burdensome, and further stating that the Commissions could address
such concerns through their anti-evasion authority).
Also, one commenter suggested that major participant obligations
should be limited in their territorial scope and should only apply
to U.S. funds or those funds that are otherwise regulated in the
U.S. See letter from AIMA I. The Commissions are addressing issues
related to the application of the major participant definitions to
non-U.S. persons in separate releases.
---------------------------------------------------------------------------

In addition, commenters raised related issues regarding the
potential attribution of positions for purposes of the major
participant analysis. Some commenters expressed the view that insurance
company separate accounts should be excluded from the major participant
determination for the insurer, because those separate accounts
generally are segregated from the insurance company's other
accounts.\1144\ Two commenters requested clarification as to how swap
and security-based swap positions of funds with a ``master-feeder''
structure should be allocated for the major participant
determinations.\1145\
---------------------------------------------------------------------------

\1144\ See letters from ACLI, FSR I and MetLife.
\1145\ See letters from MFA I (stating that in master-feeder
fund structures, money that is invested flows to the master fund for
actual investing or trading, and further explaining that the master
fund: Is the party to the master trading agreements; negotiates the
individual transactions; holds assets; receives the margin calls; is
ultimately responsible for posting collateral; and is the entity to
whom recourse is generally limited) and CCMR I.
---------------------------------------------------------------------------

3. Final Interpretation
Consistent with the approach set forth in the Proposing Release,
the Commissions do not believe that it is necessary to consider the
swap or security-based swap positions of the client accounts managed by
asset managers or investment advisers when determining whether those
entities are major participants. In reaching this conclusion we
particularly are influenced by the fact that the statutory definitions
specifically address entities that ``maintain'' substantial positions
or ``whose'' outstanding swaps and security-based swaps create
substantial counterparty exposure. Our conclusion also is influenced by
the fact that it would not appear appropriate to impose certain
regulations applicable to major participants (e.g., capital) upon those
entities.\1146\
---------------------------------------------------------------------------

\1146\ We do not believe that it is necessary to codify this
interpretation.
---------------------------------------------------------------------------

Separately, after carefully considering commenters' views and the
purposes of major participant regulation, we are modifying the
preliminary views expressed in the Proposing Release regarding the
application of the major participant analyses to the beneficial owners
of managed swap and security-based swap positions. In particular, we
conclude that the major participant analysis that applies to the
beneficial owners of those positions should focus on where the risk
associated with those positions ultimately resides, given how the
statutory major participant definitions focus on the risks posed by
large swap or security-based swap positions. Thus, for example, if the
counterparties to a swap or security-based swap position within a
managed account have recourse only to the assets of that account in the
event of default--and lack recourse to other assets of the beneficial
owners--we do not believe that it would be appropriate to attribute
that position to its beneficial owner. \1147\ Conversely, to the extent
that the counterparty to that position also has recourse to the
beneficial owner, it would be appropriate to attribute the positions to
the beneficial owner for purposes of the major participant
analysis.\1148\
---------------------------------------------------------------------------

\1147\ Thus, for example, there would not be recourse to the
owners of shares in a registered investment company that maintains
swap or security-based swap positions.
\1148\ For example, under some circumstances the positions
within the managed account may make use of a credit support annex
entered into by the beneficial owner. In that case, the counterparty
to the account's swaps and security-based swaps may have legal
recourse to the beneficial owner, making it appropriate to attribute
the position to the beneficial owner for purposes of the major
participant analysis.
---------------------------------------------------------------------------

We believe that this general approach of attributing positions when
recourse is possible also is applicable with respect to related issues
raised by commenters, including issues related to insurance company
separate accounts and master-feeder fund arrangements. For those
situations the same principle would apply--positions within an account
or entity may be attributed to another entity for purposes of the major
participant analysis if the counterparties to those positions can seek
recourse from that other entity.

J. Requests for Exclusion of Certain Entities From the Major
Participant Definitions

1. Proposed Approach
In advance of the Proposing Release, a number of commenters argued
that the Commissions should exclude various types of entities from the
major participant definitions.\1149\ While the proposed rules did not
incorporate any such exclusions, the Proposing Release solicited
comment as to potential exclusions for: Entities that maintain legacy
portfolios, investment companies, ERISA plans, registered broker-
dealers and/or registered FCMs, sovereign wealth funds, banks, state-
regulated insurers, private and state pension plans, and registered
DCOs or clearing agencies.\1150\
---------------------------------------------------------------------------

\1149\ These comments were submitted in response to the ANPRM.
See notes 4 and 5, supra.
\1150\ See Proposing Release, 75 FR at 80202-03.
---------------------------------------------------------------------------

2. Commenters' Views
Several commenters supported categorical exclusions from the major
participant definitions for various types of entities. Commenters
particularly urged the Commissions to provide exclusions for:
Entities that maintain legacy portfolios of swaps and
security-based swaps that are in run-off;\1151\
---------------------------------------------------------------------------

\1151\ See, e.g., letters from Canadian MAVs, ISDA I and MBIA.
---------------------------------------------------------------------------

Registered investment companies and related investment
advisers;\1152\
---------------------------------------------------------------------------

\1152\ See letters from Fidelity and Vanguard and joint letter
from ICI and SIFMA AMG.
---------------------------------------------------------------------------

ERISA plans, other pension funds, and endowments;\1153\
---------------------------------------------------------------------------

\1153\ See letters from CDEU, ERISA Industry Committee and SIFMA
AMG II (addressing ERISA plans); see also letters from ABC/CIEBA,
CalSTRS I, Fidelity and SIFMA AMG II, (addressing government plans)
and letter from Government of Singapore Investment Corp. (``GIC'')
(addressing other pension plans and endowments). But see letter from
AFSCME (urging caution with respect to a full exclusion of plan
swaps from major participant consideration).

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

[[Page 30691]]

Insurance companies;\1154\
---------------------------------------------------------------------------

\1154\ See letters from AFGI (supporting exclusion for state-
regulated insurers), NAIC (supporting exclusion for state-regulated
insurers to the extent they are using derivatives for the purpose of
hedging and not engaging in systemically significant derivatives
activities determined by the Financial Stability Oversight Counsel),
ACLI (supporting exclusion for life insurers) and AIA (supporting
exclusion for property-casualty insurers).
---------------------------------------------------------------------------

Certain registered FCMs and broker-dealers.\1155\
---------------------------------------------------------------------------

\1155\ See letter from Newedge (supporting exclusion for
registered FCMs and broker-dealers that engage principally in
customer swap facilitation activities but not in other activities of
swap or security-based swap dealers).
---------------------------------------------------------------------------

End users; \1156\ and
---------------------------------------------------------------------------

\1156\ Commenters making this point varied in their phrasing of
the requested exclusion. One request asked for the exclusion of any
company (regardless of its primary business) that uses swaps
predominantly to hedge business risks and that does not pose
systemic risk. See letter from CDEU. Another commenter asked for the
exclusion of any end user employing prudent risk management. See
letter from NAIC. And one commenter asked for the exclusion of
energy companies that use swaps to hedge commercial risks. See
letter from EDF Trading.
---------------------------------------------------------------------------

Various types of non-U.S. persons, including: foreign
governments and their agencies and instrumentalities (such as central
banks, treasury ministries, export agencies and governmental financing
authorities),\1157\ international organizations and multilateral
development banks,\1158\ sovereign wealth funds,\1159\ and non-U.S.
entities subject to comparable foreign regulation.\1160\
---------------------------------------------------------------------------

\1157\ See letters from Milbank Tweed and Norges Bank Investment
Management and meeting with Kreditanstalt f[uuml]r Wiederaufbau
(``KfW'').
\1158\ See letter from World Bank Group.
\1159\ See letters from China Investment Corporation (``CIC'')
and GIC.
\1160\ See letters from Newedge and SIFMA AMG II.
---------------------------------------------------------------------------

Commenters articulated a range of rationales in support of such
exclusions. These included arguments that particular types of entities:
(i) Are unlikely to meet one or more of the major participant tests;
\1161\ (ii) already are subject to regulation (and in some cases are
subject to prudential limits on their use of swaps or security-based
swaps);\1162\ (iii) do not pose systemic risk \1163\ and/or the type of
counterparty risk contemplated by Title VII; \1164\ or (iv) do not
raise concerns given that they would remain subject to the clearing,
exchange trading, and reporting requirements of Title VII.\1165\ Also,
some commenters maintained that regulating non-U.S. entities as major
participants would raise issues with respect to extra-territoriality,
international comity and sovereignty.\1166\
---------------------------------------------------------------------------

\1161\ See letters from AIMA I (addressing hedge fund managers
registered as investment advisers); AIA (addressing property-
casualty insurers) and Newedge (addressing FCMs and broker-dealers).
\1162\ See letters from Fidelity and Vanguard and joint letter
from ICI and SIFMA AMG (addressing registered investment companies
and their advisors), ABC/CIEBA, CDEU, ERISA Industry Committee and
Fidelity (addressing ERISA plans and government benefit plans), ACLI
(addressing life insurers), AIA (addressing property-casualty
insurers), NAIC (addressing state-regulated insurers), Newedge
(addressing FCMs and broker-dealers) and GIC (addressing sovereign
wealth funds).
\1163\ See letters from ABC/CIEBA and CDEU (addressing ERISA
plans), ICI I and Vanguard (addressing registered investment
companies), ACLI (addressing life insurers), CDEU and NAIC
(addressing end users), and letter from CIC and meeting with Weil
(addressing sovereign wealth funds).
\1164\ See letters from CDEU and ERISA Industry Committee
(addressing ERISA plans) and letter from GIC and meeting with Weil
(addressing sovereign wealth funds).
\1165\ See letters from Vanguard (addressing registered
investment companies), Newedge (addressing FCMs and broker-dealers),
and CIC (addressing sovereign wealth funds).
\1166\ See letters from CIC, GIC, and Milbank Tweed and meeting
with KfW (addressing foreign governments and their agencies and
instrumentalities), meeting with Weil (addressing sovereign wealth
funds)and letter from World Bank Group (addressing international
organizations and multilateral development banks).
---------------------------------------------------------------------------

In contrast to these requests, one commenter urged that the
benefits arising from regulation of major participants be considered in
determining whether to create carve-outs from the participant
definitions that are not provided in the statute.\1167\
---------------------------------------------------------------------------

\1167\ See letter from AFSCME.
---------------------------------------------------------------------------

3. Final Rules
After considering the comments received and the underlying issues,
the Commissions have determined not to provide categorical exclusions
from the major participant definitions for the types of entities
discussed by commenters.
a. Entities That Maintain Legacy Portfolios
Commenters that supported the exclusion of entities with legacy
portfolios of swaps or security-based swaps emphasized that those
portfolios are in run-off, and that those entities generally do not
engage in ongoing swap or security-based swap activity.\1168\ Several
of those commenters further expressed concerns that imposing the
regulations applicable to major participants--particularly margin and
capital rules--upon these entities could cause them to default on their
obligations and lead to market disruption.\1169\
---------------------------------------------------------------------------

\1168\ See letters from AFGI, BlackRock I, Canadian MAVs, ISDA I
and MBIA and meetings with Athilon Structured Investment Advisors
(``Athilon'') on April 18, 2011 and with Cypress Group, Invicta
Financial Group, Primus Asset Management, Inc., and Quadrant
Structured Investment Advisors on April 7, 2011.
Although the Proposing Release specifically addressed granting
an exclusion in connection with legacy positions entered into by
monoline insurers and credit derivative product companies,
commenters expressed the view that such an exclusion should apply to
other types of entities that maintain legacy portfolios, such as
certain special purpose vehicles. See letters from BlackRock I,
Canadian MAVs and ISDA.
\1169\ See letters from Athilon, BlackRock I, Canadian MAVs, and
ISDA I.
---------------------------------------------------------------------------

In the view of the Commissions, the fact that these entities no
longer engage in new swap or security-based swap transactions does not
overcome the fact that entities that are major participants will have
portfolios that are quite large and could pose systemic risk to the
U.S. financial system.
We are mindful of the significance of concerns that regulating
entities that maintain legacy portfolios has the potential to lead to
defaults and disruption. We do not believe, however, that these
concerns are best addressed by excluding those entities from major
participant regulation. Instead, in adopting substantive rules
applicable to major participants, the Commissions intend to pay
particular attention to the special issues raised by the application of
those rules to legacy portfolios.\1170\ Moreover, to the extent that
these types of concerns remain following the promulgation of those
final substantive rules, the Commissions may entertain requests for
relief or guidance on a case-by-case basis.
---------------------------------------------------------------------------

\1170\ For example, in conjunction with the SEC's proposed
margin and capital rules applicable to major participants, the SEC
expects to request comment on how the rules should apply to entities
with legacy portfolios.
---------------------------------------------------------------------------

b. Other Domestic Entities
Commenters also raised concerns regarding duplicative regulation
for entities that already are subject to other types of regulation
(e.g., state-regulated insurers, SEC-regulated registered investment
companies and broker-dealers, and CFTC-regulated registered FCMs). The
final rules nonetheless provide no such exclusion. The Dodd-Frank Act
provided for the regulation of major participants against the backdrop
of existing state and federal regulation, without opting to
categorically exclude particular types of entities. Indeed, the
definitions explicitly anticipate that

[[Page 30692]]

pension plans \1171\ and banks \1172\--both of which are subject to
existing regulation--may be major participants. Major participant
regulation provides a regulatory structure prescribed by the Dodd-Frank
Act to address the risks posed by entities whose swap or security-based
swap positions are large enough to satisfy the major participant
definitions. Other types of regulations to which these entities may be
subject serve different objectives \1173\ that are not substitutes for
major participant regulation.\1174\
---------------------------------------------------------------------------

\1171\ The first major participant test (but not the second or
third tests) excludes positions maintained by certain employee
benefit plans for the primary purpose of hedging or mitigating any
risk directly associated with the operation of the plan. See CEA
section 1a(33)(A)(i)(II); Exchange Act section 3(a)(67)(A)(ii)(I).
This tailored exclusion of certain pension plan positions suggests
that Congress did not intend to broadly exclude such plans from the
other two prongs or from the major participant definitions as a
whole. The fact that, as two commenters noted (see letters from ABC/
CIEFA and CDEU), the CFTC previously has relied on the regulatory
structure already governing ERISA plans as a basis to not regulate
these plans in other certain unrelated contexts does not alter this
conclusion.
\1172\ The third major participant test excludes entities that
are subject to bank capital standards, which suggests that such
entities may be eligible to be major participants under the first
and second tests. Also, the capital and margin requirements
applicable to major swap participants and major security-based swap
participants (see Dodd-Frank Act sections 731 and 764, respectively)
do not apply to major participants subject to capital rules set by
bank regulators, which further indicates that such entities may be
major participants.
\1173\ As some commenters noted, entities excluded from the
major participant definitions nonetheless may be subject to other
requirements of general applicability imposed by Title VII, such as
clearing, trade execution, and reporting requirements. Even where
that is the case, though, these requirements serve separate and
independent purposes. They do not stand as a substitute for the
protections that Congress has prescribed with respect to major
participants in particular.
\1174\ For example, as noted above, some commenters stated that
the major participant definitions should not apply to investment
companies registered under the ICA. See, e.g., letters from
Fidelity, ICI I and Vanguard. However, we are not adopting any such
exclusions in part because the major participant definitions focus
on the market impacts of an entity's swap and security-based swap
positions and the risk to the U.S. financial system generally, areas
that are not the focus of the regulation of investment companies
under the ICA. Moreover, based on our understanding of the swap and
security-based swap activity of registered investment companies, we
believe that registered investment companies generally are not
likely to meet the thresholds of the major participant definitions.
We will continue to monitor the effects of the rules we are adopting
today to help ensure that they do not result in any inadvertent
consequences for registered investment companies, or other entities
registered with the SEC or CFTC.
---------------------------------------------------------------------------

The Commissions expect that only a very few entities within a given
category may meet the test of being a major swap participant--or even
be close to the various thresholds for meeting that test. Entities that
do not meet the thresholds of the major participant definitions do not
need an exclusion from those definitions. Further, as noted elsewhere
in this Adopting Release, the Commissions are permitting entities to
rely on a ``safe harbor'' when their positions are far below any
threshold for any particular quarter. Some of the entities for which
exclusion has been sought may be expected to fall within the safe
harbor. Those comparatively fewer entities that will be closer to a
particular threshold, by contrast, should not be excused on a per se
basis from completing the calculations set forth in these rules and, if
the calculations demonstrate that the entity meets the test of a major
participant, from compliance with the requirements for major
participants set forth by Congress.
At the same time, the Commissions recognize the benefits of
efficiently regulating major participants that are separately
registered with and regulated by the CFTC or SEC (such as registered
FCMs or broker-dealers).\1175\ If any such registrants are required
also to register as major participants, the CFTC and SEC would seek to
coordinate their regulatory oversight as appropriate to achieve the
independent purposes of major participant regulation and those separate
regulatory requirements, while avoiding unnecessary duplication.\1176\
---------------------------------------------------------------------------

\1175\ The Commissions also sought comment as to whether the
major participant definitions should apply to derivatives clearing
organizations or clearing agencies, but received no comments in
response to this inquiry. Nonetheless, the Commissions do not
believe that Congress intended derivatives clearing organizations
registered with the CFTC or clearing agencies registered with the
SEC to be registered or regulated as major participants. The CFTC
and the SEC already exercise substantive regulatory oversight over
these clearinghouses, authority that was enhanced by Title VII.
Further, Title VIII of the Dodd-Frank Act provides for the
supervision of systemically important derivatives clearing
organizations and clearing agencies. See Dodd-Frank Act Title VIII.
We do not believe that Congress intended to place a third layer of
oversight on those entities by subjecting them to additional
regulation as major participants, and we do not interpret the major
participant definitions to do so.
\1176\ For many years, the Commissions have coordinated their
examination of dually-registered FCM/BDs through working groups
including the Joint Audit Committee and the Intermarket Financial
Surveillance Group. Moreover, pursuant to Title IV of the Dodd-Frank
Act, the CFTC and SEC have issued joint reporting rules for advisors
to private funds that are dually registered with the SEC as
investment advisers and with the CFTC as commodity pool operators or
commodity trading advisors. See CFTC and SEC, Reporting by
Investment Advisers to Private Funds and Certain Commodity Pool
Operators and Commodity Trading Advisors on Form PF; Final Rule, 76
FR 71127 (Nov. 16, 2011).
---------------------------------------------------------------------------

c. Foreign Entities
Commenters \1177\ discussed the major participant definitions in
the context of foreign governments and various entities related to
foreign governments \1178\ (i.e., foreign central banks,\1179\
international financial institutions \1180\ and sovereign wealth
funds). The CFTC provides the following guidance with respect to the
major swap participant definition and the swap dealer definition.\1181\
---------------------------------------------------------------------------

\1177\ See letters from CIC, GIC, Milbank Tweed, Norges Bank
Investment Management and the World Bank, and meetings with KfW and
Weil.
\1178\ For this purpose, we consider 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.
\1179\ For this purpose, we consider 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.
\1180\ For this purpose, we consider 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 term international financial
institution includes entities referred to as multilateral
development banks. The International Bank for Reconstruction and
Development, the International Finance Corporation and the
Multilateral Investment Guarantee Agency are parts of the World Bank
Group.)
\1181\ The SEC intends to address issues related to the
application of the major security-based swap participant definition
to non-U.S. entities as part of a separate release that the SEC is
issuing in connection with the application of Title VII to non-U.S.
persons. The SEC is also able to address concerns related to the
individual substantive rules applicable to major security-based swap
participants on a case-by-case basis.
---------------------------------------------------------------------------

As an initial matter, foreign entities are not necessarily immune
from U.S. jurisdiction for commercial activities undertaken with U.S.
counterparties or in U.S. markets.\1182\ In accordance with

[[Page 30693]]

the general rule, a per se exclusion for foreign entities from the
CEA's major swap participant or swap dealer definition, therefore, is
inappropriate. A foreign entity's swap activity may be commercial in
nature and may qualify it as a swap dealer or major swap participant.
Registration and regulation as a swap dealer or major swap participant
under such circumstances may be warranted.\1183\ This is particularly
true for foreign corporate entities and sovereign wealth funds, which
act in the market in the same manner as private asset managers.
---------------------------------------------------------------------------

\1182\ See Foreign Sovereign Immunities Act of 1976, 28 U.S.C.
1602 (``under international law, states are not immune from the
jurisdiction of foreign courts insofar as their commercial
activities are concerned * * * Claims of foreign states to immunity
should henceforth be decided by courts of the United States and of
the States in conformity with the principles set forth in this
chapter.''). See also Mendaro v. World Bank, 717 F.2d 610 (DC Cir.
1983) (multilateral development banks generally do not have immunity
in connection with their commercial dealings in the United States);
Osseiran v. International Financial Corp., 552 F.3d 836 (DC Cir.
2009) (same); Vila v. Inter-American Investment Corp., 570 F.3d 274
(DC Cir. 2009) (same).
\1183\ Such a registration requirement would have to satisfy the
requirements of CEA section 2(i), 7 U.S.C. 2(i), which provides that
the provisions of Title VII relating to swaps ``shall not apply to
activities outside the United States unless those activities--(1)
Have a direct and significant connection with activities in, or
effect on, commerce of the United States; or (2) contravene such
rules or regulations as the Commission may prescribe or promulgate
as are necessary or appropriate to prevent the evasion of any
provision of [the CEA] that was enacted by'' Title VII of the Dodd-
Frank Act.
---------------------------------------------------------------------------

On the other hand, the sovereign or international status of foreign
governments, foreign central banks and international financial
institutions that themselves participate in the swap markets in a
commercial manner is relevant in determining whether such entities are
subject to registration and regulation as a major swap participant or
swap dealer. Canons of statutory construction ``assume that legislators
take account of the legitimate sovereign interests of other nations
when they write American laws.'' \1184\ There is nothing in the text or
history of the swap-related provisions of Title VII to establish that
Congress intended to deviate from the traditions of the international
system by including foreign governments, foreign central banks and
international financial institutions within the definitions of the
terms ``swap dealer'' or ``major swap participant,'' thereby requiring
that they affirmatively register as swap dealers or major swap
participants with the CFTC and be regulated as such.\1185\ The CFTC
does not believe that foreign governments, foreign central banks and
international financial institutions should be required to register as
swap dealers or major swap participants.
---------------------------------------------------------------------------

\1184\ 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).
\1185\ To the contrary, section 752(a) of the Dodd-Frank Act
requires the CFTC 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 * * *''
---------------------------------------------------------------------------

K. Financing Subsidiary Exclusion From Major Swap Participant
Definition

In connection with the definition of major swap participant, CEA
section 1a(33)(D) excludes certain entities from the definition of a
major swap participant 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 (the ``captive finance company exception'').\1186\ This
provision of the Dodd-Frank Act is not applicable to major security-
based swap participants.
---------------------------------------------------------------------------

\1186\ 7 U.S.C. 1a(33)(D).
---------------------------------------------------------------------------

1. Proposal
The Proposing Release restated the statutory captive finance
company exception but did not further define or detail its scope or
parameters. Accordingly, the CFTC did not propose a specific rule
excluding certain financing subsidiaries from the definition of major
swap participant in the Proposing Release.
2. Commenters' Views
Commenters generally believed that the captive finance company
exception should be broadly construed to cover financing of products
being sold by the parent company or its authorized dealers, financing
of service and labor, financing of component parts and attachments, and
other general financing of the distribution network.\1187\ One
commenter said the exception should be read narrowly, because the
physical positions (in inventory, etc.) related to swaps may not be
able to be liquidated to mitigate the risks of the swaps.\1188\
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\1187\ See letters from CDEU, U.S. Chamber of Commerce, Center
for Capital Markets Competiveness (``Chamber'') dated December 30,
2011 (``Chamber II'') and NRU CFC I.
\1188\ See meeting with Duffie on February 2, 2011. In addition,
another commenter also suggested that the exception not be
interpreted broadly due to concerns regarding potential abuse. See
letter from CMOC.
---------------------------------------------------------------------------

3. Final Rules
The CFTC believes that the exception set forth in CEA section
1a(33)(D) should be construed (consistent with the statute) to provide
practical relief to those captive finance companies whose ``primary
business'' is financing and who uses swaps for the purpose of hedging
named underlying commercial risks related to interest rate and foreign
currency exposures. As an initial matter, the Commission notes that a
captive finance subsidiary or other similar entity is required to
provide financing as its primary business, i.e., this is not a
supplementary or complementary activity of the entity.\1189\
---------------------------------------------------------------------------

\1189\ Commenters generally did not focus on this initial
requirement instead commenting on other issues relating to
application of the exception.
---------------------------------------------------------------------------

In connection with the exception, commenters generally focused on
the second part of Section 1a(33)(D) of the CEA, requesting the CFTC to
interpret the phrase ``90% 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.\1190\
---------------------------------------------------------------------------

\1190\ See letters from CDEU and Chamber II. Another commenter
suggested that it should be viewed as a captive finance subsidiary
of the entities that own it in a cooperative structure. See letter
from NRU CFC I. This commenter 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 CFTC does not believe it would be appropriate to apply the
captive finance company exception in this situation.
---------------------------------------------------------------------------

The CFTC believes that the captive finance exception must be
interpreted in a manner consistent with the intention of Congress. As a
result, a person that seeks to fall within the exemption must be in the
``primary business'' of providing financing of purchases from its
parent company. Consistent with this initial requirement, the CFTC
maintains that the captive finance exception can be applied when this
financing activity finances the purchase of the products sold by the
parent company in a broad sense, including service, labor, component
parts and attachments that are related to the products.

[[Page 30694]]

L. Implementation Standard, Re-Evaluation Period and Minimum Period of
Status

1. Proposed Approach
The proposed rules provided that a person would be deemed to be a
major participant upon the earlier of: (i) The date on which it submits
a complete application for registration, or (ii) two months after the
end of the quarter in which a person meets the definition of major
participant.\1191\
---------------------------------------------------------------------------

\1191\ See proposed CFTC Regulation Sec. 1.3(hhh)(3); proposed
Exchange Act rule 3a67-7(a).
---------------------------------------------------------------------------

The proposed rules also provided that a person that has met the
criteria for designation as a major participant as a result of its swap
or security-based swap activities in a fiscal quarter, but without
exceeding any applicable threshold by more than 20 percent, would not
immediately be subject to the timing requirements discussed above.
Instead, the person would be subject to the timing requirements noted
above as soon as its daily average swap or security-based swap
positions over any fiscal quarter exceed any of the applicable daily
average thresholds.\1192\
---------------------------------------------------------------------------

\1192\ See proposed CFTC Regulation Sec. 1.3(hhh)(4); proposed
Exchange Act rule 3a67-7(b).
---------------------------------------------------------------------------

Finally, the proposed rules provided that a person would retain the
status of a major participant if its swap positions or security-based
swap positions do not fall below all of the thresholds for four
consecutive quarters.\1193\ At that time, such entity may de-register
as a major swap participant or major security-based swap participant.
---------------------------------------------------------------------------

\1193\ See proposed CFTC Regulation Sec. 1.3(hhh)(5); proposed
Exchange Act rule 3a67-7(c).
---------------------------------------------------------------------------

2. Commenters' Views
Some commenters took the view that the time for compliance should
be more than two months.\1194\ One commenter suggested that entities be
given the flexibility to have an additional evaluation period if
abnormal market events or price movements cause the failure of the
first reevaluation.\1195\ Some commenters further expressed the view
that the minimum amount of time a person would have to be registered as
a major participant would be two quarters, rather than four
quarters.\1196\
---------------------------------------------------------------------------

\1194\ See letters from BlackRock I (requesting that market
participants have eight months after they have exceeded any of the
applicable thresholds to complete the registration process and come
into compliance with applicable rules) and MetLife (suggesting that
one year would be an adequate amount of time to come into compliance
with the applicable rules); see also letters from ISDA I (suggesting
a grace period of three quarters following the effectiveness of the
proposed rules to permit analysis of whether a person is a major
participant) and Capital One (recommending establishment of an 18
month provisional registration period for major participants and for
dealers, as well as a phase-in period for applicable regulatory
requirements).
\1195\ See letter from MFA I.
\1196\ See, e.g., letters from ACLI, BG LNG I, MetLife and MFA I
(also suggesting that there be an alternative method of termination
if an entity falls below an applicable threshold by more than 20
percent).
---------------------------------------------------------------------------

3. Final Rules
a. Timing
Consistent with the proposal, the final rules provide that a person
would be deemed to be a major participant upon the earlier of the date
on which it submits a complete application for registration, or two
months after the end of the quarter in which it meets the criteria to
be a major participant.\1197\ In adopting these rules, the Commissions
are mindful of commenters' concerns that market entities be given an
adequate amount of time to come into compliance with the requirements
applicable to major participants. At the same time, it is important to
recognize that a person may submit a completed application for major
participant registration prior to the time in which it must come into
compliance with the requirements applicable to major
participants.\1198\ We believe that two months provides a reasonable
amount of time for a person to submit a completed application for
registration as a major participant.\1199\
---------------------------------------------------------------------------

\1197\ See CFTC Regulation Sec. 1.3(hhh)(3); Exchange Act rule
3a67-8(a).
\1198\ The proposed rules regarding the registration of major
security-based swap participants would provide that a person who
files a completed registration application will be conditionally
registered as a major security-based swap participant for four
months (unless a person files a certification with the SEC, which
would extend the conditional registration for an additional 30
days). See proposed Exchange Act rules 15Fb2-1(d)(1) and 15Fb3-
1(b)(2), 76 FR 65784, 65821, 65823 (Oct. 24, 2012). In other words,
under this proposal, a person who meets the criteria for being a
major security-based swap participant may have up to six months, or
longer, to come into compliance with the requirements applicable to
major security-based swap participants.
\1199\ The SEC has estimated that it would take an entity
approximately one week to be able to complete and file Form SBSE,
the most complex application form for registration as a major
security-based swap participant. The other forms for application as
a major security-based swap participant are simpler, and the SEC
estimates that they would take less time to complete. See 76 FR at
65814 at nn.130, 131, 133.
---------------------------------------------------------------------------

b. Re-Evaluation Period
Consistent with the proposal, the final rules provide that if any
entity meets the criteria for qualifying as a major participant, but
does not exceed any applicable threshold by more than 20 percent in
that particular quarter, the entity will not immediately be subject to
the timing requirements noted above, but will become subject to the
timing requirements at the end of the next fiscal quarter if such
entity exceeds any of the applicable daily average thresholds in that
next fiscal quarter.\1200\ We believe that this standard will
appropriately help to avoid applying major participant requirements to
entities that meet the major participant criteria for only a short time
due to unusual activity.\1201\
---------------------------------------------------------------------------

\1200\ See CFTC Regulation Sec. 1.3(hhh)(4); Exchange Act rule
3a67-8(b).
\1201\ While we are mindful that one commenter suggested that
this standard be extended from one quarter to four quarters, see
letter from ISDA I, we do not believe that approach would be
consistent with the goal of not causing persons to become major
participants as a result of short-term unusual activity.
---------------------------------------------------------------------------

c. Minimum Period of Status
Consistent with the proposal, the final rules provide that a person
would retain major participant status until it does not exceed any of
the applicable thresholds for four consecutive quarters following
registration.\1202\ We believe that this time period appropriately
addresses the concern that persons may move in and out of major
participant status on a rapid basis. While we recognize that some
commenters requested that this period be reduced to two quarters, we
believe that a shorter period likely would lead to administrative
confusion and burdens, as a shorter time period may be expected to lead
entities to move in and out of major participant status more
frequently.
---------------------------------------------------------------------------

\1202\ See CFTC Regulation Sec. 1.3 (hhh)(5); Exchange Act rule
3a67-8(c).
---------------------------------------------------------------------------

M. Calculation Safe Harbor

1. Proposed Approach and Commenters' Views
In the Proposing Release, we expressed the understanding that only
a limited number of persons currently have swap or security-based swap
positions of a size that potentially could cause them to fall within
the major participant definitions.\1203\ Without disagreeing with that
view, some commenters expressed concern about the costs and burdens
associated with performing the applicable calculations on a daily
basis, particularly citing the calculations' complex nature.\1204\
Certain commenters further suggested

[[Page 30695]]

that participants in the swap and security-based swap markets may
perceive an obligation to conduct the relevant calculations on a daily
basis even if they are not reasonably likely to be major participants.
Those commenters requested that the Commission adopt a safe harbor by
which persons with swap or security-based swap positions below a
certain notional threshold would not have to perform the major
participant calculations, or by which persons would not have to perform
those calculations more than monthly when the results of those
calculations are significantly below the levels required to be a major
participant.\1205\
---------------------------------------------------------------------------

\1203\ For example, in connection with the major security-based
swap participant definition, we preliminarily estimated that no more
than ten entities that would not otherwise be security-based swap
dealers would have uncollateralized mark-to-market positions or
combined uncollateralized exposure and potential future exposure
that may rise close enough to the proposed thresholds to necessitate
monitoring to determine whether they meet those thresholds. See
Proposing Release, 75 FR at 80207-08.
\1204\ See letters from MFA I and Vanguard.
\1205\ See letters from SIFMA AMG I (recommending safe harbor
when the notional amount of a person's positions is less than the
applicable thresholds for current uncollateralized exposure plus
potential future exposure, or when a person's end-of-month analysis
indicates exposures that are at least 50 percent below the
definitions' applicable current exposure plus potential future
exposure thresholds), Association of Institutional Investors
(``AII'') and Vanguard.
---------------------------------------------------------------------------

2. Final Rule
We continue to believe that under the rules we are adopting only a
limited number of persons potentially may be major participants.
Nonetheless, we recognize the significance of commenter concerns that
some persons may perceive an obligation to conduct the major
participant calculations as part of their compliance procedures even
when there is not a significant likelihood that they would be major
participants. We thus believe that a safe harbor can promote certainty
and regulatory efficiency by helping market participants appropriately
focus their compliance efforts and avoid undue compliance costs in
circumstances when they would be highly unlikely to be major
participants.
Accordingly, the Commissions are adopting a rule to incorporate a
safe harbor into the major participant analysis. A person may take
advantage of this safe harbor in any of three situations. First, a
person will not be deemed to be a major participant if: (i) the express
terms of the person's arrangements relating to swaps and security-based
swaps with its counterparties at no time would permit the person to
maintain a total uncollateralized exposure of more than $100 million to
all such counterparties, including any exposure that may result from
the application of thresholds or minimum transfer amounts established
by credit support annexes or similar arrangements; \1206\ and (ii) the
person does not maintain notional swap or security-based swap positions
of more than $2 billion in any major category of swaps or security-
based swaps, or more than $4 billion in aggregate.\1207\
---------------------------------------------------------------------------

\1206\ See CFTC Regulation Sec. 1.3(hhh)(6)(i)(A); Exchange Act
rule 3a67-8(a)(1)(i).
\1207\ See CFTC Regulation Sec. 1.3(hhh)(6)(i)(B); Exchange Act
rule 3a67-8(a)(1)(ii). For purposes of this second condition, the
measure of swap or security-based swap positions in a major category
shall include all positions in that major category. This measure
shall not exclude the hedging or ERISA positions that are excluded
from the first major participant test.
---------------------------------------------------------------------------

Alternatively, a person will not be deemed to be a major
participant if: (i) The express terms of the person's arrangements
relating to swaps and security-based swaps with its counterparties at
no time would permit the person to maintain a total uncollateralized
exposure of more than $200 million to all such counterparties,
including any exposure that may result from thresholds or minimum
transfer amounts; \1208\ and (ii) the person performs the major
participant calculations (e.g., the ``substantial position'' and
``substantial counterparty exposure'' calculations associated with the
major participant tests) as of the end of every month, and the results
of each of those monthly calculations indicate that the person's swap
or security-based swap positions lead to no more than one-half of the
level of current exposure plus potential future exposure that would
cause the person to be a major participant.\1209\
---------------------------------------------------------------------------

\1208\ See CFTC Regulation Sec. 1.3(hhh)(6)(ii)(A); Exchange
Act rule 3a67-8(a)(2)(i).
\1209\ See CFTC Regulation Sec. 1.3(hhh)(6)(ii)(B); Exchange
Act rule 3a67-8(a)(2). In the case of security-based swaps, for
example, the monthly test must indicate that the person has no more
than $1 billion in aggregate uncollateralized current exposure plus
potential future exposure in a major category (equal to one-half the
thresholds of the first and third major participant tests). A person
also must have no more than $2 billion in aggregate uncollateralized
current exposure plus potential future exposure with regard to all
of its security-based swap positions (equal to one-half the
thresholds of the second major participant test).
For purposes of conducting this analysis with regard to
positions in a major category, if the person is subject to the third
major participant test (i.e., the person is a highly leveraged
financial entity that is not subject to bank capital requirements),
the analysis must account for all of the person's swap or security-
based swap positions in that major category (without excluding
hedging positions). If the person is not subject to the third major
participant test (i.e., the person is not ``highly leveraged'' or is
not a ``financial entity'' potentially subject to the test) the
analysis may exclude those hedging positions that also are excluded
from the first major participant test.
For purposes of conducting this analysis with regard to all of
its swap or security-based swap positions, the analysis may not
exclude hedging positions (consistent with the lack of a hedging
exclusion in the second major participant test).
---------------------------------------------------------------------------

Finally, a person will not be deemed to be a major participant if
the person's current uncollateralized exposure is in connection with a
major category of swaps or security-based swaps is less than $500
million (or less than $1.5 billion with regard to the rate swap
category) and the person performs certain modified major participant
calculations (e.g., the ``substantial position'' and ``substantial
counterparty exposure'' calculations, simplified based on assumptions
that are adverse to the person) \1210\ as of the end of every month,
and the results of each of those monthly calculations indicate that the
person's swap or security-based swap positions in each major category
of swaps or security-based swaps are less than one-half of the
substantial position threshold.\1211\ This test addresses the commenter
suggestion that a safe harbor be set at one-half of the threshold
triggering major participant designation.\1212\ In addition, we have
provided a more simplified alternate version of this test whereby a
person will not be deemed to be a major participant if its monthly
calculations indicate that the person's swap or security-based swap
positions across all major categories of swaps or security-based swaps
are significantly less than the substantial counterparty exposure
threshold.\1213\ This alternative provides a simple safe harbor for
entities to apply without undertaking additional analysis to divide
their swap or security-based

[[Page 30696]]

swap positions into major categories.\1214\
---------------------------------------------------------------------------

\1210\ See CFTC Regulation Sec. 1.3(hhh)(6))iii)(A); Exchange
Act rule 3a67-9(a)(3). The simplifications and assumptions applied
to this portion of the safe harbor include the fact that a person
must use the exposure reports of its dealer counterparties when
calculating aggregate uncollateralized outward exposure to such
entities, and that potential future exposure must be calculated
without taking into account offsets for clearing, mark-to-market
margining, or netting.
\1211\ See CFTC Regulation Sec. 1.3(hhh)(6)(iii)(A); Exchange
Act rule 3a67-9(a)(3)(i)(A).
\1212\ As identified above, three commenters requested that the
Commissions provide a ``safe harbor'' in connection with the status
of a major participant. See letters from AII, SIFMA AMG II and
Vanguard. For example, one commenter stated that ``market
participants that are otherwise required to perform the calculations
should be able to do so on a less frequent basis if the entity is
below every applicable threshold by at least 50%.'' See letter from
SIFMA AMG I at 5.
\1213\ See CFTC Regulation Sec. 1.3(hhh)(6)(iii)(B); Exchange
Act rule 3a67-9(a)(3)(i)(B). The thresholds for this version of the
safe harbor are consistent with the thresholds for the safe harbor
set forth in CFTC Regulation Sec. 1.3(hhh)(6)(iii)(A) and Exchange
Act rule 3a67-9(a)(3)(i)(A), other than with respect to interest
rate swaps. We recognize that the major participant thresholds for
swaps and security-based swaps across all major categories (i.e.,
substantial counterparty exposure) are much larger than those for
each individual major category (i.e., substantial position).
However, given the purposes of the safe harbor, we do not believe
that it is appropriate to use a higher level for the test related to
all major categories as compared to the test for each individual
category.
\1214\ When calculating its potential future exposure across all
major swap or security-based swap categories for purposes of this
portion of the safe harbor, the person must use the same specified
conversion factor for all swaps or security-based swaps, with such
factor reflecting the highest risk weight applied to a major
category of swaps or security-based swaps, as applicable. See CFTC
Regulation Sec. 1.3(hhh)(6)(iii)(B)(2); Exchange Act rule 3a67-
9(a)(3)(i)(B)(2).
Also, for all three tests within the safe harbor, the person
should use the effective notional amount of a position rather than
the stated notional amount of that position if the stated notional
amount is leveraged or enhanced by the structure of the position.
See CFTC Regulation Sec. 1.3(hhh)(6)(iv); Exchange Act rule 3a67-
9(b).
---------------------------------------------------------------------------

In each of these circumstances, we believe that a safe harbor would
be warranted because it would be sufficiently unlikely that the
person's swap or security-based swap positions would cause the entity
to be a major participant.\1215\ The Commissions believe that for
compliance purposes, persons should be able to rely on the proposed
safe harbors noted above. This would benefit the swap and security-
based swap marketplace and related market participants by avoiding
unnecessary costs for various entities that, because of compliance
concerns, would engage in major participant calculations even though it
would be very unlikely that the major participant thresholds would be
met.
---------------------------------------------------------------------------

\1215\ Although commenters suggested a safe harbor based on a
notional standard or on monthly testing, the rule we are adopting
also accounts for the maximum exposure that is possible under a
person's counterparty arrangements (including the aggregate amount
of thresholds and minimum transfer amounts provided for by the
applicable credit support annexes). This is intended to better focus
the application of the safe harbor toward those entities that are
highly unlikely to be, or become, major participants.
---------------------------------------------------------------------------

The rule further provides that even if a person does not meet the
conditions required to take advantage of the safe harbor, that fact by
itself will not lead to a presumption that a person is required to
perform the calculations required to determine if it is a major
participant.\1216\ This is consistent with the safe harbor's intent to
promote certainty and efficiency in compliance efforts. While we are
not prescribing when a person should perform the major participant
calculations, participants in the swap and security-based swap markets
should be mindful that they are responsible for determining whether
they meet the major participant definitions, and that they will face
liability if they knowingly or unknowingly meet one of those
definitions without registering as a major participant.
---------------------------------------------------------------------------

\1216\ See CFTC Regulation Sec. 1.3(hhh)(6)(v); Exchange Act
rule 3a67-8(c).
---------------------------------------------------------------------------

N. Limited Designation as a Major Swap Participant or Major Security-
Based Swap Participant

1. Proposed Approach
The ``major swap participant'' and ``major security-based swap
participant'' definitions provide that the Commissions may designate a
person as a major participant for a single category of swap or
security-based swap.\1217\ Unlike the limited designation provisions of
the dealer definitions, the major participant definitions do not refer
to limited designations in connection with particular swap and
security-based swap activities. Also, unlike the dealer definitions
(which refer to limited designations in connection with a particular
``type,'' ``class'' or ``category'' of swap or security-based swap),
the major participant definitions specifically state that a person may
be designated as a major participant for one or more ``categories'' of
swap or security-based swap, without being a major participant for all
``classes'' of swap or security-based swap.
---------------------------------------------------------------------------

\1217\ See CEA section 1a(33)(C); Exchange Act section
3(a)(67)(C).
---------------------------------------------------------------------------

The proposal provided that a person who is a major participant in
general would be considered to be a major participant with respect to
all categories of swaps or security-based swaps, unless the person's
designation is limited.\1218\ We further stated that we anticipated
that a major participant could seek a limited designation at the same
time as its initial registration or at a later time, and we observed
the difficulty of setting out the conditions that would allow a person
to receive a major participant limited designation.\1219\
---------------------------------------------------------------------------

\1218\ See proposed CFTC Regulation Sec. 1.3(hhh)(2); proposed
Exchange Act rule 3a71-1(c).
\1219\ See Proposing Release, 75 FR at 80200-80201.
---------------------------------------------------------------------------

2. Commenters' Views
As discussed above, commenters generally addressed concerns
regarding limited purpose major participant designations in conjunction
with comments regarding limited purpose dealer designations.\1220\ A
few comments addressed these issues specifically in the context of the
major participant definitions.
---------------------------------------------------------------------------

\1220\ See part II.E.2, supra.
---------------------------------------------------------------------------

One commenter recommended that persons that exceed the first major
participant threshold in a major category should presumptively be
considered a limited major participant only for those categories of
swaps or security-based swaps for which they crossed the
threshold.\1221\ Another suggested a similar approach when a major
participant's swaps are concentrated in one major category.\1222\ Two
commenters suggested that limited major participant designations should
not be confined to the proposed major swap categories.\1223\
---------------------------------------------------------------------------

\1221\ See letter from ICI I (recommending that entities that
exceed the thresholds of the first major participant test be
registered as major participants only for the relevant major
category, while those entities qualifying as major participants
under the other tests would be designated as major participants for
all categories, but would still be able to apply for limited
designations).
\1222\ See letter from BG LNG I (recommending that if 50 percent
of a major participant's swaps fall within one category of swaps,
and its swaps in other categories would not separately exceed any of
the proposed thresholds, that should be presumed to be a major
participant for only that one category of swap).
\1223\ See letters from BG LNG I (specifically addressing energy
firms); and NCGA/NGSA I (asserting that while the major participant
definition is to be based on the major categories, the limited
designations should be based on a finer set of categories).
---------------------------------------------------------------------------

3. Final Rules and General Principles Applicable to Limited Major
Participant Designations
Consistent with the proposal, the final rules retain the
presumption that a person that meets one of the major participant
definitions will be deemed to be a major participant in connection with
all categories of swaps or security-based swaps.\1224\ As discussed in
the Proposing Release, a person may apply for a limited designation
when it submits a registration application, or later.\1225\ The final
rules also contain one change from the proposal, in that the provisions
of the final rules related to limited major participant designation do
not refer to the major participant's activities in connection with
swaps or security-based swaps, in contrast to the proposal, because the
relevant statutory provisions do not refer to limited designations
related to activities.
---------------------------------------------------------------------------

\1224\ See CFTC Regulation Sec. 1.3(hhh)(2); Exchange Act rule
3a71-1(c).
\1225\ See Proposing Release, 75 FR at 80200. The SEC expects to
address the process for submitting an application for limited
designation as a major security-based swap participant, along with
principles to be used by the SEC in analyzing such applications, as
part of separate rulemakings.
---------------------------------------------------------------------------

Many of the principles discussed above in the context of limited
designation of dealers also are relevant to the limited designation of
major participants. Significantly, as with limited dealer designations,
it is appropriate for major participants to be subject to a default
presumption that they should be regulated as major

[[Page 30697]]

participants for all of their swaps or security-based swaps.\1226\
---------------------------------------------------------------------------

\1226\ See part II.E.3.a, supra, discussing the statutory and
policy basis for this presumption.
---------------------------------------------------------------------------

Although a commenter suggested that different principles should
apply in the context of the first major participant test \1227\--which
is based on an entity's swap or security-based swap position in a
single major category--we do not concur. The substantive requirements
applicable to major participants do not contemplate treating entities
that exceed the first and third thresholds of the major participant
definition differently than those exceeding the second threshold.
Instead, those requirements indicate that each entity that falls within
the major participant definition must comply with registration and
other substantive requirements triggered by such designation for all of
its swap or security-based swap positions and activities. This
conclusion also is supported by the fact that the limited designation
authority provided to the Commissions is permissive rather than
mandatory, and by the challenges of demonstrating compliance with the
substantive requirements applicable to major participants in the
context of a limited designation.
---------------------------------------------------------------------------

\1227\ See letter from ICI I.
---------------------------------------------------------------------------

Indeed, as with limited dealer designation, one of the key
requirements to overcoming the default presumption of full designation
is an applicant's ability to comply with major participant regulation
in the context of a limited designation. As with limited dealer
designation, the Commissions will not designate a person as a limited
purpose major participant unless the person can demonstrate compliance
with the statutory and regulatory requirements applicable to major
participants. Accordingly, an applicant to limited purpose designations
must not only demonstrate the ability to comply with the transaction-
level major participant requirements (e.g., certain business conduct
standards and requirements related to trading records, documentation
and confirmations) in the context of a limited designation, but also to
entity-level major participant requirements (e.g., requirements related
to registration, capital, risk management, supervision, and chief
compliance officer).

V. Commission Staff Reports

To review and evaluate the operation of the ``swap dealer,''
``security-based swap dealer,'' ``major swap participant'' and ``major
security-based swap participant'' definitions, the CFTC and SEC are
directing their respective staffs to undertake future studies regarding
the rules being adopted in connection with these definitions and the
related interpretations. These studies will include the analysis of
market data and the input of public comment.
The CFTC staff is further directed to report the results of this
study to the CFTC on a date that is no later than 30 months following
the date that a swap data repository first receives swap data under the
CFTC's regulations.\1228\ The SEC staff is further directed to report
the results of this study to the SEC no later than three years
following the later of: (i) the last compliance date for the
registration and regulatory requirements for security-based swap
dealers and major security-based swap participants under Section 15F of
the Exchange Act; and (ii) the first date on which compliance with the
trade-by-trade reporting rules for credit-related and equity-related
security-based swaps to a registered security-based swap data
repository is required.\1229\ These staff reports will be made
available for public comment.
---------------------------------------------------------------------------

\1228\ The CFTC has designated a period of 30 months to ensure
that the report reflects two years of security-based swap
transaction data, and six months for the staff to analyze the data
and prepare the report. The Commissions expect that swap data
repositories and security-based swap data repositories will begin to
receive data at different times. Currently, swap data repositories
are expected to begin to receive swap data approximately 60 days
after publication of the rules further defining the term ``swap.''
See CFTC, Final Rule: Swap Data Recordkeeping and Reporting
Requirements, 77 FR 2136 (Jan. 13, 2012); CFTC, Final Rule: Swap
Data Repositories: Registration Standards, Duties and Core
Principles, 76 FR 54538 (Sept. 1, 2011). The SEC has not yet adopted
final rules for the receipt of security-based swap data by security-
based swap data repositories. Because of this difference, the timing
of the changes to the de minimis thresholds for swaps and security-
based swaps will be different.
\1229\ The SEC has designated a period of three years to ensure
that the report reflects two years of security-based swap
transaction data, and one year for the staff to analyze the data and
prepare the report.
---------------------------------------------------------------------------

A. Objectives of the CFTC Staff Report

In general, the CFTC's staff report--together with the associated
public comment--is intended to help the CFTC thoroughly evaluate the
practical implications and effects of the ``swap dealer'' and ``major
swap participant'' definitions following the regulation of dealers and
major participants under Title VII. In addition, the staff report is
intended to assist the CFTC in evaluating whether new or revised tests
or approaches would be appropriate for identifying swap dealers and
major swap participants or for providing greater clarity as to whether
particular entities do or do not fall within these definitions. The
staff report is also intended to assist the CFTC more specifically in
evaluating the potential implications of terminating the phase-in
thresholds associated with the de minimis exception to the definition
of a ``swap dealer.''
To this end, the staff report generally should review each
significant aspect of the rules being adopted in connection with the
definitions and related interpretations. With respect to the ``swap
dealer'' definition, such aspects include: (i) the factors associated
with the definition (including the application of the dealer-trader
distinction for identifying swap dealing activity); (ii) the extent of
the exclusion of swaps entered into in connection with the origination
of loans; (iii) the exclusion of certain swaps from the dealer analysis
(i.e., swaps between affiliated parties, swaps between a cooperative
and its members and swaps entered into for the purpose of hedging as
defined in the rule); and (iv) the tests and thresholds used to
implement the de minimis exception. With respect to the ``major swap
participant'' definition, such aspects include: (i) The tests and
thresholds associated with the ``substantial position'' definition;
(ii) the definition of ``hedging or mitigating commercial risk''; (iii)
the tests and thresholds associated with the ``substantial counterparty
exposure'' definition; and (iv) the definition of ``highly leveraged''.
To facilitate this review, the CFTC staff report should address--as
may be practicable in light of the data made available under the swap
regulatory reporting regime or otherwise--a range of descriptive
analytics that may be helpful in characterizing the nature of the swap
market, its participants, and their activities. Such descriptive
analytics could help inform the CFTC as to how the definitions in the
final rules are being applied in practice and whether any adjustments
to such definitions should be considered. For example, these analytics
could indicate whether the population of registered swap dealers and
major swap participants is substantially larger or smaller than
expected, and, to some extent, what elements of the definitions are
responsible for any significant differences. These analytics could also
illuminate dynamics in the market that may require new or different
treatment in the definitions. These analytics may also assist the CFTC
in considering whether it would be practical and appropriate to apply
new or different objective and readily verifiable tests or standards
for determining whether particular entities are or are not swap dealers
or major swap participants,

[[Page 30698]]

including through the possible use of safe harbors, presumptions,
thresholds, or defaults based on these tests or standards.
Depending on the availability and reliability of data and the
developments in the market and regulatory framework, among other
factors, the CFTC staff report could consider: how swaps differ among
registered swap dealers, registered major swap participants and
unregistered entities; differences among swaps in the major swap
categories; differences among swap dealing activity of entities at
various levels, including around the de minimis threshold; and
estimates of quantitative information regarding use of swaps, including
notional values, effective notional values, and collateralized and
uncollateralized exposure.
The CFTC staff report should also address, as may be practicable,
the nature and extent of the impact that the final rules and
interpretations implementing the definitions have had on certain
aspects of the swap market. Depending on the available information and
other factors, the CFTC staff report could address the impact of these
final rules and interpretations on competition in the swap market,
market participants' ability to enter into swaps with various
registered and unregistered entities, including IDIs, and the terms of
swaps.

B. Objectives of the SEC Staff Report

In general, the report of the SEC staff--together with the
associated public comment--is intended to help the SEC thoroughly
evaluate the practical implications and effects of the dealer and major
participant definitions following the regulation of dealers and major
participants pursuant to Title VII. In addition, the staff report is
intended to assist the SEC in evaluating whether new or revised tests
or approaches would be appropriate for identifying dealers and major
participants or for providing greater clarity as to whether particular
entities do or do not fall within these definitions. The staff report
also is intended to assist the SEC more specifically in evaluating
whether it is necessary or appropriate to set higher or lower
thresholds for the de minimis exception to the definition of
``security-based swap dealer.''
To this end, the staff report generally should review each
significant aspect of the rules being adopted in connection with the
definitions and related interpretations. With respect to the security-
based swap dealer definition, such aspects include: (i) The factors
associated with the definition (including the application of the
dealer-trader distinction for identifying dealing activity); (ii) the
exclusion of inter-affiliate transactions from the dealer analysis
(including the provisions limiting that exclusion to transactions among
majority-owned affiliates); and (iii) the tests and thresholds used to
implement the de minimis exception. With respect to the major security-
based swap participant definition, such aspects include: (i) The tests
and thresholds associated with the ``substantial position'' and
``substantial counterparty exposure'' definitions; (ii) the definition
of ``hedging or mitigating commercial risk'' (including whether the
definition inappropriately permits the exclusion of certain positions
from the first test of the major participant definitions, and whether
the continued availability of the exclusion should be conditioned on
assessments of hedging effectiveness and related documentation); (iii)
the definition of ``highly leveraged''; and (iv) the exclusion of
inter-affiliate transactions from the major participant analysis
(including the provision limiting that exclusion to transactions among
majority-owned affiliates).

C. Descriptive Analytics in the SEC Report

To facilitate this review, the report of the SEC staff should
address--as may be practicable in light of the data made available
under the applicable regulatory reporting regime or otherwise \1230\--a
range of descriptive analytics that may be helpful in characterizing
the nature of the security-based swap market, as well as entities
within that market and those entities' activities. Such descriptive
analytics could help inform the SEC as to how the definitions in the
final rules are being applied in practice and whether any adjustments
to such definitions should be considered. For example, these analytics
could indicate whether the populations of dealers and major
participants are substantially larger or smaller than expected, and, to
some extent, what elements of the definitions are responsible for any
significant differences. These analytics could also illuminate dynamics
in the security-based swap market that may require new or different
treatment in the definitions. For example, the analytics could indicate
that the activity in certain segments of the security-based swap
market--e.g., equity swaps--has significantly increased or decreased
since the adoption of the final rules. These analytics may also assist
the SEC in considering whether it would be practical and appropriate to
apply new or different objective and readily verifiable tests or
standards for determining whether particular entities are or are not
dealers or major participants, including through the possible use of
safe harbors, presumptions, thresholds or defaults based on these tests
or standards.
---------------------------------------------------------------------------

\1230\ The Dodd-Frank Act mandates that market participants
publicly report certain security-based swap transaction and pricing
data. See Exchange Act section 13(m). The SEC has proposed rules to
implement these requirements, which will give the Commissions and
the general public additional insight into the security-based swap
markets. See Regulation SBSR--Reporting and Dissemination of
Security-Based Swap Information, 75 FR 75208 (Dec. 2, 2010).
---------------------------------------------------------------------------

The precise nature of the descriptive analytics included in the SEC
staff report of course will depend on a number of considerations,
including the availability and reliability of data and the developments
in the market and regulatory framework. However, some salient
candidates for descriptive analysis that could be considered at the
time of the staff report include:
Characteristics of, and differences among, the security-
based swap transactions and positions of three segments of participants
in those respective markets--registered dealers, any registered major
participants, and unregistered entities.\1231\
---------------------------------------------------------------------------

\1231\ Such characteristics could include: (i) The types of
market participants in each segment; (ii) their activity and
positions (in terms of notional value, number of transactions,
average aggregate uncollateralized outward exposures, and average
aggregate potential outward exposure); (iii) the type and number of
their counterparties (including the registered/unregistered status
of such counterparties); and (iv) a network analysis of the
concentration of activity by counterparty.
---------------------------------------------------------------------------

Characteristics of, and differences among, security-based
swap transactions and positions connected with the broad product
segments identified in the final rules (e.g., credit default swaps and
other security-based swaps).\1232\
---------------------------------------------------------------------------

\1232\ Such characteristics could include: (i) The types of
market participants in each segment, including their registration
status; (ii) the amount of their activity (in terms of notional
value and number of transactions); and (iii) the type and number of
their counterparties.
---------------------------------------------------------------------------

Characteristics of, and differences among, the apparent
dealing activity of entities at various levels (including the $3
billion and $150 million de minimis levels established in the final
rule in connection with the security-based swap dealer definition)
based on their transactions and positions; \1233\
---------------------------------------------------------------------------

\1233\ Such characteristics could include a range of
quantitative criteria indicative of apparent dealing activity,
similar in some respects to the approach taken in the CDS Data
Analysis. Differences that could be reviewed include variations in
the number and size of trades and counterparties.

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

[[Page 30699]]

Characteristics of the security-based swap trading
activity of ``special entities''; \1234\
---------------------------------------------------------------------------

\1234\ Such characteristics could include: (i) The size and
nature of their counterparties; (ii) the registration status of
their counterparties; and (iii) the size and number of their
transactions.
---------------------------------------------------------------------------

Characteristics of entities entering and exiting the
security-based swap markets, using a variety of baselines; \1235\
---------------------------------------------------------------------------

\1235\ Such characteristics could include: (i) The extent to
which those entities bear indicia of dealing activity, including
those identified in the CDS Data Analysis; and (ii) the extent to
which those entities have registered as security-based swap dealers.
Potential baseline could include, for example: (i) The adoption of
these final rules; (ii) December 31, 2011, the end of the time
period considered by the CDS Data Analysis; and (iii) the last
effective date of the registration and regulatory requirements for
security-based swap dealers and major security-based swap
participants under Section 15F of the Exchange Act.
---------------------------------------------------------------------------

Estimates of security-based swap entities' current
uncollateralized exposure and potential future exposure at various
levels of security-based swap positions; \1236\ and
---------------------------------------------------------------------------

\1236\ Such estimates could be useful in ascertaining the
application of the various ``substantial position'' thresholds used
in connection with the ``major security-based swap participant''
definition.
---------------------------------------------------------------------------

Estimates of security-based swap entities' ratios of total
liabilities to equity.\1237\
---------------------------------------------------------------------------

\1237\ Such estimates could be useful in connection with
evaluating the operation of the third prong of the major participant
definition.
---------------------------------------------------------------------------

D. Additional Analyses in the SEC Staff Report

To further facilitate this review, the SEC staff report should also
address, as may be practicable, the nature and extent of the impact
that the final rules and interpretations implementing the definitions
have had on certain aspects of the security-based swap market. However,
many economic, regulatory, and other factors--both related and
unrelated to the implementation of Title VII--could impact the market
going forward. The extent to which the staff report will be able to
provide retrospective analyses regarding the effect of the definitions
on the security-based swap markets (and the robustness of any such
analysis) in significant part will be based on the nature and role of
future exogenous factors that have also affected the market. Depending
on these future factors and the potential challenges associated with
addressing them in the staff reports, some salient candidates for
retrospective impact analysis that could be considered at the time of
the report include:
Effects on competition. The report may be able to explore
connections between the definitions and the entry and exit of various
entities in the security-based swap markets. For example, to what
extent is an entity's entry or exit correlated with its registration
status or its approaching or crossing any of the thresholds established
by the definitions (e.g., the de minimis thresholds for dealers or the
``substantial position'' thresholds for major participants)? Has the
current concentration of the dealer market dissipated, persisted, or
strengthened over time? \1238\
---------------------------------------------------------------------------

\1238\ See notes 478 through 485 and accompanying text, supra.
---------------------------------------------------------------------------

Effects on investor protection. The report may be able to
explore connections between the definitions and the nature and scope of
transactions with certain classes of counterparties. For example, to
what extent do unregistered entities in the security-based swap markets
transact with counterparties such as ``special entities,'' natural
persons, small businesses, or commercial entities? Have the nature and
scope of trades by special entities or other classes of counterparties
changed since 2011? Have unregistered entities--such as dealers
operating under the de minimis threshold--emerged to engage in
transactions with special entities or other particular classes of
counterparties?
Effects on access. The report may be able to explore
connections between the definitions and the ability of certain classes
of counterparties to access products in the security-based swap market.
For example, to what extent is an entity's registration status or its
approaching or crossing any of the thresholds established by the
definitions correlated with the entity ceasing transactions with
certain classes or sizes of counterparties?
Effects of the dealer-trader distinction. The report may
be able to explore connections between market dynamics and quantifiable
metrics indicative of dealing activity. For example, are there
identifiable, objective differences between the registered security-
based swap dealers and unregistered market participant populations in
terms of number of counterparties, buy/sell ratios, posting of initial
margin, concentrations by counterparty or otherwise? If so, how does
the amount of the activity (in terms of notional value and number of
transactions) of those entities change when they move above or below
the thresholds implied by those differences? How do the characteristics
of their counterparties (in terms of number and nature) change?
Effects of de minimis thresholds. The report may be able
to explore connections between market dynamics and the de minimis
thresholds established by the definitions. For example, how does the
amount of the activity (in terms of notional value and number of
transactions) of security-based swap entities change when they move
above or below the de minimis thresholds? How do the characteristics of
their counterparties (in terms of number and nature) change?
Effects of major participant thresholds. The report may be
able to explore connections between market dynamics and the major
participant thresholds established by the definitions. For example, how
have total notional security-based swap positions changed over time for
large market participants that are not registered and that do not bear
any indicia of dealing activity? For those large participants, have
overall notional levels moved toward, or away from, the levels required
to trigger the major participant thresholds?
Other effects of the definitions. To what extent do
entities registered security-based swap dealers have overall trading
characteristics suggesting that they may not be dealers? To what extent
have entities not registered as dealers have trading characteristics
suggesting that they may be acting as dealers? In either case, do any
discrepancies between firms' registration status and their trading
characteristics suggest any gaps or areas of uncertainty regarding the
scope of the dealer definitions that may require potential
modifications?

VI. Effective Date and Implementation

Consistent with sections 754 and 774 of the Dodd-Frank Act, these
final rules will be effective on 60 days following publication in the
Federal Register. The Commissions, however, are providing for a phase-
in period for persons engaged in dealing activity below certain
amounts.
If any provision of these joint rules, or the application thereof
to any person or circumstance, is held to be invalid, such invalidity
shall not affect other provisions or application of such provisions to
other persons or circumstances that can be given effect without the
invalid provision or application.

A. CEA Rules

As explained below and as noted elsewhere in this Adopting Release,
the compliance date for various regulatory requirements is contingent
upon the adoption and effectiveness of other,

[[Page 30700]]

related, regulatory provisions and definitions. Because the CFTC
believes that the suite of rules implementing the Dodd-Frank Act are
complex and interconnected, it has determined that implementation in
certain cases can best be accomplished through separate rulemakings.
The Commissions received comments related to implementation and phase-
in that largely resulted from the CFTC's re-opening of the comment
period for several rulemakings, and a request for comment on the order
in which it should consider final rulemakings made under the Dodd-Frank
Act.\1239\ The CFTC notes that swap dealers and major swap participants
will require an implementation or compliance period based on separate
registration and regulatory requirements that are the subject of
separate rulemakings by the Commission.\1240\
---------------------------------------------------------------------------

\1239\ See CFTC, Reopening and Extension of Comment Periods for
Rulemakings Implementing the Dodd-Frank Wall Street Reform and
Consumer Protection Act, 76 FR 25274 (May 4, 2011).
\1240\ See CFTC, Final Rule: Registration of Swap Dealers and
Major Swap Participants, 775 FR 713792613 (Jan. 19, 2012).
---------------------------------------------------------------------------

As the CFTC stated recently in another rulemaking related to CPOs:

[while t]he [CFTC] recognizes that entities will need time to come
into compliance with the [CFTC]'s regulations * * * [b]ased on the
comments received indicating that a certain portion of entities
currently claiming relief [from CPO registration] under Sec.
4.13(a)(4) already have robust controls in place independent of
[CFTC] oversight, the [CFTC] believes that entities currently
claiming relief under Sec. 4.13(a)(4) should be capable of becoming
registered and complying with the [CFTC]'s regulations within 12
months following the issuance of the final rule. For entities that
are formed after the effective date of the rescission, the
Commission expects the CPOs of such entities to comply with the
Commission's regulations upon formation and commencement of
operations.\1241\
---------------------------------------------------------------------------

\1241\ CPO/CTA Compliance Release at 11265.

The Commissions are taking the same approach with respect to
implementing CFTC Regulations Sec. Sec. 1.3(m)(5) and 1.3(m)(6). The
loss of ECP status for Forex Pools currently operating other than
pursuant to the retail forex regime of a federal regulator described in
CEA section 2(c)(2)(E)(i) \1242\ may involve significant structural and
operational changes. The loss of a commodity pool's ability to rely on
CEA section 1a(18)(A)(v) if it does not fall within CEA section
1a(18)(A)(iv) may require significant structural and operational
changes. Because additional time may enable a Forex Pool affected by
CFTC Regulation Sec. 1.3(m)(5) to restructure to avoid being subject
to the retail forex regime (e.g., by redeeming U.S. non-ECP
participants) and may allow a commodity pool affected by CFTC
Regulation Sec. 1.3(m)(6) time to satisfy the terms of CEA section
1a(18)(A)(iv) (e.g., by the pool's CPO registering as such or claiming
an exemption therefrom or by the pool raising its level of total assets
above $5 million), the Commissions are delaying the effective date of
CFTC Regulations Sec. Sec. 1.3(m)(5) and 1.3(m)(6) until December 31,
2012, which is the compliance date for commodity pools no longer
permitted to claim exemption from CPO registration pursuant to recently
withdrawn CFTC Regulation 4.13(a)(4).\1243\
---------------------------------------------------------------------------

\1242\ 7 U.S.C. 2(c)(2)(E)(i).
\1243\ See CPO/CTA Compliance Release.
---------------------------------------------------------------------------

CFTC Regulation Sec. 1.3(m)(8) conditions ECP status in part on a
requirement that a commodity pool be ``formed and operated'' by a
registered CPO or by a CPO who is exempt from registration as such
pursuant to CFTC Regulation Sec. 4.13(a)(3). Due to the revocation of
CFTC Regulation Sec. 4.13(a)(4), the Commissions anticipate that many
CPOs will be registering as such in the future. However, the compliance
date for registration for CPOs required to register as such due to the
withdrawal of CFTC Regulation Sec. 4.13(a)(4) is December 31, 2012.
Furthermore, such CPOs may have formed the commodity pools that they
currently operate when such CPOs were not registered as such.
Consequently, compliance with the formation element of CFTC
Regulation Sec. 1.3(m)(8)(iii) is not required with respect to a
commodity pool formed prior to December 31, 2012. To be clear, however,
while pools in existence before December 31, 2012 need not have been
formed by a registered CPO, or by a CPO who is exempt from registration
as such pursuant to CFTC Regulation Sec. 4.13(a)(3), in order to
satisfy the formation aspect of CFTC Regulation Sec. 1.3(m)(8)(iii),
such commodity pools nevertheless must be operated by a registered CPO,
or by a CPO who is exempt from registration as such pursuant to CFTC
Regulation Sec. 4.13(a)(3), on December 31, 2012 to satisfy the
``operated by a registered CPO'' element of CFTC Regulation Sec.
1.3(m)(8)(iii).

B. Exchange Act Rules

Because the SEC has not yet promulgated final rules implementing
the substantive requirements imposed on dealers and major participants
by Title VII of the Dodd-Frank Act, persons determined to be dealers or
major participants under the regulations adopted in this Adopting
Release need not register as such until the dates provided in the SEC's
final rules regarding security-based swap dealer and major security-
based swap participant registration requirements, and will not be
subject to the requirements applicable to those dealers and major
participants until the dates provided in the applicable final
rules.\1244\
---------------------------------------------------------------------------

\1244\ See Securities Exchange Act Release No. 64678 (June 15,
2011), 76 FR 36287 (June 22, 2011) (``Effective Date Release'')
(granting exemptive relief and providing guidance in connection with
Exchange Act provisions concerning security-based swaps that were
added or amended by Title VII).
---------------------------------------------------------------------------

Moreover, as discussed above in the context of the de minimis
exception to the security-based swap dealer definition,\1245\ the SEC
is making an extended compliance period available to persons engaged in
dealing activity involving credit default swaps between $3 billion and
$8 billion in trailing annual notional amount, and to persons engaged
in dealing activity involving other types of security-based swaps
between $150 million and $400 million in trailing annual notional
amount. Persons taking advantage of that extended compliance period
will be deemed not to be security-based swap dealers during that
period, and will not be subject to registration requirements and other
requirements associated with status as a security-based swap dealer
during that period.
---------------------------------------------------------------------------

\1245\ See part II.D.5, supra.
---------------------------------------------------------------------------

The SEC previously provided limited exemptive relief in connection
with Exchange Act section 6(l),\1246\ added by the Dodd-Frank Act,
which prohibits any person from effecting a security-based swap
transaction with a person that is not an ECP, unless effected on a
national securities exchange. That relief expires as of the effective
date of final rules further defining ECP.\1247\ Accordingly, following
the effective date of these final rules, dealers and major
participants--and all other persons--will be subject to the prohibition
of section 6(l) under the definition of ECP as amended by Title VII and
as further defined by the rules.\1248\
---------------------------------------------------------------------------

\1246\ 15 U.S.C. 78f(l).
\1247\ See Effective Date Release, 76 FR at 36307.
\1248\ Because the exemptive relief that the SEC granted in
connection with section 6(l) will expire as of the effectiveness of
the ECP definition, the relief that the SEC provided from the
rescission provisions of Exchange Act section 29(b) in connection
with section 6(l) also will expire at that time. See id.

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[[Page 30701]]

VII. Administrative Law Matters--CEA Revisions (Definitions of ``Swap
Dealer'' and ``Major Swap Participant,'' and Amendments to Definition
of ``Eligible Contract Participant'')

A. Regulatory Flexibility Act

The Regulatory Flexibility Act (``RFA'') requires Federal agencies
to consider the impact of its rules on ``small entities.'' \1249\ A
regulatory flexibility analysis or certification typically is required
for ``any rule for which the agency publishes a general notice of
proposed rulemaking pursuant to'' the notice-and-comment provisions of
the Administrative Procedure Act, 5 U.S.C. 553(b).\1250\ In its
proposal, the CFTC stated that ``[t]he rules proposed by the CFTC
provide definitions that will largely be used in future rulemakings and
which, by themselves, impose no significant new regulatory
requirements. Accordingly, the Chairman, on behalf of the CFTC, hereby
certifies pursuant to 5 U.S.C. 605(b) that the proposed rules will not
have a significant economic impact on a substantial number of small
entities.''\1251\
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\1249\ 5 U.S.C. 601 et seq.
\1250\ 5 U.S.C. sections 601(2), 603, 604 and 605.
\1251\ 75 FR 80203.
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In response to the Proposing Release, one commenter stated that the
CFTC's ``rule-makings [are] an accumulation of interrelated regulatory
burdens and costs on non-financial small entities like the NFPEEU
members, who seek to transact in energy commodity swaps only to hedge
the commercial risks of their not-for-profit public service
activities.'' \1252\ In general, the commenter said that since the
Small Business Administration (``SBA'') has determined that many rural
electric cooperatives are ``small entities'' for purposes of the RFA,
if the definition of swap dealer were to cover a substantial number of
rural electric cooperatives the rule further defining swap dealer may
have a significant economic impact on a substantial number of small
entities.\1253\ Thus, the commenter concluded that the CFTC should
conduct a regulatory flexibility analysis for each of its rulemakings
under the Dodd-Frank Act, including this rulemaking.
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\1252\ See letter from NFPEEU.
\1253\ See letter from NFPEEU and meeting with NFPEEU on January
19, 2011.
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The commenter also said that the requirement in section 2(e) of the
CEA, as amended by the Dodd-Frank Act, that a person who is not an ECP
must execute swaps on a designated contract market would have the
potential to have a significant economic impact on a substantial number
of small entities if a substantial number of rural electric
cooperatives were not covered by the definition of ECP.\1254\ Another
commenter said that in considering the economic impact on small
entities of the swap dealer definition rules, the CFTC should consider
whether the availability and cost of swaps to small entities could be
affected by potential uncertainty among persons who engage in the
activities covered by the definition about whether they are required to
register as swap dealers.\1255\
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\1254\ See letter from NFPEEU.
\1255\ See letter from Dominion Resources.
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The commenters did not provide specific information on how the
further defining swap dealer would have a significant economic effect
on a substantial number of small entities. Nonetheless, the CFTC has
reevaluated this rulemaking in light of the statements made to it by
these commenters. After further consideration of those statements, the
CFTC has again determined that this final rulemaking will not have a
significant economic effect on a substantial number of small
businesses. With regard to the definition of swap dealer, the CFTC
expects that if any small entity were to engage in the activities
covered by the definition, most such entities would be eligible for the
de minimis exception from the definition.\1256\ Additionally, the
Commission does not expect that the small entities identified by NFPEEU
will be subject to registration with the Commission as a major swap
participant, as most entities with total electric output not exceeding
4 million megawatt hours are not expected to maintain outstanding swap
positions that would exceed the applicable thresholds. In general, the
major swap participant definition applies only to persons with very
large swap positions, and therefore the definition of major swap
participant is incompatible with small entity status.
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\1256\ The number of small entities that could conceivably be
covered by the definition of swap dealer is likely to be further
reduced if transactions between entities described in section 201(f)
of the Federal Power Act (which generally includes rural electric
cooperatives) are exempted from the requirements of the CEA, as
contemplated by section 4(c)(6) of the CEA.
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With regard to the definition of ECP, the CFTC notes that the costs
of executing swaps on a designated contract market raised by the
commenter arise from a requirement of the CEA, and not from any rule
promulgated by the CFTC. Last, regarding the comment that there may be
an economic impact on small entities in terms of the availability and
cost of swaps, the definition of swap dealer is being adopted to limit
uncertainty with respect to which entities will be required to register
as a swap dealer. Thus, the definition of swap dealer is intended to
avoid creating the substantial economic effect which concerns the
commenter.
Accordingly, the Chairman, on behalf of the CFTC, certifies,
pursuant to 5 U.S.C. 605(b), that the actions to be taken herein will
not have a significant economic impact on a substantial number of small
entities.

B. Paperwork Reduction Act

The Paperwork Reduction Act (``PRA'') \1257\ imposes certain
requirements on Federal agencies in connection with their conducting or
sponsoring any collection of information as defined by the PRA. The
Proposing Release stated that the proposed rules would not impose any
new recordkeeping or information collection requirements, or other
collections of information that require approval of the Office of
Management and Budget (``OMB'') under the PRA, and invited public
comment on the accuracy of the CFTC's estimate that no additional
recordkeeping or information collection requirements or changes to
existing collection requirements would result from the proposed
rules.\1258\
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\1257\ 44 U.S.C. 3501 et seq.
\1258\ 75 FR 80203.
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One commenter said that the regulatory requirements imposed on swap
dealers and major swap participants (including swap end users that may
potentially be misclassified as swap dealers or major swap
participants) will entail reporting and record keeping
requirements.\1259\ Specifically, the commenter noted that the CFTC
stated in the Proposing Release that ``any entity determined to be a
swap dealer or major swap participant would be subject to registration,
margin, capital, and business conduct requirements * * * all activities
that will have associated reporting and additional recordkeeping
requirements.'' \1260\ Another commenter said that the CFTC should
consider the implications under the PRA of all of its rulemakings under
the Dodd-Frank Act as a whole.\1261\
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\1259\ See letter from Dominion Resources.
\1260\ See id. at 6.
\1261\ See letter from NFPEEU.
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As with the proposed rules, these final rules will not impose any
new information collection requirements that require approval of OMB
under the PRA. All reporting and recordkeeping

[[Page 30702]]

requirements applicable to swap dealers and major swap participants
instead result from other rulemakings, for which the CFTC has sought
OMB approval. The CFTC submitted an information collection request to
OMB for each proposed rulemaking containing reporting or recordkeeping
requirements, including the recordkeeping and reporting requirements
referenced by the first commenter,\1262\ which estimated the
implications of the proposed collections on prospective
respondents.\1263\
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\1262\ See, e.g., 75 FR 71379, 71386 (Nov. 23, 2010) (proposed
registration rules); 75 FR 70881, 70884 (Nov. 19, 2010), 75 FR
71397, 71401 (Nov. 23, 2010), 75 FR 71391, 71394 (Nov. 23, 2010), 75
FR 80638, 80656 (Dec. 22, 2010), and 76 FR 33066, 33076 (Jun. 7,
2011); and 76 FR 27802, 27819 (May 12, 2011) (collectively, the
information collection requests for the proposed business conduct
rules).
\1263\ See 44 U.S.C. 3506 (PRA program requirements) and 3507
(PRA submission requirements).
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Moreover, in appropriate rulemakings, the CFTC sought to rely upon
information collections that already had been proposed, in order to
avoid imposing unnecessary additional burdens upon prospective
respondents.\1264\ Parties wishing to review the CFTC's information
collections on a global basis may do so at www.reginfo.gov, at which
OMB maintains an inventory aggregating each of the CFTC's currently
approved information collections, as well as the information
collections that presently are under review.
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\1264\ See, e.g., 75 FR 80638, 80656 (Dec. 22, 2010).
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C. Cost Benefit Considerations

CEA section 15(a) requires the CFTC to consider the costs and
benefits of its action before promulgating a regulation under the CEA,
specifying that the costs and benefits shall be evaluated in light of
five broad areas of market and public concern: (i) Protection of market
participants and the public; (ii) efficiency, competitiveness and
financial integrity of futures markets; (iii) price discovery; (iv)
sound risk management practices; and (v) other public interest
considerations.\1265\
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\1265\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------

1. Introduction
The terms ``major swap participant'' and ``swap dealer'' are
defined in CEA sections 1a(33) and 1a(49), as added by the Dodd-Frank
Act, to include any person that holds swap positions above a certain
level (in the case of the term ``major swap participant'') or that
engages in certain activities (in the case of the term ``swap
dealer''), with certain exclusions and exceptions, all as discussed in
parts II and IV of this Adopting Release. Section 712(d)(1) of the
Dodd-Frank Act directs the CFTC and the SEC, in consultation with the
Board, jointly to further define these and other terms. Also, CEA
section 1a(49)(D) directs the CFTC to promulgate regulations to
establish factors with respect to the making of the determination to
apply the de minimis exception to the definition of the term ``swap
dealer.''
The provisions of the Dodd-Frank Act that direct the further
definition of the terms ``swap dealer'' and ``major swap participant''
should be viewed in the context of Congress' consideration of the
consequences that would arise from regulating persons and activities
that were previously free from regulation. The Dodd-Frank Act is, in
part, a response to a financial crisis in which unregulated swaps
played a major role.\1266\ It includes provisions to regulate swap
dealers and major swap participants in order to address concerns about
this previously unregulated market. In this context, the Dodd-Frank Act
requires that rules should ``further define'' the terms ``swap dealer''
and ``major swap participant'' by establishing and providing guidance
with respect to the criteria for determining if a person is covered by
one of the statutory definitions and therefore should be subject to
certain regulatory requirements under Title VII; the Dodd-Frank Act
does not direct the Commissions to define those terms in a vacuum. So,
even in the absence of these rules, Title VII would require the
regulation of persons that act as swap dealers or hold positions
causing them to be major swap participants. Consequently, a large part
of the costs and benefits resulting from the regulation of swap dealers
and major swap participants result from the Dodd-Frank Act itself and
not from these definitional rules.
---------------------------------------------------------------------------

\1266\ See, e.g., S.Rep. 111-176, The Restoring American
Financial Stability Act of 2010 at 29.
---------------------------------------------------------------------------

2. General Cost and Benefit Considerations
In considering the comments on the proposed rules and the various
alternatives available for the final rules, the CFTC sought to
promulgate final rules that will help swap market participants and the
public to apply the statutory definitions of the terms ``swap dealer''
and ``major swap participant'' in an efficient, uniform and accurate
manner. We believe that doing so will protect market participants and
the public, promote the efficiency, competitiveness and financial
integrity of the swap markets, facilitate price discovery, encourage
sound risk management practices and advance the public interest in
general. That is, by providing direction and guidance as to which
factors are relevant in applying the statutory definitions, and how to
apply those factors to particular situations in the swap markets, the
CFTC believes the final rules will provide benefits by reducing the
cost of determining whether a particular person is covered by the
statutory definitions, helping to make similar determinations for
persons that are similarly situated, and promoting application of the
terms ``swap dealer'' and ``major swap participant'' in conformity with
the statutory definitions.
The costs and benefits considered in this final rule fall in two
categories: First, those an entity will experience in determining
whether it is a ``swap dealer'' or ``major swap participant'' as
further defined in this rulemaking; and second, those attributable to
the fact that, as interpreted in this rule, a greater or fewer number
of entities at the boundaries of the statutory definitions may be
deemed within them.
With respect to the first category, and as discussed further in
sections V.A.3.j. and V.A.4.b. below, the CFTC has endeavored to
approximate the costs of making these determinations. At the same time,
the CFTC believes that the careful consideration of, and detailed
response in this Adopting Release to, comments regarding the
application of the statutory definitions will provide useful, practical
guidance, yielding a substantial if unquantifiable benefit to entities
making such determinations.
The costs and benefits in the second category--those associated
with the rules being more or less inclusive--were a primary concern of
the CFTC and commenters throughout this rulemaking. Commenters stated
that if the CFTC's final rules were to lead to interpretations of the
statutory definitions that are over-inclusive, the result would be that
entities would likely incur significant, unjustifiable costs
attributable to various regulatory requirements intended for actual
swap dealers and major swap participants.\1267\ Other commenters were
concerned that if the rules were to lead to under-inclusive
interpretations, the benefits expected from Title VII would be
dampened.\1268\
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\1267\ See letters from API I, Atmos Energy, BG LNG I, Dominion
Resources, Hess, NCGA/NGSA I, NFPEEU, Vitol and WGCEF VIII.
\1268\ See letters from AFR, Better Markets I and Greenberger.
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The CFTC does not dismiss these potential unintended results and we

[[Page 30703]]

have responded to these comments in the policy determinations made
above.\1269\ We recognize that these definitional rules are ``gating''
rules, and that this gating function will affect whether entities at
the boundaries of the statutory definitions incur costs attributable to
the regulatory regime that Congress has prescribed and the CFTC has
implemented through other substantive regulations. Correspondingly,
these definitional rules will also affect the extent of benefits for
the swap market and the public resulting from those regulations. It is
important to also recognize, however, that as stated above, the
regulation of persons acting as swap dealers or who hold positions
causing them to be major swap participants is required by the Dodd-
Frank Act. For entities that are not on the boundaries of the statutory
definitions, but rather squarely within them or entirely outside of
them, these rules will not affect the costs and benefits that result
from their inclusion or exclusion. The latter group of costs and
benefits are a consequence of the statutory definitions prescribed by
Congress.
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\1269\ See, e.g., parts II.A.4.g, II.D.3.a and IV.B.3.a.
---------------------------------------------------------------------------

In this rulemaking, we considered that more inclusive rules and
guidance would cause some entities at the boundaries of the definitions
to be covered by one of the definitions and therefore incur both
initial and recurring direct costs of complying with Dodd-Frank Act
requirements, while less inclusive rules and guidance would have the
opposite effect.\1270\ Thus, as more or fewer entities are covered by
the definitions, the amount of such direct compliance costs incurred by
entities in the aggregate will vary. However, this variance in the
aggregate compliance costs resulting from the CFTC's definitional
guidance in this rulemaking must be distinguished from the compliance
costs that any particular entity will incur stemming from the other
rulemakings prescribing regulations applicable to swap dealers and
major swap participants. Consideration of the specific costs and
benefits attendant to various substantive regulations applicable to
swap dealers and major swap participants is beyond the limited scope of
this rulemaking.
---------------------------------------------------------------------------

\1270\ For example, the final rules specify criteria related to
application of the de minimis exception, the range of transactions
that are eligible for the exclusion of swaps in connection with the
origination of loans, and the requirements for limited designation
as a swap dealer, each of which will impact the total number of
entities that are subject to swap dealer regulation. The final rules
also specify criteria related to the thresholds for major swap
participant status, factors that may be considered in the major swap
participant calculations, and the threshold for ``highly leveraged''
status, each of which will impact the number of entities that are
major swap participants.
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Moreover, the variance in aggregate compliance costs resulting from
this rulemaking will not track, on a ``one for one'' basis, the number
of entities included in the definitions as the rules are more or less
inclusive. This is because the initial and recurring compliance costs
for any particular swap dealer or major swap participant will depend on
the size, existing infrastructure, level of swap activity, practices
and cost structure of the entity designated as such.\1271\ Another
reason that the aggregate costs resulting as more or fewer entities are
included in the definitions will not precisely track the number of such
entities is that indirect costs are likely to result as market
participants seek to avoid the regulations attendant to swap dealer or
major swap participant status by, among other things, reducing their
swap activities.\1272\ We do not expect that the extent of these
indirect costs will be directly related to the number of entities
included in the definitions.
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\1271\ It is likely that a swap dealer or major swap participant
would incur direct compliance costs related to technology, personnel
and capital. See CFTC, Registration of Swap Dealers and Major Swap
Participants; Final Rule, 77 FR 2613 (January 19, 2012); CFTC,
Business Conduct Standards for Swap Dealers and Major Swap
Participants With Counterparties; Final Rule, 77 FR 9733 (February
17, 2012) and CFTC, Swap Dealer and Major Swap Participant
Recordkeeping, Reporting, and Duties Rules; Futures Commission
Merchant and Introducing Broker Conflicts of Interest Rules; and
Chief Compliance Officer Rules for Swap Dealers, Major Swap
Participants, and Futures Commission Merchants; Final Rule, 77 FR
20128 (April 3, 2012).
\1272\ For example, those entities would lose the profits they
may have gained from those activities, and potentially from related
business activities if their customers cut back their business
relationships because the abstaining entities no longer engage in
those swap activities.
We recognize that small entities are more likely than large
entities to abstain from swap activities in order to avoid being
covered by the swap dealer definition. Smaller entities are less
likely to have existing technology and procedures that would comply
with new regulations and therefore their initial costs of compliance
with the requirements applicable to swap dealers are likely to be
larger. Moreover, the same fixed costs will have a proportionally
greater effect on small entities.
Other market participants may also bear some costs if entities
abstain from dealing activities or if large users of swaps reduce
their activities to avoid major swap participant status. These costs
could include transition costs as the other market participants
identify new counterparties with which to enter into the same swaps.
In addition, and likely more important, as more entities abstain
from swap activities, other entities that are seeking to enter into
swaps may have a reduced choice of counterparties, which may lead to
unfavorable financial terms for swaps and imperfect matches between
risks and the swaps that are available. These factors may increase
the cost of risk mitigation in general, as entities use more costly
risk management strategies in place of swaps.
See generally letters from API I, BG LNG I, BOK dated February
22, 2011 (``BOK III''), COPE I, Midsize Banks, NEM, NCGA/NGSA I,
NGFA I, Chevron Federal Credit Union, M&T I, Sidley and WGCEF I. See
also Roundtable Transcript at 39 (remarks of Eric Chern, Chicago
Trading Company), 133-34 (remarks of Brenda Boultwood,
Constellation).
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The CFTC likewise acknowledges that more or less inclusive
definitions may increase or decrease the systemic benefits expected
from the composite regulation of swap dealers and major swap
participants. These include improved transparency and market
orderliness, as well as the reduction of excess leverage and systemic
risk. The CFTC believes that less inclusive final rules could
negatively impact these interests in several ways: Those who engage in
swaps with entities that elude swap dealer or major swap participant
status and the attendant regulations could be exposed to increased
counterparty risk; customer protection and market orderliness benefits
that the regulations are intended to provide could be muted or
sacrificed, resulting in increased costs through reduced market
integrity and efficiency; \1273\ and entities that elude swap dealer or
major swap participant status may gain an unwarranted competitive
advantage over other market participants.\1274\
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\1273\ More uniform compliance with regulations leads to more
uniform expectations that market participants may reasonably have
about the financial integrity of various swap dealers and major swap
participants. Less uniform compliance, on the other hand, could
introduce additional uncertainty about the financial integrity of an
individual swap dealer or major swap participant. This could result
in reduced market efficiency. Moreover, foreseeable ``network
effects'' could magnify these costs. That is, since requirements
promoting transparency and orderly documentation are expected to
increase market participants' general level of certainty about the
swap positions held by others in the market, the wider the market
application the greater the benefit. For example, in the 2008
financial crisis, uncertainty about the potential obligations of
various market participants led to actions to restrict credit and
reduce leverage that may not have been taken if there was greater
confidence about market participants in general; this uncertainty
also hampered regulatory efforts. Significant pockets of unregulated
swap activity attributable to less inclusive definitions of the
terms ``swap dealer'' and ``major swap participant'' may result in
costs related to uncertainty and lack of information.
\1274\ The extent of any such competitive advantage would depend
on the number of entities that are inaccurately not covered by the
definitions and the extent of their swap activities relative to the
market in which they are active.
---------------------------------------------------------------------------

Generally, rules that capture more entities are likely to increase
these benefits, while rules that capture fewer entities are likely to
have the opposite effect, though there are several additional factors
that also have a bearing on the presence and magnitude of increased or
decreased benefits. These factors include the number and size of
entities whose status changes

[[Page 30704]]

under more or less inclusive rules, the number of swaps they engage in,
their connectedness to other institutions and role in the financial
system, and the types of financial instruments they would have utilized
in the absence of swap dealer and major swap participant regulations.
At this time, it is also not possible to quantify the impact of
these rules on the direct and indirect costs and benefits that result
from changing the status of an entity that is on the boundaries of the
Dodd-Frank Act's definitions of the terms ``swap dealer'' or ``major
swap participant.'' The CFTC does not have adequate information about
market participants' swap activities to determine which entities will
change their activities in response to the definitions, which would be
necessary in order to determine the significance of the impact on costs
and benefits of including or excluding those entities from the
regulations pertaining to swap dealers and major swap participants.
Costs may not be estimated in an accurate or meaningful way for many
reasons, including because all of the regulations pertaining to swap
dealers and major swap participants have not yet been issued in their
final form, and because the CFTC does not have adequate information
about market participants' existing technology, infrastructure, use of
swaps, or cost structure.\1275\ Changes in the total benefits resulting
from the definitional regulations are also difficult to quantify, since
many of the benefits of the swap dealer and major swap participant
regulations are indirect, rather than direct. As a consequence, the
CFTC may recognize and describe the impact of these rules on the
overall costs and benefits deriving from swap dealer and major swap
participant regulations, but it is not possible to quantify them at
this time.
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\1275\ Currently, prior to the implementation of Title VII, the
U.S. swap market generally is not subject to substantive regulation,
and market participants generally do not disclose detailed
information about their swap activities and positions. This lack of
data reduces our ability to analyze the swap activities of
individual market participants, as well as the market as a whole,
and thus impacts our ability to analyze the costs and benefits of
these rules. Our analysis, out of necessity, is based on data that
currently is available.
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The applicable provisions of the Dodd-Frank Act regarding the term
``eligible contract participant'' are somewhat different, in that the
statute modifies a particular clause in the pre-existing statutory
definition of the term and also provides general authority to further
define the term. The final rules adopted in this regard provide
guidance for the application of these provisions.
3. Comments on the Discussion of Costs and Benefits in the Proposing
Release
Some commenters suggested that the discussion in the Proposing
Release of the costs and benefits of the proposed rules further
defining the terms ``swap dealer, '' ``major swap participant'' and
``eligible contract participant'' was inaccurate or inadequate.\1276\
For example, commenters suggested that in considering the final rules,
the CFTC should consider empirical data regarding the costs and
benefits flowing from the rules,\1277\ opportunity costs associated
with regulatory uncertainty,\1278\ and alternatives that would impose
fewer costs.\1279\ One commenter suggested that the CFTC should issue a
second analysis of the costs and benefits of the rules for public
comment,\1280\ while another commenter said that the consideration of
cost and benefits should include the cumulative cost of interrelated
regulatory burdens arising from all the rules proposed under the Dodd-
Frank Act.\1281\
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\1276\ See letters from API I, NFPEEU, Regional Banks, Sidley
and WGCEF I, II and VIII; see also letter from FSR III.
\1277\ See letters from WGCEF I and II.
\1278\ See letter from Dominion Resources.
\1279\ See letters from NextEra I and NFPEEU.
\1280\ See letters from WGCEF I and II.
\1281\ See letter from NFPEEU.
---------------------------------------------------------------------------

Another commenter said that the cost-benefit analyses in the
Proposing Release may have understated the benefits of the proposed
rules, because focusing on individual aspects of all the rules proposed
under the Dodd-Frank Act prevents consideration of the full range of
benefits that arise from the rules as a whole, in terms of providing
greater financial stability, reducing systemic risk and avoiding the
expense of assistance to financial institutions in the future.\1282\
This commenter said the consideration of benefits of the proposed rules
should include the mitigated risk of a financial crisis.\1283\
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\1282\ See letter from Better Markets II.
\1283\ Better Markets cited estimates that the worldwide cost of
the 2008 financial crisis in terms of lost output was between $60
trillion and $200 trillion, depending primarily on the long term
persistence of the effects. See id.
---------------------------------------------------------------------------

We have endeavored to address the commenters' concerns in this
Adopting Release by undertaking careful consideration of various
alternatives proposed by commenters as described in this section. With
regard to the comments suggesting that we consider empirical data, the
CFTC found that no comprehensive, publicly available empirical data
related to the usage of swaps in all markets is available, and
commenters provided very little empirical data to aid us in this
rulemaking.
4. Costs and Benefits of the Rules Further Defining ``Swap Dealer''
The Proposing Release proposed certain factors that could be
relevant to market participants when determining whether they are
covered by the statutory definition of the term ``swap dealer.'' The
CFTC received comments in response to numerous issues and considered a
variety of alternatives in light of those comments, weighing the costs
and benefits of each. In particular, we considered alternatives with
respect to the activities indicative of holding oneself out as, or
being commonly known as, a dealer in swaps, making a market in swaps,
entering into swaps as a ``regular business,'' the exclusion available
to IDIs for swaps offered in connection with the origination of loans,
inter-affiliate swaps, swaps hedging physical positions, limited dealer
status, and the possibility of providing particularized treatment under
the definition for various types of entities.
As noted above, in considering these alternatives the CFTC's
primary objective was to promulgate a rule under which market
participants could efficiently and accurately determine whether they
are engaged in any of the activities that are included in the statutory
definition of swap dealer, and whether they are covered by any of the
exclusions in the statutory definition. The scope of our consideration
of these alternatives included the five factors specified in section
15(a) of the CEA. That is, we considered how the promulgation of final
rules that would promote application of the definition of the term
``swap dealer'' in a manner that is consistent with the statutory
definition would protect market participants and the public, promote
the efficiency, competitiveness and financial integrity of the
markets,\1284\ facilitate price discovery, encourage sound risk
management practices and serve the public interest. Rather than
describing in a separate section how we applied the elements of section
15(a) in the final rule further defining the term ``swap dealer,'' the
discussion below highlights the application of those elements where
appropriate.
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\1284\ Although by its terms, CEA section 15(a)(2)(B) applies to
the futures (not swaps) markets, the CFTC finds this factor useful
in analyzing the costs and benefits of these regulations further
defining the terms ``swap dealer,'' ``major swap participant'' and
``eligible contract participant'' as well.

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[[Page 30705]]

a. Indicia of Holding Oneself Out as a Dealer in Swaps or Being
Commonly Known in the Trade as a Dealer in Swaps
As discussed above, the Proposing Release set forth activities that
could indicate that a person is holding oneself out as a dealer or is
commonly known in the trade as a dealer in swaps.\1285\ Commenters on
this point said that persons who are not swap dealers also engage in
some of the activities identified in the proposed rule. In other words,
these commenters asserted that these activities are not accurate
indicators of swap dealer status.\1286\
---------------------------------------------------------------------------

\1285\ See part II.A.1, supra.
\1286\ See part II.A.2.a, supra.
---------------------------------------------------------------------------

Commenters were concerned that if the rule included, as bright-line
tests of swap dealer status, the proposed indicators of holding oneself
out as, or being commonly known as, a swap dealer, then the rule would
lead to an interpretation of the statutory definition that would be
more inclusive. This, in turn, would lead to the costs of a more
inclusive rule, and possibly the costs of entities abstaining from swap
activities to avoid being covered by the definition, as discussed
above.\1287\
---------------------------------------------------------------------------

\1287\ See part VII.C.2, supra.
---------------------------------------------------------------------------

While we are cognizant that providing no guidance about how to
apply the statutory provision stating that the term ``swap dealer''
includes any person who holds itself out as a dealer in swaps or is
commonly known in the trade as a dealer or market maker in swaps would
deprive market participants of interpretive guidance--thus increasing
the direct and indirect costs to apply the rule--we considered the
commenters' concern that use of the proposed characteristics as bright-
line indicators of swap dealer status could potentially result in
significant costs. Therefore, to mitigate the costs of applying the
rule and the costs that would result if the rule were more inclusive,
the Adopting Release clarifies that the identified activities are not
per se conclusive, and could be countered by other facts and
circumstances indicating that an entity is not a swap dealer. The CFTC
believes that providing guidance about the factors that are correlated
with holding oneself out as or being commonly known as a swap dealer--
even if not perfectly so--mitigates the risk that the rule would
include entities that are not actually covered by the statutory
definition and provides benefits in reducing the costs of application
of the rule.
b. Making a Market in Swaps
Commenters on this point provided several perspectives on what does
and does not constitute market making.\1288\ With those comments in
view, we considered a number of characteristics for potential inclusion
in the rule, and evaluated potential costs and benefits of each before
determining that making a market in swaps is best described as
``routinely standing ready to enter into swaps at the request or demand
of a counterparty.'' We also further described various activities that
constitute routinely standing ready, such as routinely quoting bid or
offer prices for swaps, routinely responding to requests made directly
by potential counterparties for bid or offer prices, etc. The
alternative options we considered are discussed below in light of the
five broad areas specified in section 15(a) of the CEA.
---------------------------------------------------------------------------

\1288\ See part II.A.2.b, supra.
---------------------------------------------------------------------------

Offer swaps on both sides of the market. The proposed rule stated
our view that an entity may be a market maker in swaps even if the
entity does not enter into swaps on both sides of the market. Several
commenters suggested the rule should require that an entity enter into
swaps on both sides of the market as a prerequisite to market maker
status.\1289\ We have considered these comments and concluded that an
entity could be a market maker by offering swaps on one side of the
market, while entering into transactions on the other side of the
market using other financial instruments.
---------------------------------------------------------------------------

\1289\ See letters cited in notes 52 to 54, supra.
---------------------------------------------------------------------------

Accordingly, using presence on both sides of the market as a
determinative factor in applying the definition of the term ``swap
dealer'' could cause the final rule to be under-inclusive by excluding
entities that function as market makers by entering into swaps on one
side of the market. In addition, some entities may limit their swap
dealing activities to one side of the market in an attempt to avoid
being covered by the definition, again leading to the rule being under-
inclusive.
Excluding cleared swaps from consideration. Some commenters said
cleared swaps should not be considered in determining whether an entity
is a swap dealer.\1290\ Moreover, they suggested that dealers operating
through clearinghouses might choose to exit the market if required to
register as swap dealers, which would reduce liquidity.\1291\
---------------------------------------------------------------------------

\1290\ See letters from Newedge and Traders Coalition. The
commenters said that considering cleared swaps in determining if an
entity is a swap dealer may cause entities to reduce their use of
cleared swaps, which would be contrary to the general purpose of the
Dodd-Frank Act to encourage clearing.
\1291\ See letters from CMC and Traders Coalition.
---------------------------------------------------------------------------

It is possible that some entities whose swap dealing activities are
limited to cleared swaps will abstain from those activities in order to
avoid being covered by the definition, leading to costs associated with
entities abstaining from the market, as described above. Other such
entities may continue their swap dealing activities and incur the
initial and ongoing costs of compliance with swap dealer regulations.
Benefits are linked to these compliance costs, however. For example,
the swap dealer business conduct requirements are expected to provide
benefits in terms of protecting market participants and the public. In
any case, we note that the statutory definition of the term ``swap
dealer'' does not include any factor considering whether the swaps that
an entity enters into are cleared as opposed to not cleared. Therefore,
the costs raised by commenters resulting from the absence of an
exclusion of cleared swaps are costs that result from the statutory
definition and not the final rule.
c. Regularly Entering Into Swaps With Counterparties as an Ordinary
Course of Business
The final rule incorporates the statutory provisions that the term
swap dealer includes a person that ``regularly enters into swaps with
counterparties as an ordinary course of business for its own account''
and ``does not include a person that enters into swaps for such
person's own account, either individually or in a fiduciary capacity,
but not as a part of a regular business.'' The CFTC believes that the
determinative issue in interpreting these provisions is whether an
entity's activity of entering into swaps is part of its usual and
normal course of business and is identifiable as a swap dealing
business, as discussed above.\1292\ This Adopting Release also
describes certain activities that constitute both entering into swaps
``as an ordinary course of business'' and ``as a part of a regular
business.''\1293\
---------------------------------------------------------------------------

\1292\ See part II.A.4.c, supra.
\1293\ See id.
---------------------------------------------------------------------------

The CFTC believes that dealers frequently engage in the activities
described in this Adopting Release, while non-dealers do not.\1294\ As
a consequence, such activities are useful indicators of swap dealing
activity and it is appropriate to incorporate them in

[[Page 30706]]

the guidance interpreting the final rule in order to properly apply the
statutory definition.
---------------------------------------------------------------------------

\1294\ For example, commenters suggested that these types of
activities are indicative of swap dealing. See letters from EEI/
EPSA, Hess, NextEra I, Utility Group and Vitol.
---------------------------------------------------------------------------

d. The Dealer-Trader Distinction
The Adopting Release incorporates the dealer-trader distinction as
a consideration when identifying swap dealers. While not dispositive,
the CFTC anticipates that the dealer-trader distinction will be useful
as a consideration, particularly in light of the degree to which it
overlaps with many of the other characteristics identified in the
Adopting Release that are indicative of dealing activity. The dealer-
trader distinction is likely to be familiar to some market participants
that must determine whether they are swap dealers, and to the extent
that this is true, the CFTC believes that its incorporation as a factor
in the swap dealer analysis will help to reduce uncertainty for those
entities, thereby reducing their costs of determining whether they are
dealers.\1295\ By incorporating the dealer-trader distinction as one
consideration within a broader facts and circumstances approach, the
CFTC has minimized the costs of under inclusion that could arise if the
distinction were used as a bright line test to exempt entities that
would otherwise be subject to regulation as swap dealers.\1296\
---------------------------------------------------------------------------

\1295\ See letters from CCMR I and MFA I.
\1296\ See letter from AFSCME.
---------------------------------------------------------------------------

e. Limited Designation as a Swap Dealer
The Proposing Release provided that ``a person who is a swap dealer
shall be deemed to be a swap dealer with respect to each swap it enters
into'' but explained that an entity could apply for limited
designation. Several commenters suggested that the CFTC should allow
for the possibility of ``presumptive limited designation'' as a swap
dealer in order to reduce costs.\1297\ We have decided, however, not to
provide for a presumptive limited designation in the final rule. While
a presumptive limited designation would, for the entities that seek it,
mitigate the costs of applying for limited designation and any costs
related to uncertainty about whether limited designation will be
granted,\1298\ it could also lead to costs arising from the rule being
less inclusive. Persons engaged in a broad range of activities that are
all covered by the definition of the term ``swap dealer'' would have a
significant incentive to improperly claim eligibility for a presumptive
limited designation. This would hinder the application of swap dealer
regulations to all of their swap dealing activities and thereby
increase costs in terms of lesser protection of market participants and
the public, as well as impairment of sound risk management practices.
---------------------------------------------------------------------------

\1297\ See part II.E.2.a, supra. Several commenters stated that
it is unduly burdensome to require swap dealers to apply swap dealer
requirements to all of their swaps (including swaps not resulting
from dealing activity) while they pursue limited designation. See,
e.g., letters from Capital One, Farm Credit Council I and FHLB I.
Another commenter suggested that not allowing for a presumptive
limited designation could cause some community lenders to cease
offering swaps. See letter from Capital One.
Another commenter suggested that to reduce costs, presumptive
limited designation should be available for any formal division of
an entity, to avoid the costs that would arise if any entity were to
reorganize its operations without certainty that limited designation
would be available to the reorganized entity. See letter from WGCEF
VII.
\1298\ Entities that apply for limited designation as a swap
dealer will be required to prepare a submission to the CFTC
demonstrating their compliance with swap dealer regulations in the
context of limited designation.
---------------------------------------------------------------------------

Commenters suggested that to reduce the costs of determining
whether a particular person is eligible for a limited designation as a
swap dealer, the CFTC should set out certain criteria that would be
relevant to that determination, such as the degree of complexity of an
entity's swap activities, what percentage of an entity's total swap
activities are dealing activities, the relationship between the entity
and its swap counterparties, and how difficult it would be to
distinguish between its ``designated'' and ``non-designated''
swaps.\1299\
---------------------------------------------------------------------------

\1299\ See letters from Capital One and FHLB I.
---------------------------------------------------------------------------

Rather than setting forth specific factors to be considered with
respect to limited designation as a swap dealer, this Adopting Release
takes a facts and circumstances approach, stating that all relevant
factors will be considered in the determination. This Adopting Release
also states that an important factor in determining whether a swap
dealer qualifies for a limited designation is whether the swap dealer
can demonstrate that the internal structure to which the limited
designation applies (e.g., a division or business unit) complies with
the swap dealer requirements. If such a structure is not pre-existing,
the swap dealer will incur costs in creating a structure for its swap
dealing activity in a manner that would qualify for limited
designation. These costs depend on the circumstances of that swap
dealer and cannot be quantified at this time; however, such costs are
likely to be significant for at least some swap dealers. On the other
hand, swap dealers who do qualify for the limited designation will
benefit from reduced ongoing compliance costs since some swap dealer
requirements are expected to apply to only those activities encompassed
by the limited designation.\1300\ This flexible approach will allow
entities to organize themselves in a manner that allows them to
maximize the value of limited designation, so long as they are able to
demonstrate that they will comply with swap dealer requirements. In
settling on this flexible approach, we considered how the use of a
limited designation would allow entities to minimize the effect of swap
dealer registration on their swap activities, which fosters efficiency
while also promoting sound risk management practices through swap
dealer regulation.
---------------------------------------------------------------------------

\1300\ Some swap dealer regulations may be applied at the
transactional level, while others may affect the operations and
capital structure of the entity beyond the swaps or activities for
which it has a limited designation. On this topic, some commenters
suggested that limited designation should allow the swap dealer to
limit operational compliance with swap dealer requirements to the
portion of the business that is designated as a swap dealer. See
letters from FSR I and WGCEF VII. Another commenter stated that the
CFTC should not require additional reporting regarding the non-
dealing activities. See letter from Cargill.
---------------------------------------------------------------------------

The facts and circumstances approach to limited designation will
likely lead to some costs arising from uncertainty among market
participants about whether steps they have taken or may take will
permit them to qualify for a limited designation. However, we believe
that market participants may mitigate such uncertainty costs by
contacting staff to discuss changes under consideration, or by applying
for limited designation on the basis of planned changes (rather than
making the changes and then submitting the application).
f. De Minimis Exception
The Dodd-Frank Act requires that the CFTC exempt from designation
as a swap dealer any entity ``that engages in a de minimis quantity of
swap dealing in connection with transactions with or on behalf of
customers,'' and that the CFTC ``promulgate regulations to establish
factors with respect to the making of this determination to exempt.''
\1301\
---------------------------------------------------------------------------

\1301\ CEA section 1a(49)(D), 7 U.S.C. 1(a)(49)(D).
---------------------------------------------------------------------------

The proposed rule set out certain quantitative standards for
identifying those entities whose swap activities were sufficiently
small that applying swap dealer regulations to them would not be
warranted.\1302\ Commenters raised several points regarding the
potential costs and benefits of the proposed approach. We considered
these points, addressed below, in preparing the final rule, which
provides

[[Page 30707]]

that an entity qualifies for the de minimis exception if the notional
amount of its swap positions or security-based swap positions over the
prior 12 months arising from its dealing activity is $3 billion or
less, and the notional amount of such positions with ``special
entities'' is $25 million or less. However, during a phase-in period
following the effective date of the final rules, an entity will not be
required to register as a swap dealer if the notional amount of the
swap positions it enters into over the prior 12 months arising from its
dealing activities is $8 billion or less.\1303\
---------------------------------------------------------------------------

\1302\ See part II.D.1, supra.
\1303\ See CFTC Regulation Sec. 1.3(ggg)(4)(ii).
---------------------------------------------------------------------------

In determining the level of the notional amount thresholds for the
de minimis exception, we considered comments stating that if the
thresholds were set inappropriately low, persons engaged in a smaller
quantity of swap dealing would face a choice between reducing their
swap dealing activities to a level below the thresholds or registering
as a swap dealer and incurring the costs of compliance with swap dealer
regulation.\1304\ It follows from these comments that these entities
would incur costs in making a decision about the extent to which they
should engage in swap dealing, although none of the commenters
specifically quantified the costs of making that decision. Commenters
also expressed a concern that if many entities chose to reduce or cease
their swap dealing activities in response to the de minimis thresholds,
the availability of swaps may be reduced, particularly to the smaller
swap users that typically engage in swaps with such entities, which
could lead to costs for those smaller swap users.\1305\ Some commenters
said that the CFTC should justify the final thresholds for the de
minimis exception with an economic analysis; however, these commenters
did not propose specific analyses the CFTC should perform or provide
specific information that should be included in the analysis.\1306\
---------------------------------------------------------------------------

\1304\ See, e.g., letters and meetings cited in notes 377 to
381, supra.
\1305\ See, e.g., letters and meetings cited in note 378, supra.
See also Roundtable Transcript at 201 (remarks of John Janney, Large
Public Power Council).
\1306\ See letters from API I, FSR VI, Midsize Banks, Regional
Banks and WGCEF I.
---------------------------------------------------------------------------

The CFTC evaluated data regarding index CDS that was provided by
the SEC, and made that analysis available to the public.\1307\ The data
showed that 80.8% of all participants in the index CDS market entered
into index CDS with an aggregate notional amount of less than $3
billion during 2011, and 88.7% of such market participants entered into
index CDS with an aggregate notional amount of less than $8 billion
during the same period of time. However, the 19.2% and 11.3% of market
participants above those respective thresholds, accounted for 98.9% and
97.8% of the total notional amount of index CDS entered into during
that time, which suggests that a relatively small number of entities
are responsible for a large majority of activity in the index CDS
market. The data also showed that 91.7% of all entities with 3 or more
counterparties that are not recognized by ISDA as dealers entered into
index CDS with an aggregate notional amount of $9 billion or more
during 2011, suggesting that a large majority of dealers in index CDS
likely enter into index CDS with an aggregate notional amount of $9
billion or more per year.
---------------------------------------------------------------------------

\1307\ See memorandum to the public comment file from the CFTC
Office of the Chief Economist.
---------------------------------------------------------------------------

These observations, and any conclusions derived from them, however,
must be qualified by limitations of the data, including: (i) Although
we expect that the data covers a very large part of the index CDS
market, we cannot verify what percentage of all index CDS are
represented in the data; (ii) the data is not filtered to reflect
activity that would constitute swap dealing under the Dodd-Frank Act,
so it is not possible to use the data to draw conclusions regarding any
specific entity's status as a swap dealer and (iii) the data does not
cover other classes of swaps that are relevant to the de minimis
threshold for swap dealers, such as interest rate swaps, equity swaps,
foreign exchange swaps or other commodity swaps.\1308\ In light of
these limitations, any conclusions drawn from the index CDS data must
be regarded as provisional.
---------------------------------------------------------------------------

\1308\ See id.
---------------------------------------------------------------------------

We note that no matter the level at which the de minimis thresholds
are set, there will always be some entities engaged in a quantity of
swap dealing at or above the threshold level that will face the choice
described by the commenters. As noted above, we considered the costs
and benefits of dealer regulation in determining the notional amount
standards in the final rule.\1309\ Among the costs we considered were
those that would result if entities reduce or cease their swap dealing
activities in response to the de minimis threshold and swaps become
less available in smaller or niche markets. We considered that this
could impact the competitiveness of those markets and undermine the
ability of market participants to practice sound, cost-effective risk
management.\1310\ In principle, a higher threshold would promote a
larger pool of swap-dealing entities (since entities with swap dealing
activity below the threshold need not incur costs to comply with swap
dealer regulations), meaning more potential counterparties available to
swap users. On the other hand, a greater quantity of swap dealing would
be undertaken without the customer protection, market orderliness and
market transparency benefits of dealer regulation. This, in turn would
impair the protection of market participants and the public, and
undermine sound risk management practices, as described above.\1311\ We
considered these factors in determining the level of the notional
amount standard in the final rule.
---------------------------------------------------------------------------

\1309\ See part II.D.3.a, supra. In particular, we note here
that the higher notional amount standard in the final rule, as
compared to the proposed rule, should reduce the number entities
that will face the choice described by the commenters.
\1310\ As noted above, it is not possible to quantify these
potential costs with mathematical precision. See note 421, supra.
The commenters on these points did not provide quantifications of
such costs.
\1311\ Commenters expressed various views as to what level of
benefits flow from dealer regulation. See, e.g., Roundtable
Transcript at 137-43 (remarks of John Janney, Large Public Power
Council, Bella Sanevich, NISA Investment Advisors, LLC, and Brenda
Boultwood, Constellation)
---------------------------------------------------------------------------

Some commenters advocated use of alternative measures (such as an
entity's current uncollateralized exposure from swaps, or the number or
frequency of swaps) as the de minimis gauge.\1312\ Some commenters
suggested that various types of entities should be subject to different
de minimis thresholds,\1313\ or that the rule should vary the de
minimis threshold by type of swap.\1314\ Some commenters suggested that
the de minimis exception should take into account the purpose of an
entity's swap dealing activities or the entity's general
characteristics.\1315\
---------------------------------------------------------------------------

\1312\ See letters cited in notes 384 and 385, supra.
\1313\ See letters from COPE I, Farm Credit Council I and MFX II
and meeting with Electric Companies on April 13, 2011.
\1314\ See letters from Gavilon II and ISDA I.
\1315\ See letters from Farm Credit Council I, FHLB I and MFX
II.
---------------------------------------------------------------------------

The CFTC believes that these proposed alternatives are unlikely to
better promote the efficiency, competitiveness and financial integrity
of the markets, or yield other benefits to a greater extent than the
approach adopted in the final rule.\1316\ On the

[[Page 30708]]

other hand, requiring market participants to consider more variables in
evaluating application of the de minimis exception would likely
increase their costs to make this determination. In light of these
considerations, we concluded that to establish a single notional
threshold for all of an entity's swap dealing would best protect the
markets and the public, foster efficiency and competitiveness and serve
the public interest.
---------------------------------------------------------------------------

\1316\ We considered the proposed options in terms of whether
they would promote: protection of market participants and the
public; financial integrity and efficiency of swap markets; price
discovery; sound risk management principles; and other public
interest considerations. The commenters suggesting other measures
did not offer a systematic analysis of whether the measures would
lead to more accurate determinations in all or even most cases, and
we do not believe such an analysis would be possible at this time
due to the lack of information regarding how swaps are used in all
markets. See generally part II.D.4.a, supra.
---------------------------------------------------------------------------

We believe that using a de minimis threshold based on current
uncollateralized exposure would lead to costs of calculation, which are
discussed below in connection with the definition of major swap
participant. Also, while current uncollateralized exposure may be a
useful measure of the risk arising from a swap position, it fails to
address the significance of an entity's swap dealing activity in terms
of customer protection and market orderliness, which are significant
elements in the determination of whether an entity is engaged in a de
minimis quantity of swap dealing.\1317\
---------------------------------------------------------------------------

\1317\ See part II.D.3.e, supra.
---------------------------------------------------------------------------

In response to commenters' suggestions, we considered the
feasibility of assessing the breakeven point at which a potential swap
dealer would earn enough profit from its swap dealing to support the
costs to comply with swap dealer regulation.\1318\ However, this
assessment would require access to non-public, proprietary data
regarding the gross margins associated with the swap dealing activity
of a wide variety of market participants. Such data is not available to
the CFTC.
---------------------------------------------------------------------------

\1318\ See Roundtable Transcript at 193-94 (remarks of James
Cawley, Javelin Capital Markets, and Camille Rudge, The PrivateBank
and Trust Company).
---------------------------------------------------------------------------

One commenter suggested that the de minimis threshold for swaps
related to a particular physical commodity should increase if the
general price of the commodity increases, so that a constant quantity
of the commodity could be hedged through a particular swap dealing
entity without that entity exceeding the threshold.\1319\ However, this
approach, which eschews reliance on the dollar value of swaps, would
raise the complex question of when the level of dealing in swaps
relating to the physical quantity of various commodities becomes more
than de minimis. We do not believe that this approach would provide
sufficient additional benefits beyond those resulting from the final
rule to justify the additional costs of application.
---------------------------------------------------------------------------

\1319\ See letter from NCFC I.
---------------------------------------------------------------------------

Commenters also suggested that, in order to simplify application of
the de minimis exception and thereby reduce costs, the final rule
should include an overall threshold that considers an entity's swaps
and its security-based swaps.\1320\ However, the statute includes two
different de minimis exceptions regarding the quantity of an entity's
swap dealing and its security-based swap dealing. Therefore, the
suggested approach would be contrary to the statute.
---------------------------------------------------------------------------

\1320\ See letter from NYCBA Committee.
---------------------------------------------------------------------------

The final rule provides for a lower de minimis gross notional
threshold (i.e., $25 million over the course of twelve months) for
swaps in which the counterparty is a ``special entity,'' as that term
is defined in CEA section 4s(h)(2)(C) and CFTC Regulation Sec.
23.401(c)). While it is possible that, for the reasons noted above,
this lower threshold could reduce the number of potential providers of
swaps to special entities, which may constrain the ability of special
entities to practice sound risk management strategies in a cost-
effective manner, we note that the Dodd-Frank Act provides special
entities with additional protections from market practices that could
increase the risks they face in using swaps.\1321\ We believe the
threshold in the final rule reflects an appropriate consideration of
these potential costs and the benefits that result in terms of serving
the public interest.
---------------------------------------------------------------------------

\1321\ See generally Roundtable Transcript at 210-15 (remarks of
Mary-Margaret Collier, Tennessee Comptroller of the Treasury, John
Janney, Large Public Power Council and Bella Sanevich, NISA
Investment Advisors, LLC).
---------------------------------------------------------------------------

Several commenters responded to the proposed de minimis thresholds
limiting the number of an entity's counterparties and swaps, suggesting
that the factors would not be useful in identifying entities engaged in
a de minimis quantity of swap dealing.\1322\ The final rule omits these
factors. We believe that, in general, entities which will restrict
their activities so as to remain under the de minimis notional amount
threshold are likely to be those entities that are most willing to
provide swaps with lower notional values. Counting an entity's number
of counterparties or swaps as de minimis factors could inappropriately
discourage entities from providing swaps in smaller notional amounts.
This, in turn, would likely make it more difficult for persons seeking
small notional amount swaps to find dealers willing to provide them,
which may increase their costs of hedging and discourage sound risk
management practices.
---------------------------------------------------------------------------

\1322\ Some commenters suggested that the number of
counterparties and the number of swaps are not indicators of
systemic risk. See letters cited in note 387, supra. Others claimed
that the de minimis standard should not limit the number of an
entity's counterparties for policy reasons. See letters from
Chesapeake Energy and Land O'Lakes I. Commenters also suggested that
using number of counterparties or number of swaps as a factor would
create an uneven playing field because it would discourage provision
of swaps to small end users. See letters from EEI/EPSA and NMPF.
---------------------------------------------------------------------------

g. Exclusion of Swaps Entered Into by IDIs in Connection With the
Origination of Loans
The statutory definition of the term ``swap dealer'' excludes an
IDI ``to the extent it offers to enter into a swap with a customer in
connection with originating a loan with that customer.'' \1323\ The
proposed rule would implement this statutory exclusion by providing
that an IDI's swaps with a customer in connection with originating a
loan to that customer are disregarded in determining if the IDI is a
swap dealer. To prevent evasion, the proposed rule further provided
that the statutory exclusion does not apply where the purpose of the
swap is not linked to the financial terms of the loan, the IDI enters
into a ``sham'' loan, or the purported ``loan'' is actually a synthetic
loan such as a loan credit default swap or loan total return swap.
---------------------------------------------------------------------------

\1323\ See CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A).
---------------------------------------------------------------------------

Commenters on the costs and benefits of the proposed approach
focused on the benefits of a flexible application of the exclusion,
which they asserted would promote the offering of swaps by IDIs in
connection with loans and thereby more closely tailor the risks of a
loan to the borrower's and the lender's needs, and promote the risk-
mitigating effects of swaps.\1324\ In terms of costs, commenters were
concerned that a narrow application of the loan origination exclusion
would cause IDIs to seek to avoid being covered by the definition of
the term ``swap dealer'' by limiting their offering of swaps in
connection with the origination of loans. Commenters said that the
IDIs' limitation of their swap offerings could lead borrowers to take
steps with negative ramifications, such as reduced usage of swaps for
risk mitigation (which could lead to costs from an increased risk of
default by the borrower), shifting from the lending institution to
another institution for the swap (which could lead to inefficiency
costs since two different institutions would be involved), or shifting
to

[[Page 30709]]

another institution for both the loan and the swap (which could
increase risk by increasing concentration in the markets for loans and
swaps).\1325\ To mitigate these costs, commenters suggested that the
loan origination exclusion should be construed broadly, particularly
with respect to the range of loans covered,\1326\ the type of swaps
covered,\1327\ the required timing for entering into a swap relative
the corresponding loan's origination,\1328\ and which financial
institutions could be eligible for this exclusion.\1329\
---------------------------------------------------------------------------

\1324\ See, e.g., letter from B&F Capital I.
\1325\ Commenters said that if, because of concern about
triggering the de minimis threshold, IDIs were not willing to offer
swaps at times when the borrower's hedging needs change due to loan
related events, borrowers would have an incentive to seek out
lenders who are not so constrained, and this incentive would be
particularly strong if a borrower was not able to provide collateral
to secure both a loan and a related swap from two separate
counterparties. See letters from BOKIII, FSR VI and Rabobank, New
York Branch. One commenter suggested that the impact of a narrow
loan origination exclusion should be considered in tandem with the
de minimis exception, because an expansion of one of the exceptions
could offset some of the costs that result from a narrow
interpretation of the other. See letter from FSR VI.
\1326\ See letters cited in notes 308 to 313, supra.
\1327\ See letters cited in notes 299 to 301313, supra.
\1328\ See letters cited in notes 302 to 304313, supra.
\1329\ See letters cited in notes 314 to 317304313, supra.
---------------------------------------------------------------------------

The final rule limits the loan origination exclusion to swaps with
terms that are directly related to the financial terms of the
associated loan, or are required by loan underwriting criteria to to be
in place as a condition of the loan in order to hedge commodity price
risks incidental to the borrower's business. We believe that extending
the loan origination exclusion further, to encompass a broader range of
swaps connected to a borrower's other business activities would expand
the exclusion beyond its statutory limits. This would lead to the costs
associated with the rule becoming less inclusive, such as decreased
protection of market participants and the public, as well as impaired
risk management practices and market efficiency, as described above.
This Adopting Release also includes guidance that the term ``loan''
should be construed for this purpose in accordance with the common law
definition of the term, in order to efficiently allow all interested
parties to determine which transactions and instruments are eligible to
be a basis for the exclusion. The CFTC believes that a detailed
definition of the term ``loan'' covering all of the potential
variations in how loans may be structured would be both costly to apply
(because of the level of analysis required to determine if a particular
instrument qualifies as a loan) and unnecessary (because a common law
definition of the term ``loan'' has already been established).
We believe that extending the loan origination exclusion to cover
any swap entered into by an IDI and a borrower at any point during the
life of the loan would be contrary to the statutory terms of the
exclusion, which focuses specifically on swaps entered into in
connection with the ``origination'' of loans, and could lead to the
costs of the rule being less inclusive described above. Rather, since a
primary element of a loan is the transfer of money from the lender to
the borrower, the final rule provides that the loan origination
exclusion can cover an otherwise eligible swap if the swap is entered
into during a specified period around either the execution of the loan
agreement or any draw of principal under the loan. We believe that this
aspect of the final rule accurately reflects the statutory terms of the
exclusion and will serve the public interest by being neither over-
inclusive nor under-inclusive.
Commenters generally agreed with the statement in the Proposing
Release that the exclusion should be available to IDIs in a loan
syndicate, purchasers of a loan, assignees of a loan, and participants
in a loan.\1330\ We believe that allowing the loan origination
exclusion to extend to IDIs that participate in loans accurately
reflects the statutory terms of the exclusion, so long as the IDIs'
participations are meaningful. Therefore, the rule includes a minimum
participation requirement in order to avoid inappropriate exploitation
of the exclusion--i.e., IDIs participating minimally in a loan
syndication to gain eligibility for the exclusion -- which could lead
to costs of under-inclusion. The final rule allows the exclusion to be
applied to a swap (which is otherwise covered by the exclusion) even if
the notional amount of the swap is different from the amount of the
loan tranche assigned to the IDI, so long as the IDI meets the minimum
participation requirements in the loan. This provision is expected to
facilitate minimization of the number of swaps borrowers enter into,
and the number of counterparties they face with respect to those swaps,
when entering swaps in connection with loans, thereby reducing the
operational costs and risks born by borrowers.
---------------------------------------------------------------------------

\1330\ See letters cited in note 305313, supra.
---------------------------------------------------------------------------

h. Inter-Affiliate Swaps
The Proposing Release stated that the dealer analysis should
consider the economic reality of swaps between affiliates, and
preliminarily concluded that swaps ``between persons under common
control may not involve the interaction with unaffiliated persons that
we believe is a hallmark of the elements of the definitions that refer
to holding oneself out as a dealer or being commonly known as a
dealer.'' Commenters generally agreed with the proposed approach.\1331\
Some commenters expressed the view that the proposed approach would
facilitate the use by affiliated corporate groups of centralized
market-facing conduits, which would promote efficient risk
management.\1332\
---------------------------------------------------------------------------

\1331\ See letters cited in note 341, supra.
\1332\ See letters from Kraft, ONEOK and Shell Trading II.
---------------------------------------------------------------------------

The final rule interprets the dealer definition not to encompass a
person's activities with respect to swaps between legal entities that
are under common majority ownership. The final rule also provides that
the swap dealer definition does not encompass the activities of a
cooperative with respect to swaps between the cooperative and its
members. We believe that such swaps generally serve to allocate or
transfer risks within an affiliated group, rather than to move those
risks out of the group to an unaffiliated third party, and therefore to
include such swaps in the determination of whether an entity is a swap
dealer would not be consistent with the statutory definition, nor would
it serve the public interest or promote the protection of markets or
the public. We also agree with commenters that the use of conduit
structures to enter into swaps on behalf of commonly controlled
entities has the potential to promote sound risk management practices
and the efficiency of the swap markets. Therefore, including these
swaps in the determination of whether a person is covered by the
definition of ``swap dealer'' is not likely to provide significant
benefits, but to include entities in the definition by virtue of these
swaps would lead to the costs of the rule being overinclusive, as
described above.
i. Exclusions of Swaps Entered Into for Hedging Physical Positions
Several commenters said that swaps used to hedge risks should not
be considered in determining whether a person is a swap dealer. While
the statutory definition of the term ``swap dealer'' does not
specifically address hedging activity, the Commissions believe that in
certain situations, entering into a swap for the purpose of hedging a
physical position is not indicative of, and is not, swap dealing.

[[Page 30710]]

An interim final rule provides that the determination of whether a
person is a swap dealer will not consider a swap that the person enters
into for the purpose of offsetting or mitigating certain price risks as
defined in the rule, if the swap meets conditions specified in the
rule.
When a person enters into a swap for the purpose of hedging the
person's own risks in specified circumstances, an element of the swap
dealer definition--the accommodation of the counterparty's needs or
demands--is absent. Therefore, consistent with our overall interpretive
approach to the definition, the activity of entering into such swaps
(in the particular circumstances defined in the rule) does not
constitute swap dealing. Providing an exclusion of such swaps from the
swap dealer analysis reduces costs that persons using such swaps would
incur in determining if they are swap dealers.
j. Exclusions of Certain Swaps Entered Into by Floor Traders
The CFTC believes that it would be inappropriate to require persons
who are registered with the CFTC as floor traders to include in the
swap dealer analysis swaps that they enter into, using only proprietary
funds, on or subject to the rules of a DCM or SEF and submit for
clearing to a DCO, and that meet certain other conditions specified in
the rule. The CFTC believes that a requirement that these persons
register as swap dealers (if the swap dealer registration requirement
were to apply) could lead to duplicative regulation, since they are
already registered as floor traders.
Providing an exclusion of such swaps from the swap dealer analysis
reduces costs that persons using such swaps would incur if such swap
activity were to require them to register as swap dealers. Since the
swaps are entered into on an exchange, by a person who is registered
with the CFTC and cleared, we expect that the potential impact on the
transparency, market orderliness and other goals of dealer registration
from excluding these swaps from the dealer analysis would be minimal.
Importantly, the rule requires that the person comply with the record
keeping and risk management requirements of CFTC Regulation Sec. Sec.
23.201, 23.202, 23.203, and 23.600 with respect to each such swap as if
the person. were a swap dealer. The requirement to comply with these
important provisions reduces the potential for negative consequences
from this rule.
k. Exclusions for Particular Types of Entities
Several commenters said the CFTC should interpret the statutory
definition of ``swap dealer'' to include per se exemptions from the
definition for certain types of persons or persons who engage in
certain activities.\1333\ These commenters argued, in general, that
there would be little or no benefit from construing the statute as
covering these persons or activities because they did not contribute to
the causes of the recent financial crisis or they do not pose systemic
risk.\1334\ These commenters also asserted that to interpret the
statutory definition to cover these types of persons or activities
would lead to the costs of the rule being more inclusive, as noted
above.\1335\
---------------------------------------------------------------------------

\1333\ See part II.A.2.f, supra.
\1334\ See id.
\1335\ In addition, comments along these lines asserted that to
apply dealer regulation to certain persons who are already subject
to different financial regulations would be duplicative and could
create additional costs. See letters from Farm Credit Council I,
FERC Staff, Fidelity, GIC, MFA I, and NARUC and joint letter from
ICI and SIFMA AMG.
---------------------------------------------------------------------------

As stated previously, we note that the statutory definition of the
term ``swap dealer'' applies to ``any person'' who engages in the
activities described in the statute and who does not fall within the
specific exceptions and exclusions in the statute. Therefore, the costs
of applying the statutory definition to certain types of persons
identified by the commenters arise from the provisions of the statute
and not from the CFTC's rulemaking. In addition, to provide the
requested per se exemptions from the statutory definition could also
introduce the costs of the rule being less inclusive discussed above,
such as decreased protection of market participants and the public, as
well as impaired risk management practices and market efficiency.
Regarding the argument that there is no or little economic benefit
from interpreting the statutory definition to cover persons whose
failure would not create systemic risk, the commenters making this
point did not provide evidence or analysis to indicate whether there
would be systemic risk concerns if they were to fail. While some of
these commenters asserted that their swap activities are not comparable
to the activities of the financial institutions that are generally
considered to have had a significant role in the recent crisis, and
some asserted that persons eligible for the claimed exemptions did not
play a role in the crisis, even if these assertions are taken as true
they are not determinative of whether persons of this type could in
fact be a source of systemic risk. We emphasize that the relevant
question in this regard would not be whether the failure of any one
person within the class covered by a suggested exemption would be the
source of systemic risk, but rather whether a failure of several or
many such persons would impact the efficiency, competitiveness and
financial integrity of the markets, impair sound risk management
practices or otherwise affect the protection of markets and the
public.\1336\ To be clear, we do not believe and we are not asserting
that any of the types of persons discussed by the commenters in this
regard necessarily could be the source of systemic risk concerns, but
rather we point out that the comments in this regard were general
assertions rather than a presentation of specific evidence or analysis
to support the claimed exemptions from the statutory definition. Thus,
even if the statute allowed for such exemptions, which we do not
believe it does, none of the commenters provided substantial support
for their assertions. Also, as noted above we believe that the dealer
definitions should be construed in the light of several benefits of
dealer regulation (including protection of the markets and the public,
encouraging the efficiency, competitiveness and financial integrity of
the swap markets, and the overall public interest) and not just in
terms of mitigating potential systemic risk.
---------------------------------------------------------------------------

\1336\ This is so because the commenters requested per se
exemptions for broad classes of persons and activities, rather than
for specific persons. Whether a particular type of market
participant, as a group, can be the source of systemic risk depends
on, among other things, the financial strength of each entity in the
group, the number and financial strength of their counterparties,
the total amount of swap business conducted, the amount and types of
margin posted by the entities in question as well as by their
counterparties, what portion of their swap positions are cleared,
the volatility of each swap's value as well as the covariance in
value for all the swaps in their portfolio, and numerous other
economic factors.
---------------------------------------------------------------------------

In any case, we believe that the final rule and the guidance in the
Adopting Release provide clarifications that in many respects mitigate
the costs that were raised by some of the commenters seeking per se
exemptions from the definition.
l. Other Comments on the Rule Further Defining the Term ``Swap Dealer''
Commenters cited other potential costs that could arise from the
proposed approach to interpreting the statutory definition of the term
``swap dealer,'' suggesting that the proposed approach was not
sufficiently clear, may result in multiple interpretations, and risks

[[Page 30711]]

covering entities that would not actually be covered by the statutory
definition, if it were correctly interpreted.\1337\ Other commenters
suggested that there could be high costs from application of the swap
dealer regulations due to erroneous interpretation of the statutory
definition of the term ``swap dealer,'' including high costs of
regulatory uncertainty,\1338\ and therefore it is particularly
important that the final rule provide guidance on the application of
the statutory definition.\1339\ For example, these commenters said that
if the final rule does not adequately clarify application of the
statutory definition, market participants may incur unnecessary costs
to avoid being covered by the definition of ``swap dealer,'' including
by avoiding swap activities that are associated with areas of
uncertainty under the rule.\1340\
---------------------------------------------------------------------------

\1337\ See letters from AIMA I, API I, Dominion Resources, FSR
III, NRG Energy, Peabody and Utility Group.
\1338\ See letters from API I, Dominion Resources, FERC Staff,
NextEra I and WGCEF VIII.
\1339\ See letters from API I, FSR III, M&T I, Utility Group and
Vitol.
\1340\ One area cited by commenters as a potential source of
such costs is the application for limited designation as a swap
dealer. Commenters were concerned that if the parameters of the
limited designation were uncertain, entities may incur opportunity
costs from avoiding activities that may be incompatible with a
limited designation, planning and operational costs from changing
corporate structure in ways that are not actually necessary to
obtain a limited designation, and other costs from modifying swap
activities in response to uncertainty about the steps necessary for
a limited designation. See letters from API I, BG LNG I, Dominion
Resources, NextEra I, Vitol and WGCEF VII.
---------------------------------------------------------------------------

Some commenters said that the proposed rule captures too broad a
range of entities in its further definition of the term ``swap
dealer,'' \1341\ and that the asserted over-inclusiveness of the
proposed rule could lead to direct costs for covered entities as well
as indirect costs for covered entities, other swap market participants,
and the public.\1342\ For example, the commenters assert that as
entities change their swap activities in reaction to the rule, the
objectives they previously achieved through swaps may either be
compromised, accomplished through less suitable means, or both.\1343\
As another example, the commenters assert that changes in swap
activities may reduce the choice of counterparties available to market
participants, which may lead to unfavorable financial terms for swaps
and imperfect matches between risks and swaps, which could in turn lead
to reduced usage of swaps and lower liquidity in the swap markets,
resulting ultimately in increased costs of risk mitigation in
general.\1344\
---------------------------------------------------------------------------

\1341\ See letters from BG LNG I, FSR III, NCGA/NGSA I, and
WGCEF I, II and VIII.
\1342\ See letters from API I, Atmos Energy, BG LNG I, Dominion
Resources, Hess, NCGA/NGSA Iand Vitol, and WGCEF VIII.
\1343\ For example, an entity using swaps to hedge price risks
may choose not to hedge or to use a different instrument to hedge
similar positions. If it chooses not to hedge, its risk management
objectives may be compromised. If it chooses to hedge using futures
or some other instrument, that instrument may be less suitable for
various reasons (e.g., basis risk, rollover risk, liquidity risk,
less customizability, different fee structure, etc.). However, it is
not possible to quantify the costs and benefits resulting from these
choices without knowing the terms of the individual swaps the
entities would have used and the available alternatives for each of
those swaps.
\1344\ On the other hand, entities may find that they can
achieve their risk management goals using forward contracts, futures
and other financial instruments, or they may determine that their
financial risks can be reduced in other ways.
---------------------------------------------------------------------------

The commenters did not quantify the extent of these costs that may
arise when entities change their swap activities in reaction to the
rule further defining the term ``swap dealer.''
We believe that by addressing the concerns regarding the costs and
benefits of specific aspects of the rule, discussed above in section
V.C.5., the final rule will also mitigate the indirect costs that may
arise from the rule. While it is impossible to completely eliminate the
costs that entities will incur in interpreting the rule and applying it
to their particular swap activities, we believe the final rule
mitigates these costs by providing detailed guidance. Also, these costs
may decrease over time as precedents are established to provide further
guidance on the application of the statutory definition.
For example, the final rule and the guidance in this Adopting
Release mitigate the costs of uncertainty in application of the
statutory definition by providing more detail about the interpretation
of the statute's inclusion of any person who ``makes a market in
swaps'' and the statute's exclusion of a person that enters into swaps,
``but not as a part of a regular business.'' The guidance describes
activities that are indicative of making a market in swaps and of
entering into swaps as a part of a regular business. The final rule
also provides details regarding the scope of the statutory exclusion of
swaps in connection with the origination of loans and the de minimis
exception. Also, the final rule provides that swaps between majority-
owned affiliates, swaps entered into by a cooperative with its members,
swaps entered into for hedging physical positions as defined in the
rule, and certain swaps entered into by floor traders, are excluded
from the swap dealer determination. These provisions will reduce the
costs that market participants incur in determining whether they are
covered by the statutory definition of the term ``swap dealer.''
While it is possible that some entities could choose to cease or
reduce their swap dealing activities to avoid the costs of compliance
with swap dealer regulations, which could impair the efficiency and
competitiveness of the swap markets, there are also likely to be
significant benefits derived from swap dealer regulation, including
reduced counterparty risk, better protection of the markets and the
public, and more assured financial integrity of the markets and
improved market transparency. Moreover, whether such reductions in
activity will lead to reduced liquidity in the swap markets, as some
commenters assert, is not certain. For example, if such reductions in
swap activity occur, new swap dealers may organize themselves or
existing swap dealers may expand to accommodate the demand for swaps,
although the time that would be required for this to occur and the
extent to which it would occur are uncertain.
In addition, indirect costs could arise from the rule being less
inclusive. For example, if the rule considered factors that are not
relevant to whether an entity is actually covered by the definition,
such as by providing that only entities that make a two-sided market in
swaps are makers of markets in swaps, then it is possible that entities
could change their behavior in response to that aspect of the rule. For
example, entities that previously made a two-sided market in swaps may
decide to make only a one-sided market in swaps, potentially leading to
the types of costs that commenters said would arise if entities reduce
their swap activities.
Last, several commenters raised questions and offered suggestions
about the timeline for implementation of swap dealer requirements
\1345\ and the sequencing of the CFTC's rulemaking.\1346\ While we
understand that appropriate timing of rulemaking and the implementation
of the requirements applicable to swap dealers will play a significant
role in mitigating inappropriate or avoidable costs flowing from those
requirements, this rulemaking is limited to the interpretation of the
statutory definition of the term ``swap dealer,'' and so these

[[Page 30712]]

comments are beyond the scope of this rulemaking.
---------------------------------------------------------------------------

\1345\ See letters from API I, Capital One, COPE dated March 14,
2011 (``COPE II''), FSR III,Soci[eacute]t[eacute]
G[eacute]n[eacute]rale, and Vitol and WGCEF dated March 22, 2011
(``WGCEF III'').
\1346\ See letters from ABA Securities Association, BlackRock
dated June 3, 2011 (``BlackRock III''), CDEU, Hess and WGCEF dated
March 23, 2011 (``WGCEF IV'').
---------------------------------------------------------------------------

In sum, we are cognizant that both direct and indirect costs would
arise if the rule further defining the term ``swap dealer'' did not
appropriately reflect the statutory definition of the term. Such costs,
which would arise as the rule is either more or less inclusive, are
detailed above. The Adopting Release provides benefits by interpreting
the term ``swap dealer'' in a manner that is as close as possible to
the statutory definition of the term, thereby mitigating the potential
costs of both over-inclusiveness and under-inclusiveness.
m. Costs of Applying the Rules Further Defining the Term ``Swap
Dealer''
In order to apply the rules further defining the term ``swap
dealer'' and determine whether or not it is covered by the definition,
an entity will incur direct costs in the form of personnel hours
devoted to analyzing the entity's activities with respect to swaps and
determining whether the entity is covered by the definition. These
costs will depend on the nature of the entity's swap activities in the
relevant situation. For some entities, it will be relatively clear that
they are covered by the definition and they will incur relatively few
costs in confirming that. It is expected that for many entities it will
be relatively clear that they are not covered by the definition and
they will incur little or no cost in confirming that determination.
However, for some entities, especially those that enter into swaps in a
variety of different ways and circumstances, the determination will be
more complex and will require that personnel with financial and legal
expertise review the circumstances of the entity's swap activities to
make the determination of whether the entity is covered by the
definition.
It is important to recognize that this would be the case in the
absence of any rule further defining the term ``swap dealer,'' or
regardless of the terms of the rule, because entities would have to
interpret the statutory definition to determine whether they are
covered. Thus, at a minimum, a significant portion of the costs
discussed below is attributable to the inclusion in the Dodd-Frank Act
of a definition of the term ``swap dealer'' and not from any aspect of
the final rules further defining that term. Indeed, the final rule
provides benefits by minimizing these costs by providing guidance about
the application of the statutory definitions in various situations.
The amount of time and resources that must be expended by an entity
in order to determine whether it qualifies as a dealer will vary
considerably depending on the complexity of the entity's operations. In
addition, the direct costs will vary depending on the determinations
the entity must make--reviewing whether or not it is covered by the
definition of the term ``swap dealer,'' whether it qualifies for the de
minimis exception, or whether it seeks to obtain a limited purpose
registration as a swap dealer. Depending on an entity's situation, it
may incur some or all of these costs. We did not receive any comments
quantifying the costs that an entity may incur in applying any aspect
of the definition of ``swap dealer,'' nor are we aware of any studies
or surveys regarding this particular issue. Therefore, the CFTC staff
has estimated the amount of time that entities may require to apply the
definition in various situations. These estimations are for
informational purposes and require the CFTC to consider the
aforementioned highly uncertain criteria.
Regarding the determination of whether an entity is covered by the
definition of the term ``swap dealer,'' an entity with a relatively low
degree of complexity in its organizational structure (i.e., one legal
entity) and in its swap activities (i.e., little variation in the types
of swaps they use and the purposes for which they use them) might
expect the direct cost of such a determination to be approximately
$13,000.\1347\ We estimate that approximately 250 entities of this type
would be engaged in swap activities that create sufficient uncertainty
regarding the application of the definition that they would have to
incur these costs. An entity with a moderate degree of complexity in
its organizational structure (i.e., a few legal entities) and its swap
activities (i.e., some variation in the types of swaps they use and the
purposes for which they use them) might expect the cost of such a
determination to be approximately $54,000.\1348\ We estimate that
approximately 150 entities of this type would be sufficiently uncertain
regarding the application of the definition that they would have to
incur these costs. An entity with a high degree of complexity in its
organizational structure (i.e., multiple affiliates in the corporate
group) and its swap activities (i.e., using diverse types of swaps for
various purposes) could spend approximately $170,000 when making a
determination as to whether it is covered by the definition of swap
dealer.\1349\ We estimate that approximately 50 entities of this type
would be sufficiently uncertain regarding the application of the
definition that they would have to incur these costs. Thus, the total
direct cost for all entities to determine the coverage of the
definition of the term ``swap dealer'' would be approximately
$20,000,000.
---------------------------------------------------------------------------

\1347\ This estimate is based on the following staff
requirements for this determination: 20 hours for a financial
analyst at $161/hour, 5 hours of a financial manager at $325/hour, 2
hours of a controller or chief financial officer at $722/hour, 10
hours of a compliance attorney at $355/hour, 2 hours of a senior
attorney at $992/hour, and 2 hours of a chief compliance officer at
$664/hour. We round to two significant digits. The multiplier of
5.35, which was used in the Proposing Release, is higher than the
multiplier that the CFTC has used for similar purposes in other
final rules adopted under the Dodd-Frank Act. See, e.g., CFTC, Swap
Data Recordkeeping and Reporting Requirements; Final Rule, 77 FR
2135, 2173 (Jan. 13, 2012) (adjustment factor of 1.3 for overhead
and other benefits). The CFTC believes that use of a higher
multiplier here is appropriate because some persons may retain
outside advisors to assist in making the determinations under the
rules.
The estimates of the hourly cost for these personnel are from
SIFMA's Management & Professional Earnings in the Securities
Industry 2010, modified by CFTC staff to account for an 1800-hour
work-year and multiplied by 5.35 to account for firm size, employee
benefits, and overhead. These estimates are intended to reflect
averages for compiling and analyzing the information necessary to
apply the definition of the term ``swap dealer.'' We recognize that
particular entities within each range of complexity may, based on
their circumstances, incur costs substantially greater or less than
the estimated averages.
\1348\ This estimate is based on the following staff
requirements for this determination: 40 hours for a financial
analyst at $161/hour, 10 hours of a financial manager at $325/hour,
5 hours of a controller or chief financial officer at $722/hour, 30
hours of a compliance attorney at $355/hour, 20 hours of a mid-level
attorney at $608/hour, 15 hours of a senior attorney at $992/hour,
and 5 hours of a chief compliance officer at $664/hour.
\1349\ This estimate is based on the following staff
requirements for this determination: 120 hours for a financial
analyst at $161/hour, 40 hours of a financial manager at $325/hour,
20 hours of a controller or chief financial officer at $722/hour, 80
hours of a compliance attorney at $355/hour, 60 hours of a mid-level
attorney at $608/hour, 50 hours of a senior attorney at $992/hour,
and 20 hours of a chief compliance officer at $664/hour.
---------------------------------------------------------------------------

As noted above, we estimate that approximately 450 entities (i.e.,
250 with relatively low complexity, 150 with moderate complexity and 50
with high complexity) would be sufficiently uncertain about the
application of the definition of the term ``swap dealer'' that they
would incur costs in applying the definition. This estimate includes
IDIs that apply the loan origination exclusion. It is important to
emphasize that since there is no definitive publicly available
information about how many entities are engaged in swap activities and
how they use swaps in particular situations, it is impossible to be
sure how many entities may be uncertain about whether the definition
covers

[[Page 30713]]

them to the point that they would incur such costs. However, we believe
that the number of such entities may be estimated based on certain
assumptions as discussed below.
In meetings with commenters since publication of the Proposing
Release, the CFTC has discussed extensively the universe of potential
entities that may be covered by the definition of the term ``swap
dealer'' and gathered information on the swap market and its
participants. In its FY 2012 budget drafted in February 2011, the CFTC
estimated that 140 entities may be covered by the definition of ``swap
dealer,'' \1350\ and after receiving additional information the CFTC
estimates that approximately 125 entities will be covered by the
definitions of the terms ``swap dealer'' and ``major swap
participant.'' \1351\ With these assumptions in mind, we believe it is
reasonable to estimate that for every entity covered by the
definitions, there will be about four entities (i.e., approximately
four times 120, or about 450) that are sufficiently uncertain about the
coverage of the definitions that they would incur costs in applying the
definitions.
---------------------------------------------------------------------------

\1350\ CFTC, President's Budget and Performance Plan Fiscal Year
2012, p. 13-14 (Feb. 2011), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcbudget2012.pdf. The
estimated 140 swap dealers includes ``[a]pproximately 80 global and
regional banks currently known to offer swaps in the United
States;'' ``[a]pproximately 40 non-bank swap dealers currently
offering commodity and other swaps;'' and ``[a]pproximately 20 new
potential market makers that wish to become swap dealers.'' Id.
\1351\ See CFTC, Registration of Swap Dealers and Major Swap
Participants, 77 FR 2613, 2622 (Jan. 19, 2012). The number of
persons covered by the definition of ``major swap participant'' is
estimated to be quite small, at six or fewer.
---------------------------------------------------------------------------

Our estimate that there would be about 450 such entities is also in
line with the number of entities that were sufficiently interested in
the Proposing Release that they submitted substantive comments to the
CFTC. As noted above, we received about 300 substantive comment letters
in response to the proposal. Of these, some reflected more than one
letter from a single commenter, comments from persons who did not
expect to be swap dealers, or comments from persons who were not
uncertain about their status under the definition. On the other hand,
several letters were from multiple commenters that submitted their
comments jointly. Thus, we estimate that about 225 entities were
sufficiently interested in the proposed rule further defining the term
``swap dealer'' that they submitted a substantive comment, and for each
such entity there was another entity that would also be similarly
uncertain about the definition, which supports our estimate that 450
entities in total would incur costs in applying the definition.
Regarding the determination of whether an entity is eligible for
the de minimis exception from the definition of the term ``swap
dealer,'' we note that only an entity that is engaged in some swap
dealing activity would be required to make this determination, but it
would be required to make the determination regardless of whether it is
uncertain about whether its swap activities constitute dealing (e.g.,
it would incur costs even if there were no doubt that it is engaged in
swap dealing). We also note that the number of entities that will apply
the de minimis exception is expected to be significantly greater than
the number of entities that are required to register as swap dealers.
Again, we believe that the entities making this determination would
have situations that are highly complex (we believe approximately 25
entities would fall in this category), moderately complex
(approximately 200 entities) and of low complexity (approximately 400
entities).\1352\ The direct cost of making the determination for these
entities would be approximately $42,000 in highly complex
situations,\1353\ $15,000 in moderately complex situations \1354\ and
$8,000 in situations of low complexity.\1355\ The total direct costs
for all entities would be approximately $7,300,000.
---------------------------------------------------------------------------

\1352\ The estimate of approximately 625 entities that will
apply the de minimis exception is based on our assumption that
significantly more (i.e., five times as many) entities will apply
the exception as compared to the number of entities registered as
swap dealers (which we assume to be approximately 120). This
estimate is also in line with information provided by commenters
that approximately 100 community and regional banks would
potentially apply the de minimis exception (i.e., the estimate
reflects 100 such banks along with 525 other entities that are
involved in the swap markets to a similar extent).
\1353\ This estimate is based on the following staff
requirements for this determination: 80 hours for a financial
analyst at $161/hour, 20 hours of a financial manager at $325/hour,
10 hours of a controller or chief financial officer at $722/hour, 20
hours of a compliance attorney at $355/hour, 5 hours of a senior
attorney at $992/hour, and 5 hours of a chief compliance officer at
$664/hour.
\1354\ This estimate is based on the following staff
requirements for this determination: 20 hours for a financial
analyst at $161/hour, 5 hours of a financial manager at $325/hour, 5
hours of a controller or chief financial officer at $722/hour, 10
hours of a compliance attorney at $355/hour, 2 hours of a senior
attorney at $992/hour, and 2 hours of a chief compliance officer at
$664/hour.
\1355\ This estimate is based on the following staff
requirements for this determination: 10 hours for a financial
analyst at $161/hour, 5 hours of a financial manager at $325/hour, 2
hours of a controller or chief financial officer at $722/hour, 5
hours of a compliance attorney at $355/hour, 1 hour of a senior
attorney at $992/hour, and 1 hour of a chief compliance officer at
$664/hour.
---------------------------------------------------------------------------

Third, regarding the determination of whether an entity should
apply for a limited purpose swap dealer registration, we believe that
relatively few entities would make such an application but that the
situation of each of these entities would be highly complex. We believe
approximately 20 entities would fall in this category, and the direct
cost of making the determination for each would be approximately
$250,000,\1356\ resulting in a total direct cost of approximately
$5,000,000.
---------------------------------------------------------------------------

\1356\ This estimate is based on the following staff
requirements for this determination: 200 hours for a financial
analyst at $161/hour, 120 hours of a financial manager at $325/hour,
40 hours of a controller or chief financial officer at $722/hour,
100 hours of a compliance attorney at $355/hour, 60 hours of a mid-
level attorney at $608/hour, 50 hours of a senior attorney at $992/
hour, and 40 hours of a chief compliance officer at $664/hour. The
estimate of approximately 20 entities applying the limited
designation reflects an estimate that about one in six swap dealers
would apply the designation.
---------------------------------------------------------------------------

Thus, the total initial direct cost of applying the rules further
defining the term ``swap dealer'' (including the de minimis exception
and the possibility of limited purpose registration) for all entities
would be approximately $32,000,000.
In addition to these initial costs, we believe that entities would
incur recurring costs in applying the definition. Regarding the
application of the term ``swap dealer,'' we estimate that approximately
10 percent of the entities noted above would, each year, experience
significant changes in their usage of swaps (such as beginning or
ending a new line of business) that would require reconsideration of
the application of the definition, which would result in costs
amounting to one-half of the direct cost of making the initial
determination. Applying these factors to the costs noted above, the
total recurring direct costs for all entities associated with the
application of the term ``swap dealer'' are estimated to be
approximately $1,000,000 per year. Regarding the de minimis exception,
we estimate that entities would have to incur ongoing costs of review
to determine whether the exception applies on a yearly basis, and that
the annual cost of this review would amount to one-half of the direct
cost of making the initial determination. That is, the total recurring
direct costs for all entities associated with the de minimis exception
are estimated to be approximately $3,700,000. Last, we estimate that
entities that qualify for a limited purpose swap dealer registration
would incur ongoing review costs amounting to one-quarter of the direct

[[Page 30714]]

cost of making the initial determination, or approximately $1,300,000
per year. Thus, the total recurring direct cost of applying the swap
dealer definition (including the de minimis exception and the
possibility of limited purpose registration) would be approximately
$6,000,000.
5. Costs and Benefits of the Rules Further Defining ``Major Swap
Participant''
This Adopting Release further defines a ``major swap participant''
by setting out quantitative thresholds against which a market
participant can compare its swaps activities to determine whether it is
encompassed by the definition. The rule requires potential major swap
participants to analyze their swaps in detail to determine, for
example, which of their swaps are subject to netting agreements or
mark-to-market collateralization, and the amount of collateral posted
with respect to the swaps. The rule includes a general, qualitative
definition of the swaps that may be excluded from the calculation
because they are used to ``hedge or mitigate commercial risk.'' Like
the swap dealer definition, there is a voluntary process by which a
person may request that the CFTC limit the major swap participant
designation to certain categories of swaps.
a. Background
The definition set forth in CEA section 1a(33) provides that the
term ``major swap participant'' means any person who is not a swap
dealer and (i) maintains a substantial position in swaps for any of the
major swap categories as determined by the CFTC; (ii) whose outstanding
swaps create substantial counterparty exposure that could have serious
adverse effects on the financial stability of the U.S. banking system
or financial markets; or (iii) is a financial entity that is highly
leveraged relative to the amount of capital it holds, is not subject to
capital requirements established by an appropriate Federal banking
agency, and maintains a substantial position in outstanding swaps in
any major swap category as determined by the CFTC. In connection with
the calculation of ``substantial position'' noted above, the statutory
definition specifically excludes positions held for hedging or
mitigating commercial risk, and positions maintained by any employee
benefit plan as defined in sections 3(3) and (32) of ERISA for the
primary purpose of hedging or mitigating any risk directly associated
with the operation of the plan. The statutory definition also provides
that major swap participant designations may be limited in scope so
that a person may be designated as a major swap participant in certain,
but not all, swap categories.
CEA section 1a(33)(D) excludes from the definition of the term
``major swap participant'' certain entities whose primary business is
providing financing and who use derivatives for the purpose of hedging
underlying commercial risks related to interest rate and foreign
currency exposures, 90 percent or more of which arise from financing
that facilitates the purchase or lease of products, 90 percent or more
of which are manufactured by the parent company or another subsidiary
of the parent company. There is no analogous statutory provision
applicable to major security-based swap participants.
As detailed in this Adopting Release, the definition of the term
``major swap participant'' focuses on the market impacts and risks
associated with a person's swap positions. This contrasts to the
definition of the term ``swap dealer,'' which focuses on a person's
activities and accounts for the amount or significance of those
activities only in the context of the de minimis exception. Persons
that meet the major swap participant definition would, in large part,
follow the same statutory requirements applicable to swap
dealers.\1357\ In this manner, the Dodd-Frank Act regulates entities
whose swap activities do not cause them to be swap dealers, but
nonetheless could pose a high degree of risk to the U.S. financial
system. This regulation of major swap participants is intended to
facilitate financial stability by reducing risk, increasing
transparency, and promoting market integrity.
---------------------------------------------------------------------------

\1357\ The Dodd-Frank Act provides for the registration and
regulation of major swap participants under CEA section 4s. The
particular requirements applicable to major swap participants will
be established in separate rulemakings. See notes 1240 and 425,
supra.
---------------------------------------------------------------------------

b. Costs of Applying the Rules Further Defining the Term ``Major Swap
Participant''
The actual cost of applying the rule further defining the term
``major swap participant'' to determine if a person is covered by the
definition will depend, in large part, on the nature of the person's
swap activities as well as the infrastructure such person already has
in place for the analysis and reporting of its swap activities. Many
persons will be clearly outside the definition (and a few persons may
be clearly covered by the definition) and will incur little cost to
confirm that status. However, it is reasonable to expect that a few
persons that are not swap dealers but nonetheless engage in significant
swap activity will be required to incur costs to determine whether they
are covered by the definition. The direct costs such a person would
incur would result from the incremental expense of personnel with
financial and accounting expertise who would be required to devote time
to the review of the size and nature of the person's swap positions to
determine whether the person is covered by the definition. Moreover,
there will also be technology and legal review costs related to the
determination of whether a person is a major swap participant. As is
the case for the definition of the term ``swap dealer,'' it is
important to recognize that even in the absence of any rule further
defining the term ``major swap participant,'' or regardless of the
terms of the rule, entities would incur costs in interpreting the
statutory definition to determine whether they are covered. Thus, at a
minimum, a significant portion of the costs discussed below is
attributable to the inclusion in the Dodd-Frank Act of a definition of
the term ``major swap participant'' and not from any aspect of the
final rules further defining that term. Indeed, the final rules provide
benefits by mitigating these costs by providing guidance about the
application of the statutory definitions in different situations.
The amount of time and resources that must be expended by a person
in order to determine whether it qualifies as a major swap participant
may vary considerably depending on the complexity of such person's
operations. In addition, direct costs will vary depending on the
determinations the person must make relating to the definition,
including, but not limited to, whether it engages in swap activity near
the thresholds for ``substantial position'' and ``substantial
counterparty exposure,'' and whether it is subject to a ``safe harbor''
provision as set forth in the definition. The CFTC did not receive any
comments quantifying the costs that a person may incur in applying any
aspect of the definition of the term ``major swap participant,'' nor
are we aware of any studies or surveys regarding this particular issue.
Therefore, the CFTC staff has estimated, based on its experience, the
amount of time that a person may require to determine whether it meets
the definition. These estimations are for informational purposes and
require the CFTC to consider the aforementioned highly uncertain
criteria.
The CFTC estimates that approximately 20 persons that are not swap
dealers will initially be engaged in swap activity to such an extent
that they

[[Page 30715]]

would be required to apply the calculations in the final rule in
determining whether they are covered by the definition.\1358\ The
direct cost of making such determination for each such person is
estimated to be approximately $260,000,\1359\ resulting in an initial
aggregate direct cost of approximately $5,200,000. We note that the
relatively low estimate of only 20 persons that would be required to
incur costs at this level, as compared to the many thousands of swap
market participants, reflects the relatively high thresholds for major
swap participant status. As noted above, the large majority of market
participants will be able to readily conclude that they are not covered
by the definition.
---------------------------------------------------------------------------

\1358\ As is the case with respect to the definition of the term
``swap dealer,'' we believe that the number of persons that may
incur costs in reviewing their activities and the rules will be
significantly greater than the number of entities that actually are
covered by the definition and will be required to register as major
swap participants. Similarly, since there is no definitive publicly
available information about how many entities are engaged in swap
activities and how they use swaps in particular situations, it is
impossible to be sure how many entities may be uncertain about
whether the definition covers them to the point that they would
incur such costs. Our estimate that approximately 20 entities would
be sufficiently uncertain about the application of the definition of
the term ``major swap participant'' that they would incur costs in
applying the definition is based on our assumption that about six
entities would be covered by the definition, and that for each such
entity there will be about four entities that will be uncertain
about the coverage of the definition. See note 1351, supra.
\1359\ This estimate is based on the following staff
requirements for this determination: 200 hours for a financial
analyst at $161/hour, 80 hours for a programmer analyst at $196/
hour; 120 hours of a financial manager at $325/hour, 40 hours of a
controller or chief financial officer at $722/hour, 100 hours of a
compliance attorney at $355/hour, 60 hours of a mid-level attorney
at $608/hour, 50 hours of a senior attorney at $992/hour, and 40
hours of a chief compliance officer at $664/hour.
The estimates of the hourly cost for these personnel are from
SIFMA's Management & Professional Earnings in the Securities
Industry 2010, modified by CFTC staff to account for an 1800-hour
work-year and multiplied by 5.35 to account for firm size, employee
benefits, and overhead. As is the case for the application of the
definition of the term ``swap dealer,'' we believe that that use of
a higher multiplier here is appropriate because some persons may
retain outside advisors to assist in making the determinations under
the rules. These estimates are intended to reflect averages for
compiling and analyzing the information necessary to apply the
definition of the term ``major swap participant.'' We recognize that
particular entities within each range of complexity may, based on
their circumstances, incur costs substantially greater or less than
the estimated averages. We round to two significant digits.
---------------------------------------------------------------------------

In addition to these initial costs, we believe that approximately
20 entities would incur recurring direct costs in applying the
definition of major swap participant on a daily basis, and such costs
would amount to one-third of the direct cost of making the initial
determination. Thus, the total recurring direct costs for all entities
associated with the application of the term ``major swap participant''
are estimated to be approximately $1,700,000 per year or approximately
$83,000 per year for each person.
Although the CFTC believes there will only be a limited number of
persons that potentially may be major participants, we recognize the
concerns raised by several commenters that major swap participant
calculations will be conducted as part of the person's overall
compliance function even when there is not a significant likelihood
that such person would be a major swap participant. As a result of the
potential expense and effort that a person would be required to incur
in connection with determining whether it meets the definition of major
swap participant, the final rule includes three alternative ``safe
harbor'' provisions.\1360\ These safe harbor provisions relieve persons
that are clearly not major swap participants from incurring the expense
of the calculations otherwise required under the final rule.
---------------------------------------------------------------------------

\1360\ See part IV.M, supra.
---------------------------------------------------------------------------

To apply the safe harbor provisions of the rule, the CFTC estimates
that a person would have to incur initial direct costs of approximately
$2,900 to determine whether its swap positions are within the safe
harbor.\1361\ In addition, a person would incur costs of reviewing its
swap positions on a monthly basis to monitor whether the safe harbor
continues to apply, at an annual cost equal to one-third of the direct
cost of making the initial determination, or $960. Our assumption that
approximately 1,200 entities would apply the safe harbor provisions of
the rule yields an aggregate direct initial cost of approximately
$3,500,000 and aggregate annual costs of approximately
$1,200,000.\1362\
---------------------------------------------------------------------------

\1361\ This estimate is based on the following staff
requirements for this determination: 5 hours for a financial analyst
at $161/hour, 2 hours for a financial manager at $325/hour, 1 hour
for a comptroller or chief financial officer at $722/hour, 2 hours
for a compliance attorney at $355/hour.
\1362\ Our estimate of the number of entities that will make the
safe harbor calculation includes the following: one-half of the
approximately 700 investment company sponsors that are active in the
U.S. (see the 2011 Investment Company Factbook published by the ICI,
page 14, available at http://www.ici.org/pdf/2011_factbook.pdf), a
similar number of entities (i.e., 350) that have large positions in
swaps as part of other investment management activities, one half of
the corporate entities in the ``Fortune 500'' (representing
corporate entities that have large positions in swaps) and an
additional 250 entities representing other holders of large
positions in swaps.
---------------------------------------------------------------------------

c. Major Swap Participant Thresholds
The final rule adopts the general approach in the proposed rule of
determining whether a person is a major swap participant by comparing
the exposure resulting from a person's swap positions to specific,
quantitative thresholds. The proposed thresholds for substantial
position were $3 billion in current uncollateralized exposure or $6
billion in current uncollateralized exposure plus potential future
exposure for rate swaps, and $1 billion in current uncollateralized
exposure or $2 billion in current uncollateralized exposure plus
potential future exposure for each of the other categories of swaps.
The proposed thresholds for substantial counterparty exposure are $5
billion in current uncollateralized exposure across all categories or
$8 billion in current uncollateralized exposure plus potential future
exposure across all categories.\1363\ However, there is a change for
the weight in the PFE calculations from the proposal to the final rule
of 0.2 to 0.1 for cleared swaps.
---------------------------------------------------------------------------

\1363\ See parts IV.B.3.d. and IV.E.3.
---------------------------------------------------------------------------

Commenters generally did not oppose the proposed thresholds
although several thought the thresholds should be raised.\1364\ Two
commenters supported the adoption of the thresholds as proposed.\1365\
In addition, a few other commenters thought that the thresholds were
set too high.\1366\ Other commenters suggested that the thresholds be
raised to a level that reflects systemic risk without suggesting a
specific numerical threshold.\1367\ One commenter, however, suggested
that the threshold be increased to $10 billion.\1368\ Several
commenters also said that the thresholds should be adjusted for
inflation and other changes over time in the swap market.\1369\
---------------------------------------------------------------------------

\1364\ See, e.g., letters cited in notes 796 and 798, supra.
\1365\ See letters from Dominion Resources and Fidelity.
\1366\ See letters from AFR and Greenberger.
\1367\ See letters from BlackRock I, ISDA I, MFA I and WGCEF II.
\1368\ See letter from CCMR I. In addition, ACLI commented that
thresholds for rate swaps should be increased to $4 billion for
current uncollateralized exposure and $8 billion for current
uncollateralized exposure plus potential future exposure, with
corresponding increases to substantial counterparty exposure
thresholds to $7 billion for current uncollateralized exposure and
$14 billion for current uncollateralized exposure plus potential
future exposure. See letter from ACLI.
\1369\ See letters from CDEU, COPE I, Fidelity, ISDA I, and MFA
I.
---------------------------------------------------------------------------

As discussed in part IV.B.3.d., the CFTC is adopting the thresholds
as proposed. We recognize that the level of the thresholds will have a
significant effect on whether the rules further defining the term
``major swap

[[Page 30716]]

participant'' are applied in a manner that is more or less inclusive,
and that in setting the thresholds it is possible that we may err on
the side of over- or under-inclusion. As noted above in part V.C.2., if
the rule were more inclusive, costs could arise when the persons that
are classified as major swap participants incur compliance costs, while
if the rule is less inclusive the benefits of regulating major swap
participants (in terms of reduced risk, increased transparency and
market integrity) could be reduced. We also recognize that a more
inclusive rule could lead to costs if it causes persons to make changes
to their use of swaps in order to avoid being covered by the rule.
One commenter said that the CFTC should conduct an empirical
analysis of the proposed thresholds and whether they are suitable for
identifying persons whose swap positions entail the risks enumerated in
the statutory definition of the term ``major swap participant.'' \1370\
However, the CFTC believes it is not feasible to perform such an
analysis because the comprehensive and detailed information about how
very active swap market participants use swaps that it would require is
not available.
---------------------------------------------------------------------------

\1370\ See letter from WGCEF II.
---------------------------------------------------------------------------

The CFTC believes that the threshold levels in the final rule are
appropriate to effectively monitor and oversee entities that are
systemically important or could significantly impact the U.S. financial
system. The CFTC and SEC are consistent in their approach to
thresholds. As more data regarding the use of swaps and the importance
of very large swap positions in the swap markets become available, the
CFTC may consider adjusting the thresholds.
The final rules also provide for the measure of potential future
exposure to be adjusted in the case of swap and security-based swap
positions that are centrally cleared or that are subject to daily mark-
to market margining. This is consistent with the purpose of the
potential future exposure test, which is to account for the extent to
which the current outward exposure of positions (though possibly low or
even zero at the time of measurement) might grow to levels that can
lead to high counterparty risk to counterparties or to the markets
generally. The practice of the periodic exchange of mark-to-market
margin between counterparties helps to mitigate the potential for large
future increases in current exposure.
Consistent with the proposal, the final rules reflect this ability
to mitigate risk by providing that the potential future exposure
associated with positions that are subject to daily mark-to-market
margining will equal 0.2 times the amount that otherwise would be
calculated. However, in response to commenters assertions about the
risk-mitigating effects of central clearing, and the additional level
of rigor that clearing agencies may have with regards to the process
and procedures for collecting daily margin, the final rules further
provide that the potential future exposure associated with positions
that are subject to central clearing will equal 0.1 (rather than the
proposed 0.2) times the potential future exposure that would otherwise
be calculated.\1371\
---------------------------------------------------------------------------

\1371\ See CFTC Regulation Sec. 1.3(jjj)(3)(iii)(A); Exchange
Act rule 3a67-3(c)(3)(i). The final rules further have been revised
to clarify that the 0.1 factor applies to positions cleared by a
registered clearing agency or by a clearing agency that has been
exempted from registration.
---------------------------------------------------------------------------

Although some commenters supported the complete exclusion of
cleared positions from the potential future exposure analysis,\1372\
the CFTC recognizes that central clearing cannot reasonably be expected
to entirely eliminate counterparty risk.\1373\ Accordingly, the CFTC
concluded that the use of a 0.1 factor (in lieu of the proposed 0.2) is
appropriate for cleared positions, reflecting the strong risk
mitigation features associated with central clearing, particularly the
procedures regarding the collection of daily margin and the use of
counterparty risk limits, while recognizing the presence of some
remaining counterparty risk.
---------------------------------------------------------------------------

\1372\ See, e.g., letters from MFA I and SIFMA AMG II.
\1373\ Central clearing helps to mitigate counterparty credit
risk by improving risk management and, among other things,
mutualizing the risk of counterparty failure. If multiple members of
a central counterparty fail beyond the level to which such risk is
managed, however, the central counterparty would also be at risk of
failure. Cf. Basel Committee on Banking Supervision, Consultative
Document, ``Capitalisation of bank exposures to central
counterparties,'' Nov. 25, 2011 (available at: http://www.bis.org/publ/bcbs206.pdf) (proposing that the capital charge for trade
exposures to a qualifying central counterparty should carry a low
risk weight, reflecting the relatively low risk of default of the
qualifying central counterparty). In addition, as the CFTC and SEC
discussed in the Proposing Release, see 75 FR at 80192 n. 115, for
example, central counterparties that clear credit default swaps do
not necessarily become the counterparties of their members'
customers (although even absent direct privity those central
counterparties benefit customers by providing for protection of
collateral they post as margin, and by providing procedures for the
portability of customer positions in the event of a member's
default). As a result, central clearing may not eliminate the
counterparty risk that the customer poses to the member, although
required mark-to-market margining should help control that risk, and
central clearing would be expected to reduce the likelihood that an
entity's default would lead to broader market impacts.
---------------------------------------------------------------------------

Moreover, although some commenters opposed any deduction from the
measure of potential future exposure for uncleared positions that are
margined on a daily basis,\1374\ the CFTC believes that the risk-
mitigating attributes of daily margining warrant an adjustment given
that the goal of the potential future exposure test is to account for
price movements over the remaining life of the contract.\1375\ The use
of a 0.2 factor also reflects the CFTC's expectation that the risk
mitigation associated with uncleared but margined positions would be
less than the risk mitigation associated with cleared positions.
---------------------------------------------------------------------------

\1374\ See letter from Better Markets I; see also letter from
AFR.
\1375\ The CFTC does not believe that it is appropriate to have
this type of discount when mark-to-market margining is done less
than daily, however.
---------------------------------------------------------------------------

While higher or lower alternatives to the 0.1 and 0.2 factors may
also be reasonable for positions that are cleared or margined on a
daily basis, the CFTC believes that the factors of the final rules
reasonably reflects the risk mitigating (but not risk eliminating)
features of those practices. The final rules also retain and clarify
provisions addressing when daily mark-to-market margining occurs for
purposes of this discount.\1376\
---------------------------------------------------------------------------

\1376\ The CFTC recognizes that at times, market participants
whose agreements provide for the daily exchange of variation margin
in connection with swaps in practice may not exchange collateral
daily, if the amounts at issue are relatively small (such through
the use of collateral thresholds and minimum transfer amounts). We
do not believe that such practices would be inconsistent with
providing a discount for daily margining practices. The proposed
rules sought to accommodate those practices by providing that
positions would be considered to be subject to daily mark-to-market
margining for purposes of the ``uncollateralized outward exposure''
plus ``potential outward exposure'' analysis, so long as the total
of such thresholds, and the total of such minimum transfer amounts
above $1 million are deemed to be ``uncollateralized outward
exposure'' for those purposes.
In light of commenter concerns, which indicated that the
proposal was not fully clear about the mechanics and purpose of this
approach, the relevant rule language has been revised to clarify
that this attribution of thresholds and minimum transfer amounts is
solely for the purpose of determining whether certain positions are
subject to daily mark-to-market margining for purposes of the
analysis. In addition, the final rules have been revised from the
proposal to provide that the attribution of thresholds as
``uncollateralized outward exposure'' for these purposes will be
reduced by initial margin posted, up to the amount of the threshold.
See CFTC Regulation Sec. 1.3(jjj)(iii)(B); Exchange Act rule 3a67-
3(c)(3)(ii).
---------------------------------------------------------------------------

d. Difficulty in Applying the Major Swap Participant Calculations
While commenters generally acknowledged that the proposed
quantitative threshold tests are objective, some said that the proposed
tests are difficult to understand and

[[Page 30717]]

hard to apply.\1377\ Another commenter submitted that ``[the CFTC]
should solicit feedback from market participants prior to final rule
given the complexity of tests and likely interpretive issues; proposed
tests are highly technical, and more challenging to use than may appear
at first glance; could also request volunteers to walk-through the
tests to ensure they actually function in practice.''\1378\ Several
commenters suggested means of reducing the costs of applying the
proposed tests. Some commenters requested that the CFTC adopt a ``safe
harbor'' provision in the final rules for swap users with positions
that are substantially below the thresholds.\1379\ Another commenter
opined that the rule should allow persons to rely on third-party
service providers to conduct the required calculations.\1380\ In
addition, a commenter said the rule should allow swap users to apply
standard industry practices in valuing their positions.\1381\
---------------------------------------------------------------------------

\1377\ See, e.g., letters from Fidelity, Freddie Mac, ISDA I and
SIFMA AMG II.
\1378\ See letter from WGCEF II at 11.
\1379\ See letters from AII, Vanguard and SIFMA AMG II. Another
commenter submitted that swap dealers will require counterparties to
run the major swap participant calculations in order to certify that
they are not major swap participants, even in cases where it is
readily evident that they are not major swap participants. See
meeting with CalSTRS on April 15, 2011.
\1380\ See letter from ISDA I.
\1381\ See id.
---------------------------------------------------------------------------

We believe that the guidance in this Adopting Release reduces the
costs of determining if a person is covered by the definition. For
example, in response to commenters' concerns we clarify that a person
may determine the value of its exposure using industry standard
practices.\1382\ Also, we believe that the daily calculation burdens
associated with the proposed thresholds will be addressed by safe
harbors that are available if a simplified calculation shows that a
person's exposure from its swap position is far below any threshold for
any particular month. The final rule includes safe harbors to reduce
unnecessary costs for entities that, because of compliance concerns,
would engage in major swap participant calculations even though it
would be very unlikely that the major swap participant thresholds would
be met.\1383\ Also, the CFTC will permit third-party service providers
to perform major swap participant calculations, although a person that
may be a major swap participant is not relieved of potential liability
for violations of the CEA if there is a calculation or other error by
the third-party.\1384\
---------------------------------------------------------------------------

\1382\ See part IV.B.3.b, supra.
\1383\ See part IV.M.2, supra.
\1384\ See part IV.B.3.e, supra.
---------------------------------------------------------------------------

e. Exclusions for Particular Types of Entities
Commenters said that exclusions from the major swap participant
definition should be available for certain entities including insurance
companies, registered investment companies, entities that maintain
legacy portfolios of swaps, ERISA plans, and sovereign wealth
funds.\1385\ Some commenters cited, as the underlying basis for
excluding these entities, the existing regulatory regime to which these
entities are subject and the potential for dual regulation if they were
covered by the definition of the term ``major swap participant.''\1386\
One commenter asserted that a lack of clarity with respect to proposed
exemptive relief will impose additional costs on market participants
due to the uncertainty in determining major swap participant
status.\1387\
---------------------------------------------------------------------------

\1385\ See part IV.J.2, supra.
\1386\ See id. For example, commenters said that registered
investment companies and corresponding registered investment
advisers should be excluded from the definition of major swap
participant because they are highly regulated by the SEC pursuant to
the ICA and the Investment Advisers Act of 1940, and therefore major
swap participant regulation would be duplicative. See joint letter
from ICI and SIFMA AMG.
\1387\ See letter from MetLife.
---------------------------------------------------------------------------

Several commenters said that sovereign wealth funds should be
excluded from the definition of major swap participant based on
international principles of comity and sovereign immunity.\1388\ These
commenters asserted that sovereign wealth funds are regulated in their
home country and do not represent the type of counterparty risk
contemplated by the Dodd-Frank Act. A commenter asserted that special
purpose vehicles for structured finance or securitization should be
exempted from the definition of major swap participant so as to not
harm liquidity in asset securitizations.\1389\ That commenter based its
recommendation on the understanding that special purpose vehicles have
limited functionality and resources and would accordingly be unable to
comply with the burden of regulation as a major swap participant.\1390\
---------------------------------------------------------------------------

\1388\ See letters from CIC and GIC and meeting with Weil.
\1389\ See letter from ISDA I.
\1390\ See id.
---------------------------------------------------------------------------

The final rule does not have specific exclusions for certain types
of entities. The CFTC believes that a more level playing field is
desirable to ensure no particular type of entity gains an unfair
competitive advantage in the market.
The appropriate treatment of ``legacy portfolios'' (e.g., the
monoline insurers or their special purpose vehicles) will be determined
on a case-by-case basis by the CFTC. Legacy portfolio operators
specifically commented that they are in ``run-off''/wind down mode,
thereby undertaking no new swaps that would increase their risk, with
an expectation to shut down or cease operations once their portfolio
expires.\1391\ As a result, these commenters maintain that margin or
capital requirements would likely lead to their insolvency because they
do not have the assets to satisfy the proposed requirements. The CFTC
notes that many of the compliance obligations imposed by the Dodd-Frank
Act and/or the business conduct rules promulgated thereunder will not
apply to operators of legacy portfolios because such obligations will
not be applicable to swaps executed prior to the enactment of the Dodd-
Frank Act such as the swaps in legacy portfolios.\1392\ Consequently,
the CFTC expects legacy portfolio operators' primary compliance
obligation to be related to reporting and risk management.
---------------------------------------------------------------------------

\1391\ See letters from Athilon, Berkshire Hathaway, ISDA I,
MBIA and Newedge. As noted in part IV.J.3.a, supra, the CFTC
understands that legacy portfolios are no longer entering into new
transactions other than to novate, amend and hedge their existing
positions. In connection with any potential exclusion, however,
legacy portfolios would still be required to report to SDRs
information about their swap transactions and positions. See letters
from BlackRock I and Canadian MAVs.
\1392\ See CFTC, Swap Data Recordkeeping and Reporting
Requirements: Pre-Enactment and Transition Swaps; Final Rule, 77 FR
2136 (Jan. 13, 2012).
---------------------------------------------------------------------------

f. CEA Section 15(a) Discussion
The costs and benefits of the rule further defining the term
``major swap participant'' are evaluated in light of the section 15(a)
five broad areas of market and public concern.
Protection of market participants and the public. The rule helps
parties to identify when they have substantial positions or substantial
counterparty exposures in swap markets that would cause them to be
covered by the definition of major swap participant. Under the Dodd-
Frank Act, major swap participants are subject to regulations enacted
to protect market participants and the public. The costs and benefits
of the statutory and regulatory requirements for major swap
participants are addressed in the various rulemakings in which they are
promulgated.\1393\
---------------------------------------------------------------------------

\1393\ See part VII.C.2, supra.

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

[[Page 30718]]

Efficiency, competitiveness, and financial integrity of markets. To
date, potential major swap participants have engaged in swaps in an
off-exchange marketplace that has been largely unregulated. Once the
regulations required under the Dodd-Frank Act are adopted and
effective, major swap participants will be subject to CFTC oversight
and comprehensive regulation. The CFTC believes these regulations will
improve the financial integrity of swap markets and the U.S. financial
system generally. Since the number of persons that are expected to be
major swap participants is small, the CFTC believes that these
regulations will not have a significant effect on the efficiency or
competitiveness of the markets.
Price discovery. The CFTC does not perceive any direct effect on
price discovery from the rule further defining the term ``major swap
participant.''
Sound risk management practices. The level of the major swap
participant thresholds may discourage persons from engaging in swap
activities that might cause them to exceed the major swap participant
thresholds. This reduction in the use of swaps could be costly if other
alternatives are not as suitable for the underlying risks (e.g.,
futures might have different contract sizes or expiration, and forward
contracts introduce physical risks not present in cash settled
transactions). The CFTC notes that this concern is mitigated by the
relatively high threshold levels for major swap participant status.
Other public interest considerations. The specific quantitative
thresholds in the rule set forth definitive tests for determining if a
person is covered by the definition of the term ``major swap
participant.'' This specific, quantitative threshold serves the public
interest by promoting efficient application of the rule. Also, as noted
above, major swap participants will be subject to CFTC oversight and
comprehensive regulation, which we believe will improve the financial
integrity of swap markets and the U.S. financial system generally.
6. Costs and Benefits of the Rules Relating to the Definition of
``Eligible Contract Participant''
a. Background
The ECP regulations and interpretation fall within the following
six categories:
CFTC Regulation Sec. 1.3(m)(5)(i) prevents a commodity
pool (i) in which any of the pool's direct participants is not an ECP
in its own right and (ii) that directly enters into retail forex
transactions from being an ECP under CEA section 1a(18)(A)(iv) or (v),
for purposes of retail forex transactions only. CFTC Regulation Sec.
1.3(m)(5)(ii) provides that the CFTC would look through a commodity
pool participant that directly participates in a transaction-level
commodity pool only if such direct commodity pool participant, any
entity holding an interest in such direct commodity pool participant,
or any entity in which such direct commodity pool participant holds an
interest were structured to evade subtitle A of Title VII of the Dodd-
Frank Act by permitting persons that are not ECPs to participate in
retail forex transactions. The look-through in CFTC Regulation Sec.
1.3(m)(5)(ii) does not apply to a non-commodity pool participant in a
commodity pool.
CFTC Regulation Sec. 1.3(m)(6) excludes a commodity pool
from ECP status if it does not have total assets exceeding $5,000,000
or is not operated by a person described in CEA section
1a(18)(A)(iv)(II).\1394\
---------------------------------------------------------------------------

\1394\ 7 U.S.C. 1a(18)(A)(iv)(II).
---------------------------------------------------------------------------

CFTC Regulations Sec. 1.3(m)(1)-(4) define major swap
participants, swap dealers, major security-based swap participants and
security-based swap dealers, respectively, as ECPs.
CFTC Regulation Sec. 1.3(m)(7) permits an otherwise non-
ECP to qualify as an ECP, with respect to certain swaps, based on the
collective net worth of its owners, subject to several conditions,
including that the owners are ECPs.
CFTC Regulation Sec. 1.3(m)(8) permits a Forex Pool to
qualify as an ECP notwithstanding that it has one or more direct
participants that are not ECPs if the Forex Pool (a) is not formed for
the purpose of evading regulation under CEA sections 2(c)(2)(B) or (C)
or related rules, regulations or orders, (b) has total assets exceeding
$10 million and (c) is formed and operated by a registered CPO or by a
CPO who is exempt from registration as such pursuant to CFTC Regulation
Sec. 4.13(a)(3).
Finally, the Commissions have provided an interpretation
to address an incorrect statutory cross-reference preventing certain
government entities from qualifying as ECPs under CEA section
1a(18)(A)(vii).\1395\
---------------------------------------------------------------------------

\1395\ 7 U.S.C. 1a(18)(A)(vii).
---------------------------------------------------------------------------

b. Summary of Comments
Commenters stated that commodity pools will incur costs to comply
with statutory and regulatory requirements made applicable as a result
of the Commissions' narrowing of the ECP definition.\1396\ Commenters
argued that to apply the look-through at any investment level would be
unnecessarily burdensome and disruptive to how commodity pools are
structured, with resulting costs.\1397\ One commenter advised that, if
a trading advisor cannot be sure that all pool participants are ECPs,
then it must be cautious and either register as a CPO or decide not to
engage in Retail Forex Transactions on behalf of its advised
pools.\1398\ Another commenter stated that while many existing
commodity pools have already obtained accredited investor and QEP
representations from participants, virtually none currently obtain ECP
representations from their investors.\1399\ This commenter argued that
obtaining such a representation would impose an operational burden and
additional costs, as well as require commodity pools to redeem non-
ECPs. The commenter further points out that, given the estimated $1.9
trillion of assets invested in hedge funds, the portion of those assets
that use OTC forex is likely to be substantial, and therefore
substantial time and expense would be expended in determining
eligibility requirements for the thousands of investors in funds that
use OTC forex.\1400\
---------------------------------------------------------------------------

\1396\ See letters from AIMA I, Akin Gump, Sidley, and Willkie
Farr.
\1397\ See id.
\1398\ See letter from AIMA I.
\1399\ See letter from Sidley.
\1400\ See id.
---------------------------------------------------------------------------

Commenters explained that there are costs to losing ECP status and
that the enumerated counterparty list is unclear and subject to
uncertainty because it relies on other regulators.\1401\ One commenter
argues that funds would incur compliance and transaction costs if
categorized as non-ECPs because they would have to enter into forex
transactions through a DCM and their operators would have to register
as CPOs.\1402\ That commenter also states that the markets for
exchange-traded futures are less liquid than OTC forex markets, and
that posting initial margin on a DCM is costly, since it cannot be used
to invest in riskier assets and a FOF would have to invest in liquid
and low risk (and, commensurately, lower yielding) assets necessary to
post variation margin. As another commenter points out, the resulting
increased expenses from the requirement to trade on a DCM and comply
with retail forex rules may result in higher expenses for hedge and
private equity funds, which

[[Page 30719]]

they would likely pass along to their investors.\1403\
---------------------------------------------------------------------------

\1401\ See letters from AIMA I, Akin Gump, and Sidley.
\1402\ See letter from Sidley.
\1403\ See letter for Akin Gump. This commenter also said that
these increased expenses could cause funds to terminate their
foreign currency hedging, which would increase their investors'
currency risk, causing higher volatility in the investment industry.
---------------------------------------------------------------------------

A commenter asserted that the characteristics necessary to avoid
non-ECP status may prevent free investment and could reduce liquidity
and create volatility in these markets.\1404\
---------------------------------------------------------------------------

\1404\ See letter from AIMA I. See generally part III.B.3,
supra.
---------------------------------------------------------------------------

With respect to CFTC Regulation Sec. 1.3(m)(6), a commenter
expressed concerns with the expected costs associated with the proposal
that commodity pools that do not qualify as ECPs under clause (A)(iv)
should not be able to qualify under clause (A)(v), stating that the
proposal would be difficult to comply with and would adversely impact
investment.\1405\
---------------------------------------------------------------------------

\1405\ See letter from AIMA I.
---------------------------------------------------------------------------

Two commenters agreed that the proposed addition of swap dealers,
security-based swap dealers, major swap participants, and major
security-based swap participants to the ECP definition provided a
benefit with little or no costs.\1406\ No commenter objected.
---------------------------------------------------------------------------

\1406\ See letters from Greenberger and Sidley.
---------------------------------------------------------------------------

With respect to CFTC Regulation Sec. 1.3(m)(7), commenters said
that non-ECPs have entered into swaps in reliance on the Swap Policy
Statement.\1407\ Commenters emphasized the importance of the Swap
Policy Statement to pass-through entities used by farmers,\1408\
operating companies \1409\ and commercial property developers,\1410\
noting that such entities may not meet the ECP criteria. According to
these commenters, these pass-through entities often are small and
medium-sized businesses that enter into interest rate swaps with
lending financial institutions in reliance on the Swap Policy
Statement.\1411\ The commenters explained that the loans usually are
guaranteed by the principals of the entity entering into the swap, and
that the borrower would qualify as an ECP if structured as a single-
level corporate entity or sole proprietorship.\1412\ Commenters said
that if these non-ECP entities were limited to swaps that are available
on or subject to the rules of a DCM, many regional bank borrowers would
lose the ability to use swaps, real estate companies would have less
flexibility in risk management, and smaller lenders would be at a
competitive disadvantage.\1413\ Another commenter said that Dodd-Frank
Act provisions such as the end-user clearing exception indicate that
Congress intended to preserve the availability of swaps used for
managing risks rather than for investment or speculation.\1414\
---------------------------------------------------------------------------

\1407\ See letters from B&F I, CDEU and Capstar. One element of
the Swap Policy Statement required that the swap be entered into in
connection with each swap counterparty's line of business. See Swap
Policy Statement at 30697. The CFTC stated when issuing the Swap
Policy Statement that it ``reflects the [CFTC]'s view that at this
time most swap transactions, although possessing elements of futures
or options contracts, are not appropriately regulated as such under
the [CEA] and [CFTC] regulations.'' Swap Policy Statement at 30694.
\1408\ See, e.g., letter from Rabobank, New York Branch
(relating that ``[f]or a variety of estate planning and regulatory
purposes, farmers commonly hold their ownership interests in land,
buildings and farm equipment indirectly, through a network of legal
entities'').
\1409\ See, e.g., letter from Fifth Third Bank and Union Bank,
N.A. (advising that ``[i]t is common for an operating business to
organize a separate limited liability company (for tax and legal
reasons) to acquire * * * assets * * * and to lease these assets to
the operating company[, which] becomes the borrow[er] * * * for the
loan used to acquire those assets'' and that ``[t]he limited
liability company often does not maintain sufficient capital to
qualify as an ECP'').
\1410\ See, e.g., letters from BB&T I, B&F I and Midsize Banks.
\1411\ See letters from BB&T I and B&F I. Commenters said that
these businesses may intentionally maintain less than $1 million in
equity primarily for tax and legal reasons. See letters from Capital
One and Columbia State Bank (stating that over 65% of its borrowers
are structured as limited liability companies or S corporations and
intentionally maintain less than $1 million in equity at the entity
entering into the swap).
\1412\ See letter from Columbia State Bank. See also letter from
BB&T I.
\1413\ See letters from BB&T I, Capital One, Capstar, Columbia
State Bank, Midsize Banks, NAREIT and Wells Fargo II.
\1414\ See letter from FSR I.
---------------------------------------------------------------------------

To mitigate the impact of restricting non-ECPs to swaps that are
available on or subject to the rules of DCMs, some commenters said that
an entity should be able to qualify as an ECP based on the financial
qualifications of related entities, so long as various conditions
proposed by the commenters are satisfied. Some commenters said that an
entity should be eligible to be an ECP if its swap obligations are
guaranteed by an ECP,\1415\ or if its controlling entity qualifies as
an ECP under clause (A)(v) of the statutory definition.\1416\ Another
commenter suggested revisions to the ECP definition that included
looking to the ECP status or sophistication of the majority owner of an
entity in determining if the entity itself is an ECP.\1417\ Other
commenters suggested other provisions to allow non-ECPs to enter into
swaps other than on or subject to the rules of a DCM, so long as the
non-ECP meets various conditions indicating that the swap is used in
connection with its line of business.\1418\
---------------------------------------------------------------------------

\1415\ See letters from BB&T I, Midsize Banks and Wells Fargo
II.
\1416\ See letters from CDEU and Regional Banks.
\1417\ See letter from NAREIT.
\1418\ See letters from APGA, Capital One and Gavilon dated
October 28, 2010.
---------------------------------------------------------------------------

With respect to CFTC Regulation Sec. 1.3(m)(8), several commenters
asserted that many Forex Pools are operated by sophisticated,
professional managers that do not need the protections of a retail
forex regime designed to protect non-ECPs that are engaging in retail
forex transactions.\1419\ More specifically, some commenters, based on
CFTC enforcement actions involving Forex Pools, suggested that
commodity pools of a sufficient size, and/or operated by a registered
or exempt CPO, do not pose the risks of fraud and abuse of non-ECP
customers that the statutory look-through provision is intended to
address.\1420\
---------------------------------------------------------------------------

\1419\ See letters from Millburn and Sidley.
\1420\ See letters from GXFD I and Sidley.
---------------------------------------------------------------------------

As a result, commenters suggested that the look-through provision
should not apply in determining ECP status of commodity pools that meet
certain conditions. For example, commenters suggested that the look-
through not be applied to a commodity pool with $10 million in total
assets if other factors were present--e.g., not structured to
evade,\1421\ subject to regulation under the CEA \1422\ and/or
operation by a registered CPO.\1423\ Another commenter suggested
requiring the total assets or minimum initial investment of a Forex
Pool to be sufficiently large that, in general, only legitimate pools
would exceed such thresholds.\1424\ This commenter suggested a total
asset threshold of $50 million.\1425\
---------------------------------------------------------------------------

\1421\ See letter from GFXD II.
\1422\ See letters from GFXD II and Skadden.
\1423\ See meeting with SIFMA on January 20, 2012.
\1424\ See letter from Sidley.
\1425\ See id.
---------------------------------------------------------------------------

Separately, one commenter also claimed that the statutory look-
through, if strictly implemented, might inappropriately preclude Forex
Pools and their CPOs, many of whom are registered, from engaging in
retail forex transactions with swap dealers because swap dealers are
not Enumerated Counterparties (and some swap dealers also may not be
Enumerated Counterparties in a different capacity, such as being a U.S.
financial institution).\1426\ This commenter stated that such a result
could reduce close out netting opportunities in the event of the
insolvency of a counterparty.
---------------------------------------------------------------------------

\1426\ See letter from GFXD I.
---------------------------------------------------------------------------

Finally, to reduce the adverse effects on government entities that
may need to qualify as ECPs based on their swap

[[Page 30720]]

counterparties but that would be foreclosed from doing so due to an
erroneous reference in the definition of ECP, a commenter requested the
correction of that erroneous reference.\1427\
---------------------------------------------------------------------------

\1427\ See letter from Wells Fargo I.
---------------------------------------------------------------------------

c. Response to Comments and Consideration of Costs and Benefits in the
Final Rule
CFTC Regulation Sec. 1.3(m)(5)(i) reduces the number of pools that
need to determine the ECP status of their natural person participants,
and thus reduces related costs, because it limits, absent evasion, the
pools the CFTC considers for look-through purposes to transaction-level
retail forex pools. The guidance the Commissions provide in the
preamble also reduces the scope of the potential look-through, with
attendant cost-reductions, by stating expressly that a Retail Forex
Pool using retail forex transactions solely to hedge or mitigate
currency risk would not be considered structured to evade. Thus, such
hedging or mitigation would not be the basis of a look-through. In
particular, because, according to a commenter, the typical FOF uses
retail forex transactions solely to hedge currency risk related to
fluctuations in the exchange rate between non-U.S. dollar subscription
currencies and the U.S. dollar, most, if not all, FOFs would not be
covered by the look-through. To the extent other commodity pools use
retail forex transactions solely to hedge or mitigate their currency
risk, such pools also would not be subject to the CFTC Regulation Sec.
1.3(m)(5)(ii) look-through provision. Because Regulation Sec.
1.3(m)(5)(ii) provides a look through only in cases of evasion and the
Commissions' guidance narrows considerably the scope of what might
otherwise be considered evasion, the CFTC expects the CPO of the
typical pool to be able to determine at little or no cost the ECP
status of their direct participant commodity pools; such status will be
based on CEA section 1a(18)(iv), an analysis with which such CPOs are
familiar.\1428\
---------------------------------------------------------------------------

\1428\ While the Commissions are adding additional detail
explaining the scope of CEA section 1a(18)(A)(iv)(II), the
Commissions also provide guidance on that explanation. As a result,
the CFTC does not believe that the upfront costs of determining ECP
status under CEA section 1a(18)(A)(iv) will significantly increase.
---------------------------------------------------------------------------

While the CFTC has provided guidance to reduce the costs of
applying the rule, it estimates that each affected CPO may have to
spend between 5 and 20 hours of legal time, representing a cost between
$1,800 and $7,100,\1429\ initially to determine the ECP status of the
pools that they operate, and up to 5 hours ($1,800) of additional legal
time to determine such status upon each change to the fund's structure,
operating guidelines, etc. that might implicate ECP status. Commenters
noted that drafting ECP representations and contacting existing
participants are part of the costs of determining ECP status. While the
CFTC acknowledges such costs, CFTC Regulation Sec. 1.3(m)(5) also
provides investor protection benefits to non-ECP participants in pools
that are not ECPs by requiring such pools to enter into retail forex
transactions with an Enumerated Counterparty. This provides non-ECP
participants in such pools the protections of the retail forex regime
imposed by such counterparty's federal regulator.
---------------------------------------------------------------------------

\1429\ The CFTC computed these totals by assuming from 5 to 20
hours of legal review by a compliance attorney at $355/hour based on
the 2010 SIFMA survey. See SIFMA, Report on Management and
Professional Earnings in the Securities Industry--2010. If we assume
that 5,000 potential commodity pools need to make this determination
and round to two significant digits, this results in a total
approximate cost of $8.9 million to $36 million. As is the case for
the application of the definitions of the terms ``swap dealer'' and
``major swap participant,'' these costs reflect a higher multiplier
because some persons may retain outside advisors to assist in making
the determinations under the rules.
---------------------------------------------------------------------------

The CFTC also notes that the number of categories of enumerated
counterparties available as counterparties to non-ECP commodity pools
has increased since the Commissions proposed the regulations, because
other regulators have finalized their retail forex regimes, as
discussed in greater detail above. While trading with Enumerated
Counterparties will entail doing so pursuant to the retail forex
regulations of the relevant federal regulator, such regulations will
apply to the counterparties, not the CPO. While CPOs of Retail Forex
Pools generally must register as such with the CFTC, to the extent an
exemption from registration is available under the CFTC's rules, such
CPOs need not register as a result of their retail forex transactions,
further reducing the potential costs of Regulations Sec. Sec.
1.3(m)(5)(i) and (ii). Further, commodity pools will not incur any
costs to change counterparties (with the accompanying costs of, for
example, putting in place new trading documentation) to the extent they
already trade with Enumerated Counterparties. Commenters noted that
non-ECP pools would incur costs to negotiate new trading documentation
with Enumerated Counterparties to the extent that such pools do not
currently enter into retail forex transactions with Enumerated
Counterparties and wish to continue to engage in retail forex
transactions other than on or subject to the rules of a DCM. However,
Regulation Sec. 1.3(m)(5) also provides investor protection benefits
to non-ECP participants in pools that enter into retail forex
transactions by requiring such pools to trade with Enumerated
Counterparties and to be operated by registered CPOs, absent an
applicable exemption.
To the extent that a commodity pool is precluded by CFTC Regulation
Sec. 1.3(m)(6) from achieving ECP status based on prong (A)(v) of the
ECP definition, the pool will be limited to trading swaps, if at all,
on or subject to the rules of a DCM. This could result in costs to
affected commodity pools, including margin, the costs of establishing
relationships with future commission merchants (e.g., reviewing new
account opening documentation) and opportunity costs from losing the
ability to trade swaps customized to pools' needs. Preventing commodity
pools that do not qualify under clause (A)(iv) from qualifying pursuant
to clause (v), however, closes a loophole that would allow smaller
commodity pools that are not able to satisfy the requirements of clause
(A)(iv) of the ECP definition to qualify as ECPs. Moreover, by
providing additional clarification in the preamble regarding the
meaning of CEA section 1a(18)(A)(iv)(II), the Commissions substantially
reduced the potential number of commodity pools affected by CFTC
Regulation Sec. 1.3(m)(6).
CFTC Regulations Sec. Sec. 1.3(m)(1)-(4) define major swap
participants, swap dealers, major security-based swap participants and
security-based swap dealers, respectively, as ECPs. Stating explicitly
in regulations that these entities are ECPs avoids the potentially
anomalous result of such entities, which are some of the largest and/or
most active swap market participants, not being ECPs and is in line
with expectations in the market that these entities may engage in a
full range of swap and security-based swap activities. The CFTC
believes that these regulations will not result in any significant
economic costs or benefits.
The CFTC is persuaded by commenters that allowing participants to
continue to rely on the line of business element of the Swaps Policy
Statement will mitigate unnecessary costs from the regulation but is
adding various conditions to retain adequate protection for market
participants and the public. As noted above, CFTC Regulation Sec.
1.3(m)(7) permits an entity,

[[Page 30721]]

in determining its net worth for purposes of subclause (A)(v)(III) of
the ECP definition,\1430\ to include the net worth of its owners,
solely for purposes of determining its ECP status for swaps used to
hedge or mitigate commercial risk, provided that all of its owners are
themselves ECPs (disregarding shell companies, as defined above). Under
CFTC Regulation Sec. 1.3(m)(7) as adopted, an entity seeking to
qualify under subclause (A)(v)(III) of the ECP definition in order to
enter into a swap used to hedge or mitigate commercial risk is
permitted to count the net worth of its owners in determining its own
net worth, so long as all its owners are ECPs. Accordingly, CFTC
Regulation Sec. 1.3(m)(7) will allow qualified participants the
flexibility to enter into customized swaps.
---------------------------------------------------------------------------

\1430\ CEA section 1a(18)(A)(v)(III) provides that ``a
corporation, partnership, proprietorship, organization, trust, or
other entity * * * that (aa) has a net worth exceeding $1,000,000;
and (bb) enters into an agreement, contract, or transaction in
connection with the conduct of the entity's business or to manage
the risk associated with an asset or liability owned or incurred or
reasonably likely to be owned or incurred by the entity in the
conduct of the entity's business'' is an ECP. 7 U.S.C.
1a(18)(A)(v)(III).
---------------------------------------------------------------------------

By limiting the line of business ECP prong to entities owned solely
by ECPs, the CFTC is preserving the intent behind the ECP requirement,
which is to limit the availability of customized swaps to market
participants of sufficient financial sophistication and with sufficient
assets or net worth to assess, appreciate and bear the implications and
risks of swap transactions. Although commenters proposed various
solutions to address the loss of the Swap Policy Statement, the CFTC
believes the approach adopted is the best approach; it substantively
preserves the ECP requirement and protects the real parties in interest
(i.e., the owners). Although banks and non-ECP borrowers might be able
to restructure or more highly capitalize borrowing entities or borrow
at a higher level in the ownership structure, this regulation will
allow banks and qualified businesses to continue to conduct their loan
arrangements as usual without incurring the costs, which could include
undesirable tax treatment, of such operational changes. Further,
because commenters focused on swap related risks, the Commissions
limited this regulation's application narrowly, i.e., it does not apply
for purposes of determining ECP status for: swaps not meeting the
conditions set forth in Regulation Sec. 1.3(m)(7); security-based
swaps; security-based swap agreements; mixed swaps; or agreements,
contracts or transactions that are not swaps (regardless of the purpose
for which they are used).
CFTC Regulation Sec. 1.3(m)(8) permits a Forex Pool to qualify as
an ECP notwithstanding that it has one or more direct participants that
are not ECPs if the Forex Pool (a) is not formed for the purpose of
evading regulation under CEA sections 2(c)(2)(B) or (C) or related
rules, regulations or orders, (b) has total assets exceeding $10
million and (c) is formed and operated by a registered CPO or by a CPO
who is exempt from registration as such pursuant to CFTC Regulation
Sec. 4.13(a)(3). The data presented by commenters, discussed above,
demonstrate that registered CPOs \1431\ of commodity pools over a
certain size ($10 million in total assets) historically have engaged in
retail forex misconduct to a much less significant degree than other
CPOs. Only one of the 45 unique cases presented by commenters involved
a pool with more than $10 million in total assets and a registered CPO.
Only two of those cases involved a pool operated by CPOs exempt from
registration: in both of those cases, however, the CPO raised less than
$10 million.\1432\ The CFTC also recognizes that subjecting such
commodity pools to the statutory look-through provision to protect non-
ECP customers from fraud and abuse would cause them to incur higher
costs (e.g., CPO compliance costs for those CPOs required to register
as such, and redocumenting trading relationships with new
counterparties who are Enumerated Counterparties), for intangible pool
participant protections. To further protect pool participants, the
Commissions added a requirement that, to be an ECP under the line of
business prong, the Forex Pool must not be formed for the purpose of
evading CFTC regulation of Retail Forex Pools and retail forex
transactions under CEA Section 2(c)(2)(B) or (C). Accordingly, the
Commissions have tailored CFTC Regulation Sec. 1.3(m)(8) in a manner
they believe preserves its ability to effectively protect market
participants and the public, while avoiding significant costs.
---------------------------------------------------------------------------

\1431\ CFTC Regulation Sec. 1.3(m)(8) as adopted requires that
the CPO of the Forex Pool be registered as a CPO with the CFTC. The
Commissions believe that this condition is appropriate because it
will ensure that the NFA oversees compliance by those CPOs relying
on this new regulation.
\1432\ In addition, one of those CPOs relied on the CFTC
Regulation Sec. 4.13(a)(4) CPO registration exemption. As discussed
above, the CFTC has withdrawn that exemption.
---------------------------------------------------------------------------

As noted above, CEA section 1a(18)(A)(vii)(cc) contains a statutory
cross-reference rendered incorrect due to a legislative drafting
oversight. Failing to address such error would inappropriately deprive
such entities of ECP status, imposing undue costs (e.g., the
opportunity costs of being unable to execute a desired hedge or trading
strategy using standardized exchange-traded swaps) on such entities.
Allowing a government entity the ability to qualify as an ECP based on
its counterparty's status will provide, at little or no cost, the
benefit of effectuating Congressional intent that government entities
satisfying the conditions of CEA section 1a(18)(A)(vii)(cc) be ECPs.
Therefore, the CFTC included in the preamble an interpretation treating
as an ECP government entities satisfying the conditions of CEA section
1a(18)(A)(vii)(cc) as if such section incorporated the correct cross-
reference. The CFTC believes that correcting this incorrect cross-
reference will not result in any significant economic costs or
benefits.
d. CEA Section 15(a) Discussion
Protection of market participants and the public. Congress
determined to protect retail foreign exchange investors from fraudsters
by amending the ECP definition to require a pool's participants to
qualify as ECPs for the pool to be an ECP under subsection
(A)(iv).\1433\ As discussed above, this protection, as implemented by
CFTC Regulation Sec. 1.3(m)(5) may raise the costs of legitimate
foreign exchange transactions. To mitigate these potential increased
costs, CFTC Regulations Sec. 1.3(m)(5)(i) limits the look-through to
the level of the commodity pool structure that engages in retail forex
transactions, subject to CFTC Regulation Sec. 1.3(m)(5)(ii). This
limitation provides that, if any level of the pool has been structured
to evade, the CFTC would look through the transaction-level commodity
pool's direct commodity pool participants indefinitely until reaching
non-commodity pool participants. CFTC Regulation Sec. 1.3(m)(5),
therefore, protects non-ECP members of the public in appropriate
instances.
---------------------------------------------------------------------------

\1433\ Accord letter from AIMA I.
---------------------------------------------------------------------------

[[Page 30722]]

approach adopted is the best approach because it preserves the
substance of the ECP requirement and protects the real parties in
interest (i.e., the owners).
Because registered CPOs,\1434\ and CPOs exempt from registration,
who operate commodity pools over a certain size ($10 million in total
assets) historically have engaged in retail forex misconduct to a much
less significant degree than CPOs of commodity pools below that
threshold, the CFTC believes that imposing this size threshold
requirement as a condition of ECP status pursuant to Regulation Sec.
1.3(m)(8) provides some protection to pool participants. The additional
requirement that to be an ECP under the line of business prong the
Forex Pool must not be formed for the purpose of evading CFTC
regulation of Retail Forex Pools and retail forex transactions under
CEA Section 2(c)(2)(B) or (C) will further protect pool participants.
---------------------------------------------------------------------------

\1434\ CFTC Regulation Sec. 1.3(m)(8) as adopted requires that
the CPO of the Forex Pool be registered as a CPO with the CFTC. This
condition is appropriate because it will ensure that the NFA
oversees compliance by those CPOs relying on this new regulation.
---------------------------------------------------------------------------

Efficiency, competitiveness, and the financial integrity of the
market. With respect to CFTC Regulation Sec. Sec. 1.3(m)(5) and (6),
commodity pools that do not qualify as ECPs may have to use products
listed on or subject to the rules of a DCM that might not precisely (or
at all) match such parties' needs. This may reduce or eliminate a
commodity pool's ability to engage in some transactions, but these
regulations also seek to prevent unsophisticated parties from entering
into certain transactions to prevent repeated abuses and protect
members of the public. We believe CFTC Regulations Sec. Sec.
1.3(m)(1)-(8) do not significantly impact competitiveness or the
financial integrity of markets.
Price discovery. CFTC Regulations Sec. Sec. 1.3(m)(1)-(8) only
clarify the status of entities. They do not affect price discovery.
Sound risk management practices. CFTC Regulations Sec. Sec.
1.3(m)(5) and (6) may restrict investment opportunities for certain
non-ECPs that might have otherwise qualified as ECPs.\1435\ This may
discourage the use of some sound risk management practices and/or
investment strategies. For instance, it may become more expensive for
CPOs operating non-ECP pools to use such practices and/or strategies if
such pools must enter into swaps on or subject to the rules of a DCM or
come into compliance with a retail forex regime or choose to redeem
non-ECPs to avoid such results. On the other hand, CPOs may not incur
the increased expense of such sound risk management practices and/or
investment strategies if they are able to pass such costs on to the
participants in the pools. Also, with respect to swaps, pools that are
not ECPs due to CFTC Regulation Sec. 1.3(m)(6) can enter swaps on or
subject to the rules of a DCM to the extent an appropriate swap is
listed by such DCM.
---------------------------------------------------------------------------

\1435\ CFTC Regulations Sec. 1.3(m)(1)-(4) and the interpretive
guidance regarding certain governmental ECPs have the opposite
effect, making investment opportunities available to certain ECPs
that might otherwise not have qualified as ECPs.
---------------------------------------------------------------------------

In contrast, CFTC Regulations Sec. Sec. 1.3(m)(7) and (8) allow
qualified participants to engage in swaps that are not on a DCM. This
gives qualified participants more choices for their hedges, and may
provide an opportunity for better risk management.
Other public interest considerations. CFTC Regulations Sec. Sec.
1.3(m)(1)-(4) state that major swap participants, swap dealers, major
security-based swap participants, and security-based swap dealers,
respectively, are ECPs. The interpretive guidance regarding certain
governmental ECPs remedies an incorrect statutory cross-reference with
respect to the ability of a subset of governmental entities to qualify
as ECPs under CEA section 1a(18)(A)(vii).\1436\
---------------------------------------------------------------------------

\1436\ 7 U.S.C. 1a(18)(A)(vii).
---------------------------------------------------------------------------

VIII. Administrative Law Matters--Exchange Act Revisions (Definitions
of ``Security-Based Swap Dealer'' and ``Major Security-Based Swap
Participant'')

A. Economic Analysis

1. Overview
The SEC is sensitive to the costs and benefits of our rules. Some
of these costs and benefits stem from statutory mandates, while others
are affected by the discretion we exercise in implementing the
mandates. We have requested comment on all aspects of the costs and
benefits of the proposal, including any effect our proposed rules may
have on efficiency, competition, and capital formation. In considering
the economic consequences of these final rules, moreover, we have been
mindful of the link between the scope of the persons who are deemed to
be dealers or major participants pursuant to these rules and the costs
and benefits associated with the regulatory requirements that are
applicable to dealers and major participants, as well as the direct
assessment costs (as defined below) these rules will impose on certain
market participants.
As the SEC noted in the Proposing Release, the definitions of
``security-based swap dealer'' and ``major security-based swap
participant'' implicate two categories of potential costs. First, there
are costs that arise from the regulatory requirements that will apply
to those types of entities (e.g., the registration, margin, capital and
business conduct requirements that would apply to dealers and major
participants).\1437\ The Proposing Release also noted that there are
costs that entities will incur in determining whether they fall within
the definitions of ``security-based swap dealer'' and ``major security-
based swap participant.'' \1438\ Commenters that addressed these issues
discussed both types of costs.\1439\ Our consideration of these issues
has been informed by the comments we received.
---------------------------------------------------------------------------

\1437\ See Proposing Release, 75 FR at 80206.
\1438\ See Proposing Release, 75 FR at 80206-07.
\1439\ See, e.g., letters from Representatives Bachus and Lucas
(``Casting an overly-broad net in defining these terms could force
some smaller participants to leave the marketplace as a result of
increased costs, or eliminate certain types of contracts used for
hedging. If either occurs, businesses will be left exposed to market
volatility and the consequences will ultimately be felt by Americans
in the forms of increased consumer costs.''); ISDA (suggesting that
imposing dealer regulation beyond persons whose business is to make
markets would be inconsistent with the Dodd-Frank Act's intent to
preserve growth and innovation in the swap markets); ABC/CIEBA
(stating that major participant thresholds will cause persons who
pose no systemic risk to incur substantial costs associated with
major participant registration and regulation); SIFMA-AMG
(addressing complexity and burden of analyzing potential status as a
major participant, and urging implementation of a calculation safe
harbor).
---------------------------------------------------------------------------

In adopting these final rules, we have sought to take into account
the broader costs and benefits associated with the regulation of
security-based swap dealers and major security-based swap participants,
which we refer to in this section as ``programmatic'' costs and
benefits. We have also considered the direct costs that persons would
incur to assess whether they fall within the dealer or major
participant definitions or to assess the potential availability of
limited registration as a dealer or major participant. We refer to
these costs as ``assessment'' costs.\1440\ The programmatic costs and
benefits and the assessment costs raise distinct analytic issues.
---------------------------------------------------------------------------

\1440\ We expect that the benefits resulting from the
identification and registration of dealers and major security-based
participants will likely accrue primarily at the programmatic level.
To the extent appropriate given the purposes of Title VII, we have
sought to mitigate the costs entities will incur in connection with
such identification and registration.
---------------------------------------------------------------------------

We discuss below certain of the costs and benefits--both
programmatic and assessment-related--that we have considered in
adopting these rules. These costs and benefits have informed the policy
choices described above.

[[Page 30723]]

Accordingly, the analysis below includes references throughout to the
earlier discussions of the policy decisions taken by the Commissions.
In considering the costs and benefits of these rules, we are
mindful of the various considerations that must be taken into account
in establishing the baseline against which those costs and benefits may
be evaluated. A key consideration is that the definitions, while
integral to the regulatory requirements that will be imposed on dealers
and major participants pursuant to Title VII, do not themselves
establish the scope or nature of those substantive requirements or
their related costs and benefits. In light of this consideration
associated with definitional rulemaking, the baseline we are using to
consider the costs and benefits associated with the definitions
presumes that the other Title VII rules that implement the statutory
requirements applicable to security-based swap dealers and major
security-based swap participants will be adopted (and will be the
subject of their own economic analysis), but as yet there are no
dealers or major participants subject to any of these requirements. The
costs and benefits described below are therefore those that may arise
in connection with (1) identifying a subset of current and future
market participants as either security-based swap dealers or major
security-based swap participants (i.e., the assessment costs) and (2)
subjecting that subset, through the definitional lines we are drawing,
to a complete, fully effective complement of Title VII statutory and
regulatory requirements (i.e., the programmatic costs and benefits).
Accordingly, in determining the appropriate scope of the
definitions being adopted in these rules, we considered what type of
persons should be regulated as dealers and major participants under
Title VII, in light of the purposes of the statute, the overall
regulatory framework, and the data currently available to us. We thus
have sought to adopt regulations that would include entities within the
scope of the dealer and major participant definitions to the extent
that encompassing persons with their level of security-based swap
activities or positions would be necessary and appropriate given the
purposes of the statute (for example, because the institution may pose
market or other risks of the type addressed by Title VII). Conversely,
to the extent that we expect that the regulation of certain types of
market participants would not serve the statutory purposes, we have
sought to exclude them from the scope of the definitions, thereby
reducing unnecessary burdens on entities whose regulation may not be
necessary or appropriate to further the purposes of the statute.
We recognize that the costs and benefits arising from these rules
will affect competition, efficiency, and capital formation in the
security-based swap market broadly, with the impact not being limited
to the specific entities that fall within the meaning of the terms
``security-based swap dealer'' and ``major security-based swap
participant.'' In the sections that follow we begin with a
consideration of the costs and benefits of the rule that affect the
regulated market participants that fall within the meaning of these
terms, and conclude with a consideration of the potential effects of
this rule on competition, efficiency, and capital formation.
2. Programmatic Costs and Benefits Associated With These Definitions'
Scope
a. Programmatic Costs
The scope of these definitions will directly affect the number of
market participants subject to Title VII and the rules thereunder and
thus will directly affect the overall costs associated with the
regulation of dealers and major participants pursuant to Title VII.
Persons who fall within the statutory definitions of security-based
swap dealer and major security-based swap participant, as further
defined by these rules, will incur a number of upfront costs and
ongoing costs in connection with their status as dealers or major
participants. Those include, but are not limited to, costs of complying
with requirements related to: registration; reporting, recordkeeping,
confirmation and documentation; sales practices; margin, capital and
segregation of customer collateral; and maintaining a chief compliance
officer.\1441\ We expect that the significance of those programmatic
costs will outstrip the more discrete and entity-specific assessment
costs (discussed in more detail below) that individual entities will
incur in determining whether they fall within the dealer and major
participant definitions.
---------------------------------------------------------------------------

\1441\ For example, dealers and major participants will be
subject to business conduct requirements of section 15F of the
Exchange Act, and thus will be required, among other things, to
determine that their counterparty meets certain eligibility
standards before entering into security-based swaps with them and to
disclose information about material risks and characteristics,
material incentives, conflicts of interest, the daily mark, and
clearing rights. See Securities Exchange Act Release No. 64766 (June
29, 2011), 76 FR 42396, 42406, 42410 (July 18, 2011). Also, for
example, in connection with registration requirements we expect
security-based swap dealers and major security-based swap
participants to incur costs in connection with completing and filing
forms, providing related certifications, addressing additional
requirements in connection with associated persons, as well as
certain additional costs. See Securities Exchange Act Release No.
65543 (Oct. 12, 2011), 76 FR 65784, 65813-18 (Oct. 24, 2011). The
costs associated with these and other substantive rules applicable
to dealers and major participants are being addressed in more detail
in connection with the applicable rulemakings.
---------------------------------------------------------------------------

The programmatic costs linked to compliance by regulated entities
with specific requirements are not the only overall costs associated
with the regulation of dealers and major participants. Other potential
costs associated with the establishment of a new regulatory structure
over dealers and major participants, such as costs related to the
potential reduction of competition in the market, the deterrence of new
entrants, or reductions in capital formation, are discussed more fully
below.\1442\
---------------------------------------------------------------------------

\1442\ See part VIII.A.4, infra.
---------------------------------------------------------------------------

b. Programmatic Benefits
The regulation of dealers and major participants also will provide
a number of programmatic benefits to the security-based swap market and
to market participants. As discussed above,\1443\ registered security-
based swap dealers and major participants will be subject to a number
of entity-level and transaction-level requirements that we expect to
produce a broad array of benefits consistent with the purposes of Title
VII.\1444\
---------------------------------------------------------------------------

\1443\ See part II.D.3.a, supra.
\1444\ In application, the programmatic requirements applicable
to security-based swap dealers may differ from the programmatic
requirements applicable to major security-based swap participants.
For example, the proposed business conduct rules applicable to
dealers include ``know your customer,'' suitability and ``pay to
play'' requirements that would not also apply to major participants.
See Exchange Act Release No. 64766 (June 29, 2011), 76 FR 42396,
42399-401 (July 18, 2011).
---------------------------------------------------------------------------

For example, section 15F(e) of the Exchange Act and related rules
impose capital and margin requirements on dealers and major
participants,\1445\ which will reduce the financial risks of these
institutions and contribute to the stability of the security-based swap
market in particular and the U.S. financial system more generally.
Section 3E of the Exchange Act, among other things, requires security-
based swap dealers that collect margin from counterparties to cleared
security-based swap transactions to maintain that collateral in
segregated accounts, as well as providing counterparties to uncleared
security-based swap transactions with security-based swap dealers and
major

[[Page 30724]]

security-based swap participants with the right to require the
segregation of assets held as collateral with an independent third-
party custodian. These protections provide market participants who
enter into transactions with these entities confidence that their
collateral accounts will remain separate from the dealer or major
participant's assets in the event of bankruptcy.\1446\ Title VII also
requires registered entities to implement risk management policies and
procedures that should allow them to avoid taking on excessive risk and
to better deal with market fluctuations that might otherwise endanger
the financial health of the entity.\1447\
---------------------------------------------------------------------------

\1445\ See Exchange Act section 15F(e).
\1446\ See Exchange Act section 3E.
\1447\ See Exchange Act section 15F(j)(2).
---------------------------------------------------------------------------

Title VII further imposes a range of business conduct requirements
upon these registered entities, which should deter fraudulent or
deceptive conduct and increase information transparency for customers
and counterparties seeking to access the security-based swap market.
For example, section 15F(h)(3)(B) of the Exchange Act and related rules
establish certain disclosure requirements for dealers and major
participants,\1448\ while section 15F(h)(3)(C) of the Act and related
rules require that communications by these entities meet certain
standards of fairness and balance.\1449\ Section 15F(j)(5) of the Act
and related rules introduce requirements intended to address potential
conflicts of interest that may arise in transactions between a dealer
or major participant and its counterparty.\1450\ Title VII also
establishes higher levels of protection for special entities entering
into transactions with dealers or major participants.\1451\ As we
discuss in more detail in our analysis of the competitive effects of
these rules, these protections, and the related increase in
transparency in dealings with registered entities may be expected to
improve the competitiveness and efficiency of the market.
---------------------------------------------------------------------------

\1448\ See Exchange Act section 15F(h)(3)(B).
\1449\ See Exchange Act section 15F(h)(3)(C).
\1450\ See Exchange Act section 15F(j)(5).
\1451\ See Exchange Act sections 15F(h)(2), (h)(4), (h)(5).
---------------------------------------------------------------------------

Finally, Title VII also imposes requirements that are designed to
promote effective market operation and transparency. Sections 15F(f),
(g), and (j)(3) of the Exchange Act and related rules impose certain
reporting, recordkeeping, and regulatory disclosure requirements upon
registered entities, which should enhance the volume and quality of
information available in the market and facilitate effective oversight
by the Commission.\1452\ Section 15F(i) establishes regulatory
standards related to the confirmation, processing, netting,
documentation and valuation of security-based swaps, which should
enhance the efficiency of the procedures surrounding the execution of
security-based swap transactions.\1453\
---------------------------------------------------------------------------

\1452\ See Exchange Act section 15F(f) (reporting and
recordkeeping requirements); Exchange Act section 15F(g) (daily
trading records requirements); and Exchange Act section 15F(j)(3)
(requirements related to the disclosure of information to
regulators).
\1453\ See Exchange Act section 15F(i).
---------------------------------------------------------------------------

We expect that the regulation of security-based swap dealers and
major participants through these provisions will advance the
transparency, risk reduction and counterparty protection purposes of
Title VII.\1454\ While these benefits will be significant, they will
not be entirely measurable, as it is not possible to quantify the
benefits of mitigating or avoiding a future financial crisis, or the
benefits of avoiding an unsuitable security-based swap
transaction.\1455\ Those benefits, moreover, can be expected to
manifest themselves over the long-term and be distributed over the
market as a whole.
---------------------------------------------------------------------------

\1454\ Prior to the enactment of the Dodd-Frank Act, a Treasury
Department blueprint for financial reform articulated benefits of
comprehensive regulation of derivatives: ``OTC derivatives markets,
including CDS markets, should be subject to comprehensive regulation
that addresses relevant public policy objectives: (1) preventing
activities in those markets from posing risk to the financial
system; (2) promoting the efficiency and transparency of those
markets; (3) preventing market manipulation, fraud, and other market
abuses; and (4) ensuring that OTC derivatives are not marketed
inappropriately to unsophisticated parties.'' Department of the
Treasury, Financial Regulatory Reform--A New Foundation 46-47
(2009).
\1455\ See note 421, supra. The significance of these potential
benefits is suggested by the 2008 financial crisis. Better Markets
cited estimates that the worldwide cost of the 2008 financial crisis
in terms of lost output was between $60 trillion and $200 trillion,
depending primarily on the long-term persistence of the effects. See
letter from Better Markets. We recognize, however, that this
estimate addresses the aggregate cost of the financial crisis, and
that Title VII is directed to only one aspect of the factors that
contributed to the crisis.
---------------------------------------------------------------------------

c. The Relation Between These Rules and the Programmatic Costs and
Benefits
In adopting these final rules, we recognize that: (a) The choices
reflected by these rules will affect how many persons and which persons
ultimately will be deemed to be dealers or major participants; and (b)
those results, combined with the substantive requirements that are to
be adopted in connection with the dealer and major participant
regulatory regime, ultimately will determine the programmatic costs and
benefits that will be associated with the substantive regulation of
dealers and major participants.
This is not to say that there would be a one-to-one correlation
between the regulation (or non-regulation) of any particular entity as
a dealer or major participant and the additional (or reduced)
programmatic costs and benefits that would be associated with the
regulation (or non-regulation) of that entity. Some of the costs of
regulating a particular person as a dealer or major participant, such
as costs of registration, may largely be fixed. At the same time, other
costs associated with regulating that person as a dealer or major
participant (e.g., costs associated with margin and capital
requirements) may be variable, reflecting the level of the person's
security-based swap activity. Similarly, the regulatory benefits that
would arise from deeming that person to be a dealer or major
participant (e.g., benefits associated with increased transparency and
efficiency, and reduced risks faced by customers and counterparties),
although not quantifiable, may be expected to be variable in a way that
reflects the person's security-based swap activity. In addition, it is
reasonable to believe that the implementation of Title VII itself will
change the security-based swap market, and, with the full
implementation of Title VII--which in part is conditioned on these
definitions--more information will be available for this
analysis.\1456\
---------------------------------------------------------------------------

\1456\ The lack of market data is particularly significant in
the context of total return swaps on equity and debt. We do not have
the same amount of information regarding those products as we have
in connection with the present market for single-name credit default
swaps.
---------------------------------------------------------------------------

Given these limitations on our ability to conduct a quantitative
assessment of the programmatic costs and benefits associated with these
definitional terms, we have considered these costs and benefits
primarily in qualitative terms. In that framework it is possible to
identify a subset of such entities that, because of the volume of their
dealing activity or the size of their security-based swap exposure,
appear to be the types of entities for which the other statutory
requirements of Title VII were created. We have therefore sought to
adopt definitions that would capture these entities, as the statute
requires us to do, without imposing the costs of Title VII on those
entities for which regulation currently may not be justified in light
of those purposes. We believe that this approach will maximize the
benefits provided by Title VII while minimizing costs to the extent

[[Page 30725]]

consistent with the purposes of the statute.
Moreover, as discussed above, the SEC has directed the staff to
report to the Commission on all aspects of the dealer and major
participant definitions no later than three years following the later
of: (i) the last compliance date for the registration and regulatory
requirements for security-based swap dealers and major security-based
swap participants under Section 15F of the Exchange Act; and (ii) the
first date on which compliance with the trade-by-trade reporting rules
for credit-related and equity-related security-based swaps to a
registered security-based swap data repository is required. This report
will provide the SEC and market participants with more information
about the security-based swap market following the implementation of
Title VII--including information regarding the business of dealers and
major participants, the characteristics of positions they and other
market participants hold, the structure of the market, and how Title
VII has affected those aspects of the market. This report, which will
take into account the additional data from our observations of the
security-based swap market and the functioning of the associated
regulatory requirements, is intended to help the SEC assess whether to
make changes to the scope of the dealer and major participant
definitions (as well as to assess future actions related to the
extended compliance period in connection to the de minimis exception to
the security-based swap dealer definition).
d. Analysis of the Effect of Specific Rules on Programmatic Costs and
Benefits
We have sought to establish definitions that capture the types of
entities whose security-based swap activity or whose security-based
swap positions warrant regulation under Title VII as dealers or major
participants, and to exclude the types of entities whose activity or
positions may not warrant such regulation. The relationship between a
given rule and the scope of the persons that ultimately will fall
within the dealer or major participant definitions--along with the
related costs and benefits--manifests itself in different ways
depending on the rule at issue. Some of these rules may be expected to
have a close link to the overall programmatic costs and benefits
associated with dealer and major participant regulation because they
play a significant role in determining the overall scope of the
definitions (for example, because they are relevant to the status of
relatively more entities). Other rules may be expected to affect the
status of relatively fewer entities and thus have a smaller effect on
those programmatic costs and benefits.
We anticipate that the report that the SEC staff will make to the
Commission following the full implementation of Title VII with regard
to these definitions will help us more fully evaluate the programmatic
impact of all of these rules, both in terms of the number of potential
major participants and dealers that would result from the definition we
are adopting as well as potential alternatives, and in terms of the
associated programmatic costs and benefits.
i. Core Rules That Implicate Programmatic Costs and Benefits
The core definitional terms with respect to establishing the scope
of the dealer and major participant definitions are those relating to:
(i) the core dealer definition, (ii) the dealer de minimis exception,
and (iii) the definitions of ``substantial position'' and ``substantial
counterparty exposure'' within the major participant definition.

A. Dealer Definition

Exchange Act rule 3a71-1 defines ``security-based swap dealer'' and
thus plays a central role in determining the scope of the Title VII
regulatory regime going forward. Based on the available data regarding
activity in the market for single-name credit default swaps, including
the application of various criteria that may be indicative of dealing
activity in that market, and taking into account the availability of
the de minimis exception to the dealer definition, we estimate that 50
or fewer entities ultimately may have to register with the SEC as
security-based swap dealers.\1457\ This is consistent with the estimate
that accompanied the proposal.\1458\
---------------------------------------------------------------------------

\1457\ This estimate--which potentially overstates the number of
potential dealers--is consistent with the data considered in the CDS
Data Analysis. That analysis implied a range of alternative
estimates--from 16 possible dealers to 93 possible dealers--based on
currently available data and reflecting a $3 billion de minimis
level. Compare CDS Data Analysis at table 2a (identifying 16
potential dealers above the $3 billion level based on the criterion
of having 20 or more unique counterparties) with CDS Data Analysis
at table 2c (identifying 93 potential dealers above that level based
on the criterion of having 10 or more unique counterparties).
However, most of the criteria applied by the CDS Data Analysis as
potentially indicative of dealer activity suggested estimates of
fewer than 50 possible dealers after accounting for the $3 billion
de minimis level. See id. at table 2b (identifying 32 possible
dealers based on the criterion of having 15 or more unique
counterparties); id. at table 3 (identifying 16, 19, or 25 possible
dealers based on the criterion of having a certain number of
counterparties not identified as dealers by ISDA); id. at table 4
(identifying 32 possible dealers based on the criterion of having a
``flat notional book''); id. at table 5 (identifying 33 possible
dealers based on the criterion of having ``flat transaction
volume''); id. at table 7 (identifying 40 possible dealers that meet
two or more of the other criteria cited in the analysis); id. at
table 8 (identifying 27 possible dealers that meet three or more of
the other criteria cited in the analysis). Only two criteria
suggested estimates in excess of 50 possible dealers above the $3
billion level. See id. at table 2c (identifying 93 possible dealers
based on the criterion of having 10 or more unique counterparties,
which may also be explained by the fact that non-dealers may
maintain trading relations with multiple dealers); id. at table 6
(identifying 52 possible dealers based on the criterion of posting
initial margin with low frequency, which may also be explained by
underreporting of margin due to the fact that such reporting was
voluntary with respect to the data underlying the CDS Data
Analysis).
While recognizing that alternative criteria for identifying
possible dealing activity produced varied results, we believe that
the results largely are consistent with the estimate of 50 or fewer
security-based swap dealer registrants. We further believe that it
is appropriate to place particular weight on one criterion that
identified possible dealing activity based on whether an entity
engaged in security-based swap transactions with three or more
counterparties that themselves were not identified as dealers by
ISDA. That analysis identified 28 entities possibly engaged in
dealing activity (with 25 of those with trailing notional
transactions that exceed the $3 billion de minimis threshold we are
adopting). See CDS Data Analysis at table 3c. We believe that this
metric serves as a useful proxy for the application of the dealer-
trader distinction, given that persons with the business model of
seeking to profit by providing liquidity in general may reasonably
be expected to engage in transactions with persons who are not
themselves recognized as dealers.
In estimating that 50 or fewer entities ultimately may have to
register as dealers, we are seeking to take a conservative approach
that recognizes both the limitations on the conclusions that may be
drawn from available data and the potential for changes in the
security-based swap market. We recognize that the criteria applied
in the CDS Data Analysis are imperfect in that they do not directly
apply the dealer-trader distinction, and that some alternative
criteria may prove to be superior predictors of actual dealing
activity. We also recognize that the estimate may overstate the
number of possible registered dealers insofar as not all of the
activity of persons identified as potential dealers based on the CDS
Data Analysis necessarily reflects dealing activity, meaning that in
practice a greater number of entities may be able to take advantage
of the de minimis exception, and fewer entities would have to
register as dealers, than estimates implied by that analysis may
suggest. This estimate of 50 potential dealers further seeks to
reflect the potential for growth in the size of the security-based
swap market, as well as growth in the number of registered dealers
as a result of competition promoted by the policies contemplated by
the Dodd-Frank Act, and the possibility that some business groups
that are identified as a single entity for purposes of this data
ultimately may register multiple legal entities as security-based
swap dealers.
\1458\ The proposal estimated approximately 50 entities would be
required to register as security-based swap dealers, based on
discussions with industry. See Proposing Release, 75 FR at 80209,
n.188. Commenters did not contradict this estimate. To the extent
that the actual number of registrants differs from this estimate, it
is reasonable to assume that the actual number will be lower than
the estimate in the proposal because the de minimis level
established by the final rules for credit default swaps that are
security-based swaps--as described above, by far the overwhelming
majority of the security-based swap market--is higher than the level
that was proposed (i.e., $3 billion vs. $100 million).

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

[[Page 30726]]

Alternative approaches to identifying dealer activity, including
those suggested by commenters, may have led to a lower or higher number
of potential dealers out of the over 1,000 total participants in the
security-based swap market. For example, commenters variously
suggested, among other approaches, that the dealer definition should be
interpreted to be coextensive with the concept of market making
activity, that dealer status should be limited to persons available to
take either side of the market at any time, or that dealer status
should be limited to transactions arising from a ``customer''
relationship.\1459\ Following those alternative approaches potentially
would reduce the ultimate number of persons required to register as
dealers.
---------------------------------------------------------------------------

\1459\ See part II.A.2, supra.
---------------------------------------------------------------------------

In adopting the final rules and providing interpretive guidance
that adapts our traditional dealer-trader analysis for the security-
based swap market, we have sought to capture those entities whose
security-based swap activity is warranted due to the nature of their
interactions with counterparties, or is warranted to promote market
stability and transparency. In this respect, we have sought to limit
the costs imposed by regulation under Title VII to those entities whose
regulation would serve the transparency, customer protection, and
market stability purposes of the statute while not imposing those costs
on entities whose regulation may not produce sufficient benefit in
terms of those purposes. The core dealer analysis that we have adopted
here focuses on activity that characterizes dealers, as the statutory
text requires, and does so while drawing on a well-established approach
used in an analogous securities dealer context by a wide range of
financial intermediaries.\1460\
---------------------------------------------------------------------------

\1460\ See part II.A.5, supra (discussing the application of the
dealer-trader distinction to the security-based swap market).
---------------------------------------------------------------------------

B. De Minimis Exception to the Dealer Definition

Exchange Act rule 3a71-2 implements the de minimis exception to the
dealer definition. This rule will directly affect the scope of the
dealer definition by excepting certain entities that otherwise would be
encompassed by the dealer definition but whose security-based swap
dealing activities fall below a specified notional threshold. As above,
we believe that the application of the final rule implementing the de
minimis exception, in combination with application of the dealer-trader
distinction, reasonably may be expected to result in 50 or fewer
entities ultimately registering with the SEC as security-based swap
dealers.\1461\
---------------------------------------------------------------------------

\1461\ See note 1457, supra.
---------------------------------------------------------------------------

As discussed above, the final rule implementing the de minimis
exception reflects our attempt to focus the application of dealer
regulation onto those entities for which that regulation would be
appropriate, taking into account the comparative costs and benefits of
dealer regulation, and the high degree of concentration of dealing
activity in the security-based swap market.\1462\ The final rule
particularly provides that a dealer may take advantage of the exception
if the notional amount of its dealing activity involving security-based
swaps that are credit default swaps over the trailing 12 months is no
more than $3 billion. For other types of swaps, a dealer may take
advantage of the exception if the notional amount of its dealing
activity is no more than $150 million. The threshold for dealing
activity with counterparties that are ``special entities,'' regardless
of the type of security-based swap, is $25 million. The final rule also
eliminates proposed tests based on the number of an entity's dealing
counterparties and on the number of its dealing security-based swaps.
This approach also mitigates concerns raised by some commenters about
the exception being overly narrow.\1463\
---------------------------------------------------------------------------

\1462\ See parts II.D, supra. Regardless of the criterion used
for identifying entities engaged in dealing activity, analysis of
2011 transaction data for single-name credit default swaps indicates
that possible dealers with $3 billion or more in trailing notional
activity account for over 98 percent of all the trailing notional
activity by such entities. See CDS Data Analysis at 8-17.
\1463\ See part II.D.2, supra. Conversely, some commenters
suggested lower thresholds than those provided in the final rule, an
approach that reasonably would be expected to lead more entities to
have to register as security-based swap dealers. We did not adopt
these lower thresholds because we determined that, given our
understanding of the current structure of the market, it was
unnecessary to do so to achieve the purposes of Title VII. Under any
of the metrics used in the CDS Data Analysis (with the exception of
the metrics relying on the posting of margin, which are, for reasons
provided in the analysis, particularly unreliable), for example,
retaining the proposed de minimis threshold of $100 million would
have captured at most an additional 0.75 percent of transaction
activity engaged in by entities captured by the respective analysis.
See CDS Data Analysis at 8-17.
In adopting this rule we also considered alternative approaches
and thresholds suggested by some commenters that potentially may
lead fewer entities to have to register as security-based swap
dealers. For example, while some commenters supported the use of an
exposure-based threshold rather than a notional threshold, we
declined to adopt this approach because the use of an exposure
threshold could permit a virtually unlimited amount of dealing
activity within the de minimis exception so long as exposures are
collateralized (or offset, as generally occurs with dealing
activity), a result inconsistent with the purposes of Title VII.
---------------------------------------------------------------------------

We have concluded that a $3 billion threshold for security-based
swaps that are credit default swaps would appropriately apply dealer
regulatory requirements to entities that comprise the vast majority of
domestic dealing activities in these products, while not imposing the
fixed costs of dealer regulation upon those entities responsible for
only a small portion of total dealing activity, and avoiding the threat
of leaving an excessive amount of dealing activity outside the ambit of
dealer regulation.\1464\ We believe that this approach strikes a
balance that appropriately maximizes the benefits of dealer regulation
while avoiding the application of the fixed costs of dealer regulation
onto those entities for which dealer regulation may not significantly
contribute to those benefits and avoiding the threat of allowing an
excessive volume of unregulated dealing activity.\1465\
---------------------------------------------------------------------------

\1464\ As noted above, a sufficiently high de minimis threshold
could allow a significant amount of unregulated security-based swap
dealing activity to develop among entities whose dealing activity
does not exceed the de minimis threshold. See part II.D.5.b, supra.
\1465\ As noted above, an extended compliance period will be
available to entities that engage in $8 billion or less in annual
notional dealing activity in security-based swaps that are credit
default swaps (or $400 million in dealing activity in other types of
security-based swaps), to help facilitate the orderly implementation
of Title VII and to afford the SEC additional time to study the
security-based swap market as it evolves in the new regulatory
framework. See part II.D.5.c.ii, supra.
---------------------------------------------------------------------------

Similar considerations influenced our determination that a $3
billion de minimis threshold would be inappropriate for persons engaged
in dealing activity involving other types of security-based swaps,
given the comparatively smaller size of that market.\1466\ We instead
have set the threshold at a level that reflects the relative volume in
the security-based swap market of security-based swaps that are not
credit default swaps.\1467\
---------------------------------------------------------------------------

\1466\ See part II.D.5.d, supra.
\1467\ See id. (discussing rationale for use of $150 million
threshold and $400 million phase-in level in connection with those
types of security-based swaps).
---------------------------------------------------------------------------

The final rule implementing the de minimis exception also sets
forth a lower notional threshold for dealing activities involving
``special entities,'' consistent with the special protections that
Title VII affords those entities. While we recognize that this lower
threshold may deter certain entities that are not registered as dealers
from

[[Page 30727]]

entering into security-based swap transactions with special entities,
and hence may have the effect of reducing the availability of security-
based swaps to those entities or increasing their costs,\1468\ we
believe that this lower threshold is appropriate to avoid undermining
those separate Title VII protections.\1469\
---------------------------------------------------------------------------

\1468\ We expect any such effect will likely be minimal. An
analysis of 2011 transaction data regarding single-name credit
default swap transactions involving special entities shows that 16
counterparties account for all transactions with special entities.
Although all but one of these entities engaged in more than $25
million in transactions with such entities in 2011, all of these
entities engaged in total single-name credit default swap activity
well in excess of the $3 billion de minimis threshold that applies
to dealers generally. See CDS Data Analysis, Table 9 and note 8.
Consequently, it is possible that all 16 entities would have been
required to register as dealers under the standard de minimis
threshold of $3 billion, regardless of the lower de minimis
threshold for special entities.
\1469\ See note 179, supra (discussing business conduct
requirements applicable to dealing activities involving special
entities).
---------------------------------------------------------------------------

The final rule implementing the de minimis exception further
provides that security-based swap activities of affiliates under common
control with an entity should be considered when determining whether
the entity can avail itself of the de minimis exception. That is
intended to avoid evasion of the dealer registration requirement; thus,
while a contrary approach might be expected to reduce the number of
registered dealers, such an approach would not be consistent with the
purposes of Title VII.\1470\
---------------------------------------------------------------------------

\1470\ See note 437, supra (discussing use of common control
standard in this anti-evasion context, rather than the majority
ownership standard used in connection with the inter-affiliate
exclusions from the dealer and major participant definitions).
---------------------------------------------------------------------------

C. ``Substantial Position'' and ``Substantial Counterparty Exposure''
Definitions
Exchange Act rules 3a67-3 and 3a67-5 define ``substantial
position'' and ``substantial counterparty exposure,'' which constitute
key terms within the major participant definition. The rules defining
these thresholds--including the use of current exposure and potential
future exposure tests, the specific features of those tests, and the
thresholds associated with those tests\1471\--can be expected to
directly influence the overall number of persons who may fall with the
major participant definition.
---------------------------------------------------------------------------

\1471\ As detailed above in part IV.B.3, an entity will
generally be required to register as a major security-based swap
participant if its current security-based swap exposure exceeds $1
billion in a single major category of security-based swaps or to a
single counterparty or if its current security-based swap exposure
plus its potential future exposure exceeds $2 billion in a single
major category of security-based swaps or to a single counterparty.
The current exposure test looks to an entity's current
uncollateralized exposure posed by its security-based swap positions
in a given category; the potential future exposure test looks to the
effective notional exposure represented by an entity's security-
based swap positions, with certain adjustments for cleared or
margined positions and netting.
---------------------------------------------------------------------------

These tests seek to capture persons whose security-based swap
positions pose sufficient risk to counterparties and the markets
generally that regulation as a major participant is warranted.\1472\
Based on available data regarding the single-name credit default swap
market--which we believe will comprise the majority of security-based
swaps--we estimate that the number of major security-based swap
participants likely will be fewer than five and, in actuality, may be
zero. As discussed above, an entity that posts daily variation margin
in connection with those positions generally would need to have
security-based swap positions approaching $100 billion to reach the
levels of potential future exposure required to meet the substantial
position threshold, even before accounting for the impact of netting,
while an entity that clears its security-based swaps generally would
need to have positions approaching $200 billion.\1473\ The available
data shows that as of December 2011 a single entity had aggregate gross
notional positions (i.e., aggregate buy and sell notional positions) in
single-name credit default swaps exceeding $100 billion, and three
others had aggregate gross notional positions between $50 and $100
billion.\1474\ However, as discussed above, the purchase of credit
protection is weighed less heavily than the sale of credit protection
for purposes of the analysis,\1475\ meaning that an entity's positions
reflecting single-name credit protection sold to its counterparties may
be expected to be more of a key determinant of the entity's potential
future exposure level under the rules we are adopting. The data shows
that no entities have more than $100 billion in positions arising from
selling single-name credit protection and that only two have between
$50 and $100 billion in positions arising from such transactions.\1476\
---------------------------------------------------------------------------

\1472\ See parts IV.C.3 and IV.E.3, supra.
\1473\ See note 914, supra. Although it is possible that a
notional position of $20 billion could cause an entity to be a major
participant in the absence of central clearing or mark-to-market
margining (and assuming that there is no risk reduction associated
with netting or with certain positions that pose lower credit risk),
we expect that those entities (such as hedge funds) that may be
expected to have large positions would, as a matter of course, post
mark-to-market margin in connection with positions that are not
cleared. See Proposing Release, 75 FR 80207-08 n.181 (stating our
understanding that banks, securities firms, and hedge funds
typically collateralize most or all of their mark-to-market exposure
to U.S. banks as a matter of practice). Accordingly, we believe that
$100 billion provides a reasonable focus for the analysis.
\1474\ See CDS Data Analysis at table 10.
\1475\ See part IV.B.3.c.iii, supra.
\1476\ See id. Although this data describes aggregate notional
positions only for single-name credit default swaps and does not
include analysis of positions in other types of security-based
swaps, as noted above, credit default swaps appear to account for
approximately 95 percent of the security-based swap market. That
fact reduces the likelihood that positions involving security-based
swaps that are not credit-related would cause a person to be a major
security-based swap participant, or lead any entity to find it
necessary to perform the major participant analysis in connection
with those instruments.
---------------------------------------------------------------------------

While a ``substantial position'' or ``substantial counterparty
exposure'' also can be established by a sufficiently high amount of
current uncollateralized exposure, the available data does not provide
information about individual entities' uncollateralized exposure in
connection with security-based swap positions. We note, however, our
understanding that certain of the financial entities that may have
large security-based swap positions, such as hedge funds, tend to
collateralize their security-based swap exposures as a matter of
course, which would reduce the potential impact of this aspect of the
test.
As noted above, commenters suggested both higher and lower
thresholds, as well as different discounts or risk multipliers for
certain positions.\1477\ If the final rules defining ``substantial
position'' and ``substantial counterparty exposure'' incorporated
higher major participant thresholds, potentially fewer entities may be
major participants. Conversely, lower thresholds may have led to a
higher number of major participants, with the upper bound being
represented by the over 1,000 non-dealer entities that participate in
the security-based swap market.\1478\
---------------------------------------------------------------------------

\1477\ See part IV.B.2, supra.
\1478\ See CDS Analysis at tables 10 through 12.
---------------------------------------------------------------------------

By potentially capturing more or fewer major participants, such
alternatives would have correspondingly increased or decreased the
programmatic costs and benefits associated with Title VII regulation of
major participants. As discussed above, however, the tests incorporated
into the final rules, and the thresholds associated with those tests,
are in our view tailored to capture only those entities that pose the
risks that major participant regulation in Title VII seeks to address;
in other words, these thresholds and related calculations

[[Page 30728]]

incorporate the risk criteria embedded in the major participant
definition.\1479\ For example, we have declined to exclude centrally
cleared positions from the potential future exposure test, instead
permitting entities to discount those positions for purposes of the
analysis, because central clearing cannot reasonably be expected to
fully eliminate all counterparty risk that may affect the broader
markets. Based on this fact, we conclude that it would be
inappropriate, given the purposes of Title VII, to exclude an entity
from the major participant definition simply because all of its
security-based swap positions arise from cleared transactions.\1480\
Similar considerations informed our approach to other aspects of the
substantial position and substantial counterparty position tests, as
discussed more fully above.\1481\
---------------------------------------------------------------------------

\1479\ See part IV.B.3, supra (discussing the decisions made
regarding the substantial position definition and the reasoning
behind the adopted approach). For example, we have concluded that
the proposed thresholds are set prudently in a manner that takes
into account the financial system's ability to absorb losses of a
particular size, the need for major participant regulation not to
encompass entities only after they pose significant risks to the
market, and the need to account for the possibility that multiple
market participants may fail close in time. In addition, as
discussed above, we believe that this threshold is tailored to
address the types of events associated with the failure of AIG FP.
See part IV.B.3.d, supra.
\1480\ Central clearing helps to mitigate counterparty credit
risk by improving risk management and, among other things,
mutualizing the risk of counterparty failure. If multiple members of
a central counterparty fail beyond the level to which such risk is
managed, however, the central counterparty would also be at risk of
failure. Cf. Basel Committee on Banking Supervision, Consultative
Document, ``Capitalisation of bank exposures to central
counterparties,'' Nov. 25, 2011 (available at: http://www.bis.org/publ/bcbs206.pdf) (proposing that the capital charge for trade
exposures to a qualifying central counterparty should carry a low
risk weight, reflecting the relatively low risk of default of the
qualifying central counterparty).
\1481\ See part IV.B.3, supra.
---------------------------------------------------------------------------

ii. Rules That May Be Expected To Have a Lesser Effect on Programmatic
Costs and Benefits
Several of the final rules may be expected to have relatively
smaller effects on the scope of the major participant and dealer
definitions because they are likely to affect relatively fewer
entities. By extension, they will also have a smaller effect on the
programmatic costs and benefits arising from these definitions.

A. Limited Purpose Dealer and Major Participant Designations

Exchange Act rules 3a67-1 and 3a71-1 retain the presumption that a
person that is encompassed within the major participant or dealer
definitions will be deemed to be a dealer or major participant with
respect to all of its security-based swap activities or positions,
unless the SEC exercises its authority to limit the person's
designation as a dealer to specified categories of swaps or security-
based swaps, or to specified activities. This presumption may affect
programmatic costs in at least two ways.
First, by not providing for registration as a limited purpose major
participant or dealer as a matter of course, the final rules may be
expected to increase the costs associated with the registration of
those entities that seek designation as dealers or major participants
or dealers. Aside from the costs of registration described in the SEC's
proposal related to the registration of dealers and major
participants,\1482\ we expect that entities seeking to register as a
limited purpose major participant or dealer would incur some additional
marginal costs associated with making applications for limited
designation.\1483\
---------------------------------------------------------------------------

\1482\ See ``Registration of Security-Based Swap Dealers and
Major Security-Based Swap Participants,'' Exchange Act Rel. No. 34-
65543 (``Registration Proposing Release''), 76 FR 65784, 65814-65818
(describing various costs associated with registration, including
$11,800 per entity to complete and file form SBSE and between
approximately $94,000 and $610,000 per entity to certify to the
capabilities of the entity seeking registration).
\1483\ These costs may include the costs of identifying how the
entity would be able, as a limited designation entity, to comply
with the various entity-level requirements of Title VII.
---------------------------------------------------------------------------

In addition, the presumption against limited purpose designation
may be expected to reduce the number of limited purpose major
participants and dealers below the number that would otherwise register
as limited purpose entities absent the presumption. In concept, broader
availability of limited purpose registration of major participants or
dealers may be expected to reduce the programmatic costs associated
with regulation under Title VII, without necessarily reducing certain
programmatic benefits if appropriately crafted. In particular, any
programmatic effects of an appropriately scoped limited designation
likely would affect only the transaction-level requirements applicable
to dealers and major participants (e.g., certain business conduct
standards and requirements related to trading records, documentation
and confirmations), potentially reducing costs and benefits that would
otherwise arise from such requirements with respect to transactions
that occur outside the limited designation. At the same time, certain
of the entity-level regulatory requirements applicable to dealers and
major participants as a whole (such as requirements related to capital)
would continue to apply in the context of limited designation, ensuring
that a limited purpose designation would not undermine the counterparty
protection and systemic risk concerns of Title VII.
Notwithstanding these effects, we believe that the presumption
against limited purpose designations is appropriate. This conclusion
reflects the statutory language, the difficulty of separating a
dealer's activities from its non-dealing activities (or a major
participant's security-based swap positions taken under its limited
purpose designation from other of its security-based swap positions)
for compliance purposes, and the challenges of applying dealer or major
participant regulatory requirements to only a portion of the entity's
security-based swap business. Instead, we will consider limited purpose
applications on an individual basis through analysis of the unique
circumstances of each applicant.\1484\
---------------------------------------------------------------------------

\1484\ We will consider applications for limited purpose
designation in the context of the registration requirements for
major participants and dealers. In that context, we could consider
applications on a case-by-case basis, pursuant to requests by
specific major participants or dealers. This could help to ensure
that any person that is designated as a limited purpose major
participant or dealer is able to comply with the regulatory
requirements applicable to major participants or dealers.
Accordingly, we intend to further consider issues regarding limited
designations, including associated costs, in a release relating to
the specific registration requirements (for example, the form used
for registration) for major participants and dealers. Furthermore,
as noted above, the SEC is directing the staff to prepare a report
on all aspects of the dealer and major participant definitions. Upon
completion of this report, the SEC may further assess whether
changes to the presumption against limited designation are warranted
in light of the then-current state of the security-based swap market
and the types of business in which security-based swap dealers are
engaged.
---------------------------------------------------------------------------

We note that the available data does not indicate how many, or
which, entities may have business models that conceivably could make
limited purposed designations appropriate (e.g., large positions in one
major category of security-based swaps accompanied by minor positions
in the other).\1485\
---------------------------------------------------------------------------

\1485\ The study that will be conducted in connection with the
dealer and major participant definitions may also provide relevant
information regarding limited designations of dealers and major
participants.
---------------------------------------------------------------------------

B. Inter-Affiliate Exclusions From Dealer and Major Participant
Definitions

Exchange Act rules 3a67-3 and 3a71-1 respectively exclude inter-
affiliate security-based swaps from the calculation of substantial
position and substantial counterparty position thresholds under the
major participant

[[Page 30729]]

definition, and from the de minimis calculation under the dealer
definition. The inter-affiliate exclusion from the major participant
and dealer definitions has the potential to affect the scope of these
definitions for those entities that engage in inter-affiliate
transactions by leading some entities not to meet the major participant
or dealer de minimis thresholds when they otherwise would have met
those thresholds (or by allowing certain centralized hedging facilities
to look only at their market-facing activities in conducting the
dealer-trader analysis). The exclusion or inclusion of certain inter-
affiliate transactions thus may have some impact on the programmatic
costs and benefits associated with dealer and major participant
regulation.
We are adopting a majority-ownership standard for determining
whether transactions between affiliates can be excluded from these
threshold calculations because such transactions between entities whose
economic interests are aligned to a degree represented by majority
ownership do not appear to pose the kinds of counterparty and market
risks that Title VII addresses.\1486\ Some commenters suggested lower
levels of control (such as common control) that may be expected to lead
to fewer entities being registered as dealers or major participants,
with associated impacts on programmatic costs and benefits. In our
view, however, such alternative standards would not be consistent with
the scope of the interactions to which dealer regulation is intended to
apply, or with an alignment of economic interests consistent with an
exclusion from the major participant definitions.
---------------------------------------------------------------------------

\1486\ See parts II.C.2.b and IV.G.2, supra (discussing nature
of inter-affiliate security-based swap transactions).
---------------------------------------------------------------------------

We also note that the data upon which the staff assessment of
credit default swap transactions and positions is based excludes
certain inter-affiliate credit default swap transactions. As a result,
estimates of market concentration and the distribution of dealing
activity or credit default swap positions derived from this data should
reflect to some extent the effect of the inter-affiliate exclusions we
are adopting in this rule.

C. Commercial Risk Hedging Exclusion

Exchange Act rule 3a67-4 defines ``hedging or mitigating commercial
risk'' as that term is used in the major participant definition. The
scope of this definition has the potential to determine whether certain
market participants will be major participants by virtue of the first
statutory major participant test, and will therefore affect the scope
of the programmatic costs and benefits associated with major
participant regulation. In application, this effect may be limited in
light of the fact that we estimate that, as discussed above, only five
or fewer entities--perhaps as few as zero--may have to register as
major security-based swap participants.
The final rule adopts an ``economically appropriate'' standard for
determining whether a security-based swap position hedges or mitigates
commercial risk, and sets forth exclusions for security-based swap
positions that have a speculative or trading purpose. As we discuss
above, we carefully considered the alternative approaches suggested by
some commenters, including the suggestion that the definition should
encompass positions that hedge speculative or trading positions and the
suggestion that the definition should incorporate a ``congruence''
standard. We concluded, however, that these approaches are inconsistent
with the focus of the statutory text, which is on ``commercial risk.''
\1487\ We also concluded that broadening the exclusion as some
commenters suggested could largely exclude security-based swap
positions from the first major participant test. This would produce a
result that we believe to be contrary to the purposes of that part of
the statutory definition, which envisions that entities might be
required to register as major participants by virtue of their security-
based swap positions.
---------------------------------------------------------------------------

\1487\ See parts IV.C.5.a and IV.C.5.b, supra (discussing
rationale for excluding hedges of speculative and trading positions
from the definition).
---------------------------------------------------------------------------

D. ``Financial Entity'' Definition

Exchange Act rule 3a67-6 defines ``financial entity'' for purposes
of the third test of the major participant definition, which applies to
certain highly leveraged non-bank financial entities and does not
prevent them from excluding commercial risk hedging positions when
conducting the substantial position analysis (in contrast to the first
test within the major participant definition, which permits exclusion
of those hedging positions).
Although the scope of the financial entity definition has the
potential to affect the number of persons who are captured by the third
test of the statutory major participant definition (and thus, by
extension, the programmatic costs and benefits associated with major
participant regulation), we believe that as a practical matter such an
effect would be minimal. This is based on our view that persons that
have security-based swap positions large enough and risky enough to
potentially lead to major participant status to be financial in nature
and thus would likely fall within any reasonable interpretation of the
term ``financial entity,'' \1488\ thus making such entities potentially
subject to the third major participant test (to the extent that such
entities are subject to bank capital requirements).
---------------------------------------------------------------------------

\1488\ See Federal Reserve Bank of New York staff reports, ``An
Analysis of CDS Transactions: Implications for Public Reporting''
(2011) at table 3 (``NY Fed analysis'') (available at http://www.newyorkfed.org/research/staff_reports/sr517.pdf) (discussing
credit default swap trade frequency by market type, and indicating
that most activity is done by entities of a financial nature).
---------------------------------------------------------------------------

E. ``Highly Leveraged'' Definition

Exchange Act rule 3a67-7 defines ``highly leveraged'' for purposes
of the third prong of the major participant definition, which applies
to certain non-banks as described above. In adopting the final rule, we
have considered alternative approaches suggested by commenters. For
example, a number of commenters favored the use of a 15 to 1 leverage
ratio, which may be expected to reduce the number of persons who are
deemed to be ``highly leveraged'' and thus subject to the third test.
Conversely, some commenters favored a ratio that is lower than the one
found in the final rule, which may be expected to increase the number
of entities deemed to be highly leveraged.\1489\
---------------------------------------------------------------------------

\1489\ See part IV.F.2.b, supra.
---------------------------------------------------------------------------

The final rule defines ``highly leveraged'' as a leverage ratio of
12 to 1 or higher. In our view, this ratio reasonably sets forth
objective criteria for identifying entities that pose a heightened risk
of being unable to meet their obligations through their use of
leverage. This 12 to 1 ratio reflects a number of factors, including
the use of a 12 to 1 ratio in connection with certain broker-dealer
capital rules, as well as reasons to distinguish the use of a 15 to 1
ratio in Title I of the Dodd-Frank Act.\1490\
---------------------------------------------------------------------------

\1490\ See part IV.F.3.b, supra (discussing the rationale for
using a 12 to 1 ratio for purposes of defining the term ``highly
leveraged'' in the context of the major participant definitions).
---------------------------------------------------------------------------

As with the financial entity definition in rule 3a67-6, as a
practical matter we do not believe that expanding or narrowing the
leverage ratio within any reasonable definition of ``highly leveraged''
for purposes of the third major participant test will have a
significant impact on the programmatic costs and benefits of major
participant regulation. In part, this is because we believe that in
many circumstances the

[[Page 30730]]

sales of credit protection cannot reasonably be interpreted to
constitute the hedging of commercial risk,\1491\ meaning that such
positions in any event may be expected to be considered as part of the
analysis of the first major participant test. The programmatic impact
of this definition further is mitigated by the fact that we believe
that there will be relatively few entities whose security-based swap
positions would cause them to be major participants.
---------------------------------------------------------------------------

\1491\ See note 1019, supra.
---------------------------------------------------------------------------

F. ``Major'' Categories of Security-Based Swaps

Exchange Act rule 3a67-2 defines ``major'' categories of security-
based swaps, a term that plays a role in the two statutory major
participant tests that turn upon the presence of a substantial position
in a ``major'' category of security-based swaps. The final rule retains
the proposal's division of those instruments into debt-based and other
categories. As discussed above, these major categories are broadly
consistent with market usage and statistics, and we believe that it is
reasonable for entities undertaking this analysis to use these
categories in calculating whether they have a substantial
position.\1492\
---------------------------------------------------------------------------

\1492\ See part IV.A.3 (discussing rationale for final ``major''
categories).
---------------------------------------------------------------------------

In theory, it is possible that the categorization of security-based
swaps for these purposes could result in a particular entity exceeding
the applicable thresholds in a major category, causing it to be a major
security-based swap participant and triggering the Title VII
registration and regulatory requirements.\1493\ The relationship
between the major security-based swap categories as we have defined
them in this rule and the programmatic costs and benefits associated
with major participant regulation will depend largely on how the
security-based swap positions of entities with security-based swap
exposures approaching these thresholds are distributed between these
categories.
---------------------------------------------------------------------------

\1493\ In other words, the dividing line that the rule sets
between the major category of debt-based security-based swaps and
the major category for other security-based swaps (or other dividing
lines based on different or additional major categories) could
determine whether an entity's security-based swap positions exceed
or fall below the major participant thresholds for a particular
major category, and hence whether the entity will be deemed to be a
major participant.
---------------------------------------------------------------------------

The available data suggests that the debt-based major category
(i.e., credit default swaps) accounts for the vast majority of
security-based swap positions.\1494\ Absent an approach that breaks
single-name credit default swaps in to multiple ``major'' categories--
which itself would not appear to be justified based on current
information--this suggests that this categorization as a practical
matter will not have a significant effect on the programmatic costs and
benefits of major participant regulation.\1495\
---------------------------------------------------------------------------

\1494\ See note 476, supra.
\1495\ For example, an alternative approach might divide narrow-
based index CDS and single-name CDS into separate major categories.
We believe, however, that single-name CDS account for the large
majority of debt-based security-based swaps, see id., suggesting
that most entities' status as major participants would turn on their
single-name CDS exposures under any reasonable approach to defining
major categories and that the subtraction of narrow-based index CDS
exposures in the calculation of substantial exposure would, given
their relatively small market volume, have little effect on whether
most entities meet the substantial exposure threshold. Thus, we
believe that the decision to classify all debt-based security-based
swaps in a single category will likely have minimal effect, if any,
on any entity's status as a major participant, as compared to
dividing debt-based security-based swaps into two categories.
---------------------------------------------------------------------------

G. Registration Period

Exchange Act rules 3a67-8 and 3a71-2 establish periods for
registration as a dealer and major participant, as well as periods for
revaluating or terminating one's status as a registered entity. As
such, these provisions may affect the length of time that particular
entities may be deemed to be major participants or dealers, and hence
subject to the requirements applicable to those entities. However, any
effect of delaying or accelerating dealer or major participant status
on the programmatic costs and benefits associated with major
participant or dealer status likely will be negligible compared to the
overall programmatic costs and benefits associated with major
participant or dealer regulation.

H. Calculation Safe Harbor

Exchange Act rule 3a67-9 establishes a calculation safe harbor for
the major participant threshold tests. We do not believe that this safe
harbor changes the scope of the major participant definition, as it
should not exclude from the major participant definition any entity
that would otherwise fall within the definition if that entity
performed the substantial position calculations.\1496\ Accordingly, we
do not believe that the safe harbor would have a material effect on the
programmatic costs and benefits associated with major participant
regulation.
---------------------------------------------------------------------------

\1496\ See part IV.M.2, supra.
---------------------------------------------------------------------------

I. Interpretation Related to Guarantees

In adopting these final rules, we also have finalized an
interpretation regarding when a person will have security-based swap
positions attributed to it by virtue of having guaranteed the positions
of another party. In general, we have clarified that an entity's
security-based swap positions need not be attributed to its parent
unless the counterparty has recourse to the parent. We also clarified
that, even in the presence of a guarantee, positions of certain
regulated entities--including swap dealers, security-based swap
dealers, major participants, broker-dealers, FCMs and certain entities
subject to U.S. bank capital requirements--will not be attributed to
the guarantor.\1497\
---------------------------------------------------------------------------

\1497\ See part IV.H.3, supra.
---------------------------------------------------------------------------

We recognize that attributing security-based swap positions to the
entity guaranteeing another entity's security-based swap transactions
may increase the number of major participants. At the same time,
excluding certain regulated entities from the attribution requirement
even in the presence of a guarantee may help prevent a guarantor, such
as a holding company, from being deemed to be a major participant when
the risks associated with those positions already are subject to
regulation.
We do not currently possess data relating to the existence of
guarantees of the security-based swap positions of other parties and
thus cannot reasonably estimate the number of additional entities that
may be brought within the ambit of major participant regulation by
virtue of this interpretation. However, we note that, to the extent
that guarantees of another entity's security-based swap positions
creates the level of exposure--and corresponding risk to the market and
to counterparties--that warrants regulation under Title VII, it would
appear inconsistent with the purposes of the statute not to subject
that entity to major participant regulation.

J. Other Interpretations

Finally, in this release we also have provided a number of
additional interpretations and discussions in connection with the
dealer and major participant definitions. These include, among others:
the rejection of requests for entity-specific exclusions from the
dealer and major participant definitions; \1498\ interpretations
regarding the application of the ERISA exclusion from the first major

[[Page 30731]]

participant test,\1499\ and interpretations regarding the application
of the major participant analysis to managed accounts.\1500\ In theory,
each of these interpretations potentially has a programmatic
impact.\1501\ For the reasons discussed above, we believe that these
interpretations reflect reasonable choices.
---------------------------------------------------------------------------

\1498\ See parts II.A.6 and IV.J, supra (stating that such
exclusions from the dealer definition would have no basis in the
statutory text and would be inconsistent with the activity focus of
the dealer definition, and not providing entity exclusions from the
major participant definition because entities that meet the
thresholds of the rules may pose high risk to the U.S. financial
system regardless of how they are organized).
\1499\ See part IV.D, supra (interpreting the provision to
exclude security-based swap positions entered into for the primary
purpose of hedging or mitigating risks associated with operation of
the plan, consistent with the statutory language that does not limit
the hedging exclusion for ERISA plans to commercial risk; also
clarifying that such positions may be eligible for exclusion even if
they are held by a non-plan entity that holds plan assets).
\1500\ See part IV.I, supra (clarifying that the position will
be attributed to the client account rather than to the investment
advisers or asset managers and that a beneficial owner should be
required to treat the positions of such an account as its own only
if the security-based swap counterparty has recourse to the
beneficial owner).
\1501\ For example, attributing security-based swap positions to
investment advisors would have increased the likelihood of advisers
being deemed to be major participants. Our interpretations do not
take that approach, however, as we believe that it would be
inconsistent with the focus of the statutory definition.
---------------------------------------------------------------------------

3. Analysis of Assessment Costs
Certain persons engaged in security-based swap activity are likely
to incur costs in connection with evaluating whether they fall within
the dealer or major participant definitions.\1502\ As detailed below,
we have considered these assessment costs in adopting definitional
rules and interpretations that seek to capture entities whose security-
based swap activity or whose security-based swap positions warrant
regulation under Title VII as dealers or major participants, while
excluding entities whose activity or positions do not warrant such
regulation.
---------------------------------------------------------------------------

\1502\ These costs are distinguishable from the costs associated
with registration as a dealer or major participant (which for
purposes of this analysis we treat programmatic costs) and the other
programmatic costs discussed above.
---------------------------------------------------------------------------

a. Assessment Costs Associated With the ``Security-Based Swap Dealer''
Definition
i. Core Dealer Analysis and De Minimis Exception

A. Overview

Exchange Act rule 3a71-1 in part restates the statutory definition
of ``security-based swap dealer'' to consolidate the definition and
related interpretations for market participants' ease of reference. In
conjunction with these final rules the SEC has set forth
interpretations to provide additional guidance to implement the
statutory approach of capturing persons that engage in certain
security-based swap activities while excluding persons that do not
engage in those activities as part of a ``regular business.'' \1503\ We
believe that this guidance--including its reliance on the distinction
between dealing activity and non-dealing activity such as hedging or
trading--will allow a number of market participants to readily conclude
that their security-based swap activities will not cause them to be
security-based swap dealers. In adopting this approach, we have
considered alternative views, expressed by some commenters, that would
have had the effect of narrowing the statutory definition's
scope.\1504\
---------------------------------------------------------------------------

\1503\ See part II.A.5, supra.
\1504\ These include suggestions that: the dealer definition
should be interpreted to be coextensive with the concept of market
making activity; the dealer definition requires that a person be
available to take either side of the market at any time; the dealer
definition should not extend to persons solely engaged in security-
based swap activity on swap execution facilities; the dealer
definition should exclude persons whose security-based swap dealing
activity is relatively small compared to its other activities; and
dealing activity requires the presence of a ``customer''
relationship. See id. (discussing interpretive approach to
``security-based swap dealer'' definition). Conversely, a few
commenters suggested rejection of the dealer-trader distinction, and
implied that the dealer definition should be applied more broadly.
See id.
These also include suggestions that the dealer analysis
incorporate particular per se exclusions. Although we recognize that
such approaches may be simpler for market participants to implement,
we nonetheless do not believe that such per se exclusions would be
consistent with the statutory definition, which identifies dealers
based on their security-based swap activities. See part II.A.6,
supra (discussing reasons not to include per se exclusions from the
dealer definitions).
---------------------------------------------------------------------------

Exchange Act rule 3a71-2 specifies when a person that otherwise
would be a security-based swap dealer can take advantage of the de
minimis exception. In adopting the rule's tests and thresholds--
including the use of a $3 billion notional threshold in connection with
dealing activity involving credit default swaps that are security-based
swaps, a $150 million notional threshold in connection with other types
of security-based swaps, higher phase-in levels in connection with
those thresholds, and a separate $25 million threshold in connection
with dealing activity involving ``special entities''--we have
considered a range of alternative approaches and thresholds suggested
by commenters.\1505\
---------------------------------------------------------------------------

\1505\ See parts II.D.3 and II.D.5, supra.
---------------------------------------------------------------------------

In application, the assessment costs associated with the core
dealer test and de minimis exception are linked.

B. Assessment Costs Associated With the Final Rules and Interpretations

We recognize that certain participants in the security-based swap
market may incur costs in connection with the facts-and-circumstances
analysis of whether they are security-based swap dealers as defined in
the statute and in the final rules, particularly with regard to the
application of the dealer-trader distinction and the de minimis
exception.
As noted above, analysis of market data indicates that the
overwhelming number of participants in the single-name credit default
swap market in 2011 had total activities (dealing or non-dealing) of
significantly less than $3 billion notional amount over the prior 12
months.\1506\ In general--aside from potential dealing activity
involving other types of security-based swaps and dealing activity
involving ``special entities''--such persons likely would not be deemed
to be security-based swap dealers regardless of whether their current
level of security-based swap activities constitutes dealing (apart from
those entities that increase their dealing activity following the
implementation of Title VII).
---------------------------------------------------------------------------

\1506\ Of 1,084 entities with single-name credit default swap
transaction activity over the 12 months ending in December 2011, 961
entities, or 88.7 percent, engaged in less than $3 billion notional
in such activity. These 961 entities were responsible for
approximately 3.2 percent of the notional value of all single-name
credit default swap transactions during that period. See CDS Data
Analysis, table 1.
---------------------------------------------------------------------------

On the other hand, some market participants whose security-based
swap activities exceed, or are not materially below, the $3 billion de
minimis threshold may be expected to incur costs in connection with the
dealer analysis. Those entities reasonably may conclude that they need
to incur costs to analyze their security-based swap activities to
determine whether those activities are non-dealing in nature (e.g.,
hedging or trading), or whether those activities instead are dealing in
nature (e.g., part of a business purpose of providing liquidity in
connection with security-based swaps), consistent with the statute and
the rules and guidance provided in this release.\1507\
---------------------------------------------------------------------------

\1507\ The use of the $8 billion phase-in level in connection
with these activities may also be expected to temporarily mitigate
such costs.
---------------------------------------------------------------------------

There are over 1,000 entities (U.S. and non-U.S.) that from time to
time may engage in single-name credit default swap transactions.\1508\
Of this number,

[[Page 30732]]

however, only 123 entities engaged in more than $3 billion in single-
name credit default swap transactions over the previous 12 months. For
purposes of analyzing the assessment costs of this rule, we have
assumed that all of these entities would perform the dealer
analysis.\1509\ We also recognize that some entities whose activities
fall below the de minimis threshold may opt to engage in this analysis
out of an abundance of caution or to meet internal compliance
requirements, and for purposes of this analysis have assumed that the
43 entities whose activity during the trailing 12 month period fell
between $2 and $3 billion also would engage in the dealer analysis,
leading to a total of 166.\1510\
---------------------------------------------------------------------------

\1508\ See CDS Data Analysis, table 1. The Federal Reserve Bank
of New York has published data that is consistent with this
analysis. See NY Fed analysis at 10 (noting that for a three month
period spanning from May through July of 2010, there were 933 unique
market participants in the credit default swap market).
As noted above, see note 148, supra, in relying on the
available data we are not indicating our views as to the application
of Title VII to non-U.S. persons. Issues regarding the
extraterritorial application of Title VII instead will be addressed
in a separate release.
\1509\ See CDS Data Analysis, table 1. This approach potentially
overstates the number of entities that would need to engage in the
analysis. Of entities with more than $3 billion in activity over the
trailing 12 month period, some number can be expected to determine,
given the nature of their business, that they are (or are not)
dealers under the definition without having to engage in this
analysis. For example, the NY Fed analysis discussed above found
that so-called G14 dealers were responsible for roughly 78 percent
of CDS transactions as buyer and 85 percent of CDS transactions as
sellers, and that so-called ``other dealers'' were responsible for
approximately an additional seven percent of CDS transactions as
sellers and six percent as buyers. See NY Fed analysis at 9, table
3. Many of these entities would likely determine that performing
this analysis was unnecessary.
\1510\ For the reasons stated above, we also believe that this
number potentially overstates the number of entities with less than
$3 billion in activity over the trailing 12 month period that would
be likely to engage in this analysis. Because it appears that all
entities engaged in security-based swap transactions with special
entities engaged in more than $8 billion in security-based swap
transactions in 2011, see CDS Data Analysis at 21 n.8, we do not
expect that the de minimis threshold for dealing activity involving
special entities to cause market participants to incur costs
independent of those associated with the general de minimis
threshold.
---------------------------------------------------------------------------

This estimate of 166 entities, although derived from data about
total (dealing and non-dealing) transactions,\1511\ illustrates a
potential upper bound for the total costs arising from security-based
swap dealer determinations, to the extent that all market participants
whose security-based swap activity approaches or exceeds the $3 billion
de minimis threshold identify a need to retain outside counsel to
analyze their status under the security-based swap dealer definition.
In that context, this estimate suggests that the costs of analysis may
approach $4.2 million.\1512\
---------------------------------------------------------------------------

\1511\ The CDS Data Analysis uses criteria that screen for
likely characteristics of entities engaged in dealing activity. See
CDS Data Analysis at 2. However, the available data does not permit
identification of which of these entities' transactions arise from
dealing activity and which arise from non-dealing activity (such as
proprietary trading or hedging). It is therefore likely that the
notional amounts provided in each table of the data analysis include
both dealing and non-dealing activity. For purposes of the economic
analysis of our rules further defining ``security-based swap
dealer,'' we have assumed that the entire notional amount for each
entity appearing in Tables 2-9 represents dealing activity. Although
this potentially results in an overestimate of dealing activity for
these entities--and thus in an overestimate of the costs associated
with conducting the dealer analysis--we believe that this represents
a conservative approach to evaluating the assessment costs of these
rules.
\1512\ This total is based on the assumption that 166 market
participants would seek outside legal counsel to determine their
status under the security-based swap dealer definition, with such
analysis costing an average of $25,000 per entity.
The average cost incurred by such entities in connection with
outside counsel is based on staff experience in undertaking legal
analysis of status under federal securities laws, and assumes that
the legal analysis for a complex entity on average may cost $30,000,
and that the legal analysis for a less complex entity on average may
cost $20,000. The use of inside counsel in lieu of outside counsel
would reduce this upper bound.
We recognize that the complexity of market participants may vary
greatly, and that we do not have insight into market participants
such that we could reasonably determine how many entities may be
considered more or less complex for these purposes. Thus, based on
our understanding of the market we believe that an average of the
costs associated with more complex and less complex entities
equaling $25,000 would reasonably approximate the average costs for
entities across the credit default swap market, assuming that all
such participants perceive a need to retain outside counsel for
purposes of the analysis.
---------------------------------------------------------------------------

In accounting for the de minimis exception in estimating these
costs, we note our expectation that market participants generally would
be aware of the notional amount of their activity involving security-
based swaps as a matter of good business practice. Consequently, we
would not expect market participants to incur costs in determining the
availability of the de minimis exception significantly in excess of the
costs associated with the general dealer determination.\1513\
---------------------------------------------------------------------------

\1513\ We note that different cost estimates have been used for
purposes of the ``swap dealer'' definition under the CEA. We do not
believe that the estimate of the number of persons who would have to
engage in a dealer analysis under the CEA would be germane to the
analysis of the costs associated with the Exchange Act's ``security-
based swap dealer'' definition, given the wide range of markets that
are exclusive to the ``swap'' definition. We also do not believe
that the basis that underpins the CFTC's estimate of the cost of
performing the dealer analysis under the definition of swap as set
forth in the CEA would be relevant to the Exchange Act definition.
In part, this is because we believe that the entities whose
security-based swap activities may cause them to be dealers likely
would have businesses that are financial in nature. We thus expect
that those entities would be particularly sensitive to the link
between the business purpose of their activities and the dealer
definition. In many cases those entities also should be familiar
with the use of the dealer-trader distinction in connection with
their activities involving other types of securities.
We also note that different cost estimates have been used for
purposes of the de minimis exception under the CEA. We expect,
however, that entities whose security-based swap activities may
cause them to be dealers likely would have businesses that are
financial in nature. We thus expect that those entities would: (a)
be well placed to distinguish their security-based swap dealing
activities from their non-dealing activities under the dealer-trader
distinction; and (b) would be familiar with the notional amount of
their security-based swap activities over the prior year.
---------------------------------------------------------------------------

We recognize that additional market participants may be expected to
incur these types of assessment costs to the extent that they engage in
activity involving other types of security-based swaps in an amount
close to, or in excess of, $150 million annually. Because the market
for these other types of security-based swaps appears to be highly
concentrated (like the single-name credit default swap market) and to
involve many of the same entities,\1514\ we expect the number of
entities that will incur assessment costs solely by virtue of this
lower threshold also to be small.
---------------------------------------------------------------------------

\1514\ See, e.g., OCC Quarterly Report at tables 1 and 10
(listing notional credit and equity derivatives for largest U.S.
banks and trust companies). See also note 429, supra.
---------------------------------------------------------------------------

In addition, we recognize that some market participants potentially
may incur these types of assessment costs to the extent they engage in
security-based swap activities in an amount close to, or in excess of,
$25 million annually.\1515\
---------------------------------------------------------------------------

\1515\ We believe that any such costs would be modest, in light
of data indicating that persons who are counterparties to special
entities in the single-name credit default swap market may otherwise
have to register as dealers notwithstanding the lower threshold
connected with special entities. See note 1510, supra.
---------------------------------------------------------------------------

For the reasons discussed above we believe that the approach we are
adopting in the final rules is necessary and appropriate given the
goals of Title VII and the statute's express requirement that we
implement a de minimis exception to the dealer definition.
ii. Additional Issues Related to the Dealer Analysis

A. Limited Designation of Dealers

Exchange Act rule 3a71-1(c) implements the portion of the
``security-based swap dealer'' definition that provides for limited
purpose registration of dealers. The rule provides for a presumption
that a person that acts as a security-based swap dealer is a dealer
with regard to all of its security-based swaps or security-based swap
activities, unless the SEC limits its designation. While we recognize
that permitting persons to more broadly take advantage of limited
dealer designations potentially would lower the cumulative costs that
individual dealers otherwise would incur to determine whether to

[[Page 30733]]

seek a limited designation,\1516\ after careful consideration of
commenter concerns we have determined that it is appropriate to adopt a
presumption against limited designation.\1517\
---------------------------------------------------------------------------

\1516\ A default presumption in favor of the availability of
limited designations may be expected to reduce the costs associated
with an entity determining whether it qualifies for such relief,
such as the costs of hiring outside legal counsel to undertake this
analysis to determine that they could take advantage a limited
designation relief.
\1517\ In this regard we note the relative lack of data about
the types of security-based swap positions held by particular
entities that will fall within the dealer definition. Our decision
takes into account the difficulty of separating a dealer's
activities from its non-dealing activities for compliance purposes,
and the challenges of applying dealer requirements to only a portion
of the entity's security-based swap activities. In reaching our
decision, we have especially been influenced by the statutory
definition's discretionary language in connection with the potential
for limited designations, and by the need for persons subject to
limited designations to be able to comply with the statutory and
regulatory requirements applicable to major participants. See part
II.E.3, supra (discussing limited designation principles applicable
to dealers).
We note that the discussion of limited designation of ``swap
dealers'' under the CEA generally seeks to quantify the costs
associated with applications for limited designations. However, we
believe that the costs of applying for a limited designation are
dependent upon the application process for this type of registration
category. As noted previously, the SEC expects to address the
limited designation application process for security-based swap
dealers in separate rulemakings. See id. As such, we believe that
the costs associated with security-based swap dealer limited
designation applications under the Exchange Act are more
appropriately addressed in the context of those separate
rulemakings.
---------------------------------------------------------------------------

Certain persons who satisfy the dealer definition may incur costs
in determining whether to seek a limited designation. We believe that
such costs would affect no more than the 166 entities that potentially
may be expected to engage in the dealer analysis,\1518\ and expect
these costs to be included in the estimated costs of seeking outside
legal counsel described above.
---------------------------------------------------------------------------

\1518\ As discussed above, see note 1457, supra, we have
estimated that 50 or fewer entities ultimately may have to register
as security-based swap dealers.
---------------------------------------------------------------------------

B. Exclusion of Inter-Affiliate Security-Based Swaps

Exchange Act rule 3a71-1 also provides that security-based swaps
between majority-owned affiliates will be excluded for purposes of the
dealer analysis. After consideration of commenter views, we are
adopting this standard, rather than potential alternatives such as a
common control test, because we believe that it is appropriate, in
light of the goals of Title VII, that the dealer definition not capture
entities by virtue of security-based swap transactions with affiliated
entities that have a sufficient alignment of economic interests to
avoid raising systemic risk, customer protection, and other concerns
that dealer regulation is intended to address.\1519\ Moreover, we note
that a majority-ownership test should, given its objective nature,
impose fewer assessment costs on market participants than a more
subjective common control test.
---------------------------------------------------------------------------

\1519\ See part II.C.2, supra.
---------------------------------------------------------------------------

Some market entities may need to incur costs in connection with
determining whether particular security-based swap positions may be
excluded from the dealer analysis by virtue of the inter-affiliate
exclusion. Such costs potentially could be incurred by any of the
approximately 166 entities that we believe may engage in the dealer
analysis. The costs specifically associated with that assessment may
vary depending on factors including the extent to which those entities
engage in inter-affiliate security-based swaps, but we expect these
costs to be included in the estimated costs of seeking outside legal
counsel described above.

C. Timing Issues Connected to the De Minimis Exception

In response to commenter concerns, Exchange Act rule 3a71-2
specifies that an entity that no longer may rely on the de minimis
exception, because its dealing activity has exceeded the exception's
thresholds, has two months to submit a completed application to
register as a dealer.\1520\ The final rule also specifies that a person
who has been registered as a dealer for at least 12 months may withdraw
from registration while continuing to engage in a limited amount of
dealing activity under the exception.
---------------------------------------------------------------------------

\1520\ See part II.D.6, supra (discussing rational for final
rule addressing registration period for entities that exceed the de
minimis threshold).
---------------------------------------------------------------------------

In adopting these rules we have carefully considered alternatives
that would lead to slower entry and faster exit from dealer status, and
we recognize that providing particular entities with additional time to
register as a dealer may have the potential to reduce the costs
associated with the registration process.\1521\ We believe, however,
that a two-month period for registration should provide entities with
sufficient time to register without incurring additional expenses--both
for large firms with security-based swap businesses well above the $3
billion threshold, and for mid-sized firms that fluctuate near the $3
billion threshold amount. We also conclude that this approach will
appropriately help to avoid applying dealer requirements to entities
that no longer meet the dealer criteria, and will avoid the prospect of
persons moving in and out of dealer status overly frequently.
---------------------------------------------------------------------------

\1521\ For example, a shorter period for registration might be
expected to cause some entities to incur over-time costs arising
from the need to complete the registration process within a short
time frame, whereas a longer time period could have enabled such an
entity to avoid those costs.
---------------------------------------------------------------------------

b. Assessment Costs Associated With the ``Major Security-Based Swap
Participant'' Definition
i. ``Substantial Position'' and ``Substantial Counterparty Exposure''
Definitions

A. Overview of ``Substantial Position'' and ``Substantial Counterparty
Exposure'' Definitions

Exchange Act rule 3a67-3 defines the term ``substantial position''
for purposes of the first and third tests of the statutory major
participant definition (which address whether a person has a
``substantial position'' in a major category of security-based swaps).
The final rule sets forth two tests for identifying the presence of a
substantial position--one test based on a $1 billion daily average
measure of uncollateralized mark-to-market exposure, and one based on a
$2 billion daily average measure of combined uncollateralized mark-to-
market exposure and potential future exposure. Both of those daily
measures would be calculated and averaged over a calendar quarter. In
developing the ``substantial position'' tests and their associated
thresholds, we have sought to capture those entities whose security-
based swap positions have the potential to pose significant risks to
financial markets, while not capturing other entities for which major
participant regulation and its associated costs would be
unwarranted.\1522\
---------------------------------------------------------------------------

\1522\ See part IV.B.3, supra (discussing basis for the
substantial position analysis we are adopting).
---------------------------------------------------------------------------

Exchange Act rule 3a67-5 defines ``substantial counterparty
exposure that could have serious adverse effects on the financial
stability of the United States banking system or financial markets,'' a
phrase that comprises part of the second test of the ``major security-
based swap participant'' definition. The analysis set forth in this
rule parallels the ``substantial position'' analysis, but: (i) Contains
higher thresholds; (ii) examines an entity's security-based swap
positions as a whole (rather than focusing on a particular ``major''
category); and (iii) would not exclude certain hedging positions.\1523\
---------------------------------------------------------------------------

\1523\ See part IV.E.3, supra (discussing basis for the
substantial counterparty exposure analysis we are adopting).
---------------------------------------------------------------------------

In adopting these definitions, we carefully considered alternative

[[Page 30734]]

approaches suggested by commenters, including suggestions that the
thresholds should be raised or lowered, and that certain positions
should be excluded from the potential future exposure test, or that the
test should discount certain positions differently.\1524\ We have
retained the tests largely as proposed, however, as we believe that the
tests appropriately address the risk criteria embedded in the major
participant definition.\1525\ We also believe that the tests minimize
the assessment costs to these entities in a manner consistent with the
statutory definition. For example, the decision to base the potential
future exposure analysis on tests used by bank regulators for purposes
of setting prudential capital reflects our view that it would be
appropriate to implement the analysis by building upon an existing
regulatory approach that is less subjective--and thus less costly--for
market participants to utilize (as compared to, for example, a VaR
approach \1526\) and would lead to reproducible results, rather than
seeking to develop a brand new approach.\1527\
---------------------------------------------------------------------------

\1524\ See parts IV.B.2 and IV.E.2, supra.
\1525\ See part IV.B.3, supra (discussing the decisions made
regarding the substantial position definition and the reasoning
behind the adopted approach). For example, we have concluded that
the proposed thresholds are set prudently in a manner that takes
into account the financial system's ability to absorb losses of a
particular size, the need for major participant regulation not to
encompass entities only after they pose significant risks to the
market, and the need to account for the possibility that multiple
market participants may fail close in time. In addition, as
discussed above, we believe that this threshold is tailored to
address the types of events associated with the failure of AIG FP.
See part IV.B.3.d, supra.
As discussed above, for an entity with no current
uncollateralized exposure--and before accounting for netting--it
would take a $100 billion notional portfolio of marked-to-market
security-based swaps that reflect written protection on credit to
meet the $2 billion potential future exposure threshold for
security-based credit derivatives, and it would take a $200 billion
notional portfolio of cleared positions to meet that threshold. Even
in the absence of clearing or daily mark-to-market margining, it
would take a minimum $20 billion notional portfolio of written
protection on credit (reflecting the 0.10 multiplier in the risk
adjustment tables) to meet the $2 billion potential future exposure
threshold. Accounting for netting (which can reduce potential future
exposure measures by up to 60 percent) could materially increase
that required amount. See note 914, supra.
\1526\ For example, because value-at-risk measures typically
account only for market risk and not for other types of risk, an
approach based on such measures would likely require separate
calculations for these other risks, as well as calculations to
account for possible losses in the event of a severe market
downturn; such an approach would also require the selection of
appropriate parameters for the test. See Concept Release: Net
Capital, Exchange Act Rel. No. 39456, at 13-19 (comparing value-at-
risk and haircut approaches to net capital calculations).
\1527\ See part IV.B.3.c, supra.
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B. Assessment Costs Associated With the Final Rules Defining
``Substantial Position'' and ``Substantial Counterparty Exposure''

Certain market participants may be expected to incur costs in
connection with the determination of whether they have a ``substantial
position'' in security-based swaps or pose ``substantial counterparty
exposure'' in connection with security-based swaps.
Based on a review of notional positions maintained in 2011 by
entities with single-name credit default swap positions, we estimate
that approximately 12 entities have security-based swap positions of
such an amount that, as a matter of prudence, they may reasonably find
it necessary to engage in the requisite calculations, particularly
given the additional availability of the calculation safe harbor.\1528\
In our view, the data indicates that other than approximately 12
entities, the non-dealer market participants in the security-based swap
market use these products in such limited amounts that they reasonably
would conclude that they do not need to undertake the calculations used
to determine whether they have a ``substantial position.'' \1529\
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\1528\ In the Proposing Release, we stated that based on our
understanding of the market, we concluded that only 10 entities had
security-based swap positions of a size to necessitate performing
the calculations to determine whether they meet those thresholds.
See Proposing Release, 75 FR at 80207-08. Some commenters challenged
the assumption that only approximately 10 entities would engage in
the requisite calculations. Those commenters took the view that
certain entities with smaller security-based swap positions would
perceive a need to conduct the relevant calculations on a daily
basis even if they are not reasonably likely to be major
participants, and, to address that concern, requested a safe harbor
from having to perform the major participant calculations. See
letters from SIFMA AMG I and Vanguard.
\1529\ As discussed above, an entity that margins its positions
daily generally would need to have security-based swap positions
approaching $100 billion notional to meet the substantial position
threshold, assuming no current uncollateralized exposure, while an
entity that clears those positions generally would need positions
approaching $200 billion notional to meet the threshold. See note
914, supra. We believe that it is reasonable to assume that most
entities that will have security-based swap positions large enough
to potentially cause them to be major participants in practice will
post variation margin in connection with those positions that they
do not clear, making $100 billion the relevant measure. The
available data shows that as of December 2011 a single entity had
aggregate gross notional positions from bought and sold credit
protection exceeding $100 billion, four had aggregate gross notional
single-name credit default swap positions exceeding $50 billion, and
12 had aggregate gross notional single-name credit default swap
positions exceeding $25 billion. See CDS Data Analysis at table 10.
Making allowances for certain entities that may determine, due to
internal policies or other reasons, that they need to conduct this
analysis and cannot rely on the calculation safe harbor we also are
adopting, we believe that it is reasonable to assume that entities
with aggregate gross notional single-name credit default swap
positions exceeding $25 billion may identify a need to perform the
major participant analysis. (In the Proposing Release, we stated
that based on our understanding of the market, we thought that fewer
than ten entities had security-based swap positions of a size to
necessitate performing the calculations to determine whether they
meet those thresholds. See Proposing Release, 75 FR at 80207-08.)
We believe, moreover, that the estimate that 12 entities will
perceive a need to perform this analysis in practice may overstate
the number of entities that reasonably will find it necessary to
perform the major participant analysis, given that only four
entities had $25 billion or more of aggregate gross notional single-
name credit default swap positions arising from the selling of
credit protection. See id. As discussed above, moreover, we believe
that fewer than five entities ultimately may be required to register
as major security-based swap participants. See part VIII.A.2.d.i.C,
supra.
Finally, we note that this estimate may also overstate the size
of positions held by individual legal entities, thus further
overstating the number of legal entities that have security-based
swap positions of such a size as to potentially trigger major
participant status. This is because the data in the analysis at
times aggregates multiple affiliated accounts--which may reflect the
legal entities that are counterparties to the security-based swap--
at the parent level. While such aggregation is appropriate for these
purposes given that parents may be deemed to be major participants
by virtue of security-based swap positions that they guarantee, the
aggregation in fact may tend to overstate the extent to which a
legal entity bears credit risk in connection with security-based
swaps.
To the extent that an entity's security-based swap transactions
are not cleared or associated with the posting of variation margin,
security-based swap positions of $20 billion may lead to sufficient
potential future exposure to cause the entity to be a major
participant. As we have noted, we believe that few if any entities
with significant security-based swap positions will have a
significant number of such transactions. Even then, the data
indicates that only a total of 32 entities have notional credit
default swap positions in excess of $10 billion. See CDS Data
Analysis at table 10 (showing that 32 entities have aggregate gross
single-name credit default swap positions of $10 billion or
greater).
---------------------------------------------------------------------------

Although some commenters noted concerns about the complexity of the
major participant calculation,\1530\ commenters did not appear to
directly question the Proposing Release's per-entity cost
estimates.\1531\ After further

[[Page 30735]]

consideration, however, we are modifying that estimate, in that we
believe that the annual per-entity costs associated with the assessment
will amount to $15,268, and the annual one-time per-entity costs
associated with the assessment will amount to approximately
$13,692.\1532\ The total industry-wide assessment costs associated with
the major participant definition, given our expectation that 12
entities will need to engage in this analysis, is $183,216 for annual
costs and $164,304 for annual one-time costs.\1533\
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\1530\ E.g., letter from WGCEF II (addressing technical
complexity of the proposed major participant calculations).
\1531\ Based on industry discussions, in the Proposing Release
we estimated that those 10 entities would incur one-time programming
costs of approximately $13,444 per entity, or $134,440 in total, and
that these entities would incur annual ongoing costs of $7,260 per
entity, or $72,600 in total. See Proposing Release, 75 FR at 80207-
08, nn.183-86 and accompanying text (providing a summary of the
methodology used to estimate these costs). The hourly cost figures
in the Proposing Release for the positions of Compliance Attorney,
Compliance Manager, Programmer Analyst, and Senior Internal Auditor
were based on data from SIFMA's Management & Professional Earnings
in the Securities Industry 2009. For purposes of the cost estimates
in this release, we have updated these figures with more recent data
as follows: the figure for a Compliance Attorney is $322/hour, the
figure for a Compliance Manager is $279/hour, the figure for a
Programmer Analyst is $196/hour, and the figure for a Senior
Internal Auditor is $198/hour, each from SIFMA's Management &
Professional Earnings in the Securities Industry 2011, modified by
SEC staff to account for an 1800-hour work-year and multiplied by
5.35 to account for bonuses, firm size, employee benefits, and
overhead. We have also updated the Proposing Release's $450/hour
figure for a Chief Financial Officer, which was based on data from
2010. Using the consumer price index to make an inflation adjustment
to this figure, we have multiplied the 2010 estimate by 1.03 and
arrived at a figure of $464/hour for a Chief Financial Officer in
2011. Incorporating these new cost figures, the updated one-time
programming costs based upon our assumptions regarding the number of
hours required in the proposing release would be $13,692 per entity,
or $136,920 in total, and the annual ongoing costs would be $7,428
per entity, or $74,280 in total.
\1532\ This revision in part is based on the addition of an
ongoing cost of a Programmer Analyst who we estimate would spend an
additional 40 hours annually on software maintenance attributable to
the modifications made to an automated system to undertake these
tests. We further estimate that the hourly wage of a Programmer
Analyst would be approximately $196. The $196/hour figure for a
Programmer Analyst is from SIFMA's Management & Professional
Earnings in the Securities Industry 2011, modified by SEC staff to
account for an 1800-hour work-year and multiplied by 5.35 to account
for bonuses, firm size, employee benefits, and overhead. Based on
these assumptions, we estimate these additional costs as $7,840 per
year per entity and $94,080 per year for all entities as follows:
(Programmer Analyst at $196 per hour for 40 hours) x (12 entities) =
$94,080.
\1533\ These adjustments do not materially change the estimated
costs associated with performing these calculations.
To the extent that additional entities perceive a need to
perform the major participant calculations provided by the rules,
notwithstanding a relatively low position in security-based swaps,
these costs would differ. For example, if we assume that 32 entities
will perceive the need to conduct the major participant analysis,
see note 1529, supra, initial legal costs will total approximately
$960,000 (based on the per-entity cost estimate of $30,000); one-
time industry-wide costs would total approximately $440,000 (based
on the per-entity cost estimate of $13,692); and annual industry-
wide costs would total approximately $490,000 (based on the per-
entity cost estimate of $15,268 addressed below).
At the extreme, available data indicates that 1,188 participants
have single-name credit default swap positions in the security-based
swap market (excluding ISDA-recognized dealers and ICE Trust). See
CDS Data Analysis at table 10, To the extent that none of these
1,188 entities avail themselves of the calculation safe harbor we
are adopting, and that all of them engage in the full major
participant analysis, then there potentially will be initial legal
costs of approximately $35.6 million (based on the per-entity cost
estimate of $30,000), one-time industry-wide costs of approximately
$16.3 million (based on the per-entity cost estimate of $13,692),
and annual industry-wide costs of approximately $18.1 million (based
on the per-entity cost estimate of $15,268 addressed below).
In practice, however, we think that the estimates for 12
entities more fairly assesses the relevant costs for the reasons
discussed above. See note 1529, supra. In our view, a large number
of participants in the market have notional security-based swap
positions low enough to permit them to conclude that they do not
have to engage in the relevant calculations. See id.
---------------------------------------------------------------------------

We believe that these estimates also address the assessment costs
under the ``substantial counterparty exposure'' test. Because credit
default swaps may be expected to constitute the bulk of the likely
security-based swap market, it is possible that participants in the
market may be more likely to have a ``substantial position'' in debt-
related security-based swaps than they would be to meet this second
test. Nonetheless, we conservatively estimate that the same
approximately 12 entities would engage in the ``substantial
counterparty exposure'' calculation as would undertake the
``substantial position'' calculation.\1534\ Given the link between this
rule and the ``substantial position'' calculations, however, we do not
anticipate that the ``substantial counterparty exposure'' test would
create incremental costs additional to those associated with the
definition of ``substantial position.'' \1535\ We thus believe that the
estimate of assessment costs in connection with the ``substantial
position'' analysis (consisting of one-time programming costs of
approximately $13,692 per entity, and annual costs of $15,268 per
entity) also adequately addresses the costs of assessment under this
statutory test.\1536\
---------------------------------------------------------------------------

\1534\ See part VIII.A.3.b.i.A, supra. These costs would differ
if additional entities perceive a need to perform the major
participant calculations provided by the rules, notwithstanding a
relatively low position in security-based swaps. Commenters have
taken the view that more than 10 entities may identify a need to
perform the requisite calculations. As already noted, based on the
analysis of 2011 transaction data, we have revised this estimate
upward to 12 entities, though we believe that the actual number is
likely to be smaller. In any event, these concerns should be
addressed by the calculation safe harbor that we are adopting as
part of these final rules.
\1535\ See Proposing Release, 75 FR at 80209.
\1536\ We note that higher cost estimates have been used for
purposes of the ``major swap participant'' definition under the CEA.
We expect, however, that the entities that may have security-based
swap positions of a size that could lead them to be major
participants likely would have businesses that are financial in
nature (rather than being non-financial entities that use security-
based swaps as part of their commercial activities). As such, we
would expect those entities to generally be cognizant of, or in a
good position to obtain information about: their uncollateralized
exposure with counterparties (to the extent that those financial
entities have any material amount of uncollateralized exposure); the
total notional amount of their security-based swap positions; the
notional amount of those positions that are subject to central
clearing or daily mark-to-market margining; and the extent to which
those positions are in-the-money or out-of-the-money (for purposes
of calculating the netting discount to the potential future exposure
calculation). We also expect that security-based swaps will be used
less frequently for hedging purposes than swaps. See, e.g.,
Bernadette A. Minton, Ren[eacute] Stulz & Rohan Williamson, ``How
Much Do Banks Use Credit Derivatives to Hedge Loans?,'' 35 J. Fin.
Serv. Res. 1 (2008) (noting that the ``net notional amount of credit
derivatives used for hedging of loans in 2005 represents less than
2% of the total notional amount of credit derivatives held by
banks''). Accordingly, there is reason to believe that the costs of
calculation associated with the ``major security-based swap
participant'' assessment will be lower than the costs associated
with the ``major swap participant'' assessment.
---------------------------------------------------------------------------

At the same time, upon further consideration we believe these rules
also may impose certain interpretive costs, including those related to
obtaining legal counsel, on market participants. Given the size and
complexity of the entities that may find it necessary to analyze their
status under the major participant definition, we believe that it is
reasonable to conclude that at least some entities with security-based
swap positions that approach the major participant thresholds are
likely to seek legal counsel for interpretation of various aspects of
the rules pertaining to the major participant definition. The costs
associated with obtaining such legal services would vary depending on
the relevant facts and circumstances, including the size and complexity
of the person's security-based swap positions, and the extent to which
these interpretations may be germane to whether the entity ultimately
is deemed to be a major participant. We believe, however, that $30,000
represents a reasonable estimate of the upper end of the range of the
costs of obtaining the services of outside counsel in undertaking the
legal analysis of the entity's status as a major participant.\1537\

[[Page 30736]]

Based on the conclusion that no more than 12 entities have security-
based swap positions that they would face enough of a possibility of
being a major participant that they would need to engage in such
analysis,\1538\ we estimate that the total legal costs associated with
evaluating the various elements of this definition may approach
$360,000.\1539\
---------------------------------------------------------------------------

\1537\ The average cost incurred by such entities in connection
with outside counsel is based on staff experience in undertaking
legal analysis of status under federal securities laws. The staff
believes that costs associated with obtaining outside legal counsel
relating to such determinations range from $20,000 to $30,000
depending on the complexity of the entity. We believe that an entity
that maintains security-based swap exposures of the size that would
necessitate undergoing this analysis will generally be large,
complex financial organizations. We also recognize that, while the
major participant test may be more objective and quantitative than
the dealer test (and therefore require a less involved legal
analysis), the test is novel (unlike the core dealer test, which
draws on the dealer-trader distinction familiar to many market
participants) and, as such, may cause entities to incur additional
costs in interpreting and applying the test. Together, these factors
lead us to estimate that entities undertaking this analysis will
incur legal costs at the upper end of our estimated range. The use
of inside counsel in lieu of outside counsel would reduce this upper
bound.
The legal costs associated with the major participant analysis
may include, among other things, legal advice with respect to
whether an affiliate with which the entity enters into security-
based swap transactions qualifies as an ``affiliate'' under rule
3a67-3, whether particular transactions fall within the definition
of security-based swap, whether certain types of security-based swap
transactions fall within the debt-based security-based swap or other
security-based swap category, whether the entity falls within the
definition of ``financial entity,'' and whether certain types of
security-based swap transactions qualify for the hedging exclusion
under the substantial exposure tests. We recognize that the
complexity of the analysis required for any of these issues may vary
considerably across entities, depending on each entity's individual
business model.
The major participant test is based on daily average exposures
over the course of the previous quarter, and, as discussed further
below, some number of entities may decide to establish a system that
will monitor their exposure on an ongoing basis. To the extent that
the entity does so, we expect that any initial legal analysis should
permit the entity to make determinations about these calculations on
an ongoing basis. As such, we assume that any additional costs
associated with outside counsel with respect to ongoing monitoring
of positions would be negligible.
\1538\ See note 1529, supra.
\1539\ If 32 entities were to perform this analysis, as
discussed above, the market-wide legal costs associated with the
analysis would total $960,000.
---------------------------------------------------------------------------

ii. Calculation Safe Harbor
We also are adopting Exchange Act rule 3a67-9, which provides a
safe harbor from the definition of ``major security-based swap
participant'' for market participants whose security-based swap
positions fall below certain thresholds. This safe harbor responds to
concerns raised by commenters that--based on internal compliance
policies and procedures, out of an abundance of caution, or for other
reasons--certain entities may feel compelled to perform the full major
participant calculations even if their security-based swap positions
did not rise to a level near the thresholds in the ``substantial
position'' or ``substantial counterparty exposure'' definitions.\1540\
---------------------------------------------------------------------------

\1540\ In particular, some commenters challenged the assumption
in the Proposing Release that only approximately 10 entities had
security-based swap positions large enough to lead them to engage in
the major participant calculations. Those commenters took the view
that certain entities with smaller security-based swap positions
would perceive a need to conduct the relevant calculations on a
daily basis even if they are not reasonably likely to be major
participants, and, to address that concern, requested a safe harbor
from having to perform the major participant calculations. See
letters from SIFMA AMG I and Vanguard.
---------------------------------------------------------------------------

The safe harbor makes use of three alternative tests. The first of
these is based on the maximum possible uncollateralized exposure under
the applicable credit support arrangements, and on the notional amount
of a participant's security-based swap positions. The two other
alternatives entail monthly calculations, with the second alternative
using calculations based on the maximum possible uncollateralized
exposure under the applicable credit support arrangements and monthly
adaptations of the substantial position and substantial counterparty
exposure calculations, and the third alternative using calculations
based on uncollateralized exposure and a modified version of the
potential future exposure calculation.
Although the provisions of the safe harbor we are adopting do not
mirror the safe harbors suggested by commenters,\1541\ the inclusion of
this safe harbor should help address commenter concerns regarding
entities with small positions that would nonetheless feel compelled
(due to their own internal compliance programs, or otherwise) to
undertake the major participant calculations. While recognizing that
more liberal standards for this safe harbor \1542\ could further
mitigate costs of assessing major participant status, the safe harbor
may be expected to help some entities avoid the costs associated with
assessing if they are major participants.
---------------------------------------------------------------------------

\1541\ See part IV.M, supra (discussing rationale for safe
harbor).
\1542\ See part IV.M.2, supra (discussing rationale for final
rule implementing safe harbor).
---------------------------------------------------------------------------

It is not clear how many firms may ultimately seek to rely on the
calculation safe harbor.\1543\ Participants in the security-based swap
market vary greatly in the size of their positions, and may be expected
to vary greatly in the complexity of their operations, and in the
requirements of their internal compliance and risk management policies.
As a result, it is possible that some firms with relatively small
positions may choose to undertake the safe harbor analysis while
significantly larger firms may determine that such analysis is
unnecessary.
---------------------------------------------------------------------------

\1543\ As noted previously in part VIII.A.3.b.i.B, supra, we
expect that approximately 12 entities may have security-based swap
positions in an amount such that it may be reasonably necessary for
them to undertake the major participant calculations. To the extent,
however, that entities with smaller positions nonetheless identify a
reason to perform a major participant analysis, the safe harbor
would permit those entities to conclude that they are not major
participants without the need to engage in the full set of
calculations otherwise anticipated by the rules.
---------------------------------------------------------------------------

The first of the three alternatives within the safe harbor would be
based on the maximum possible uncollateralized exposure under the
applicable credit support arrangements, and on the notional amount of a
participant's security-based swap positions. We believe that as a
matter of good business practice large participants in the security-
based swap market already would be aware of that information, making
the test relatively simple to implement. We also note that available
data indicates that 1,073 of the 1,188 entities with single-name credit
default swap positions (other than ISDA-recognized dealers and ICE
Trust), have notional positions less than $2 billion, potentially
making the first test of the safe harbor available to them.\1544\
---------------------------------------------------------------------------

\1544\ See CDS Data Analysis at table 10.
---------------------------------------------------------------------------

The other alternatives within the safe harbor would also entail
monthly calculations, with such calculations for the second alternative
based on the maximum possible uncollateralized exposure under the
applicable credit support arrangements and monthly adaptations of the
substantial position and substantial counterparty exposure
calculations, while the monthly calculation for the third alternative
is based on uncollateralized exposure and a modified version of the
potential future exposure calculation. Both of these would entail
additional analysis beyond current industry practices, causing entities
to incur higher costs than the first alternative, but no more than
would be required to complete the full major participant test.\1545\
---------------------------------------------------------------------------

\1545\ We expect that the outer bounds of the assessment costs
associated with this safe harbor will be no higher than the one-time
costs associated with conducting the major participant analysis,
given that, to the extent that an entity determines that performing
the safe harbor analysis is more expensive, it would likely choose
to perform the less-costly major participant analysis. As such, the
upper bound of costs associated with the safe harbor is not likely
to exceed our estimates of the costs associated with the full major
participant analysis, and should in fact be considerably lower.
We estimate that one-time costs associated with establishing a
system to identify and monitor security-based swap positions, as may
be necessary to perform the monthly assessments anticipated by two
of the three alternative tests that comprise the safe harbor, would
be similar to the one-time costs associated with the major
participant analysis, and that, therefore, up to 1,188 entities may
incur one-time industry-wide costs of approximately $16.3 million.
See note 1533 and accompanying text, supra. The annual costs
associated with monthly assessment would be expected to be less than
the costs of daily assessment, and $9.1 million--approximately half
of the estimated $18.1 million estimated annual costs if all 1,188
entities found it necessary to perform the daily assessment required
by the substantial position test (see id.)--may be a reasonable
estimate of that amount, given the relative simplicity of the test
and the less frequent assessments that it requires. In practice,
however, we believe that the costs associated with this safe harbor
will be less because we expect that far fewer entities would
perceive a need to rely on these aspects of the safe harbor,
particular given that, as noted above, approximately 1,073 entities
have aggregate gross notional single-name credit default swap
positions under $2 billion. See note 1544 and accompanying
discussion, supra.
We note that our analysis of the safe harbor in connection with
the ``major security-based swap participant'' definition differs
from that of the CFTC with regard to the ``major swap participant''
safe harbor. This, in part, reflects the differences between the
markets for swaps and security-based swaps. We also note our
expectation that many of the entities that may opt to avail
themselves of the safe harbor likely would have businesses that are
financial in nature (rather than being non-financial entities that
use security-based swaps as part of their commercial activities). As
such, we would expect those entities to generally be cognizant of,
or in a good position to obtain information about: Their maximum
potential uncollateralized exposure with security-based swap
counterparties; the total notional amount of their security-based
swap positions; the notional amount of those positions that are
subject to central clearing or daily mark-to-market margining; and
the extent to which those positions are in-the-money or out-of-the-
money (for purposes of calculating the netting discount to the
potential future exposure calculation). Other non-financial entities
seeking to take advantage of the safe harbor may minimize their
costs by utilizing whichever safe harbor option may be expected to
most closely align with the security-based swap information that
readily is available to such entities.

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[[Page 30737]]

iii. Additional Issues Related to the Major Participant Analysis

A. ``Major'' Categories of Security-Based Swaps

Exchange Act rule 3a67-2 sets forth two ``major'' categories of
security-based swaps for purposes of the first and third tests of the
major participant definitions--one consisting of debt-based security-
based swaps and the other consisting of other security-based swaps
(including equity swaps). These categories are consistent with our
understanding of the ways in which those products are used, as well as
market statistics and current market infrastructures,\1546\ and we
believe it is appropriate that those market categories be reflected in
the major participant definition.
---------------------------------------------------------------------------

\1546\ In particular, the major categories of security-based
swaps adopted in these final rules are consistent with how bank
derivatives data is presented by the Office of the Comptroller of
the Currency, as well as with categories used by derivatives market
infrastructure such as The Depository Trust & Clearing Corporation.
See part IV.A.3, supra.
---------------------------------------------------------------------------

The consistency of the rule with current market practices should
help mitigate any assessment costs incurred by market participants.
Moreover, we do not expect that market participants will be required to
incur costs to determine the major category with respect to a large
majority of their security-based swap positions, given that the vast
majority of security-based swaps likely fall within the debt-based
security-based swap major category. Also, in adopting the final rules
we also have provided additional guidance related to the categorization
of certain types of instruments in response to commenter concerns.
Nonetheless, given the fact-specific nature of any such assessment, we
recognize that some entities may seek the opinion of legal counsel as
to how specific security-based swap transactions should be categorized
for purposes of this rule (such as legal costs associated with having
counsel analyze a particular security-based swap to determine its
status under these rules, to the extent that certain types of security-
based swaps with complex, novel or bespoke structures are not readily
categorized within one of the two identified major categories). We
expect that these costs would be included in the estimated costs of
seeking outside legal counsel in connection with the major participant
analysis, as described above.\1547\
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\1547\ Entities may also incur programming and other costs
related to recording the classification of their security-based swap
transactions in systems designed to monitor current exposure and
potential future exposure, but we expect these costs to be one
component of entities' overall system costs relating to its
substantial position calculations, which we discuss in further
detail above. See part VIII.A.3.b.i.B, supra.
---------------------------------------------------------------------------

B. Definition of ``Hedging or Mitigating Commercial Risk''

Exchange Act rule 3a67-4 defines the term ``hedging or mitigating
commercial risk'' for purposes of the exclusion from the first major
participant test. Among other aspects, this rule makes use of an
``economically appropriate'' standard, and sets forth exclusions for
security-based swap positions that have a speculative or trading
purpose.
As discussed above, we carefully consider alternative approaches
suggested by some commenters, including the suggestion that the
definition should encompass positions that hedge speculative or trading
positions and the suggestion that the definition should incorporate a
``congruence'' standard.\1548\ We concluded, however, that these
approaches are inconsistent with the focus of the statutory text, which
is on ``commercial risk,'' and in adopting this definition we have
sought to set forth criteria that reasonably distinguish hedging
positions from other positions. We believe that the approach we are
adopting, which seeks to exclude positions that hedge commercial risk
without also excluding other types of positions, is necessary and
appropriate in light of the statute.\1549\
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\1548\ See parts IV.C.5.a and IV.C.5.b, supra (discussing
rationale for excluding positions hedging speculative and trading
positions from the definition).
\1549\ See parts IV.C.3 and IV.C.5, supra.
---------------------------------------------------------------------------

Some market participants may be expected to incur costs in
connection with determining whether certain security-based swap
positions fall within this hedging exclusion.\1550\ Any such costs of
analyzing the status of particular security-based swaps as a hedge of
commercial risk would reflect the unique character of individual
positions and the business purpose associated with the position. Such
costs may be particularly relevant for security-based swaps of a more
complex nature, or for security-based swaps that introduce some degree
of basis risk in connection with the hedge. Because of the facts-and-
circumstances nature of this analysis,\1551\ we believe that some
entities may seek the opinion of legal counsel as to whether certain
transactions qualify for the commercial hedging exclusion at the time
they conduct their initial analysis, and these costs would likely be
encompassed within the estimated costs of legal services related to the
major participant definition.\1552\
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\1550\ We have incorporated provisions into the final rule
designed to provide guidance to market participants as to which
types of security-based swap positions could be expected to fall
within this exclusion. This release also provides further guidance
as to the scope of the exclusion.
\1551\ The transaction-related costs of making a hedging
determination would apply only to entities with security-based swap
positions that are near to or exceed the substantial position
threshold prior to taking advantage of the hedging exclusion. This
may be expected to mitigate costs associated with making this
determination.
\1552\ Separately, the proposed rule defining this term would
have included certain documentation and assessment conditions that
commenters stated could lead to significant costs. Commenters
expressed concerns regarding the application of these conditions and
the associated costs. As discussed previously in this release, we
have determined not to include these conditions in the final rule.
See part IV.C.5.d, supra.
---------------------------------------------------------------------------

C. Definitions of ``Financial Entity'' and ``Highly Leveraged''

Exchange Act rule 3a67-6 defines the term ``financial entity'' for
purposes of the third major participant test. This definition is
largely consistent with the statutory ``financial entity'' definition
used in Title VII's exception from mandatory clearing for commercial
end-users.\1553\ However, in response to commenter concerns, the final
rules exclude centralized hedging facilities from the ``financial
entity'' definition (in a way that itself is consistent with that Title
VII hedging exception).\1554\

[[Page 30738]]

Although particular market participants may incur costs in connection
with determining whether they fall within the ``financial entity''
definition, we believe that such costs would be minimal in light of the
objective nature of the definition, and its consistency with the use of
the term elsewhere in Title VII. We also recognize that entities may
seek the opinion of legal counsel as to whether the entity falls within
the scope of this ``financial entity'' definition, but believe that
these costs would likely be encompassed within the estimated costs of
legal services related to the major participant definition.
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\1553\ See Exchange Act section 3C(g).
\1554\ In addition, we considered, but do not incorporate, some
commenters' suggestion that ``financial entity'' be defined more
narrowly, such as by excluding employee benefit plans. See part
IV.F.3.a, supra, (discussing rationale for final rule defining
``financial entity'').
---------------------------------------------------------------------------

Exchange Act rule 3a67-7 defines the term ``highly leveraged,''
also for purposes of the third statutory major participant test. After
considering commenters' views, the final rule defines that term based
on a 12 to 1 leverage ratio, as discussed in greater detail above. In
adopting this leverage ratio, we also modify the proposed method of
calculating leverage in certain respects,\1555\ but conclude that it
would not be appropriate to provide special methodologies for insurers
to measure leverage.\1556\ It is possible that certain market
participants will incur costs in connection with determining whether
they are ``highly leveraged'' for purposes of the major participant
definitions. In part, we believe that those costs are mitigated by the
fact that the final rules identify ``highly leveraged'' entities based
on a ratio of liabilities to equity, which we expect are simpler for
entities to implement than alternative methods for measuring leverage,
such as risk-adjusted methods.
---------------------------------------------------------------------------

\1555\ See part IV.F.3.b, supra (addressing leverage ratio
calculation for certain employee benefit plans).
\1556\ See note 1107, supra (providing special rules related to
the calculation of leverage for certain employee benefit plans).
---------------------------------------------------------------------------

We recognize that the unavailability of an alternative method of
calculation for insurers may have the effect of increasing certain
insurers' cost of calculating leverage for purposes of determining
whether they fall within the major participant definition, to the
extent that insurers have security-based swap positions that are close
enough to the relevant thresholds that they have to perform the
required calculations.\1557\ We believe, however, that a uniform
approach to defining ``highly leveraged'' is appropriate here given
that the large insurance firms that are most likely to meet the major
participant definition would be expected already to use GAAP in
preparing their financial statements. This should mitigate any
additional costs arising from the absence of an alternative calculation
method for insurers.
---------------------------------------------------------------------------

\1557\ We note that many large insurers of the type that
maintain security-based swap positions in an amount that would
require them to perform the major participant calculations may be
publicly traded companies, in which case they would already
calculate their financial statements according to GAAP for purposes
of public disclosure, and thus would not incur additional costs due
to our decision not provide special methodologies for insurers to
calculate their leverage. We also expect that the concerns of many
smaller insurers that are not publicly traded and thus may not use
GAAP will be addressed by our inclusion of the safe harbor for major
participant calculations.
In addition, publicly available information regarding insurer
use of derivatives suggests that the potential costs to insurers
arising from the definition of ``major security-based swap
participant'' may be negligible. As of the end of 2010, U.S.
insurers as a whole had enter into roughly $33.5 billion in notional
amount of credit default swaps (not distinguishing between credit
default swaps that fall within the ``security-based swap''
definition and those that are ``swaps''). See National Association
of Insurance Commissioners, ``Insights into the Insurance Industry's
Derivatives Exposure'' (available at http://www.naic.org/capital_markets_archive/110610.htm) (stating that life insurers had entered
into roughly $27.1 billion of that amount, and that property and
casualty insurers had entered into roughly $6.4 billion of that
amount). Even if those positions were concentrated within single
entity, they would not necessarily lead that entity to exceed the
thresholds that could cause it to be a major participant, see note
914, supra, suggesting that, given the likely distribution of these
positions across a significant number of insurers, few or no
insurers may have exposures that approach the thresholds.
---------------------------------------------------------------------------

D. Limited Designations of Major Participants

Exchange Act rule 3a67-1 in part implements the portion of the
``major security-based swap participant'' definition that provides for
limited purpose registration of major participants. The rule sets forth
a presumption that a person that acts as a major security-based swap
participant in general will be deemed to be a major participant with
regard to all of its security-based swaps, unless the SEC limits its
designation.
In adopting this rule we have considered the alternative, suggested
by some commenters, of permitting persons to more broadly take
advantage of limited major participant designations.\1558\ Our decision
to use this presumption takes into account the difficulty of separating
a major participant's positions taken under its limited purpose
designation from other of its positions for purposes of compliance, and
the challenges of applying major participant regulatory requirements to
only a portion of the entity's security-based swap activities. The
presumption further reflects the statutory definition's discretionary
language in connection with the potential for limited designations, and
the need for persons subject to limited designations to be able to
comply with the statutory and regulatory requirements applicable to
major participants.\1559\
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\1558\ Such an approach may be expected to lower the cumulative
costs that major participants would incur in determining whether to
seek a limited designation. For example, a default presumption in
favor of the availability of limited designations may be expected to
reduce the costs that certain entities would incur to determine that
they could take advantage of limited designation relief, and thus
reduce the costs associated with an entity determining whether it
qualifies for such relief, such as the costs of hiring outside legal
counsel to undertake this analysis to determine that they could take
advantage a limited designation relief. A default presumption in
favor of limited designations also would be expected to reduce costs
in connection with the registration process for entities seeking
limited designation status, as discussed above. See part
VIII.A.2.d.ii.A, supra.
\1559\ See part IV.N.3, supra (discussing limited designation
principles applicable to major participants). We note that the
discussion of limited designation of ``swap dealers'' under the CEA
generally seeks to quantify the costs associated with applications
for limited designations. However, we believe that the costs of
applying for a limited designation are dependent upon the
application process for this type of registration category. As noted
previously, the SEC expects to address the limited designation
application process for major security-based swap participants in
separate rulemakings. See id. As such, we believe that the costs
associated with major security-based swap participant limited
designation applications under the Exchange Act are more
appropriately addressed in the context of that separate rulemaking.
---------------------------------------------------------------------------

Certain persons who satisfy the major participant definition may
incur costs in determining whether to seek a limited designation.
Consistent with the discussion above, in general we believe that such
costs would affect no more than 12 entities.\1560\ These costs could,
however, vary significantly depending on the structure or other
characteristics of an entity's business.
---------------------------------------------------------------------------

\1560\ See note 1529, supra.
---------------------------------------------------------------------------

E. Exclusion of Inter-Affiliate Security-Based Swaps

Exchange Act rule 3a67-3 provides that security-based swap
transactions between majority-owned affiliates will be excluded for
purposes of the substantial position test.\1561\ We have concluded that
majority ownership represents an alignment of interests appropriate to
justify an inter-affiliate exclusion.\1562\ Moreover, we note that a
majority-ownership test should, given its objective nature, impose
fewer assessment costs on market participants than a more subjective
common control test.
---------------------------------------------------------------------------

\1561\ This exclusion also applies to the ``substantial
counterparty exposure'' analysis.
\1562\ See part IV.G.2, supra (discussing rationale for the
approach we are adopting, and considering alternative approaches).
---------------------------------------------------------------------------

Some market entities may incur costs in connection with determining
whether

[[Page 30739]]

particular security-based swap positions may be excluded from the major
participant analysis by virtue of the inter-affiliate exclusion. It is
possible that such costs could be incurred by any of the approximately
12 entities that we believe reasonably may have to engage in the major
participant calculations.\1563\ We believe that any costs arising out
of such an analysis would be encompassed within the $30,000 estimated
for legal services related to the major participant definition as a
whole.
---------------------------------------------------------------------------

\1563\ The data underlying this assessment already excludes
certain inter-affiliate credit default swaps.
---------------------------------------------------------------------------

F. Timing Requirements, Reevaluation Period and Termination of Status

Exchange Act rule 3a67-8 specifies the time at which an entity that
satisfies the major participant tests would be deemed to be a ``major
security-based swap participant,'' and also addresses the time at which
an entity's status as a major security-based swap participant would be
terminated. In adopting this rule we have considered alternatives that
would lead to slower entry and faster exit from major participant
status, and we believe that the approach that we are adopting provides
a reasonable amount of time for registration based on the proposed
registration process, will appropriately help to avoid applying major
participant requirements to entities that meet the major participant
criteria for only a short time due to unusual activity, and will avoid
the prospect of persons moving in and out of major participant status
overly frequently.\1564\
---------------------------------------------------------------------------

\1564\ See part IV.L.3, supra (discussing rationale for the
final rules addressing timing, reevaluation and termination).
---------------------------------------------------------------------------

Persons falling within the major participant definitions will incur
costs in connection with the registration process,\1565\ and it is
possible that alternative timing approaches could allow such persons to
register at a more deliberate pace, potentially reducing the associated
costs.\1566\ Such cost differences may affect the up-to-twelve entities
that we believe reasonably may have to engage in the major participant
calculations. Moreover, altering the timing requirements may not
significantly decrease costs associated with registration because in
all cases we would expect the same preparatory actions to be taken, and
we believe that the final rules provide sufficient time for entities to
perform the activities necessary for compliance.\1567\
---------------------------------------------------------------------------

\1565\ Registration Proposing Release, 76 FR at 65814-65818.
\1566\ For example, it is possible that an entity may perceive
the steps associated with the registration process as requiring it
to take additional steps to complete the registration process within
the time frame we are adopting, whereas a longer time period could
have enabled such an entity to avoid those costs.
\1567\ Specific costs associated with the registration process
will be addressed by the SEC in final rules related to the
registration of major security-based swap participants that have not
yet been adopted. However, we expect any additional costs arising
from the timing provisions of this rule to be insignificant.
---------------------------------------------------------------------------

4. Consideration of Burden on Competition, and Promotion of Efficiency,
Competition, and Capital Formation
Section 3(f) of the Exchange Act requires the SEC, whenever it
engages in rulemaking and is required to consider or determine whether
an action is necessary or appropriate in the public interest, to
consider, in addition to the protection of investors, whether the
action would promote efficiency, competition, and capital
formation.\1568\ In addition, section 23(a)(2) of the Exchange Act
\1569\ requires the SEC, when adopting rules under the Exchange Act, to
consider the impact such rules would have on competition. Section
23(a)(2) of the Exchange Act also prohibits the SEC from adopting any
rule that would impose a burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act.
---------------------------------------------------------------------------

\1568\ 15 U.S.C. 78c(f).
\1569\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

We are adopting these rules and interpretive guidance pursuant to
authority under section 712(d) of the Dodd-Frank Act, which requires
the Commissions to further define several terms, including ``security-
based swap dealer'' and ``major security-based swap participant.''
\1570\ In the Proposing Release, we stated that we preliminarily
believed that the proposed Exchange Act rules would not result in any
burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Act, that they would not
significantly affect capital formation, and that they would improve
efficiency. We requested comment on each of these issues, and certain
commenters raised concerns that overbroad definitions would lead to
undue competitive impacts.\1571\
---------------------------------------------------------------------------

\1570\ The SEC is also acting pursuant to its rulemaking
authority provided by Exchange Act sections 3 and 23(a).
\1571\ See, e.g., letters from Representatives Bachus and Lucas
(``Casting an overly-broad net in defining these terms could force
some smaller participants to leave the marketplace as a result of
increased costs, or eliminate certain types of contracts used for
hedging.''), SIFMA--Regional Dealers (stating that the proposed de
minimis exception ``is unnecessarily narrow, will discourage smaller
dealers from competing in the market and will limit the availability
of efficient and cost-effective intermediation services to small-
and medium-sized organizations'') and Midsize Banks (stating that a
reduction in small dealers due to an overly narrow de minimis
exception would ``curtail economic development going forward and
would leave end-users less options for hedging risks with community
and smaller regional dealers'').
---------------------------------------------------------------------------

In adopting these final rules, we recognize that the most
significant impact of the dealer and major participant definitions will
derive from those definitions' role in implementing Title VII,
particularly given the significant impacts that Title VII will have on
the security-based swap market. Many of these impacts may be expected
to be positive, because Title VII imposes, among other measures,
requirements that may be expected to promote safety and soundness,
transparency, and competition within the security-based swap market. We
recognize, however, that regulation also can pose costs that have
negative impacts on the markets.
In adopting these definitional rules and interpretations, moreover,
we have sought to fairly reflect the statutory definitions and their
underlying intent. Given the link between these definitional rules and
interpretations and the Title VII framework, the scope of the
definitions will affect the ultimate regulatory benefits and costs that
will accompany the full implementation of Title VII. Definitions that
capture more entities will tend to promote the Title VII benefits, but
will also risk increasing the accompanying costs. Definitions that
capture fewer entities may be expected to lead to the converse result.
a. Competitive Impacts
As noted above, the SEC is required to consider the effect of these
rules and interpretations on competition. The SEC also is prohibited
from adopting any rule that would impose a burden on competition that
is not necessary or appropriate in furtherance of the purposes of the
Exchange Act. Because these definitional rules and interpretations will
help determine which entities within the market are subject to the
Title VII requirements that govern dealers and major participants, they
may also affect competition within the security-based swap market.
In enacting Title VII, Congress set forth a regulatory framework
for OTC derivatives; security-based swaps represent one segment of the
overall OTC derivatives market. Within the security-based swap market,
dealers compete for business from counterparties, while non-dealers
that participate in the market use security-based swaps for purposes
that can

[[Page 30740]]

include speculation and hedging. To date, security-based swaps
primarily have traded in the over-the-counter market, and have not been
subject to comprehensive regulation in the U.S. We understand that
entities engaged in dealing activity within this market facilitate the
vast majority of security-based swap transactions.\1572\ Dealing
activity within the market also is highly concentrated.\1573\ This
concentration in large part appears to reflect the fact that larger
entities possess competitive advantages in engaging in over-the-counter
security-based swap dealing activities, particularly with regard to
having sufficient financial resources to provide potential
counterparties with adequate assurances of financial performance.\1574\
As such, it is reasonable to conclude that there are high barriers to
entry in connection with security-based swap dealing activity.\1575\
---------------------------------------------------------------------------

\1572\ Data from the credit default swap trade information
warehouse operated by DTCC indicates that as of the week ending
October 7, 2011, single-name credit default swaps involving two
counterparties that are not dealers (as identified by DTCC)
constitutes roughly 0.2 percent of the notional amount of all open
positions involving single-name credit default swaps (amounting to
$24.6 billion gross notional out of a total of $15.2 trillion gross
notional). Conversely, single-name credit default swaps involving
two dealers (as identified by DTCC) constitute roughly 74.2 percent
of the total notional amount (amounting to $11.3 trillion gross
notional out of the $15.2 trillion total). See http://www.dtcc.com/products/derivserv/data/index.php (as of October 7, 2011). We have
no reason to believe that the market for other types of security-
based swaps exhibits different amounts of concentration with regard
to dealer activity.
\1573\ As discussed above in the context of the de minimis
exception to the security-based swap dealer definition, analysis of
available data shows that, under any metric used to screen for
dealers in our CDS Data Analysis, over 90 percent of activity in
single-name credit default swaps among entities identified as
dealers is attributable to the fourteen or fifteen largest of those
entities. We have no reason to believe that the concentration of
dealing activity involving other types of security-based swaps
significantly differs from the concentration of dealers in the
single-name credit default swap market.
\1574\ See Pirrong, note 487, supra, at 17-18 (noting that
counterparties seek to reduce risk of default by engaging in credit
derivative transactions with well capitalized firms).
\1575\ See id., at 18-19 (noting lack of success among new
entrants into derivatives dealing market due to perception that AAA
rating for subsidiary is less desirable than a slightly lower rating
for a larger entity, and suggesting that there are ``economies of
scale in bearing default risk'' that may induce ``substantial
concentration in dealer activities'').
---------------------------------------------------------------------------

At the same time, commenters have noted that some entities engage
in smaller volumes of security-based swap dealing activity. Some small
and mid-size banks, for example, routinely provide such services
involving relatively small notional amounts to their customers.\1576\
Although these relatively smaller dealers in general may not compete
directly with the largest dealers (because they service a different
segment of the market), they may be expected to play a role in helping
certain types of customers (such as customers with a relatively smaller
need for security-based swaps) enter into security-based swaps, thus
promoting the availability of these products.
---------------------------------------------------------------------------

\1576\ See letter from FSR I.
---------------------------------------------------------------------------

Fundamentally, in considering the competitive impacts associated
with Title VII regulation of dealers and major participants--and hence
the competitive impacts associated with the dealer and major
participant definitions--we recognize that one consequence of the
current concentrated market structure \1577\ is the potential for risk
spillovers and systemic risk, which can occur when the financial sector
as a whole (or certain key segments) becomes undercapitalized. Risk
spillovers emerge when losses and financial distress at one firm lead
to losses and financial distress for the financial sector as a whole,
either through direct counterparty relationships or the deterioration
of asset values. As financial distress spreads, the aggregate financial
system may become undercapitalized, hindering its ability to provide
financial intermediation services. If firms do not internalize this
aggregate cost, the financial system may end up holding more risk than
its aggregate capital can manage.
---------------------------------------------------------------------------

\1577\ See, e.g., notes 478 and 485, supra, and accompanying
text.
---------------------------------------------------------------------------

In enacting Title VII, Congress set forth a framework that will
impose new costs and regulatory burdens, including capital, margin, and
registration requirements, on persons who act as security-based swap
dealers, and on persons whose security-based swap positions are large
enough to cause them to be major security-based swap participants.
While the substantive rules associated with capital, margin, and
registration requirements have yet to be finalized, we have sought to
set the dealer and major participant definitions in such a way as to
impose the substantive rules on those entities most likely to
contribute to an aggregate capital shortfall without imposing
unnecessary burdens on those who do not pose similar risks to the
market.\1578\ It is reasonable to expect that it is the largest
security-based swap entities that are more likely to contribute to an
aggregate capital shortfall than smaller participants, as more risk is
likely to be concentrated within these entities.\1579\
---------------------------------------------------------------------------

\1578\ We expect that implementation of Title VII will provide
both the SEC and market participants with more information about the
business of dealers and major participants, the characteristics of
positions they and other market participants hold, the structure of
the market, and how each of these have changed under the Title VII
framework. For that reason the SEC has directed the staff to report
to the Commission on all aspects of the dealer and major participant
definitions. See part V, supra.
\1579\ See Acharya, Pedersen, Philippon, and Richardson,
Measuring Systemic Risk (May 2010) (available at http://vlab.stern.nyu.edu/public/static/SR-v3.pdf) (working paper that
derives an empirical measure of a financial entity's expected
contribution to an aggregate capital shortfall that scales with the
size of the institution, and that shows using historical data that
their measure predicted the risks that emerged during the recent
financial crisis).
---------------------------------------------------------------------------

As discussed above, persons who fall within the statutory
definitions of security-based swap dealer and major security-based swap
participant will incur a range of one-time costs and ongoing costs by
virtue of that status.\1580\ Also, as discussed above, market
participants may incur costs in connection with determining whether
their security-based swap activities or positions will cause them to be
dealers or major participants.\1581\ To the extent the costs associated
with these statutorily mandated requirements are relatively fixed or
large enough, they may negatively affect competition within the market.
This may, for example, lead smaller dealers or entities for whom
dealing is not a core business to exit the market, which could cause
smaller customers to have less access to the market or to incur higher
costs in accessing the market. Such costs might also deter the entry of
new firms into the market. If sufficiently high, these costs of
compliance may increase concentration among dealers. We also recognize
that some market participants may be expected to incur costs in
connection with determining their status as a dealer or major
participant, but such costs can be expected to be significantly less
than the costs associated with the various rules applicable to dealers
or major participants.
---------------------------------------------------------------------------

\1580\ As discussed above, for example, security-based swap
dealers and major security-based swap participants will have to meet
minimum capital and margin requirements, maintain specified business
and transaction records and adhere to certain standards of business
conduct, along with other obligations. See, e.g., notes 178 to 180,
supra.
\1581\ See part VIII.A.3, supra.
---------------------------------------------------------------------------

Conversely, certain aspects of Title VII may enhance competition in
the market. For example, the business conduct and other requirements of
Title VII may enhance the availability of information to market
participants. Measures designed to equalize access to information
through disclosure requirements should promote participation, which may
intensify price competition among dealers, and thus

[[Page 30741]]

may increase participation in the security-based swap market. Other
aspects of Title VII, such as rules promoting access of dealers to
central clearing facilities, also may be expected to enhance
competition in the market.
i. Security-Based Swap Dealer Definition
Persons who are deemed to be dealers may be expected to incur costs
in connection with the substantive rules applicable to dealers, and to
incur comparatively smaller costs in connection with determining
whether they fall within the dealer definition. We cannot rule out the
possibility that the prospects of these aggregate costs might deter new
entrants from engaging in security-based swap activity that potentially
could lead them to be dealers.\1582\ We also cannot rule out the
possibility that the imposition of those costs could lead some persons
who currently engage in dealing activity involving security-based swaps
to lessen or cease that activity. Those effects--if they were to
occur--would be expected to reduce competition in the market.
Conversely, the application of the Title VII requirements applicable to
dealers, such as, for example, the business conduct requirements
related to disclosures to counterparties, may be expected to enhance
the availability of information to market participants. The resulting
reduction in information asymmetries may be expected to promote
participation, and therefore competition, in the market. Accordingly,
the scope of the rules and interpretations defining security-based swap
dealer, including the scope of the de minimis exception to the dealer
definition, can be expected to affect competition in the market in a
variety of ways.\1583\
---------------------------------------------------------------------------

\1582\ We do think it unlikely that the costs associated with
determining an entity's status, considered on their own, would have
any measurable effect on competition. As noted above, we estimate
that the cost of making this determination to be $30,000 at most,
and likely significantly less for most entities. See note 1537,
supra. In other words, the costs would amount to, at most, 0.1
percent of the de minimis threshold, and it is likely that few firms
would feel compelled to conduct this analysis until their dealing
volume approached the de minimis threshold.
\1583\ At the same time, it is possible that these additional
costs associated with dealer regulation will be comparatively small
compared to the existing barriers to entry in the market
(particularly the need for resources to provide counterparties with
sufficient assurance of performance). Cf. Pirrong, note 487, supra,
at 18-19 (noting that firms with smaller balance sheets, relative to
largest dealers, ``have largely failed to make major inroads as
derivatives dealers despite concerted efforts to do so''). It thus
is possible the incremental costs associated with dealer regulation
may not be of the magnitude to cause persons who currently engage in
security-based swap dealing activity to exit the market.
---------------------------------------------------------------------------

As discussed above, in rule 3a71-1 we have codified the statutory
definition of security-based swap dealer and provided guidance to
interpret the contours of this definition in the context of the dealer-
trader distinction. After considering commenters' views, we believe
that this guidance interprets the statute to give effect to the four
dealer tests and the ``regular business'' exclusion in a way that
reflects the features of the security-based swap market. This use of
the dealer-trader distinction--which parallels the analysis that
securities market participants currently use in the context of the
Exchange Act's ``dealer'' definition--also should help reduce the
potential competitive effects associated with the costs that market
participants incur to analyze their possible status as a dealer by
imposing fewer costs than a more novel approach.\1584\
---------------------------------------------------------------------------

\1584\ As noted above, we have declined to adopt per se
exclusions or overly simple tests, even though they might impose
fewer assessment costs on market participants conducting the dealer
analysis because we do not believe that such exclusions or tests
would capture the full range of entities that should be regulated as
dealers under Title VII. Moreover, the nature of the tests being
adopted are straightforward to implement and rely on information
that already should be readily available to market participants.
---------------------------------------------------------------------------

Moreover, as discussed above, in rule 3a71-2 we have adopted a de
minimis test and thresholds that will impose the costs associated with
dealer regulation upon entities that engage in the bulk of dealing
activity in the market, without imposing those costs upon persons who
account for a small portion of dealing activity (and for which dealer
regulation may be accompanied by comparatively modest benefits). We
believe this will mitigate some of the potential competitive burdens
associated with dealer status that could fall on entities engaged in a
smaller amount of dealing activity, without leaving an undue amount of
dealing activity outside of the ambit of dealer regulation. As
discussed in detail above, we believe we have set the threshold in a
way that appropriately considers this risk along with the benefits
afforded to smaller entities by a higher threshold. Furthermore, after
considering commenters' views, we believe that this approach strikes a
balance that appropriately will implement the transparency, risk, and
customer and counterparty protection goals of Title VII. This approach,
including the general use of a $3 billion threshold, also can
facilitate the initial entrance of dealers into the market, and permit
persons to engage in limited dealing activity that helps smaller
entities participate in the market. While we recognize that the lower
threshold associated with dealing activity involving ``special
entities'' has the potential to reduce competition to provide dealing
services to those entities, we believe that this lower threshold is
appropriate to preserve the protections that Title VII affords to those
entities.
In rule 3a71-1, we also have set forth a presumption that a person
that acts as a dealer in the security-based swap market will be a
dealer with regard to all of its security-based swaps. We recognize
that this presumption may have competitive impacts: on the one hand, by
imposing regulatory costs on a wider range of activities, certain
entities concentrated in discrete security-based swap segments may face
higher costs than they might without the presumption; on the other
hand, the presumption suggests a single, uniform baseline for
competition across dealers. While these impacts may bear out in a
number of ways, we believe that the presumption is appropriate in light
of the statutory language and the need to help ensure that security-
based swap dealers comply with all applicable legal requirements.
In rule 3a71-1, we also have provided an exclusion from dealer
status in connection with security-based swaps involving majority-owned
affiliated counterparties. To the extent that the scope of this
exclusion may have competitive impacts--such as in connection with
dealing activity involving affiliates that are not majority-owned, and
that hence cannot take advantage of the exclusion--we believe that the
exclusion appropriately applies the Title VII dealer requirements in a
way that reflects the economic reality of swaps among affiliates, which
generally does not raise the customer protection or market risk
concerns addressed by Title VII.
In sum, to the extent that the application of Title VII dealer
requirements to certain persons were to pose a net burden on
competition in the security-based swap market, we believe those effects
would be a necessary or appropriate consequence of implementing the
statutory definitions consistent with the purposes of the Title VII
amendments to the Exchange Act.
ii. Major Security-Based Swap Participant Definition
As we discuss above, we have estimated that entities approaching
the level of exposure required to be a major participant may incur
certain costs in connection with analyzing their

[[Page 30742]]

status.\1585\ Given the size of the exposures and notional amounts
required to trigger the major participant test (e.g., $1 billion in
daily average current uncollateralized exposure in a major category),
we do not believe that these costs of assessment would materially
impact the competitive role played in the security-based swap market by
persons who have positions large enough that they potentially may be
major participants.
---------------------------------------------------------------------------

\1585\ See text accompanying note 1532, supra (estimating
assessment costs as roughly $44,000 in the first year, and $15,268
in subsequent years).
---------------------------------------------------------------------------

We expect that the programmatic costs associated with the rules
applicable to major participants will be more significant. Presumably,
a market participant will weigh the costs of complying with the rules
against the benefit it expects from maintaining security-based swap
positions of a magnitude that would require registration as a major
participant, in deciding whether to continue to maintain such
positions. We cannot rule out the possibility that the prospect of
those costs could deter persons from maintaining security-based swap
positions of such a magnitude, and that this may reduce competition in
the market.\1586\
---------------------------------------------------------------------------

\1586\ The extent of such possible deterrence is mitigated by
the fact that major participant status is a prospect only for those
persons with very large security-based swap positions.
---------------------------------------------------------------------------

As discussed above, Exchange Act rules 3a67-1 through 3a67-9 and
the accompanying interpretations reflect choices that we believe are
reasonably designed to satisfy the risk criteria set forth in the major
participant definition.\1587\ In reaching these conclusions we
considered commenters' views on a variety of issues, including
suggested alternative approaches that would lessen the likelihood of
particular entities being deemed to be major participants (e.g.,
alternative tests, higher thresholds, a broader hedging exclusion, and
a higher leverage test). We believe that the choices reflected in the
final rules and interpretations are necessary or appropriate in
furtherance of the purposes of the Exchange Act and reasonably reflect
the criteria set forth by the statutory definition.
---------------------------------------------------------------------------

\1587\ See part VIII.A.2, supra.
---------------------------------------------------------------------------

b. Efficiency and Capital Formation
As noted above, in adopting these final rules and interpretations
we also are required to consider whether these actions would promote
efficiency and capital formation.
In significant part, the effect of these rules on efficiency and
capital formation are linked to the effect of these rules on
competition. For example, markets that are competitive, with fair and
transparent pricing and equal access to security-based swaps, may be
expected to promote the efficient allocation of capital. Similarly,
definitional rules that promote, or do not unduly restrict, competition
can be accompanied by regulatory benefits that minimize the risk of
market failure and thus promote efficiency within the market. Such
competitive markets would increase the efficiency by which market
participants could transact in security-based swaps for speculative,
trading, hedging and other purposes.
Definitional rules and interpretations of an appropriate scope also
can be expected to promote capital formation by facilitating the
appropriate use of security-based swaps for hedging purposes, and thus
by contributing to liquidity and reducing costs in connection with the
issuance of equity and debt securities. In the context of credit
default swaps based on loans, moreover, definitional rules and
interpretations of an appropriate scope can be expected to promote
capital formation by facilitating loans to businesses that may not
otherwise be made absent such a swap. Since credit risk is correlated,
lenders may find it desirable to hedge credit risks on their loan
portfolios by purchasing protection through single-name or index credit
default swaps. Even though there is basis risk in this type of trade,
it should be particularly effective at reducing exposure to systemic
credit events. More generally, security-based swaps can be expected to
promote risk transfer to persons better positioned and more willing to
bear certain risks (e.g., the transfer of risks from hedgers to
speculators).
Conversely, definitional rules that are accompanied by too many
competitive burdens pose the risk of imposing excessive costs of
regulation that could deter the efficient allocation of capital to
security-based swaps. Such rules also may be expected to reduce the
capital formation benefits that otherwise would be associated with
security-based swaps. Definitional rules of an inappropriate scope
further may reduce the availability of security-based swaps and thus
direct market participants not to seek to address certain business
needs, or to use less effective financial instruments to meet their
business needs. For example, major participant thresholds that broadly
capture much of the security-based swap market would discourage certain
entities from participating in the market, particularly if the
regulatory costs for major participants are high. This could make it
difficult for hedgers to find a counterparty, which would make it more
expensive to hedge risks and hinder efficient risk-sharing in the
broader economy. In addition, definitional rules that pose the risk of
creating a market that contains an undue amount of unregulated dealing
activity--as may be the result of a de minimis threshold that is too
high--would lead to disparate treatment of dealers and could undermine
the benefits of Title VII.
The rules and interpretations that we are adopting in connection
with the dealer and major participant definitions are designed to apply
the statutory definitions in a way that reasonably effects the goals of
Title VII. For example, the rule implementing the de minimis exception
to the dealer definition is designed to focus the application of the
dealer definition in a way that implements the benefits associated with
the regulation of security-based swap dealers under Title VII, without
imposing the costs associated with those regulations on those entities
responsible for only a small portion of total dealing activity. In
addition, the rules and interpretations in connection with the major
participant definition are geared to focus major participant regulation
on entities whose security-based swap positions pose a particularly
high degree of credit risk to the market, without applying those
regulations on persons who pose a lesser degree of risk.
In conclusion, we believe that the rules and interpretations may be
expected to promote efficiency in the allocation of capital to
security-based swaps, and to promote the capital formation benefits of
security-based swaps, by helping to focus the costs and burdens of the
regulation of dealers and major participants under Title VII upon those
persons for whom the imposition of those costs are most appropriate
given their overall activity and positions in the security-based swap
market. The rules and interpretations similarly may be expected to
apply certain Title VII requirements (e.g., counterparty disclosure
requirements that can be expected to reduce information asymmetries) to
those entities that engage in activities or maintain positions in the
security-based swap market such that their compliance with these
requirements may promote the efficiency and capital allocation benefits
associated with such regulation.

B. Paperwork Reduction Act Analysis

The Proposing Release addressed a potential new ``collection of
information'' requirement, within the

[[Page 30743]]

meaning of the Paperwork Reduction Act of 1995,\1588\ because the
proposed definition of the term ``hedging or mitigating commercial
risk'' included documentation and assessment conditions.
---------------------------------------------------------------------------

\1588\ 44 U.S.C. 3501.
---------------------------------------------------------------------------

As discussed above, final rule defining ``hedging or mitigating
commercial risk'' does not contain those proposed documentation and
assessment conditions. Accordingly, the Paperwork Reduction Act does
not apply to these definitions.\1589\
---------------------------------------------------------------------------

\1589\ Consistent with the discussion above, we recognize that
the substantive rules applicable to dealers and major participants
may contain collections of information, and that these definitions
will affect which entities are subject to those collections of
information. We believe that these Paperwork Reduction Act issues
are more appropriately addressed in connection with the substantive
rules applicable to dealers and major participants.
---------------------------------------------------------------------------

C. Regulatory Flexibility Act Certification

The Regulatory Flexibility Act (``RFA'') \1590\ requires Federal
agencies, in promulgating rules, to consider the impact of those rules
on small entities. Section 603(a) \1591\ of the Administrative
Procedure Act,\1592\ as amended by the RFA, generally requires the SEC
to undertake a regulatory flexibility analysis of all proposed rules,
or proposed rule amendments, to determine the impact of such rulemaking
on ``small entities.'' \1593\ Section 605(b) of the RFA provides that
this requirement shall not apply to any proposed rule or proposed rule
amendment, which if adopted, would not have a significant economic
impact on a substantial number of small entities.\1594\
---------------------------------------------------------------------------

\1590\ 5 U.S.C. 601 et seq.
\1591\ 5 U.S.C. 603(a).
\1592\ 5 U.S.C. 551 et seq.
\1593\ Although Section 601(b) of the RFA defines the term
``small entity,'' the statute permits the Commissions to formulate
their own definitions. The SEC has adopted definitions for the term
small entity for the purposes of SEC rulemaking in accordance with
the RFA. Those definitions, as relevant to this proposed rulemaking,
are set forth in Rule 0-10, 17 CFR 240.0-10. See Securities Exchange
Act Release No. 18451 (Jan. 28, 1982), 47 FR 5215 (Feb. 4, 1982)
(File No. AS-305).
\1594\ See 5 U.S.C. 605(b).
---------------------------------------------------------------------------

For purposes of SEC rulemaking in connection with the RFA, a small
entity includes: (i) When used with reference to an ``issuer'' or a
``person,'' other than an investment company, an ``issuer'' or
``person'' that, on the last day of its most recent fiscal year, had
total assets of $5 million or less,\1595\ or (ii) a broker-dealer with
total capital (net worth plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as of which its audited
financial statements were prepared pursuant to Rule 17a-5(d) under the
Exchange Act,\1596\ or, if not required to file such statements, a
broker-dealer with total capital (net worth plus subordinated
liabilities) of less than $500,000 on the last day of the preceding
fiscal year (or in the time that it has been in business, if shorter);
and is not affiliated with any person (other than a natural person)
that is not a small business or small organization.\1597\ Under the
standards adopted by the Small Business Administration, small entities
in the finance and insurance industry include the following: (i) For
entities engaged in credit intermediation and related activities,
entities with $175 million or less in assets; \1598\ (ii) for entities
engaged in non-depository credit intermediation and certain other
activities, entities with $7 million or less in annual receipts; \1599\
(iii) for entities engaged in financial investments and related
activities, entities with $7 million or less in annual receipts; \1600\
(iv) for insurance carriers and entities engaged in related activities,
entities with $7 million or less in annual receipts; \1601\ and (v) for
funds, trusts, and other financial vehicles, entities with $7 million
or less in annual receipts.\1602\
---------------------------------------------------------------------------

\1595\ See 17 CFR 240.0-10(a).
\1596\ See 17 CFR 240.17a-5(d).
\1597\ See 17 CFR 240.0-10(c).
\1598\ See 13 CFR 121.201 (Subsector 522).
\1599\ See id. at Subsector 522.
\1600\ See id. at Subsector 523.
\1601\ See id. at Subsector 524.
\1602\ See id. at Subsector 525.
---------------------------------------------------------------------------

The Proposing Release stated that based on feedback from industry
participants about the security-based swap markets, the SEC
preliminarily believes that any entities that would qualify as
security-based swap dealers and major security-based swap market
participants would exceed the thresholds defining ``small entities,''
and that the SEC believes it is unlikely that the proposed rules would
have a significant economic impact on any small entity. As a result,
the SEC certified that the proposed rules would not have a significant
economic impact on a substantial number of small entities for purposes
of the RFA, and requested written comments regarding this
certification.\1603\
---------------------------------------------------------------------------

\1603\ See Proposing Release, 75 FR at 80211.
---------------------------------------------------------------------------

While we received comment letters that addressed cost issues in
connection with the proposed rules, we did not receive any comments
that specifically addressed whether the rules defining ``security-based
swap dealer'' or ``major security-based swap participant'' would have a
significant economic impact on small entities.
The SEC continues to believe that the types of entities that would
engage in more than a de minimis amount of dealing activity involving
security-based swaps--which generally would be major banks--would not
be ``small entities'' for purposes of the RFA. Similarly, the SEC
continues to believe that the types of entities that may have security-
based swap positions above the level required to be a ``major security-
based swap participant'' would not be a ``small entity'' for purposes
of the RFA. Accordingly, the SEC certifies that the final rules
defining ``security-based swap dealer'' or ``major security-based swap
participant'' would not have a significant economic impact on a
substantial number of small entities for purposes of the RFA.

Statutory Basis and Text of the Amendments

List of Subjects in 17 CFR Part 1

Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements.

Commodity Futures Trading Commission

For the reasons stated in the preamble, the CFTC is adopting the
following amendments to 17 CFR part 1.

PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

0
1. The authority citation for part 1 is revised to read as follows:

Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g,
6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 12c,
13a, 13a-1, 16, 16a, 19, 21, 23, and 24, as amended by Title VII of
the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.
L. 111-203, 124 Stat. 1376 (2010).

0
2. Amend Sec. 1.3 by revising paragraph (m) and adding paragraphs
(ggg) through (mmm) to read as follows:

Sec. 1.3 Definitions.

* * * * *
(m) Eligible contract participant. This term has the meaning set
forth in Section 1a(18) of the Act, except that:
(1) A major swap participant, as defined in Section 1a(33) of the
Act and paragraph (hhh) of this section, is an eligible contract
participant;
(2) A swap dealer, as defined in Section 1a(49) of the Act and
paragraph (ggg) of this section, is an eligible contract participant;
(3) A major security-based swap participant, as defined in Section
3(a)(67) of the Securities Exchange Act

[[Page 30744]]

of 1934 and Sec. 240.3a67-1 of this title, is an eligible contract
participant;
(4) A security-based swap dealer, as defined in Section 3(a)(71) of
the Securities Exchange Act of 1934 and Sec. 240.3a71-1 of this title,
is an eligible contract participant;
(5)(i) A transaction-level commodity pool with one or more direct
participants that is not an eligible contract participant is not itself
an eligible contract participant under either Section 1a(18)(A)(iv) or
Section 1a(18)(A)(v) of the Act for purposes of entering into
transactions described in Sections 2(c)(2)(B)(vi) and 2(c)(2)(C)(vii)
of the Act; and
(ii) In determining whether a commodity pool that is a direct
participant in a transaction-level commodity pool is an eligible
contract participant for purposes of paragraph (m)(5)(i) of this
section, the participants in the commodity pool that is a direct
participant in the transaction-level commodity pool shall not be
considered unless the transaction-level commodity pool, any commodity
pool holding a direct or indirect interest in such transaction-level
commodity pool, or any commodity pool in which such transaction-level
commodity pool holds a direct or indirect interest, has been structured
to evade subtitle A of Title VII of the Dodd-Frank Wall Street Reform
and Consumer Protection Act by permitting persons that are not eligible
contract participants to participate in agreements, contracts, or
transactions described in Section 2(c)(2)(B)(i) or Section
2(c)(2)(C)(i) of the Act;
(6) A commodity pool that does not have total assets exceeding
$5,000,000 or that is not operated by a person described in subclause
(A)(iv)(II) of Section 1a(18) of the Act is not an eligible contract
participant pursuant to clause (A)(v) of such Section;
(7)(i) For purposes of a swap (but not a security-based swap,
security-based swap agreement or mixed swap) used to hedge or mitigate
commercial risk, an entity may, in determining its net worth for
purposes of Section 1a(18)(A)(v)(III) of the Act, include the net worth
of any owner of such entity, provided that all the owners of such
entity are eligible contract participants;
(ii)(A) For purposes of identifying the owners of an entity under
paragraph (m)(7)(i) of this section, any person holding a direct
ownership interest in such entity shall be considered to be an owner of
such entity; provided, however, that any shell company shall be
disregarded, and the owners of such shell company shall be considered
to be the owners of any entity owned by such shell company;
(B) For purposes of paragraph (m)(7)(ii)(A) of this section, the
term shell company means any entity that limits its holdings to direct
or indirect interests in entities that are relying on this paragraph
(m)(7); and
(C) In determining whether an owner of an entity is an eligible
contract participant for purposes of paragraph (m)(7)(i) of this
section, an individual may be considered to be a proprietorship
eligible contract participant only if the individual--
(1) Has an active role in operating a business other than an
entity;
(2) Directly owns all of the assets of the business;
(3) Directly is responsible for all of the liabilities of the
business; and
(4) Acquires its interest in the entity seeking to qualify as an
eligible contract participant under paragraph (m)(7)(i) of this section
in connection with the operation of the individual's proprietorship or
to manage the risk associated with an asset or liability owned or
incurred or reasonably likely to be owned or incurred by the individual
in the operation of the individual's proprietorship; and
(iii) For purposes of paragraph (m)(7)(i) of this section, a swap
is used to hedge or mitigate commercial risk if the swap complies with
the conditions in paragraph (kkk) of this section; and
(8) Notwithstanding Section 1a(18)(A)(iv) of the Act and paragraph
(m)(5) of this section, a commodity pool that enters into an agreement,
contract, or transaction described in Section 2(c)(2)(B)(i) or Section
2(c)(2)(C)(i)(I) of the Act is an eligible contract participant with
respect to such agreement, contract, or transaction, regardless of
whether each participant in such commodity pool is an eligible contract
participant, if all of the following conditions are satisfied:
(i) The commodity pool is not formed for the purpose of evading
regulation under Section 2(c)(2)(B) or Section 2(c)(2)(C) of the Act or
related Commission rules, regulations or orders;
(ii) The commodity pool has total assets exceeding $10,000,000; and
(iii) The commodity pool is formed and operated by a registered
commodity pool operator or by a commodity pool operator who is exempt
from registration as such pursuant to Sec. 4.13(a)(3) of this chapter.
* * * * *
(ggg) Swap Dealer. (1) In general. The term swap dealer means any
person who:
(i) Holds itself out as a dealer in swaps;
(ii) Makes a market in swaps;
(iii) Regularly enters into swaps with counterparties as an
ordinary course of business for its own account; or
(iv) Engages in any activity causing it to be commonly known in the
trade as a dealer or market maker in swaps.
(2) Exception. The term swap dealer does not include a person that
enters into swaps for such person's own account, either individually or
in a fiduciary capacity, but not as a part of regular business.
(3) Scope of designation. A person who is a swap dealer shall be
deemed to be a swap dealer with respect to each swap it enters into,
regardless of the category of the swap or the person's activities in
connection with the swap. However, if a person makes an application to
limit its designation as a swap dealer to specified categories of swaps
or specified activities of the person in connection with swaps, the
Commission shall determine whether the person's designation as a swap
dealer shall be so limited. If the Commission grants such limited
designation, such limited designation swap dealer shall be deemed to be
a swap dealer with respect to each swap it enters into in the swap
category or categories for which it is so designated, regardless of the
person's activities in connection with such category or categories of
swaps. A person may make such application to limit the categories of
swaps or activities of the person that are subject to its swap dealer
designation at the same time as, or after, the person's initial
registration as a swap dealer.
(4) De minimis exception. (i) Except as provided in paragraph
(ggg)(4)(vi) of this section, a person that is not currently registered
as a swap dealer shall be deemed not to be a swap dealer as a result of
its swap dealing activity involving counterparties, so long as the swap
positions connected with those dealing activities into which the
person--or any other entity controlling, controlled by or under common
control with the person--enters over the course of the immediately
preceding 12 months (or following the effective date of final rules
implementing Section 1a(47) of the Act, 7 U.S.C. 1a(47), if that period
is less than 12 months) have an aggregate gross notional amount of no
more than $3 billion, subject to a phase in level of an aggregate gross
notional amount of no more than $8 billion applied in accordance with
paragraph (ggg)(4)(ii) of this section, and an aggregate gross notional
amount of no more than $25 million with regard to swaps in which the
counterparty is a ``special entity'' (as that term is defined in
Section 4s(h)(2)(C) of the Act, 7

[[Page 30745]]

U.S.C. 6s(h)(2)(C), and Sec. 23.401(c) of this chapter). For purposes
of this paragraph, if the stated notional amount of a swap is leveraged
or enhanced by the structure of the swap, the calculation shall be
based on the effective notional amount of the swap rather than on the
stated notional amount.
(ii) Phase-in procedure and staff report. (A) Phase-in period. For
purposes of paragraph (ggg)(4)(i) of this section, except as provided
in paragraph (ggg)(4)(vi) of this section, a person that engages in
swap dealing activity that does not exceed the phase-in level set forth
in paragraph (ggg)(4)(i) shall be deemed not to be a swap dealer as a
result of its swap dealing activity until the ``phase-in termination
date'' established as provided in paragraph (ggg)(4)(ii)(C) or (D) of
this section. The Commission shall announce the phase-in termination
date on the Commission Web site and publish such date in the Federal
Register.
(B) Staff report. No later than 30 months following the date that a
swap data repository first receives swap data in accordance with part
45 of this chapter, the staff of the Commission shall complete and
publish for public comment a report on topics relating to the
definition of the term ``swap dealer'' and the de minimis threshold.
The report should address the following topics, as appropriate, based
on the availability of data and information: the potential impact of
modifying the de minimis threshold, and whether the de minimis
threshold should be increased or decreased; the factors that are useful
for identifying swap dealing activity, including the application of the
dealer-trader distinction for that purpose, and the potential use of
objective tests or safe harbors as part of the analysis; the impact of
provisions in paragraphs (ggg)(5) and (6) of this section excluding
certain swaps from the dealer analysis, and potential alternative
approaches for such exclusions; and any other analysis of swap data and
information relating to swaps that the Commission or staff deem
relevant to this rule.
(C) Nine months after publication of the report required by
paragraph (ggg)(4)(ii)(B) of this section, and after giving due
consideration to that report and any associated public comment, the
Commission may either:
(1) Terminate the phase-in period set forth in paragraph
(ggg)(4)(ii)(A) of this section, in which case the phase-in termination
date shall be established by the Commission by order published in the
Federal Register; or
(2) Determine that it is necessary or appropriate in the public
interest to propose through rulemaking an alternative to the $3 billion
amount set forth in paragraph (ggg)(4)(i) of this section that would
constitute a de minimis quantity of swap dealing in connection with
transactions with or on behalf of customers within the meaning of
section 1(a)(47)(D) of the Act, 7 U.S.C. 1(a)(47)(D), in which case the
Commission shall by order published in the Federal Register provide
notice of such determination, which order shall also establish the
phase-in termination date.
(D) If the phase-in termination date has not been previously
established pursuant to paragraph (ggg)(4)(ii)(C) of this section, then
in any event the phase-in termination date shall occur five years after
the date that a swap repository first receives swap data in accordance
with part 45 of this chapter.
(iii) Registration period for persons that can no longer take
advantage of the exception. A person that has not registered as a swap
dealer by virtue of satisfying the requirements of this paragraph
(ggg)(4), but that no longer can take advantage of that de minimis
exception, will be deemed not to be a swap dealer until the earlier of
the date on which it submits a complete application for registration
pursuant to Section 4s(b) of the Act, 7 U.S.C. 6s(b), or two months
after the end of the month in which that person becomes no longer able
to take advantage of the exception.
(iv) Applicability to registered swap dealers. A person who
currently is registered as a swap dealer may apply to withdraw that
registration, while continuing to engage in swap dealing activity in
reliance on this section, so long as that person has been registered as
a swap dealer for at least 12 months and satisfies the conditions of
paragraph (ggg)(4)(i) of this section.
(v) Future adjustments to scope of the de minimis exception. The
Commission may by rule or regulation change the requirements of the de
minimis exception described in paragraphs (ggg)(4)(i) through (iv) of
this section.
(vi) Voluntary registration. Notwithstanding paragraph (ggg)(4)(i)
of this section, a person that chooses to register with the Commission
as a swap dealer shall be deemed to be a swap dealer.
(5) Insured depository institution swaps in connection with
originating loans to customers. Swaps entered into by an insured
depository institution with a customer in connection with originating a
loan with that customer shall not be considered in determining whether
the insured depository institution is a swap dealer.
(i) An insured depository institution shall be considered to have
entered into a swap with a customer in connection with originating a
loan, as defined in paragraphs (ggg)(5)(ii) and (iii) of this section,
with that customer only if:
(A) The insured depository institution enters into the swap with
the customer no earlier than 90 days before and no later than 180 days
after the date of execution of the applicable loan agreement, or no
earlier than 90 days before and no later than 180 days after any
transfer of principal to the customer by the insured depository
institution pursuant to the loan;
(B)(1) The rate, asset, liability or other notional item underlying
such swap is, or is directly related to, a financial term of such loan,
which includes, without limitation, the loan's duration, rate of
interest, the currency or currencies in which it is made and its
principal amount;
(2) Such swap is required, as a condition of the loan under the
insured depository institution's loan underwriting criteria, to be in
place in order to hedge price risks incidental to the borrower's
business and arising from potential changes in the price of a commodity
(other than an excluded commodity);
(C) The duration of the swap does not extend beyond termination of
the loan;
(D) The insured depository institution is:
(1) The sole source of funds to the customer under the loan;
(2) Committed to be, under the terms of the agreements related to
the loan, the source of at least 10 percent of the maximum principal
amount under the loan; or
(3) Committed to be, under the terms of the agreements related to
the loan, the source of a principal amount that is greater than or
equal to the aggregate notional amount of all swaps entered into by the
insured depository institution with the customer in connection with the
financial terms of the loan;
(E) The aggregate notional amount of all swaps entered into by the
customer in connection with the financial terms of the loan is, at any
time, not more than the aggregate principal amount outstanding under
the loan at that time; and
(F) If the swap is not accepted for clearing by a derivatives
clearing organization, the insured depository institution reports the
swap as required by section 4r of the Act, 7 U.S.C. 6r (except as
otherwise provided in section 4r(a)(3)(A), 7 U.S.C. 6r(a)(3)(A), or
section 4r(a)(3)(B), 7 U.S.C. 6r(a)(3)(B) of the Act).

[[Page 30746]]

(ii) An insured depository institution shall be considered to have
originated a loan with a customer if the insured depository
institution:
(A) Directly transfers the loan amount to the customer;
(B) Is a part of a syndicate of lenders that is the source of the
loan amount that is transferred to the customer;
(C) Purchases or receives a participation in the loan; or
(D) Otherwise is the source of funds that are transferred to the
customer pursuant to the loan or any refinancing of the loan.
(iii) The term loan shall not include:
(A) Any transaction that is a sham, whether or not intended to
qualify for the exclusion from the definition of the term swap dealer
in this rule; or
(B) Any synthetic loan, including, without limitation, a loan
credit default swap or loan total return swap.
(6) Swaps that are not considered in determining whether a person
is a swap dealer. (i) Inter-affiliate activities. In determining
whether a person is a swap dealer, that person's swaps with majority-
owned affiliates shall not be considered. For these purposes the
counterparties to a swap are majority-owned affiliates if one
counterparty directly or indirectly owns a majority interest in the
other, or if a third party directly or indirectly owns a majority
interest in both counterparties to the swap, where ``majority
interest'' is the right to vote or direct the vote of a majority of a
class of voting securities of an entity, the power to sell or direct
the sale of a majority of a class of voting securities of an entity, or
the right to receive upon dissolution or the contribution of a majority
of the capital of a partnership.
(ii) Activities of a cooperative. (A) Any swap that is entered into
by a cooperative with a member of such cooperative shall not be
considered in determining whether the cooperative is a swap dealer,
provided that:
(1) The swap is subject to policies and procedures of the
cooperative requiring that the cooperative monitors and manages the
risk of such swap;
(2) The cooperative reports the swap as required by Section 4r of
the Act, 7 U.S.C. 6r (except as otherwise provided in Section
4r(a)(3)(A) of the Act, 7 U.S.C. 6r(a)(3)(A) or Section 4r(a)(3)(B) of
the Act, 7 U.S.C. 6r(a)(3)(B)); and
(3) if the cooperative is a cooperative association of producers,
the swap is primarily based on a commodity that is not an excluded
commodity.
(B) For purposes of this paragraph (ggg)(6)(ii), the term
cooperative shall mean:
(1) A cooperative association of producers as defined in section
1a(14) of the Act, 7 U.S.C. 1a(14), or
(2) A person chartered under Federal law as a cooperative and
predominantly engaged in activities that are financial in nature as
defined in section 4(k) of the Bank Holding Company Act of 1956, 12
U.S.C. 1843(k).
(C) For purposes of this paragraph (ggg)(6)(ii), a swap shall be
deemed to be entered into by a cooperative association of producers
with a member of such cooperative association of producers when the
swap is between a cooperative association of producers and a person
that is a member of a cooperative association of producers that is
itself a member of the first cooperative association of producers.
(iii) Swaps entered into for the purpose of hedging physical
positions. In determining whether a person is a swap dealer, a swap
that the person enters into shall not be considered, if:
(A) The person enters into the swap for the purpose of offsetting
or mitigating the person's price risks that arise from the potential
change in the value of one or several--
(1) Assets that the person owns, produces, manufactures, processes,
or merchandises or anticipates owning, producing, manufacturing,
processing, or merchandising;
(2) Liabilities that the person owns or anticipates incurring; or
(3) Services that the person provides, purchases, or anticipates
providing or purchasing;
(B) The swap represents a substitute for transactions made or to be
made or positions taken or to be taken by the person at a later time in
a physical marketing channel;
(C) The swap is economically appropriate to the reduction of the
person's risks in the conduct and management of a commercial
enterprise;
(D) The swap is entered into in accordance with sound commercial
practices; and
(E) The person does not enter into the swap in connection with
activity structured to evade designation as a swap dealer.
(iv) Swaps entered into by floor traders. In determining whether a
person is a swap dealer, each swap that the person enters into in its
capacity as a floor trader as defined by section 1a(23) of the Act or
on or subject to the rules of a swap execution facility shall not be
considered for the purpose of determining whether the person is a swap
dealer if the person:
(A) Is registered with the Commission as a floor trader pursuant to
Sec. 3.11 of this chapter;
(B) Enters into swaps with proprietary funds for that trader's own
account solely on or subject to the rules of a designated contract
market or swap execution facility and submits each such swap for
clearing to a derivatives clearing organization;
(C) Is not an affiliated person of a registered swap dealer;
(D) Does not directly, or through an affiliated person, negotiate
the terms of swap agreements, other than price and quantity or to
participate in a request for quote process subject to the rules of a
designated contract market or a swap execution facility;
(E) Does not directly or through an affiliated person offer or
provide swap clearing services to third parties;
(F) Does not directly or through an affiliated person enter into
swaps that would qualify as hedging physical positions pursuant to
paragraph (ggg)(6)(iii) of this section or hedging or mitigating
commercial risk pursuant to paragraph (kkk) of this section (except for
any such swap executed opposite a counterparty for which the
transaction would qualify as a bona fide hedging transaction);
(G) Does not participate in any market making program offered by a
designated contract market or swap execution facility; and
(H) Notwithstanding the fact such person is not registered as a
swap dealer, such person complies with Sec. Sec. 23.201, 23.202,
23.203, and 23.600 of this chapter with respect to each such swap as if
it were a swap dealer.
(hhh) Major Swap Participant. (1) In general. The term major swap
participant means any person:
(i) That is not a swap dealer; and
(ii)(A) That maintains a substantial position in swaps for any of
the major swap categories, excluding both positions held for hedging or
mitigating commercial risk, and positions maintained by any employee
benefit plan (or any contract held by such a plan) as defined in
paragraphs (3) and (32) of Section 3 of the Employee Retirement Income
Security Act of 1974, 29 U.S.C. 1002, for the primary purpose of
hedging or mitigating any risk directly associated with the operation
of the plan;
(B) Whose outstanding swaps create substantial counterparty
exposure that could have serious adverse effects on the financial
stability of the United States banking system or financial markets; or
(C) That is a financial entity that:
(1) Is highly leveraged relative to the amount of capital such
entity holds and that is not subject to capital requirements
established by an

[[Page 30747]]

appropriate Federal banking agency (as defined in Section 1a(2) of the
Act, 7 U.S.C. 1a(2)); and
(2) Maintains a substantial position in outstanding swaps in any
major swap category.
(2) Scope of designation. A person that is a major swap participant
shall be deemed to be a major swap participant with respect to each
swap it enters into, regardless of the category of the swap or the
person's activities in connection with the swap. However, if a person
makes an application to limit its designation as a major swap
participant to specified categories of swaps, the Commission shall
determine whether the person's designation as a major swap participant
shall be so limited. If the Commission grants such limited designation,
such limited designation major swap participant shall be deemed to be a
major swap participant with respect to each swap it enters into in the
swap category or categories for which it is so designated, regardless
of the person's activities in connection with such category or
categories of swaps. A person may make such application to limit its
designation at the same time as, or after, the person's initial
registration as a major swap participant.
(3) Timing requirements. A person that is not registered as a major
swap participant, but that meets the criteria in this rule to be a
major swap participant as a result of its swap activities in a fiscal
quarter, will not be deemed to be a major swap participant until the
earlier of the date on which it submits a complete application for
registration as a major swap participant pursuant to Section 4s(a)(2)
of the Act, 7 U.S.C. 6s(a)(2), or two months after the end of that
quarter.
(4) Reevaluation period. Notwithstanding paragraph (hhh)(3) of this
section, if a person that is not registered as a major swap participant
meets the criteria in this rule to be a major swap participant in a
fiscal quarter, but does not exceed any applicable threshold by more
than twenty percent in that quarter:
(i) That person will not be deemed a major swap participant
pursuant to the timing requirements specified in paragraph (hhh)(3) of
this section; but
(ii) That person will be deemed a major swap participant pursuant
to the timing requirements specified in paragraph (hhh)(3) of this
section at the end of the next fiscal quarter if the person exceeds any
of the applicable daily average thresholds in that next fiscal quarter.
(5) Termination of status. A person that is deemed to be a major
swap participant shall continue to be deemed a major swap participant
until such time that its swap activities do not exceed any of the daily
average thresholds set forth within this rule for four consecutive
fiscal quarters after the date on which the person becomes registered
as a major swap participant.
(6) Calculation of status. A person shall not be deemed to be a
``major swap participant,'' regardless of whether the criteria
paragraph (hhh)(1) of this section otherwise would cause the person to
be a major swap participant, provided the person meets the conditions
set forth in paragraphs (hhh)(6)(i), (ii) or (iii) of this section.
(i) Caps on uncollateralized exposure and notional positions.
(A) Maximum potential uncollateralized exposure. The express terms
of the person's agreements or arrangements relating to swaps with its
counterparties at no time would permit the person to maintain a total
uncollateralized exposure of more than $100 million to all such
counterparties, including any exposure that may result from thresholds
or minimum transfer amounts established by credit support annexes or
similar arrangements; and
(B) Maximum notional amount of swap positions. The person does not
maintain swap positions in a notional amount of more than $2 billion in
any major category of swaps, or more than $4 billion in the aggregate
across all major categories; or
(ii) Caps on uncollateralized exposure plus monthly calculation.
(A) Maximum potential uncollateralized exposure. The express terms
of the person's agreements or arrangements relating to swaps with its
counterparties at no time would permit the person to maintain a total
uncollateralized exposure of more than $200 million to all such
counterparties (with regard to swaps and any other instruments by which
the person may have exposure to those counterparties), including any
exposure that may result from thresholds or minimum transfer amounts
established by credit support annexes or similar arrangements; and
(B) Calculation of positions. (1) At the end of each month, the
person performs the calculations prescribed by paragraph (jjj) of this
section with regard to whether the aggregate uncollateralized outward
exposure plus aggregate potential outward exposure as of that day
constitute a ``substantial position'' in a major category of swaps, or
pose ``substantial counterparty exposure that could have serious
adverse effects on the financial stability of the United States banking
system or financial markets''; these calculations shall disregard
provisions of those rules that provide for the analyses to be
determined based on a daily average over a calendar quarter; and
(2) Each such analysis produces thresholds of no more than:
(i) $1 billion in aggregate uncollateralized outward exposure plus
aggregate potential outward exposure in any major category of swaps; if
the person is subject to paragraph (jjj) of this section, by virtue of
being a highly leveraged financial entity that is not subject to
capital requirements established by an appropriate Federal banking
agency, this analysis shall account for all of the person's swap
positions in that major category (without excluding hedging positions),
otherwise this analysis shall exclude the same hedging and related
positions that are excluded from consideration pursuant to paragraph
(jjj)(1)(i) of this section; or
(ii) $2 billion in aggregate uncollateralized outward exposure plus
aggregate potential outward exposure (without any positions excluded
from the analysis) with regard to all of the person's swap positions.
(iii) Calculations based on certain information. (A)(1) At the end
of each month, the person's aggregate uncollateralized outward exposure
with respect to its swap positions in each major swap category is less
than $1.5 billion with respect to the rate swap category and less than
$500 million with respect to each of the other major swap categories;
and
(2) At the end of each month, the sum of the amount calculated
under paragraph (hhh)(6)(iii)(A)(1) of this section with respect to
each major swap category and the total notional principal amount of the
person's swap positions in each such major swap category, adjusted by
the multipliers set forth in paragraph (jjj)(3)(ii)(1) of this section
on a position-by-position basis reflecting the type of swap, is less
than $3 billion with respect to the rate swap category and less than $1
billion with respect to each of the other major swap categories; or
(B)(1) At the end of each month, the person's aggregate
uncollateralized outward exposure with respect to its swap positions
across all major swap categories is less than $500 million; and
(2) The sum of the amount calculated under paragraph
(hhh)(6)(iii)(B)(1) of this section and the product of the total
effective notional principal amount of the person's swap positions in
all major security-based swap categories multiplied by 0.15 is less
than $1 billion.
(C) For purposes of the calculations set forth in this paragraph
(hhh)(6)(iii):

[[Page 30748]]

(1) The person's aggregate uncollateralized outward exposure for
positions held with swap dealers shall be equal to such exposure
reported on the most recent reports of such exposure received from such
swap dealers; and
(2) The person's aggregate uncollateralized outward exposure for
positions that are not reflected in any report of exposure from a swap
dealer (including all swap positions it holds with persons other than
swap dealers) shall be calculated in accordance with paragraph (jjj)(2)
of this section.
(iv) For purposes of the calculations set forth in this paragraph
(hhh)(6), the person shall use the effective notional amount of a
position rather than the stated notional amount of the position if the
stated notional amount is leveraged or enhanced by the structure of the
position.
(v) No presumption shall arise that a person is required to perform
the calculations needed to determine if it is a major swap participant,
solely by reason that the person does not meet the conditions specified
in paragraph (hhh)(6)(i), (ii) or (iii) of this section.
(7) Exclusions. A person who is registered as a derivatives
clearing organization with the Commission pursuant to section 5b of the
Act and regulations thereunder, shall not be deemed to be a major swap
participant, regardless of whether the criteria in this paragraph (hhh)
otherwise would cause the person to be a major swap participant.
(iii) Category of swaps; major swap category. For purposes of
Section 1a(33) the Act, 7 U.S.C. 1a(33), and paragraph (hhh) of this
section, the terms major swap category, category of swaps and any
similar terms mean any of the categories of swaps listed below. For the
avoidance of doubt, the term swap as it is used in this paragraph (iii)
has the meaning set forth in Section 1a(47) of the Act, 7 U.S.C.
1a(47), and the rules thereunder.
(1) Rate swaps. Any swap which is primarily based on one or more
reference rates, including but not limited to any swap of payments
determined by fixed and floating interest rates, currency exchange
rates, inflation rates or other monetary rates, any foreign exchange
swap, as defined in Section 1a(25) of the Act, 7 U.S.C. 1a(25), and any
foreign exchange option other than an option to deliver currency.
(2) Credit swaps. Any swap that is primarily based on instruments
of indebtedness, including but not limited to any swap primarily based
on one or more broad-based indices related to debt instruments or
loans, and any swap that is an index credit default swap or total
return swap on one or more indices of debt instruments.
(3) Equity swaps. Any swap that is primarily based on equity
securities, including but not limited to any swap based on one or more
broad-based indices of equity securities and any total return swap on
one or more equity indices.
(4) Other commodity swaps. Any swap that is not included in the
rate swap, credit swap or equity swap categories.
(jjj) Substantial position. (1) In general. For purposes of Section
1a(33) of the Act, 7 U.S.C. 1a(33), and paragraph (hhh) of this
section, the term ``substantial position'' means swap positions that
equal or exceed any of the following thresholds in the specified major
category of swaps:
(i) For rate swaps:
(A) $3 billion in daily average aggregate uncollateralized outward
exposure; or
(B) $6 billion in:
(1) Daily average aggregate uncollateralized outward exposure plus
(2) Daily average aggregate potential outward exposure.
(ii) For credit swaps:
(A) $1 billion in daily average aggregate uncollateralized outward
exposure; or
(B) $2 billion in:
(1) Daily average aggregate uncollateralized outward exposure plus
(2) Daily average aggregate potential outward exposure.
(iii) For equity swaps:
(A) $1 billion in daily average aggregate uncollateralized outward
exposure; or
(B) $2 billion in:
(1) Daily average aggregate uncollateralized outward exposure plus
(2) Daily average aggregate potential outward exposure.
(iv) For other commodity swaps:
(A) $1 billion in daily average aggregate uncollateralized outward
exposure; or
(B) $2 billion in:
(1) Daily average aggregate uncollateralized outward exposure plus
(2) Daily average aggregate potential outward exposure.
(2) Aggregate uncollateralized outward exposure. (i) In general.
Aggregate uncollateralized outward exposure in general means the sum of
the current exposure, obtained by marking-to-market using industry
standard practices, of each of the person's swap positions with
negative value in a major swap category, less the value of the
collateral the person has posted in connection with those positions.
(ii) Calculation of aggregate uncollateralized outward exposure. In
calculating this amount the person shall, with respect to each of its
swap counterparties in a given major swap category, determine the
dollar value of the aggregate current exposure arising from each of its
swap positions with negative value (subject to the netting provisions
described below) in that major category by marking-to-market using
industry standard practices; and deduct from that dollar amount the
aggregate value of the collateral the person has posted with respect to
the swap positions. The aggregate uncollateralized outward exposure
shall be the sum of those uncollateralized amounts across all of the
person's swap counterparties in the applicable major category.
(iii) Relevance of netting agreements. (A) If the person has one or
more master netting agreement in effect with a particular counterparty,
the person may measure the current exposure arising from its swaps in
any major category on a net basis, applying the terms of those
agreements. Calculation of net current exposure may take into account
offsetting positions entered into with that particular counterparty
involving swaps (in any swap category) as well as security-based swaps
and securities financing transactions (consisting of securities lending
and borrowing, securities margin lending and repurchase and reverse
repurchase agreements), and other financial instruments that are
subject to netting offsets for purposes of applicable bankruptcy law,
to the extent these are consistent with the offsets permitted by the
master netting agreements.
(B) Such adjustments may not take into account any offset
associated with positions that the person has with separate
counterparties.
(iv) Allocation of uncollateralized outward exposure. If a person
calculates current exposure with a particular counterparty on a net
basis, as provided by paragraph (jjj)(2)(iii) of this section, the
portion of that current exposure that should be attributed to each
``major'' category of swaps for purposes of the substantial position
analysis should be calculated according to the formula:

[[Page 30749]]

[GRAPHIC] [TIFF OMITTED] TR23MY12.000

Where: ES(MC) equals the amount of aggregate current exposure
attributable to the entity's swap positions in the ``major'' swap
category at issue; Enet total equals the entity's aggregate current
exposure to the counterparty at issue, after accounting for the
netting of positions and the posting of collateral; OTMS(MC) equals
the exposure associated with the entity's out-of-the-money positions
in swaps in the ``major'' category at issue, subject to those
netting arrangements; and OTMS(O) equals the exposure associated
with the entity's out-of-the-money positions in the other ``major''
categories of swaps, subject to those netting arrangements; and
OTMnon-S equals the exposure associated with the entity's out-of-
the-money positions associated with instruments, other than swaps,
that are subject to those netting arrangements.

(3) Aggregate potential outward exposure. (i) In general. Aggregate
potential outward exposure in any major swap category means the sum of:
(A) The aggregate potential outward exposure for each of the
person's swap positions in a major swap category that are not subject
to daily mark-to-market margining and are not cleared by a registered
or exempt clearing agency or derivatives clearing organization, as
calculated in accordance with paragraph (jjj)(3)(ii) of this section;
and
(B) The aggregate potential outward exposure for each of the
person's swap positions in such major swap category that are either
subject to daily mark-to-market margining or are cleared by a
registered or exempt clearing agency or derivatives clearing
organization, as calculated in accordance with paragraph (jjj)(3)(iii)
of this section.
(ii) Calculation of potential outward exposure for swaps that are
not subject to daily mark-to-market margining and are not cleared by a
registered or exempt clearing agency or derivatives clearing
organization. (A) In general. (1) For positions in swaps that are not
subject to daily mark-to-market margining and are not cleared by a
registered or exempt clearing agency or a derivatives clearing
organization, potential outward exposure equals the total notional
principal amount of those positions, multiplied by the following
factors on a position-by-position basis reflecting the type of swap.
For any swap that does not appropriately fall within any of the
specified categories, the ``other commodities'' conversion factors set
forth in the following Table 1 are to be used. If a swap is structured
such that on specified dates any outstanding exposure is settled and
the terms are reset so that the market value of the swap is zero, the
remaining maturity equals the time until the next reset date.

Table 1--Conversion Factor Matrix for Swaps
--------------------------------------------------------------------------------------------------------------------------------------------------------
Foreign exchange Precious metals
Residual maturity Interest rate rate and gold (except gold) Other commodities
--------------------------------------------------------------------------------------------------------------------------------------------------------
One year or less.................................................. 0.00 0.01 0.07 0.10
Over one to five years............................................ 0.005 0.05 0.07 0.12
Over five years................................................... 0.015 0.075 0.08 0.15
--------------------------------------------------------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------
Residual maturity Credit Equity
------------------------------------------------------------------------
One year or less...................................... 0.10 0.06
Over one to five years................................ 0.10 0.08
Over five years....................................... 0.10 0.10
------------------------------------------------------------------------

(2) Use of effective notional amounts. If the stated notional
amount on a position is leveraged or enhanced by the structure of the
position, the calculation in paragraph (jjj)(3)(ii)(A)(1) of this
section shall be based on the effective notional amount of the position
rather than on the stated notional amount.
(3) Exclusion of certain positions. The calculation in paragraph
(jjj)(3)(ii)(A)(1) of this section shall exclude:
(i) Positions that constitute the purchase of an option, if the
purchaser has no additional payment obligations under the position;
(ii) Other positions for which the person has prepaid or otherwise
satisfied all of its payment obligations; and
(iii) Positions for which, pursuant to law or a regulatory
requirement, the person has assigned an amount of cash or U.S. Treasury
securities that is sufficient at all times to pay the person's maximum
possible liability under the position, and the person may not use that
cash or those Treasury securities for other purposes.
(4) Adjustment for certain positions. Notwithstanding paragraph
(jjj)(3)(ii)(A)(1) of this section, the potential outward exposure
associated with a position by which a person buys credit protection
using a credit default swap or index credit default swap, or associated
with a position by which a person purchases an option for which the
person retains additional payment obligations under the position, is
capped at the net present value of the unpaid premiums.
(B) Adjustment for netting agreements. Notwithstanding paragraph
(jjj)(3)(ii)(A) of this section, for positions subject to master
netting agreements the potential outward exposure associated with the
person's swaps with each counterparty equals a weighted average of the
potential outward exposure for the person's swaps with that
counterparty as calculated under paragraph (jjj)(3)(ii)(A) of this
section, and that amount reduced by the ratio of net current exposure
to gross current exposure, consistent with the following equation as
calculated on a counterparty-by-counterparty basis:

PNet = 0.4 * PGross + 0.6 * NGR * PGross

Where: PNet is the potential outward exposure, adjusted for
bilateral netting, of the person's swaps with a particular
counterparty; PGross is the potential outward exposure without
adjustment for bilateral netting as calculated pursuant to paragraph
(jjj)(3)(ii)(A) of this section; and NGR is the ratio of the current
exposure arising from its swaps in the major category as calculated
on a net basis according to paragraphs (jjj)(2)(iii) and (iv) of
this section, divided by the current exposure arising from its swaps
in the major category as calculated in the absence of those netting
procedures.

(iii) Calculation of potential outward exposure for swaps that are
either subject to daily mark-to-market margining or are cleared by a
registered or exempt clearing agency or derivatives clearing
organization. For positions in swaps that are subject to daily mark-to-
market margining or that are cleared by a registered or exempt clearing
agency or derivatives clearing organization:
(A) Potential outward exposure equals the potential exposure that
would be attributed to such positions using the procedures in paragraph
(jjj)(3)(ii) of this section multiplied by:
(1) 0.1, in the case of positions cleared by a registered or exempt
clearing agency; or

[[Page 30750]]

(2) 0.2, in the case of positions that are subject to daily mark-
to-market margining but that are not cleared by a registered or exempt
clearing agency.
(B) Solely for purposes of calculating potential outward exposure:
(1) A swap shall be considered to be subject to daily mark-to-
market margining if, and for so long as, the counterparties follow the
daily practice of exchanging collateral to reflect changes in the
current exposure arising from the swap (after taking into account any
other financial positions addressed by a netting agreement between the
counterparties).
(2) If the person is permitted by agreement to maintain a threshold
for which it is not required to post collateral, the position still
will be considered to be subject to daily mark-to-market margining for
purposes of calculating potential outward exposure, but the total
amount of that threshold (regardless of the actual exposure at any
time), less any initial margin posted up to the amount of that
threshold, shall be added to the person's aggregate uncollateralized
outward exposure for purposes of paragraph (jjj)(1)(i)(B), (ii)(B),
(iii)(B) or (iv)(B) of this section, as applicable.
(3) If the minimum transfer amount under the agreement is in excess
of $1 million, the position still will be considered to be subject to
daily mark-to-market margining for purposes of calculating potential
outward exposure, but the entirety of the minimum transfer amount shall
be added to the person's aggregate uncollateralized outward exposure
for purposes of paragraph (jjj)(1)(i)(B), (ii)(B), (iii)(B) or (iv)(B)
of this section, as applicable.
(4) A person may, at its discretion, calculate the potential
outward exposure of positions in swaps that are subject to daily mark-
to-market margining in accordance with paragraph (jjj)(3)(ii) of this
section in lieu of calculating the potential outward exposure of such
swap positions in accordance with this paragraph (jjj)(3)(iii).
(4) Calculation of daily average. Measures of daily average
aggregate uncollateralized outward exposure and daily average aggregate
potential outward exposure shall equal the arithmetic mean of the
applicable measure of exposure at the close of each business day,
beginning the first business day of each calendar quarter and
continuing through the last business day of that quarter.
(5) Inter-affiliate activities. In calculating its aggregate
uncollateralized outward exposure and its aggregate potential outward
exposure, the person shall not consider its swap positions with
counterparties that are majority-owned affiliates. For these purposes
the counterparties to a swap are majority-owned affiliates if one
counterparty directly or indirectly owns a majority interest in the
other, or if a third party directly or indirectly owns a majority
interest in both counterparties to the swap, where ``majority
interest'' is the right to vote or direct the vote of a majority of a
class of voting securities of an entity, the power to sell or direct
the sale of a majority of a class of voting securities of an entity, or
the right to receive upon dissolution or the contribution of a majority
of the capital of a partnership.
(kkk) Hedging or mitigating commercial risk. For purposes of
Section 1a(33) of the Act, 7 U.S.C. 1a(33) and paragraph (hhh) of this
section, a swap position is held for the purpose of hedging or
mitigating commercial risk when:
(1) Such position:
(i) Is economically appropriate to the reduction of risks in the
conduct and management of a commercial enterprise (or of a majority-
owned affiliate of the 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; or
(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
(B) Governmental Accounting Standards Board Statement 53,
Accounting and Financial Reporting for Derivative Instruments; and
(2) Such position is:
(i) Not held for a purpose that is in the nature of speculation,
investing or trading; and
(ii) Not held to hedge or mitigate the risk of another swap or
security-based swap position, unless that other position itself is held
for the purpose of hedging or mitigating commercial risk as defined by
this rule or Sec. 240.3a67-4 of this title.
(lll) Substantial counterparty exposure. (1) In general. For
purposes of Section 1a(33) of the Act, 7 U.S.C. 1a(33), and paragraph
(hhh) of this section, the term substantial counterparty exposure that
could have serious adverse effects on the financial stability of the
United States banking system or financial markets means a swap position
that satisfies either of the following thresholds:
(i) $5 billion in daily average aggregate uncollateralized outward
exposure; or
(ii) $8 billion in:
(A) Daily average aggregate uncollateralized outward exposure plus
(B) Daily average aggregate potential outward exposure.
(2) Calculation methodology. For these purposes, the terms daily
average aggregate uncollateralized outward exposure and daily average
aggregate potential outward exposure shall be calculated the same way
as is prescribed in paragraph (jjj) of this section, except that these
amounts shall be calculated by reference to all of the person's swap
positions, rather than by reference to a specific major swap category.
(mmm) Financial entity; highly leveraged. (1) For purposes of
Section 1a(33) of the Act, 7 U.S.C. 1a(33), and paragraph (hhh) of this
section, the term financial entity means:
(i) A security-based swap dealer;
(ii) A major security-based swap participant;
(iii) A commodity pool as defined in Section 1a(10) of the Act, 7
U.S.C. 1a(10);
(iv) A private fund as defined in Section 202(a) of the Investment

[[Page 30751]]

Advisers Act of 1940, 15 U.S.C. 80b-2(a);
(v) An employee benefit plan as defined in paragraphs (3) and (32)
of Section 3 of the Employee Retirement Income Security Act of 1974, 29
U.S.C. 1002; and
(vi) A person predominantly engaged in activities that are in the
business of banking or financial in nature, as defined in Section 4(k)
of the Bank Holding Company Act of 1956, 12 U.S.C. 1843(k).
(2) For purposes of Section 1a(33) of the Act, 7 U.S.C. 1a(33), and
paragraph (hhh) of this section, the term highly leveraged means the
existence of a ratio of an entity's total liabilities to equity in
excess of 12 to 1 as measured at the close of business on the last
business day of the applicable fiscal quarter. For this purpose,
liabilities and equity should each be determined in accordance with
U.S. generally accepted accounting principles; provided, however, that
a person that is an employee benefit plan, as defined in paragraphs (3)
and (32) of Section 3 of the Employee Retirement Income Security Act of
1974, 29 U.S.C. 1002, may exclude obligations to pay benefits to plan
participants from the calculation of liabilities and substitute the
total value of plan assets for equity.

Securities and Exchange Commission

Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and
particularly, Sections 3 and 23 thereof, and Sections 712 and 761(b) of
the Dodd-Frank Act, the SEC is adopting Rules 3a67-1, 3a67-2, 3a67-3,
3a67-4, 3a67-5, 3a67-6, 3a67-7, 3a71-1, and 3a71-2 under the Exchange
Act.
For the reasons stated in the preamble, the SEC is amending Title
17, Chapter II, of the Code of the Federal Regulations, as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934

0
3. The authority citation for part 240 is amended by adding the
following citation in numerical order:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77jjj, 77kkk, 78c, 78d, 78e, 78f, 78g, 78i,
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4, 78p, 78q,
78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37,
80b-3, 80b-4, 80b-11, and 7201 et seq., 18 U.S.C. 1350; 12 U.S.C.
5221(e)(3), and Pub. L. 111-203, Sec. 939A, 124 Stat. 1376 (2010),
unless otherwise noted.
* * * * *
Sections 3a67-1 through 3a67-9 and 3a71-1 and 3a71-2 are also
issued under Pub. L. 111-203, Sec. Sec. 712, 761(b), 124 Stat. 1841
(2010).
* * * * *
0
4. Add an undesignated center heading and Sec. Sec. 240.3a67-1 through
240.3a67-9 and Sec. Sec. 240.3a71-1 and 240.3a71-2 to read as follows:

Security-Based Swap Dealer and Participant Definitions

Sec.
240.3a67-1 Definition of ``major security-based swap participant.''
240.3a67-2 Categories of security-based swaps.
240.3a67-3 Definition of ``substantial position.''
240.3a67-4 Definition of ``hedging or mitigating commercial risk.''
240.3a67-5 Definition of ``substantial counterparty exposure.''
240.3a67-6 Definition of ``financial entity.''
240.3a67-7 Definition of ``highly leveraged.''
240.3a67-8 Timing requirements, reevaluation period and termination
of status.
240.3a67-9 Calculation of major participant status by certain
persons.
240.3a71-1 Definition of ``security-based swap dealer.''
240.3a71-2 De minimis exception.
240.3a71-2A Report regarding the ``security-based swap dealer'' and
``major security-based swap participant'' definitions (Appendix A to
17 CFR 240.3a71-2).
* * * * *

Sec. 240.3a67-1 Definition of ``major security-based swap
participant.''

(a) General. Major security-based swap participant means any
person:
(1) That is not a security-based swap dealer; and
(2)(i) That maintains a substantial position in security-based
swaps for any of the major security-based swap categories, excluding
both positions held for hedging or mitigating commercial risk, and
positions maintained by any employee benefit plan (or any contract held
by such a plan) as defined in paragraphs (3) and (32) of section 3 of
the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002)
for the primary purpose of hedging or mitigating any risk directly
associated with the operation of the plan;
(ii) Whose outstanding security-based swaps create substantial
counterparty exposure that could have serious adverse effects on the
financial stability of the United States banking system or financial
markets; or
(iii) That is a financial entity that:
(A) Is highly leveraged relative to the amount of capital such
entity holds and that is not subject to capital requirements
established by an appropriate Federal banking agency (as defined in 15
U.S.C. 78c(a)(72)); and
(B) Maintains a substantial position in outstanding security-based
swaps in any major security-based swap category.
(b) Scope of designation. A person that is a major security-based
swap participant in general shall be deemed to be a major security-
based swap participant with respect to each security-based swap it
enters into, regardless of the category of the security-based swap or
the person's activities in connection with the security-based swap,
unless the Commission limits the person's designation as a major
security-based swap participant to specified categories of security-
based swaps.

Sec. 240.3a67-2 Categories of security-based swaps.

For purposes of section 3(a)(67) of the Act, 15 U.S.C. 78c(a)(67),
and the rules thereunder, the terms major security-based swap category,
category of security-based swaps and any similar terms mean either of
the following categories of security-based swaps:
(a) Debt security-based swaps. Any security-based swap that is
based, in whole or in part, on one or more instruments of indebtedness
(including loans), or on a credit event relating to one or more issuers
or securities, including but not limited to any security-based swap
that is a credit default swap, total return swap on one or more debt
instruments, debt swap, debt index swap, or credit spread.
(b) Other security-based swaps. Any security-based swap not
described in paragraph (a) of this section.

Sec. 240.3a67-3 Definition of ``substantial position.''

(a) General. For purposes of section 3(a)(67) of the Act, 15 U.S.C.
78c(a)(67), and Sec. 240.3a67-1, the term substantial position means
security-based swap positions that equal or exceed either of the
following thresholds in any major category of security-based swaps:
(1) $1 billion in daily average aggregate uncollateralized outward
exposure; or
(2) $2 billion in:
(i) Daily average aggregate uncollateralized outward exposure; plus
(ii) Daily average aggregate potential outward exposure.
(b) Aggregate uncollateralized outward exposure. (1) General.
Aggregate uncollateralized outward exposure in general means the sum of
the current exposure, obtained by marking-to-market using industry
standard practices, of each of the person's security-based swap
positions

[[Page 30752]]

with negative value in a major security-based swap category, less the
value of the collateral the person has posted in connection with those
positions.
(2) Calculation of aggregate uncollateralized outward exposure. In
calculating this amount the person shall, with respect to each of its
security-based swap counterparties in a given major security-based swap
category:
(i) Determine the dollar value of the aggregate current exposure
arising from each of its security-based swap positions with negative
value (subject to the netting provisions described below) in that major
category by marking-to-market using industry standard practices; and
(ii) Deduct from that dollar amount the aggregate value of the
collateral the person has posted with respect to the security-based
swap positions.
(iii) The aggregate uncollateralized outward exposure shall be the
sum of those uncollateralized amounts across all of the person's
security-based swap counterparties in the applicable major category.
(3) Relevance of netting agreements. (i) If a person has one or
more master netting agreements with a counterparty, the person may
measure the current exposure arising from its security-based swaps in
any major category on a net basis, applying the terms of those
agreements. Calculation of current exposure may take into account
offsetting positions entered into with that particular counterparty
involving security-based swaps (in any security-based swap category) as
well as swaps and securities financing transactions (consisting of
securities lending and borrowing, securities margin lending and
repurchase and reverse repurchase agreements), and other financial
instruments that are subject to netting offsets for purposes of
applicable bankruptcy law, to the extent these are consistent with the
offsets permitted by the master netting agreements.
(ii) Such adjustments may not take into account any offset
associated with positions that the person has with separate
counterparties.
(4) Allocation of uncollateralized outward exposure. If a person
calculates current exposure with a particular counterparty on a net
basis, as provided by paragraph (b)(3) of this section, the amount of
current uncollateralized exposure attributable to each ``major''
category of security-based swaps should be calculated according to the
following formula:
[GRAPHIC] [TIFF OMITTED] TR23MY12.001

Note to paragraph (b)(4). Where: ESBS(MC) equals the
amount of aggregate current exposure attributable to the entity's
security-based swap positions in the ``major'' category at issue
(either security-based credit derivatives or other security-based
swaps); Enet total equals the entity's aggregate current
exposure to the counterparty at issue, after accounting for the
netting of positions and the posting of collateral;
OTMSBS(MC) equals the current exposure associated with
the entity's out-of-the-money positions in security-based swaps in
the ``major'' category at issue, subject to those netting
arrangements; and OTMSBS(O) equals the current exposure
associated with the entity's out-of-the-money positions in the other
``major'' category of security-based swaps, subject to those netting
arrangements; and OTMnon-SBS equals the current exposure
associated with the entity's out-of-the-money positions associated
with instruments, other than security-based swaps, that are subject
to those netting arrangements.

(c) Aggregate potential outward exposure. (1) General. Aggregate
potential outward exposure means the sum of:
(i) The aggregate potential outward exposure for each of the
person's security-based swap positions in a major security-based swap
category that are neither cleared by a registered or exempt clearing
agency nor subject to daily mark-to-market margining, as calculated in
accordance with paragraph (c)(2) of this section; and
(ii) The aggregate potential outward exposure for each of the
person's security-based swap positions in a major security-based swap
category that are either cleared by a registered or exempt clearing
agency or subject to daily mark-to-market margining, as calculated in
accordance with paragraph (c)(3) of this section.
(2) Calculation of potential outward exposure for security-based
swaps that are not cleared by a registered or exempt clearing agency or
subject to daily mark-to-market margining. (i) General. (A)(1) For
positions in security-based swaps that are not cleared by a registered
or exempt clearing agency or subject to daily mark-to-market margining,
potential outward exposure equals the total notional principal amount
of those positions, multiplied by the following factors on a position-
by-position basis reflecting the type of security-based swap. For any
security-based swap that is not of the ``debt'' type, the ``equity and
other'' conversion factors are to be used:

------------------------------------------------------------------------
Equity
Residual maturity Debt and
other
------------------------------------------------------------------------
One year or less...................................... 0.10 0.06
Over one to five years................................ 0.10 0.08
Over five years....................................... 0.10 0.10
------------------------------------------------------------------------

(2) If a security-based swap is structured such that on specified
dates any outstanding exposure is settled and the terms are reset so
that the market value of the security-based swap is zero, the remaining
maturity equals the time until the next reset date.
(B) Use of effective notional amounts. If the stated notional
amount on a position is leveraged or enhanced by the structure of the
position, the calculation in paragraph (c)(2)(i)(A) of this section
shall be based on the effective notional amount of the position rather
than on the stated notional amount.
(C) Exclusion of certain positions. The calculation in paragraph
(c)(2)(i)(A) of this section shall exclude:
(1) Positions that constitute the purchase of an option, such that
the person has no additional payment obligations under the position;
(2) Other positions for which the person has prepaid or otherwise
satisfied all of its payment obligations; and
(3) Positions for which, pursuant to regulatory requirement, the
person has assigned an amount of cash or U.S. Treasury securities that
is sufficient to pay the person's maximum possible liability under the
position, and the person may not use that cash or those Treasury
securities for other purposes.
(D) Adjustment for certain positions. Notwithstanding paragraph
(c)(2)(i)(A) of this section, the potential outward exposure associated
with a position by which a person buys credit protection using a credit
default swap, or associated with a position by which a person purchases
an option for which the person retains additional payment obligations
under the position, is capped at the net present value of the unpaid
premiums.
(ii) Adjustment for netting agreements. Notwithstanding paragraph
(c)(2)(i) of this section, for positions subject to master netting
agreements the

[[Page 30753]]

potential outward exposure associated with the person's security-based
swaps with each counterparty equals a weighted average of the potential
outward exposure for the person's security-based swaps with that
counterparty as calculated under paragraph (c)(2)(i) of this section,
and that amount reduced by the ratio of net current exposure to gross
current exposure, consistent with the following equation as calculated
on a counterparty-by-counterparty basis:

PNet = 0.4 x PGross + 0.6 x NGR x PGross

Note to paragraph (c)(2)(ii): Where: PNet is the potential
outward exposure, adjusted for bilateral netting, of the person's
security-based swaps with a particular counterparty; PGross is the
potential outward exposure without adjustment for bilateral netting,
as calculated pursuant to paragraph (c)(2)(i) of this section; and
NGR is the ratio of:
1. The current exposure arising from its security-based swaps in
the major category as calculated on a net basis according to
paragraphs (b)(3) and (4) of this section, divided by
2. The current exposure arising from its security-based swaps in
the major category as calculated in the absence of those netting
procedures.

(3) Calculation of potential outward exposure for security-based
swaps that are either cleared by a registered or exempt clearing agency
or subject to daily mark-to-market margining. For positions in
security-based swaps that are cleared by a registered or exempt
clearing agency or subject to daily mark-to-market margining:
(i) Potential outward exposure equals the potential outward
exposure that would be attributed to such positions using the
procedures in paragraph (c)(2) of this section, multiplied by:
(A) 0.1, in the case of positions cleared by a registered or exempt
clearing agency; or
(B) 0.2, in the case of positions that are subject to daily mark-
to-market margining but that are not cleared by a registered or exempt
clearing agency.
(ii) Solely for purposes of calculating potential outward exposure:
(A) A security-based swap shall be considered to be subject to
daily mark-to-market margining if, and for as long as, the
counterparties follow the daily practice of exchanging collateral to
reflect changes in the current exposure arising from the security-based
swap (after taking into account any other financial positions addressed
by a netting agreement between the counterparties).
(B) If the person is permitted by agreement to maintain a threshold
for which it is not required to post collateral, the position still
will be considered to be subject to daily mark-to-market margining for
purposes of calculating potential outward exposure, but the total
amount of that threshold (regardless of the actual exposure at any
time) less any initial margin posted up to the amount of that
threshold, shall be added to the person's aggregate uncollateralized
outward exposure for purposes of paragraph (a)(2) of this section.
(C) If the minimum transfer amount under the agreement is in excess
of $1 million, the position still will be considered to be subject to
daily mark-to-market margining for purposes of calculating potential
outward exposure, but the entirety of the minimum transfer amount shall
be added to the person's aggregate uncollateralized outward exposure
for purposes of paragraph (a)(2) of this section.
(D) A person may, at its discretion, calculate the potential
outward exposure of positions in security-based swaps that are subject
to daily mark-to-market margining in accordance with paragraph (c)(2)
of this section in lieu of calculating the potential outward exposure
of such positions in accordance with this paragraph (c)(3).
(d) Calculation of daily average. Measures of daily average
aggregate uncollateralized outward exposure and daily average aggregate
potential outward exposure shall equal the arithmetic mean of the
applicable measure of exposure at the close of each business day,
beginning the first business day of each calendar quarter and
continuing through the last business day of that quarter.
(e) Inter-affiliate activities. In calculating its aggregate
uncollateralized outward exposure and its aggregate potential outward
exposure, a person shall not consider its security-based swap positions
with counterparties that are majority-owned affiliates. For these
purposes the parties are majority-owned affiliates if one party
directly or indirectly owns a majority interest in the other, or if a
third party directly or indirectly owns a majority interest in both
counterparties to the security-based swap, where ``majority interest''
is the right to vote or direct the vote of a majority of a class of
voting securities of an entity, the power to sell or direct the sale of
a majority of a class of voting securities of an entity, or the right
to receive upon dissolution or the contribution of a majority of the
capital of a partnership.

Sec. 240.3a67-4 Definition of ``hedging or mitigating commercial
risk.''

For purposes of section 3(a)(67) of the Act, 15 U.S.C. 78c(a)(67),
and Sec. 240.3a67-1, a security-based swap position shall be deemed to
be held for the purpose of hedging or mitigating commercial risk when:
(a)(1) Such position is economically appropriate to the reduction
of risks that are associated with the present conduct and management of
a commercial enterprise (or of a majority owned affiliate of the
enterprise), or are reasonably expected to arise in the future conduct
and management of the commercial enterprise, where such risks arise
from:
(i) 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 (or
of an affiliate under common control with the enterprise);
(ii) 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 (or of an affiliate under common control
with the enterprise); or
(iii) 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 (or of an
affiliate under common control with the enterprise);
(2) Depending on the applicable facts and circumstances, the
security-based swap positions described in paragraph (a)(1) of this
section may be expected to encompass, among other positions:
(i) Positions established to manage the risk posed by a customer's,
supplier's or counterparty's potential default in connection with:
Financing provided to a customer in connection with the sale of real
property or a good, product or service; a customer's lease of real
property or a good, product or service; a customer's agreement to
purchase real property or a good, product or service in the future; or
a supplier's commitment to provide or sell a good, product or service
in the future;
(ii) Positions established to manage the default risk posed by a
financial counterparty (different from the counterparty to the hedging
position at issue) in connection with a separate transaction (including
a position involving a credit derivative, equity swap, other security-
based swap, interest rate swap, commodity swap, foreign exchange swap
or other swap, option, or future that itself is for the purpose of
hedging or mitigating commercial risk pursuant to this section or 17
CFR 1.3(kkk));

[[Page 30754]]

(iii) Positions established to manage equity or market risk
associated with certain employee compensation plans, including the risk
associated with market price variations in connection with stock-based
compensation plans, such as deferred compensation plans and stock
appreciation rights;
(iv) Positions established to manage equity market price risks
connected with certain business combinations, such as a corporate
merger or consolidation or similar plan or acquisition in which
securities of a person are exchanged for securities of any other person
(unless the sole purpose of the transaction is to change an issuer's
domicile solely within the United States), or a transfer of assets of a
person to another person in consideration of the issuance of securities
of such other person or any of its affiliates;
(v) Positions established by a bank to manage counterparty risks in
connection with loans the bank has made; and
(vi) Positions to close out or reduce any of the positions
described in paragraphs (a)(2)(i) through (a)(2)(v) of this section;
and
(b) Such position is:
(1) Not held for a purpose that is in the nature of speculation or
trading; and
(2) Not held to hedge or mitigate the risk of another security-
based swap position or swap position, unless that other position itself
is held for the purpose of hedging or mitigating commercial risk as
defined by this section or 17 CFR 1.3(kkk).

Sec. 240.3a67-5 Definition of ``substantial counterparty exposure.''

(a) General. For purposes of section 3(a)(67) of the Act, 15 U.S.C.
78c(a)(67), and Sec. 240.3a67-1, the term substantial counterparty
exposure that could have serious adverse effects on the financial
stability of the United States banking system or financial markets
means a security-based swap position that satisfies either of the
following thresholds:
(1) $2 billion in daily average aggregate uncollateralized outward
exposure; or
(2) $4 billion in:
(i) Daily average aggregate uncollateralized outward exposure; plus
(ii) Daily average aggregate potential outward exposure.
(b) Calculation. For these purposes, daily average aggregate
uncollateralized outward exposure and daily average aggregate potential
outward exposure shall be calculated the same way as is prescribed in
Sec. 240.3a67-3, except that these amounts shall be calculated by
reference to all of the person's security-based swap positions, rather
than by reference to a specific major security-based swap category.

Sec. 240.3a67-6 Definition of ``financial entity.''

(a) General. For purposes of section 3(a)(67) of the Act, 15 U.S.C.
78c(a)(67), and Sec. 240.3a67-1, the term financial entity means:
(1) A swap dealer;
(2) A major swap participant;
(3) A commodity pool as defined in section 1a(10) of the Commodity
Exchange Act (7 U.S.C. 1a(10));
(4) A private fund as defined in section 202(a) of the Investment
Advisers Act of 1940 (15 U.S.C. 80b-2(a));
(5) An employee benefit plan as defined in paragraphs (3) and (32)
of section 3 of the Employee Retirement Income Security Act of 1974 (29
U.S.C. 1002); and
(6) A person predominantly engaged in activities that are in the
business of banking or financial in nature, as defined in section 4(k)
of the Bank Holding Company Act of 1956 (12 U.S.C. 1843k).
(b) Exclusion for centralized hedging facilities. (1) General.
Notwithstanding paragraph (a) of this section, for purposes of this
section the term financial entity shall not encompass a person that
would be a financial entity solely as a result of the person's
activities that facilitate hedging and/or treasury functions on behalf
of one or more majority-owned affiliates that themselves do not
constitute a financial entity.
(2) Meaning of majority-owned. For these purposes the
counterparties to a security-based swap are majority-owned affiliates
if one counterparty directly or indirectly owns a majority interest in
the other, or if a third party directly or indirectly owns a majority
interest in both counterparties to the security-based swap, where
``majority interest'' includes, but is not limited to, the right to
vote or direct the vote of a majority of a class of voting securities
of an entity, the power to sell or direct the sale of a majority of a
class of voting securities of an entity, or the right to receive upon
dissolution or the contribution of a majority of the capital of a
partnership.

Sec. 240.3a67-7 Definition of ``highly leveraged.''

(a) General. For purposes of section 3(a)(67) of the Act, 15 U.S.C.
78c(a)(67), and Sec. 240.3a67-1, the term highly leveraged means the
existence of a ratio of an entity's total liabilities to equity in
excess of 12 to 1 as measured at the close of business on the last
business day of the applicable fiscal quarter.
(b) Measurement of liabilities and equity. For purposes of this
section, liabilities and equity generally should each be determined in
accordance with U.S. generally accepted accounting principles;
provided, however, that a person that is an employee benefit plan, as
defined in paragraphs (3) and (32) of section 3 of the Employee
Retirement Income Security Act of 1974 (29 U.S.C. 1002), may, for
purposes of this paragraph (b):
(1) Exclude obligations to pay benefits to plan participants from
the calculation of liabilities; and
(2) Substitute the total value of plan assets for equity.

Sec. 240.3a67-8 Timing requirements, reevaluation period, and
termination of status.

(a) Timing requirements. A person that is not registered as a major
security-based swap participant, but that meets the criteria in Sec.
240.3a67-1 to be a major security-based swap participant as a result of
its security-based swap activities in a fiscal quarter, will not be
deemed to be a major security-based swap participant until the earlier
of the date on which it submits a complete application for registration
pursuant to section 15F of the Act (15 U.S.C. 78o-10) or two months
after the end of that quarter.
(b) Reevaluation period. Notwithstanding paragraph (a) of this
section, if a person that is not registered as a major security-based
swap participant meets the criteria in Sec. 240.3a67-1 to be a major
security-based swap participant in a fiscal quarter, but does not
exceed any applicable threshold by more than twenty percent in that
quarter:
(1) That person will not immediately be deemed a major security-
based swap participant pursuant to the timing requirements specified in
paragraph (a) of this section; but
(2) That person will be deemed a major security-based swap
participant pursuant to the timing requirements specified in paragraph
(a) of this section at the end of the next fiscal quarter if the person
exceeds any of the applicable daily average thresholds in that next
fiscal quarter.
(c) Termination of status. A person that is deemed to be a major
security-based swap participant shall continue to be deemed a major
security-based swap participant until such time that its security-based
swap activities do not exceed any of the daily average thresholds set
forth within Sec. 240.3a67-

[[Page 30755]]

1 for four consecutive fiscal quarters after the date on which the
person becomes registered as a major security-based swap participant.

Sec. 240.3a67-9 Calculation of major participant status by certain
persons.

A person shall not be deemed to be a major security-based swap
participant, regardless of whether the criteria in Sec. 240.3a67-1
otherwise would cause the person to be a major security-based swap
participant, provided the person meets the conditions set forth in
paragraph (a) of this section.
(a) Conditions. (1) Caps on uncollateralized exposure and notional
positions. (i) Maximum potential uncollateralized exposure. The express
terms of the person's agreements or arrangements relating to security-
based swaps with its counterparties at no time would permit the person
to maintain a total uncollateralized exposure of more than $100 million
to all such counterparties, including any exposure that may result from
thresholds or minimum transfer amounts established by credit support
annexes or similar arrangements; and
(ii) Maximum notional amount of security-based swap positions. The
person does not maintain security-based swap positions in an effective
notional amount of more than $2 billion in any major category of
security-based swaps, or more than $4 billion in aggregate; or
(2) Caps on uncollateralized exposure plus monthly calculation. (i)
Maximum potential uncollateralized exposure. The express terms of the
person's agreements or arrangements relating to security-based swaps
with its counterparties at no time would permit the person to maintain
a total uncollateralized exposure of more than $200 million to all such
counterparties (with regard to security-based swaps and any other
instruments by which the person may have exposure to those
counterparties), including any exposure that may result from thresholds
or minimum transfer amounts established by credit support annexes or
similar arrangements; and
(ii) Calculation of positions. (A) At the end of each month, the
person performs the calculations prescribed by Sec. Sec. 240.3a67-3
and 240.3a67-5 with regard to whether the aggregate uncollateralized
outward exposure plus aggregate potential outward exposure as of that
day constitute a substantial position in a major category of security-
based swaps, or pose substantial counterparty exposure that could have
serious adverse effects on the financial stability of the United States
banking system or financial markets; these calculations shall disregard
provisions of those rules that provide for the analyses to be
determined based on a daily average over a calendar quarter; and
(B) Each such analysis produces thresholds of no more than:
(1) $1 billion in aggregate uncollateralized outward exposure plus
aggregate potential outward exposure in any major category of security-
based swaps; if the person is subject to Sec. 240.3a67-3(a)(2)(iii),
by virtue of being a highly leveraged financial entity that is not
subject to capital requirements established by an appropriate Federal
banking agency, this analysis shall account for all of the person's
security-based swap positions in that major category (without excluding
hedging positions), otherwise this analysis shall exclude the same
hedging and related positions that are excluded from consideration
pursuant to Sec. 240.3a67-3(a)(2)(i); or
(2) $2 billion in aggregate uncollateralized outward exposure plus
aggregate potential outward exposure (without any positions excluded
from the analysis) with regard to all of the person's security-based
swap positions.
(3) Calculations based on certain information. (i) At the end of
each month:
(A)(1) The person's aggregate uncollateralized outward exposure
with respect to its security-based swap positions is less than $500
million with respect to each of the major security-based swap
categories; and
(2) The sum of the amount calculated under paragraph
(a)(3)(i)(A)(1) of this section with respect to each major security-
based swap category and the total notional principal amount of the
person's security-based swap positions in each such major security-
based swap category, adjusted by the multipliers set forth in Sec.
240.3a67-3(c)(2)(i)(A) on a position-by-position basis reflecting the
type of security-based swap, is less than $1 billion with respect to
each of the major security-based swap categories; or
(B)(1) The person's aggregate uncollateralized outward exposure
with respect to its security-based swap positions across all major
security-based swap categories is less than $500 million; and
(2) The sum of the amount calculated under paragraph
(a)(3)(i)(B)(1) of this section and the product of the total effective
notional principal amount of the person's security-based swap positions
in all major security-based swap categories multiplied by 0.10 is less
than $1 billion.
(ii) For purposes of the calculations set forth in paragraph
(a)(3)(i) of this section:
(A) The person's aggregate uncollateralized outward exposure for
positions held with security-based swap dealers shall be equal to such
exposure reported on the most recent reports of such exposure received
from such security-based swap dealers; and
(B) The person's aggregate uncollateralized outward exposure for
positions that are not reflected in any report of exposure from a
security-based swap dealer (including all security-based swap positions
it holds with persons other than security-based swap dealers) shall be
calculated in accordance with Sec. 240.3a67-3(b)(2).
(b) For purposes of the calculations set forth by this section, the
person shall use the effective notional amount of a position rather
than the stated notional amount of the position if the stated notional
amount is leveraged or enhanced by the structure of the position.
(c) No presumption shall arise that a person is required to perform
the calculations needed to determine if it is a major security-based
swap participant, solely by reason that the person does not meet the
conditions specified in paragraph (a) of this section.

Sec. 240.3a71-1 Definition of ``security-based swap dealer.''

(a) General. The term security-based swap dealer in general means
any person who:
(1) Holds itself out as a dealer in security-based swaps;
(2) Makes a market in security-based swaps;
(3) Regularly enters into security-based swaps with counterparties
as an ordinary course of business for its own account; or
(4) Engages in any activity causing it to be commonly known in the
trade as a dealer or market maker in security-based swaps.
(b) Exception. The term security-based swap dealer does not include
a person that enters into security-based swaps for such person's own
account, either individually or in a fiduciary capacity, but not as a
part of regular business.
(c) Scope of designation. A person that is a security-based swap
dealer in general shall be deemed to be a security-based swap dealer
with respect to each security-based swap it enters into, regardless of
the type, class, or category of the security-based swap or the person's
activities in connection with the security-based swap, unless the
Commission limits the person's

[[Page 30756]]

designation as a security-based swap dealer to specified types,
classes, or categories of security-based swaps or specified activities
of the person in connection with security-based swaps.
(d) Inter-affiliate activities. (1) General. In determining whether
a person is a security-based swap dealer, that person's security-based
swaps with majority-owned affiliates shall not be considered.
(2) Meaning of majority-owned. For these purposes the
counterparties to a security-based swap are majority-owned affiliates
if one counterparty directly or indirectly owns a majority interest in
the other, or if a third party directly or indirectly owns a majority
interest in both counterparties to the security-based swap, where
``majority interest'' is the right to vote or direct the vote of a
majority of a class of voting securities of an entity, the power to
sell or direct the sale of a majority of a class of voting securities
of an entity, or the right to receive upon dissolution or the
contribution of a majority of the capital of a partnership.

Sec. 240.3a71-2 De minimis exception.

(a) Requirements. For purposes of section 3(a)(71) of the Act (15
U.S.C. 78c(a)(71)) and Sec. 240.3a71-1, a person that is not currently
registered as a security-based swap dealer shall be deemed not to be a
security-based swap dealer, and, therefore, shall not be subject to
section 15F of the Act (15 U.S.C. 78o-10) and the rules, regulations
and interpretations issued thereunder, as a result of security-based
swap dealing activity that meets the following conditions:
(1) Notional thresholds. The security-based swap positions
connected with the dealing activity in which the person--or any other
entity controlling, controlled by or under common control with the
person--engages over the course of the immediately preceding 12 months
(or following the effective date of final rules implementing section
3(a)(68) of the Act (15 U.S.C. 78c(a)(68)) if that period is less than
12 months) have:
(i) An aggregate gross notional amount of no more than $3 billion,
subject to a phase-in level of an aggregate gross notional amount of no
more than $8 billion applied in accordance with paragraph (a)(2)(i) of
this section, with regard to credit default swaps that constitute
security-based swaps;
(ii) An aggregate gross notional amount of no more than $150
million, subject to a phase-in level of an aggregate gross notional
amount of no more than $400 million applied in accordance with
paragraph (a)(2)(i) of this section, with regard to security-based
swaps not described in paragraph (a)(1)(i) of this section; and
(iii) An aggregate gross notional amount of no more than $25
million with regard to all security-based swaps in which the
counterparty is a special entity (as that term is defined in section
15F(h)(2)(C) of the Act (15 U.S.C. 78o-10(h)(2)(C)).
(2) Phase-in procedure. (i) Phase-in period. For purposes of
paragraphs (a)(1)(i) and (ii) of this section, a person that engages in
security-based swap dealing activity that does not exceed either of the
phase-in levels set forth in paragraphs (a)(1)(i) and (ii) of this
section, as applicable, shall be deemed not to be a security-based swap
dealer, and, therefore, shall not be subject to Section 15F of the Act
(15 U.S.C. 78o-10) and the rules, regulations and interpretations
issued thereunder, as a result of its security-based swap dealing
activity, until the ``phase-in termination date'' established as
provided in paragraph (a)(2)(ii) of this section; provided, however,
that this phase-in period shall not be available to the extent that a
person engages in security-based swap dealing activity with
counterparties that are natural persons, other than natural persons who
qualify as eligible contract participants by virtue of section
1a(18)(A)(xi)(II) of the Commodity Exchange Act, (7 U.S.C.
1a(18)(A)(xi)(II)). The Commission shall announce the phase-in
termination date on the Commission Web site and publish such date in
the Federal Register.
(ii) Establishment of phase-in termination date. (A) Nine months
after the publication of the staff report described in Appendix A of
this section, and after giving due consideration to that report and any
associated public comment, the Commission may either:
(1) Terminate the phase-in period set forth in paragraph (a)(2)(i)
of this section, in which case the phase-in termination date shall be
established by the Commission by order published in the Federal
Register; or
(2) Determine that it is necessary or appropriate in the public
interest to propose through rulemaking an alternative to the $3 billion
and $150 million amounts set forth in paragraphs (a)(1)(i) and (ii) of
this section, as applicable, that would constitute a de minimis
quantity of security-based swap dealing in connection with transactions
with or on behalf of customers within the meaning of section
3(a)(71)(D) of the Act, (15 U.S.C. 78c(a)(71)(D)), in which case the
Commission shall by order published in the Federal Register provide
notice of such determination to propose through rulemaking an
alternative, which order shall also establish the phase-in termination
date.
(B) If the phase-in termination date has not been previously
established pursuant to paragraph (a)(2)(ii)(A) of this section, then
in any event the phase-in termination date shall occur five years after
the data collection initiation date defined in paragraph (a)(2)(iii) of
this section.
(iii) Data collection initiation date. The term ``data collection
initiation date'' shall mean the date that is the later of: the last
compliance date for the registration and regulatory requirements for
security-based swap dealers and major security-based swap participants
under Section 15F of the Act (15 U.S.C. 78o-10); or the first date on
which compliance with the trade-by-trade reporting rules for credit-
related and equity-related security-based swaps to a registered
security-based swap data repository is required. The Commission shall
announce the data collection initiation date on the Commission Web site
and publish such date in the Federal Register.
(3) Use of effective notional amounts. For purposes of paragraph
(a)(1) of this section, if the stated notional amount of a security-
based swap is leveraged or enhanced by the structure of the security-
based swap, the calculation shall be based on the effective notional
amount of the security-based swap rather than on the stated notional
amount.
(b) Registration period for persons that no longer can take
advantage of the exception. A person that has not registered as a
security-based swap dealer by virtue of satisfying the requirements of
paragraph (a) of this section, but that no longer can take advantage of
the de minimis exception provided for in paragraph (a) of this section,
will be deemed not to be a security-based swap dealer under section
3(a)(71) of the Act (15 U.S.C. 78c(a)(71)) and subject to the
requirements of section 15F of the Act (15 U.S.C. 78o-10) and the
rules, regulations and interpretations issued thereunder until the
earlier of the date on which it submits a complete application for
registration pursuant to section 15F(b) (15 U.S.C. 78o-10(b)) or two
months after the end of the month in which that person becomes no
longer able to take advantage of the exception.
(c) Applicability to registered security-based swap dealers. A
person who currently is registered as a security-based swap dealer may
apply to withdraw that registration, while continuing to engage in
security-based swap dealing activity in reliance on this

[[Page 30757]]

section, so long as that person has been registered as a security-based
swap dealer for at least 12 months and satisfies the conditions of
paragraph (a) of this section.
(d) Future adjustments to scope of the de minimis exception. The
Commission may by rule or regulation change the requirements of the de
minimis exception described in paragraphs (a) through (c) of this
section.
(e) Voluntary registration. Notwithstanding paragraph (a) of this
section, a person that chooses to register with the Commission as a
security-based swap dealer shall be deemed to be a security-based swap
dealer, and, therefore, shall be subject to Section 15F of the Act (15
U.S.C 78o-10) and the rules, regulations and interpretations issued
thereunder.

Sec. 240.3a71-2A Report regarding the ``security-based swap dealer''
and ``major security-based swap participant'' definitions (Appendix A
to 17 CFR 240.3a71-2).

Appendix A to Sec. 240.3a71-2 sets forth guidelines applicable to
a report that the Commission has directed its staff to make in
connection with the rules and interpretations further defining the
Act's definitions of the terms ``security-based swap dealer''
(including the de minimis exception to that definition) and ``major
security-based swap participant.'' The Commission intends to consider
this report in reviewing the effect and application of these rules
based on the evolution of the security-based swap market following the
implementation of the registration and regulatory requirements of
Section 15F of the Act (15 U.S.C. 78o-10). The report may also be
informative as to potential changes to the rules further defining those
terms. In producing this report, the staff shall consider security-
based swap data collected by the Commission pursuant to other Title VII
rules, as well as any other applicable information as the staff may
determine to be appropriate for its analysis.
(a) Report topics. As appropriate, based on the availability of
data and information, the report should address the following topics:
(1) De minimis exception. In connection with the de minimis
exception to the definition of ``security-based swap dealer,'' the
report generally should assess whether any of the de minimis thresholds
set forth in paragraph (a)(1) of Sec. 240.3a71-2 should be increased
or decreased;
(2) General security-based swap dealer analysis. In connection with
the definition of ``security-based swap dealer,'' the report generally
should consider the factors that are useful for identifying security-
based swap dealing activity, including the application of the dealer-
trader distinction for that purpose, and the potential use of more
objective tests or safe harbors as part of the analysis;
(3) General major security-based swap participant analysis. In
connection with the definition of ``major security-based swap
participant,'' the report generally should consider the tests used to
identify the presence of a ``substantial position'' in a major category
of security-based swaps, and the tests used to identify persons whose
security-based swap positions create ``substantial counterparty
exposure,'' including the potential use of alternative tests or
thresholds;
(4) Commercial risk hedging exclusion. In connection with the
definition of ``major security-based swap participant,'' the report
generally should consider the definition of ``hedging or mitigating
commercial risk,'' including whether that latter definition
inappropriately permits certain positions to be excluded from the
``substantial position'' analysis, and whether the continued
availability of the exclusion for such hedging positions should be
conditioned on a person assessing and documenting the hedging
effectiveness of those positions;
(5) Highly leveraged financial entities. In connection with the
definition of ``major security-based swap participant,'' the report
generally should consider the definition of ``highly leveraged,''
including whether alternative approaches should be used to identify
highly leveraged financial entities;
(6) Inter-affiliate exclusions. In connection with the definitions
of ``security-based swap dealer'' and ``major security-based swap
participant,'' the report generally should consider the impact of rule
provisions excluding inter-affiliate transactions from the relevant
analyses, and should assess potential alternative approaches for such
exclusions; and
(7) Other topics. Any other analysis of security-based swap data
and information the Commission or the staff deem relevant to this rule.
(b) Timing of report. The report shall be completed no later than
three years following the data collection initiation date, established
pursuant to Sec. 240.3a71-2(a)(2)(iii).
(c) Public comment on the report. Following completion of the
report, the report shall be published in the Federal Register for
public comment.

Dated: April 27, 2012.

By the Commodity Futures Trading Commission.
David A. Stawick,
Secretary.
Dated: April 27, 2012.

By the Securities and Exchange Commission.
Elizabeth M. Murphy,
Secretary.

Note: The following appendices will not appear in the Code of
Federal Regulations:

Appendices by the Commodity Futures Trading Commission to Joint Final
Rule Entitled ``Further Definition of `Swap Dealer,' `Security-Based
Swap Dealer,' `Major Swap Participant,' `Major Security-Based Swap
Participant' and `Eligible Contract Participant.' ''--Commission Voting
Summary and Statements of Commissioners

Appendix 1--Commodity Futures Trading Commission Voting Summary

On this matter, Chairman Gensler and Commissioners Sommers,
Chilton and Wetjen voted in the affirmative; Commissioner O'Malia
voted in the negative.

Appendix 2--Statement of Chairman Gensler

I support the final rule to further define entities, which is
pivotal to lowering risk that swap dealers may pose to the rest of
the economy. The entities rule fulfills Congress' direction to
further define the terms ``swap dealer,'' ``major swap participant''
and ``eligible contract participant'' and appropriately addresses
the many comments we received. It will provide essential direction
to market participants on whether they will be required to register.
Regulating banks and other firms that deal in derivatives as
swap dealers is central to financial reform. Leading up to the
financial crisis, it was assumed by many that swap dealers were
largely regulated. The 2008 crisis revealed the inadequacy of this
approach: While banks were regulated for safety and soundness,
including their lending activities, there was no comprehensive
regulation of their swap dealing activity. Similarly, bank
affiliates dealing in swaps, and subsidiaries of insurance and
investment bank holding companies dealing in swaps, were not subject
to specific regulation of their swap dealing activities under U.S.
law, and thus often had ineffective or no oversight.
A prime example of this fact was AIG. AIG was a holding company
with a number of regulated insurance companies, but its unregulated
swaps subsidiary brought down the company and helped to nearly
topple the U.S. economy.
The final rule gives market participants guidance on the Dodd-
Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act) definition of swap dealer:
First, it does so by allowing market participants to
draw on useful precedents developed by the SEC in the traditional

[[Page 30758]]

securities market to help distinguish between dealing and trading.
Second, it does so by providing further clarity on the
Dodd-Frank Act's term ``makes a market in swaps'' by focusing on
entities that routinely seek to profit by accommodating other market
participants' demand for swaps.
Third, it does so by clarifying another key term
``regular business,'' focusing on whether a person has an
identifiable swap dealing business.
Fourth, it does so by fulfilling Congress' mandate that
swaps entered into by an insured depository institution in
connection with originating a loan are not to be considered dealing
activity.
Fifth, it does so by providing direction on the
distinction between hedging and dealing and within this provides a
specific rule for swaps that hedge price risk associated with a
physical commodity.
Sixth, it does so by clarifying that a swap between an
agricultural cooperative or a cooperative financial institution and
its members does not constitute dealing.
Seventh, it does so by setting a de minimis threshold
for swap dealing, as directed by Congress. The threshold is $3
billion total, across all asset classes, subject to a phase in level
of $8 billion. As we proposed, the final rule would define as a swap
dealer any entity with more than $25 million of dealing activity
with pension funds and municipals--so-called ``special entities.''
True to congressional intent, end-users other than those
genuinely making markets in swaps won't be required to register as
swap dealers. The swap dealer definition benefited from the many
comments from end-users who use swaps to hedge their risk.
As the swap dealing market is dominated by large entities,
though, I believe that the final swap dealer definition will
encompass the vast majority of swap dealing activity, as Congress
had intended. For those who question the level of the de minimis, we
considered the threshold in the context of an overall $300 trillion
notional amount U.S. swaps market. Further, the statute defines swap
dealing by referencing ``making a market in swaps'' and conducting a
``regular business'' in swaps. The $3 billion threshold in the rule
represents, on average, $12 million a trading day, with the phase-in
of $8 billion representing, on average, $32 million notional amount
per trading day. Putting this in perspective, the interest rate swap
market, transacts, on average, over $500 billion notional amount per
day. As further reference, the futures markets for crude oil traded
this year, on average, $65 billion of notional amount per day.
During this phase-in period the Commissions will collect and
analyze data to evaluate the appropriate de minimis threshold.
Another question that has been raised is whether the swap dealer
definition should appropriately be activities-based or relate to how
an entity is classified. The final rule is consistent with
Congressional intent that we take an activities-based approach.
Though many of these large swap dealers are financial entities,
Congress anticipated that some non-banks would be registered as swap
dealers. Congress provided in Dodd-Frank that capital and margin for
bank swap dealers would be set by the bank regulators, but for non-
bank swap dealers, by the CFTC. Instructive in this regard is the
list of primary dealers on the International Swaps and Derivatives
Association's (ISDA) Web site, which includes a number of non-bank
dealers. The Association describes as meeting that designation an
entity ``that deals in derivatives as part of its business.''
Congress closed the so-called ``Enron loophole,'' which let traders
evade oversight by using electronic trading platforms. But it is
important to recall that Enron was also a swap dealer. Congress did
not intend to create a new type of loophole in its place.
Congress drafted the swap dealer definition recognizing the fact
that some entities are involved in swap dealing activities, as well
as other lines of business. Section 1a(49)(C) provides that an
entity is a swap dealer only if it engages in swap dealing as ``a
regular business.'' But it does not say that swap dealing must be
its only regular business. Further, section 1a(49)(B) specifically
provides for the regulation of a single entity as a swap dealer for
one part of its business and not for the other part of its business.
Given the business realities reflected in the statutory language,
there is no compelling reason to think that an entities-based
approach would better interpret the statute or that it would, in
practice, be simpler than an approach based on what a business
actually does.
The rule also further defines the term ``major swap
participant.'' Relying on Congress' three-prong test, this category
is clearly limited to only those entities with swaps positions that
pose a risk large enough to threaten the U.S. financial system.
The further definition of the term ``eligible contract
participant'' provides guidance regarding who is eligible to
transact swaps off of an exchange. Based upon the many comments
received, we incorporated further guidance to ensure that small
businesses and real estate developers can continue to have access to
swaps to hedge commercial risks. The final rule also clarifies how
the eligible contract participant definition applies to certain
foreign exchange transactions conducted by commodity pools.

Appendix 3--Statement of Commissioner O'Malia

In General

I respectfully dissent from the Commodity Futures Trading
Commission's (the ``Commission'' or ``CFTC'') approval today of the
Entities Rule,\1\ which is a joint final and interim final rule with
the Securities and Exchange Commission (``SEC'') under the Dodd-
Frank Wall Street Reform and Consumer Protection Act (the ``Dodd-
Frank Act'').\2\ I have a number of concerns with each definition in
the CFTC Entities Rule. However, this dissent focuses on the ``swap
dealer'' definition.
---------------------------------------------------------------------------

\1\ Further Definition of ``Swap Dealer,'' ``Security-Based Swap
Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap
Participant,'' and ``Eligible Contract Participant;'' Final Rule,
(to be codified at 17 CFR part 1), available at [------------]. As
stated below, this final rule and interim final rule is joint
between the Commission and the SEC. Therefore, within this dissent,
(i) the term ``Entities Rule'' refers to the entire rule, (ii) the
term ``CFTC Entities Rule'' refers to only the CFTC portion of such
rule, and (iii) the term ``SEC Entities Rule'' refers to the SEC
portion of such rule.
\2\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
---------------------------------------------------------------------------

Preliminarily, in its proposal,\3\ the Commission ignored basic
canons of statutory construction \4\ in defining ``swap dealer.''
\5\ Specifically, the statutory definition has four clauses,
lettered (A) through (D). As discussed below, the Commission defined
``swap dealer'' as encompassed only within CEA section 1a(49)(A).
Thus, the Commission advanced a definition focusing on activities,
rather than

[[Page 30759]]

the entities conducting these activities.\6\ The Commission then
minimized the other clauses of the definition. Specifically, the
Commission characterized CEA section 1a(49)(C) as an ``exception''
for certain activities. The Commission also characterized CEA
section 1a(49)(B) as only authorizing ``limited designation.'' \7\
---------------------------------------------------------------------------

\3\ See Further Definition of ``Swap Dealer,'' ``Security-Based
Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based
Swap Participant,'' and ``Eligible Contract Participant;'' Proposed
Rule, 75 FR 80174 (Dec. 21, 2010) (the ``Proposal'').
\4\ The canons of statutory construction are ``important rules
and conventions'' that the judiciary applies to determine the
meaning of statutory provisions. Congressional Research Service,
Report for Congress, Statutory Interpretation: General Principles
and Recent Trends, updated August 31, 2008 (the ``CRS Report'')
(Summary). In general, it behooves agencies (such as the Commission)
to adhere to such canons so that its regulations, if subject to
legal challenge, would be more likely to survive judicial scrutiny.
In the CFTC Entities Rule, the Commission acknowledges the
importance of canons of statutory construction, since it cites to
certain canons in determining the application of its ``eligible
contract participant'' definition. See Section III(B)(4) of the CFTC
Entities Rule.
\5\ The statutory definition of ``swap dealer'' can be found in
section 1a(49) of the Commodity Exchange Act (the ``CEA''), 7 U.S.C.
1a(49). For purposes of reference, the text of CEA section 1a(49) is
as follows:
``(49) SWAP DEALER.--
``(A) IN GENERAL.--The term `swap dealer' means any person who--
``(i) holds itself out as a dealer in swaps;
``(ii) makes a market in swaps;
``(iii) regularly enters into swaps with counterparties as an
ordinary course of business for its own account; or
``(iv) engages in any activity causing the person to be commonly
known in the trade as a dealer or market maker in swaps, provided
however, in no event shall an insured depository institution be
considered to be a swap dealer to the extent it offers to enter into
a swap with a customer in connection with originating a loan with
that customer.
``(B) INCLUSION.--A person may be designated as a swap dealer
for a single type or single class or category of swap or activities
and considered not to be a swap dealer for other types, classes, or
categories of swaps or activities.
``(C) EXCEPTION.--The term `swap dealer' does not include a
person that enters into swaps for such person's own account, either
individually or in a fiduciary capacity, but not as a part of a
regular business.
``(D) DE MINIMIS EXCEPTION.--The Commission shall exempt from
designation as a swap dealer an entity that engages in a de minimis
quantity of swap dealing in connection with transactions with or on
behalf of its customers.
The Commission shall promulgate regulations to establish factors
with respect to the making of this determination to exempt.''
\6\ See Proposed Rule; 75 FR at 80175, 80179 (stating that ``The
Dodd-Frank Act defines the terms `swap dealer' * * * in terms of
whether a person engages in certain types of activities involving
swaps or security-based swaps * * * Based on the plain meaning of
the statutory definition, so long as a person engages in dealing
activity that is not de minimis, as discussed below, the person is a
swap dealer * * *'').
\7\ The following example illustrates the difference between (i)
an ``exception'' and (ii) an ``exclusion.'' Imagine a circle
entitled ``swap dealer.'' ``Exceptions'' are circles within the
``swap dealer'' circle. In essence, entities within those circles
are subcategories of ``swap dealer'' permitted special treatment.
``Exclusions'' are circles entirely separate from the ``swap
dealer'' circle. In essence, entities within those circles are not
``swap dealers'' in the first instance. As described below, CEA
section 1a(49)(C), 7 U.S.C. 1a(49)(C), provides a mandatory
``exclusion'' from the ``swap dealer'' definition for--at a
minimum--non-financial entities that do not have ``a regular
business'' of entering into swap transactions. To be clear, this
``exclusion'' applies to entities, and not solely to their
activities. Similarly, CEA section 1a(49)(B), 7 U.S.C. 1a(49)(B),
provides a discretionary ``exclusion'' from the ``swap dealer''
definition (rather than just ``limited designation,'' as the
Commission contends).
---------------------------------------------------------------------------

I have always disagreed with the Proposal. By focusing on the
activities in CEA section 1a(49)(A), the Commission essentially used
the ``swap dealer'' definition to capture commercial end-users.\8\
Congress clearly precluded this result. As described below, CEA
section 1a(49)(C) provides a mandatory exclusion for commercial end-
users.\9\ Alternatively, CEA section 1a(49)(B) permits the
Commission to exercise its discretion to exclude commercial end-
users, so long as the Commission articulates a rational basis for
such differential treatment.\10\ The Commission has many reasons for
exercising its discretion, including certain statutory reasons.
---------------------------------------------------------------------------

\8\ See, e.g., Opening Statement, Sixth Series of Proposed
Rulemakings under the Dodd-Frank Act, Dec. 1, 2010, available at
http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement120110; and Jobs on Main Street vs. Wall Street: The
Choice Should be Clear, 2011 Futures Industry Association Energy
Forum, New York, Keynote Address, Sept. 14, 2011, available at
http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-8.
\9\ See supra note 5 for the exact text of CEA section
1a(49)(C), 7 U.S.C. 1a(49)(C). See also supra note 7 for an
explanation of the difference between (i) an ``exception'' and (ii)
an ``exclusion.'' The collapse of CEA section 1a(49)(C) (referencing
``a regular business'') into CEA section 1a(49)(A)(iii), 7 U.S.C.
1a(49)(A)(iii) (referencing ``an ordinary course of business''),
illustrates that the Commission still considers entities within CEA
section 1a(49)(C) as subcategories of ``swap dealers,'' absent
Commission largesse.
\10\ Id. for the exact text of CEA section 1a(49)(B), 7 U.S.C.
1a(49)(B).
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Today, the Commission has erected the CFTC Entities Rule on the
infirm scaffold of the Proposal. To be sure, the Commission has
performed astonishing contortions to afford greater certainty to
commercial end-users.\11\ However, the Commission could have
provided equivalent or superior certainty by properly construing CEA
sections 1a(49)(C) and (B), either initially or in a re-proposal. By
preserving and furthering the statutory misconstructions in the
Proposal, the CFTC Entities Rule may ultimately provide illusory
comfort. Therefore, I cannot support the CFTC Entities Rule.
---------------------------------------------------------------------------

\11\ In the CFTC Entities Rule, the Commission departs from the
Proposal in the following ways, among others: (i) acknowledging that
there is a difference between dealing, trading, and hedging; (ii)
setting forth an explicit exception for swaps that an entity enters
into in its capacity as a floor trader (as defined in CEA section
1a(23), 7 U.S.C. 1a(23)); (iii) providing another explicit exception
for certain hedging activities; (iv) providing an exception for
swaps between majority-owned affiliates; and (iv) setting forth a
phase-in period with a higher de minimis threshold.
---------------------------------------------------------------------------

The ``Swap Dealer'' Definition: Fundamental Misconstruction

CEA section 1a(49)(A): Not the Entire ``Swap Dealer''
Definition

A statute should be read as a ``harmonious whole.'' \12\ This
statement is a basic canon of statutory construction.\13\ The
Commission has failed to follow such canon in defining ``swap
dealer.''
---------------------------------------------------------------------------

\12\ See, e.g., the CRS Report, p. CRS-2.
\13\ Id.
---------------------------------------------------------------------------

As mentioned above, in the CFTC Entities Rule (as in the
Proposal), the Commission insists that CEA section 1a(49)(A) is the
entirety of the ``swap dealer'' definition. According to the
Commission, any entity engaged in any activity enumerated in CEA
section 1a(49)(A) is a ``swap dealer'' \14\ (unless otherwise
``excepted'').\15\ Specifically, the Commission states: ``The Dodd-
Frank Act definitions of the term `swap dealer' * * * focus on
whether a person engages in particular types of activities involving
swaps * * *.'' \16\ Also, the Commission states: ``The CEA * * *
[definition] in general encompass persons that engage in any of the
[activities in CEA section 1a(49)(A)].'' \17\ Finally, the
Commission characterizes the activities in CEA section 1a(49)(A) as
``dealer activities.'' \18\
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\14\ As mentioned above, CEA section 1a(49)(A), 7 U.S.C.
1a(49)(A), states that the term ``swap dealer'' means ``any person
who--(i) holds itself out as a dealer in swaps; (ii) makes a market
in swaps; (iii) regularly enters into swaps with counterparties as
an ordinary course of business for its own account; or (iv) engages
in any activity causing the person to be commonly known in the trade
as a dealer or market maker in swaps.''
\15\ See supra note 9.
\16\ Section II of the CFTC Entities Rule.
\17\ Id.
\18\ Id.
---------------------------------------------------------------------------

CEA section 1a(49)(C): Mandatory Exclusion for Entities

CEA section 1a(49) contradicts in both its language and
structure the Commission's focus on the activities of CEA section
1a(49)(A). Specifically, CEA section 1a(49)(C), when properly
construed, sets forth a mandatory exclusion that focuses on the
characteristics of an entity, and not exclusively on its activities.
CEA section 1a(49)(C) states: ``The term `swap dealer' does not
include a person that enters into swaps for such person's own
account, either individually or in a fiduciary capacity, but not as
part of a regular business.''
First, CEA section 1a(49)(C) is as central to the ``swap
dealer'' definition as CEA section 1a(49)(A). CEA section 1a(49)(C)
begins with ``The term `swap dealer' does not include * * *''. In
comparison, CEA section 1a(49)(A) begins with ``The term `swap
dealer' means * * *''. Therefore, according to their plain language,
CEA section 1a(49)(C) and CEA section 1a(49)(A) are equal and
opposite of each other. In essence, CEA section 1a(49)(C) sets forth
the exclusion criteria for the ``swap dealer'' definition, whereas
CEA section 1a(49)(A) sets forth the inclusion criteria.
Second, CEA section 1a(49)(C) focuses on the characteristics of
entities, and not solely on their activities. CEA section 1a(49)(C)
states that ``[t]he term `swap dealer' does not include a person
that enters into swaps * * * not as part of a regular business.'' In
contrast, CEA section 1a(49)(A)(iii) states that the ``swap dealer''
definition encompasses any person that ``regularly enters into swaps
with counterparties as an ordinary course of business for its own
account.'' If the Commission is correct in presuming that CEA
section 1a(49)(A) focuses on activities, then the phrase ``regularly
enters into swaps * * * as an ordinary course of business'' must
refer to an activity. However, Congress used different words in CEA
section 1a(49)(C). According to a basic canon of statutory
construction, when Congress uses different words, it intends
different meanings. In other words, a court should strive to give
effect to every word of a statute.\19\
---------------------------------------------------------------------------

\19\ The CRS Report, p. CRS-14 (stating that ``A basic principle
of statutory construction is that courts should `give effect, if
possible to every clause and word of a statute, avoiding, if it may
be, any construction which implies that the legislature was ignorant
of the meaning of the language it employed.'' (quoting Montclair v.
Ramsdell, 107 U.S. 147, 152 (1883)). See also the CRS Report, CRS-
12, footnote 62 (discussing the ``modern variant'' of this canon).
---------------------------------------------------------------------------

The Commission could have easily given effect to every word of
CEA section 1a(49)(C), while according the same respect to CEA
section 1a(49)(A)(iii). Juxtaposing CEA section 1a(49)(C) and CEA
section 1a(49)(A)(iii), the following construction emerges: a
``person'' (i.e., an entity) is not a ``swap dealer'' if it enters
into swaps for ``its own account'' (i.e., as principal) in the
``ordinary course of business'' (i.e., normally while conducting
business), provided that entering into these swaps is not its
``regular business'' (i.e., entering into swaps is ancillary to its
core business).\20\
---------------------------------------------------------------------------

\20\ As mentioned below, certain financial entities may also
satisfy these criteria, such as ``special entities'' (as defined in
CEA section 4s(h)(2)(C), 7 U.S.C. 6s(h)(2)(C) (e.g., certain
employee benefit plans covered by the Employee Retirement Income
Security Act of 1974 (``ERISA'')). If the Commission wanted to
prevent other financial entities from abusing CEA section 1a(49)(C),
7 U.S.C. 1a(49)(C), the Commission could have preliminarily limited
the exclusion to commercial end-users (or other entities that the
Commission determines could be excluded based on a holistic reading
of the Dodd-Frank Act and the CEA, including small financial
institutions as delineated in CEA section 2(h)(7)(C), 7 U.S.C.
2(h)(7)(C)). Additionally, if the Commission wanted to prevent
commercial end-users (or such other entities) from abusing CEA
section 1a(49)(C) (by, e.g., entering into non-ancillary
transactions in swaps), the Commission has anti-evasion authority
under section 721(c) of the Dodd-Frank Act.
The regulations that the Commission promulgates under the Dodd-
Frank Act will irrevocably change the structure of the swap markets.
Such changes have benefits and costs. To properly weigh the benefits
and costs of its regulations under CEA section 15(a), 7 U.S.C.
19(a), it would have behooved the Commission to have discussed (i)
categorically excluding certain entities from the ``swap dealer''
definition within the phase-in period, and (ii) exercising anti-
evasion authority, if the Commission found it necessary based on its
surveillance of the swaps market.

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[[Page 30760]]

If the Commission had adopted this construction, the Commission
would have per se excluded commercial end-users. Such exclusion
would have permitted these entities to freely hedge their business
risks, whether financial or physical, without fear of becoming a
``swap dealer.'' Just to provide some context, commercial end-users
include Caterpillar, John Deere, and ConAgra Foods. These entities
have ``a regular business'' of supplying energy, food, and other
tangible products to America. To these entities, swaps are ancillary
tools that they can use to manage risk. These entities suffered
from--rather than perpetrated--the 2008 financial crisis. Yet, these
entities (either individually or through trade associations) took
the time to draft and submit comment letters to the Commission--
sometimes multiple letters--because they were afraid of being
defined as ``swap dealers.''
If the Commission had any doubt regarding the above
construction, the Commission could have referred to various letters
from members of Congress. Such letters explicitly state that
Congress intended to exclude commercial end-users. For example,
former Chairman Christopher Dodd and Chairwoman Blanche Lincoln
circulated a joint letter stating: ``Congress does not intend to
regulate end-users as Major Swap Participants or Swap Dealers just
because they use swaps to hedge or manage the commercial risks
associated with their business.'' \21\ Both senators Dodd and
Lincoln were instrumental in shaping the legislation that became the
Dodd-Frank Act.
---------------------------------------------------------------------------

\21\ Letter from Chairman Christopher Dodd, Committee on
Banking, Housing, and Urban Affairs, United States Senate, and
Chairman Blanche Lincoln, Committee on Agriculture, Nutrition, and
Forestry, United States Senate, to Chairman Barney Frank, Financial
Services Committee, United States House of Representatives, and
Chairman Collin Peterson, Committee on Agriculture, United States
House of Representatives (June 30, 2010) (the ``Dodd-Lincoln
Letter'').
The Dodd-Lincoln Letter (as well as the Stabenow-Lucas Letter
(as defined below)) appears to have embraced a broader conception of
``commercial risk'' than the Commission. See infra note 42.
---------------------------------------------------------------------------

Recently, Chairwoman Debbie Stabenow and Chairman Frank Lucas
reiterated this point: [I]t is important for the Commission to
finalize the swap dealer definition in a manner that is not overly
broad, and that will not impose significant new regulations on
entities that Congress did not intend to be regulated as swap
dealers. The Commission's final rulemaking further defining `swap
dealing' should clearly distinguish swap activities that end-users
engage in to hedge or mitigate the commercial risks associated with
their businesses, including swaps entered into by end-users to hedge
physical commodity price risk, from swap dealing.\22\
---------------------------------------------------------------------------

\22\ Letter from Chairwoman Debbie Stabenow, Committee on
Agriculture, Nutrition, and Forestry, United States Senate, and
Chairman Frank D. Lucas, Committee on Agriculture, United States
House of Representatives to Chairman Gary Gensler, United States
Commodity Futures Trading Commission (March 29, 2012) (the
``Stabenow-Lucas Letter'').
---------------------------------------------------------------------------

It is important to note that Chairwoman Stabenow and Chairman
Lucas lead the Congressional committees charged with overseeing the
Commission.
[cir] CEA section 1a(49)(B): Discretionary Exclusion for
Entities
In the alternative (assuming that the Commission rejects the
above construction), CEA section 1a(49)(B) also contradicts the
Commission's focus on the activities in CEA section 1a(49)(A).
Specifically, CEA section 1a(49)(B), when properly construed, sets
forth a permissive exclusion focused on entities, with respect to
either their activities or their swaps. CEA section 1a(49)(B)
states: ``A person may be designated as a swap dealer for a single
type or single class or category of swap or activities and
considered not to be a swap dealer for other types, classes, or
categories of swaps or activities.''
First, CEA section 1a(49)(B) references ``[a] person.'' CEA
section 1a(38) \23\ defines ``person'' as ``import[ing] the plural
or singular.'' Read together, the sections indicate that CEA section
1a(49)(B) focuses on either (i) an entity or (ii) multiple entities.
---------------------------------------------------------------------------

\23\ 7 U.S.C. 1a(38).
---------------------------------------------------------------------------

Second, CEA section 1a(49)(B) states that ``[a] person'' (or
``persons'') could be ``considered not to be'' a ``swap dealer'' for
``types, classes, or categories of swaps.'' So, an entity could be
excluded from the ``swap dealer'' definition with respect to, e.g.,
physical commodity swaps, regardless of its activity with respect to
such swaps. That indicates that the ``swap dealer'' definition does
not solely focus on activity, as the Commission maintains. Instead,
the characteristics of the entity and the underlying swaps are also
relevant.
Third, CEA section 1a(49)(B) states that ``[a] person'' (or
``persons'') could be ``considered not to be'' a ``swap dealer'' for
certain ``activities.'' So, even if an entity engages in
``activities'' in CEA section 1a(49)(A), that entity may
nevertheless not be a ``swap dealer.'' That indicates that the
``swap dealer'' definition may not even predominantly focus on
activity.
Finally, CEA section 1a(49)(B) permits the Commission to include
one ``person'' (or a group of ``persons'') engaging in certain
activities in the ``swap dealer'' definition, but to exclude another
``person'' (or group of ``persons'') engaging in the same
activities. Of course, the Commission has to articulate a rational
basis for differential treatment. As discussed below, there may be
certain statutory bases for differentiation (including the reference
to ``financial entity'' in the end-user exception). Nothing in CEA
section 1a(49)(B) prevents the Commission from so differentiating
through rulemaking (rather than individual determinations).
[cir] Unnecessary Statutory Contortions
Instead of following the canons of statutory construction and
properly interpreting CEA section 1a(49)(C) and CEA section
1a(49)(B), the Commission engages in a series of contortions with
seemingly opposing purposes. Upon review, these contortions appear
to stem from a desire of the Commission to provide a measure of
certainty to commercial end-users in the CFTC Entities Rule, without
explicitly contradicting the Proposal.
Preliminarily, the Commission appears to broadly define ``swap
dealer'' to capture commercial end-users. For example, both the
Proposal and the CFTC Entities Rule obfuscate the application of CEA
section 1a(49)(C) to entities (rather than solely to activities) by
collapsing CEA section 1a(49)(C) into CEA section
1a(49)(A)(iii).\24\ In

[[Page 30761]]

performing such collapse, the Commission states that it
``continue[s] to believe, as stated in the [Proposal], that the
phrases `ordinary course of business' and `a regular business' are,
for purposes of the definition of `swap dealer' essentially
synonymous.'' \25\ Neither the Proposal nor the CFTC Entities Rule
fully supports collapsing CEA section 1a(49)(C)--one of four clauses
in the statutory ``swap dealer'' definition--into CEA section
1a(49)(A)(iii)--a subparagraph of one clause. Further, neither the
Proposal nor the CFTC Entities Rule fully supports interpreting two
separate phrases (i.e., ``ordinary course of business'' and
``regular business'') as meaning the same thing. The Commission
similarly minimizes CEA section 1a(49)(B) as providing for ``limited
designation'' only, rather than an alternate source of authority for
the Commission to exclude certain entities from the ``swap dealer''
definition.\26\
---------------------------------------------------------------------------

\24\ In Section II(A)(4)(d) of CFTC Entities Rule, the
Commission states: ``We recognize, as noted by one commenter (see
letter from ISDA I), that the `regular business' exclusion is not
limited solely to the `ordinary course of business' test of the swap
dealer definition. Our interpretations of the other three tests are,
and should be read to be, consistent with the exclusion of
activities that are not part of a regular business.''
Preliminarily, I would note that more than one commenter
observed the collapse.
Secondarily, as noted above, CEA section 1a(49)(C), 7 U.S.C.
1a(49)(C), applies to entities (and not solely to activities).
Therefore, the Commission does not (and really cannot) argue that
the collapse of CEA section 1a(49)(C) into CEA section
1a(49)(A)(iii), 7 U.S.C. 1a(49)(A)(iii), has little to no impact on
its construction of CEA sections 1a(49)(A)(i), (ii), and (iv), 7
U.S.C. 1a(49)(A)(i), (ii), and (iv).
Finally, although it is ambiguous in the CFTC Entities Rule (and
not contemplated in the Proposal), it seems like the Commission may
be indirectly relying on its reference to the dealer-trader
distinction to justify its collapse of CEA section 1a(49)(C) and
1a(49)(A)(iii). Interestingly, the SEC does not state that ``regular
business'' in Exchange Act section 3(a)(71)(C), 15 U.S.C.
78c(a)(71)(C)) (parallel to CEA section 1a(49)(C)), is
``synonymous'' with ``ordinary course of business'' in Exchange Act
section 3(a)(71)(A)(iii), 15 U.S.C. 78c(a)(71)(A) (parallel to CEA
section 1a(49)(A)(iii)). Of course, it may have been understood that
the SEC would hew more closely to the dealer-trader distinction, as
historically applicable to securities, and thus would focus on
activities and not entities. See Section II(A)(3) of the Entities
Rule. However, one wonders that of all the distinctions that the
Commission makes or attempts to preserve between the swaps and
securities-based swaps markets, the Commission does not acknowledge
(i) the ``high degree of concentration'' of dealing in the
securities-based swaps markets among the largest financial entities
and (ii) the lack of similar concentration in the swaps markets
(particularly with respect to markets that commercial end-users
frequent, such as the physical commodity swaps markets). Compare
generally Section II(D)(5) of the SEC Entities Rule (which
repeatedly references ``high degree of concentration'') with Section
II(D)(4) of the CFTC Entities Rule (which does not contain such
references). See also Section II(A)(2)(e)(iii) of the CFTC Entities
Rule (describing comments with respect to electricity swaps). The
Commission should have accorded greater consideration to differences
in market structure before dismissing a construction of CEA section
1a(49)(C) as focusing on entities (and as independent of CEA section
1a(49)(A)(iii)).
\25\ Section II(A)(4)(d) of the CFTC Entities Rule.
\26\ The Commission characterizes CEA section 1a(49)(B), 7
U.S.C. 1a(49)(B), as ``limited designation'' based on a series of
misconstructions. First, as noted above, the Commission insists that
CEA section 1a(49)(A), 7 U.S.C. 1a(49)(A), is the entirety of the
``swap dealer'' definition. Second, the Commission then interprets
CEA section 1a(49)(B) to apply to the registration of an entity as a
``swap dealer,'' and not to the ``swap dealer'' definition. Third,
because CEA section 1a(49)(B) applies to registration, the
Commission concludes that it would be appropriate to apply an
individualized, facts-and-circumstances analysis.
In actuality, CEA section 1a(49)(B) does more than provide for
``limited designation.'' First, as discussed above, CEA section
1a(49)(A) sets forth general parameters for defining ``swap
dealer.'' The entirety of the ``swap dealer'' definition is actually
CEA sections 1a(49)(A), (B), (C), and (D), 7 U.S.C. 1a(49)(A), (B),
(C), and (D). Second, CEA section 1a(49)(B) is in the definition of
``swap dealer.'' It is not in CEA section 4s(a), 7 U.S.C. 6s(a),
which pertains to registration of ``swap dealers.'' Therefore, the
Commission should have considered the effect of CEA section
1a(49)(B) in delineating the universe of entities that need to seek
registration with the Commission, and not solely the effect of CEA
section 1a(49)(B) in determining the scope of registration that the
Commission would afford such entities. Third, because CEA section
1a(49)(B) relates to the definition and not the registration of
``swap dealers,'' the Commission articulates no basis for an
individualized, facts-and-circumstances determination.
---------------------------------------------------------------------------

However, after appearing to broadly define ``swap dealer'', the
Commission then cobbles together various measures that aim--with
differing levels of success--to provide a measure of certainty to
commercial end-users. The most important (and successful) of these
measures is a higher de minimis threshold. Two other important
measures are: (i) referencing the dealer-trader distinction and (ii)
incorporating an explicit hedging exception.
Although these measures reflect positive policy choices, they
also reflect various compromises that may ultimately diminish the
certainty that they seek to provide. As mentioned above, the
Commission could have provided equivalent or superior certainty by
properly construing CEA sections 1a(49)(C) and (B), either initially
or in a re-proposal.
[cir] Reference to the Dealer-Trader Distinction
In the CFTC Entities Rule, the Commission states that it
``believe[s] that the dealer-trader distinction--which already forms
a basis for identifying which persons fall within the longstanding
Exchange Act definition of `dealer'--in general provides an
appropriate framework for interpreting the statutory definition of
the term `swap dealer.''' \27\ In so recognizing, the Commission
departs from the Proposal.\28\ I have always argued that differences
exist among (i) dealing, (ii) trading, and (iii) hedging. I have
also recommended that the Commission provide guidance to clearly
distinguish among the three categories. Such guidance would aid
market participants in determining whether to register as a ``swap
dealer.'' Although the CFTC Entities Rule contains (i) an interim
final hedging exception \29\ and (ii) a final ``floor trader''
exclusion, \30\ both provisions are limited in scope. Therefore,
market participants will still need clear guidance on Commission
interpretation of the dealer-trader distinction, in order to
determine whether their trading or hedging transactions may cause
them to be deemed ``swap dealers.''
---------------------------------------------------------------------------

\27\ Section II(A)(4)(a) of the CFTC Entities Rule.
\28\ The Commission acknowledges such departure, but attempts to
mitigate its legal effect by emphasizing that (i) the dealer-trader
framework overlaps with the functional approach in the Proposal, and
(ii) the Commission has changed its interpretative approach to the
``swap dealer'' definition in response to comments. See Section
II(A)(4)(a) of the CFTC Entities Rule.
\29\ As described below, this exception only applies to physical
commodity swaps. Therefore, commercial end-users would not be able
to rely on this exception for swaps to hedge financial risks.
Moreover, small financial institutions would not be able to rely on
this exception (as they most likely would be hedging financial
risk), even if the Commission were to permit them to use the end-
user exception. Finally, even financial entities (such as ``special
entities'') may engage in ``hedging'' without ``dealing.'' The CFTC
Entities Rule does not provide much clarity on how such financial
entities could demonstrate that they are not ``dealing'' (other than
the amorphous distinction between ``purpose'' and ``consequences'').
\30\ The final ``floor trader'' exclusion has many limitations.
For example, an entity cannot rely on this exclusion if it
participates in a market-making program offered by a designated
contract market (``DCM'') or swap execution facility. One wonders
what would happen if an entity participates in a DCM market-making
program for futures, and then the Commission requires such futures
to be converted to swaps in a forthcoming rulemaking. See, e. g.,
Core Principles and Other Requirements for Designated Contract
Markets, 75 FR 80572 (Dec. 22, 2010).
---------------------------------------------------------------------------

Unfortunately, the Commission has missed its opportunity in the
CFTC Entities Rule. After reading the relevant portions of the
rulemaking multiple times, it is still unclear to me exactly how the
Commission intends to distinguish among (i) dealing, (ii) trading
(outside of the limited ``floor trader'' exclusion), and (iii)
hedging (outside of the specific hedging exception, which I discuss
below). For example, the Commission states: ``[t]he principles
embedded within the `dealer trader distinction' are also applicable
to distinguishing dealers from non-dealers such as hedgers or
investors.'' \31\ I agree with this statement. The Commission also
cites to more support from the SEC Entities Rule--specifically the
fact that ``[t]he `dealer-trader' nomenclature has been used for
decades.'' \32\ I also agree with this statement. However, the
Commission then states: ``These same principles, though instructive,
may be inapplicable to swaps in certain circumstances or may be
applied differently in the context of dealing activities involving
commodity, interest rate, or other types of swaps.'' \33\ I do not
know whether to agree or disagree with this statement, given its
ambiguity. Thus, for all of its girth, the CFTC Entities Rule fails
to answer a basic question--namely, under which circumstances would
an entity be deemed a dealer (rather than a trader or hedger) with
respect to specific swap transactions? \34\
---------------------------------------------------------------------------

\31\ Section II(A)(4)(a) of the CFTC Entities Rule.
\32\ Section II(A)(5)(a) of the SEC Entities Rule.
\33\ Section II(A)(3) of the Entities Rule.
\34\ For example, in Section II(A)(4)(a) of the CFTC Entities
Rule, the Commission sets forth a list of indicia that are either
``particularly similar to'' or ``generally consistent with * * * the
dealer-trader distinction as it will be applied to determine whether
a person is a security-based swap dealer.'' However, the Commission
immediately undermines any comfort that such list could provide by
stating ``[t]o clarify, the activities listed in the text are
indicative of acting as a swap dealer. Engaging in one or more of
these activities is not a prerequisite to a person being covered by
the swap dealer definition.''
---------------------------------------------------------------------------

The Commission appears to argue that inherent differences
between the swaps markets and securities markets (other than
security-based swaps) justify its selective incorporation of dealer-
trader elements (which elements, in themselves, apparently vary
according to unknown facts and circumstances). For example, the
Commission states that an entity need not engage in two-way
transactions in order to fall within the ``swap dealer'' definition.
One justification that the Commission advances is that ``swaps thus
far are not significantly traded on exchanges or other trading
systems'' and that this ``[attribute]--along with the lack of
`buying and selling' language in the swap dealer definition * * *--
suggest that concepts of what it means to make a market need to be
construed flexibly in the contexts of the swap market.'' \35\
However, in the same section of the CFTC Entities Rule, the
Commission states: ``many cash market securities also are not
significantly traded on those systems.'' \36\ Therefore, the
Commission advances a justification for selective incorporation of
dealer-trader elements and then contradicts its justification in the
same paragraph. Thus, even if market participants wished to
understand Commission reasoning to determine whether they need to
register as ``swap dealers,'' they may not be able to do so.
---------------------------------------------------------------------------

\35\ Section II(A)(4)(a) of the CFTC Entities Rule.
\36\ Id.
---------------------------------------------------------------------------

Finally, the Commission and the SEC appear to emphasize
different dealer-trader elements. For example, the Commission tends
to emphasize ``accommodating demand

[[Page 30762]]

or facilitating interest in the instrument.'' \37\ In contrast, the
SEC tends to emphasize ``a business model that seeks to profit by
providing liquidity.'' \38\ The Commission fails to provide a
rationale for its difference in focus.\39\ On its face,
``accommodating demand or facilitating interest'' seems to capture
more traders and hedgers than having ``a business model that seeks
to profit by providing liquidity.''
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\37\ See generally Section II(A)(4) of the CFTC Entities Rule.
\38\ See generally Section II(A)(5) of the SEC Entities Rule.
The CFTC Entities Rule does acknowledge that seeking to profit
from providing liquidity is one indicia of dealing. However, the
CFTC Entities Rule limits its discussion of this indicia to CEA
section 1a(49)(A)(ii), 7 U.S.C. 1a(49)(A)(ii), which emphasizes
market-making. The Commission appears to rely more heavily on
``accommodating demand or facilitating interest'' (without
necessarily emphasizing a ``business model that seeks to profit from
providing liquidity'') in its interpretation of the remainder of CEA
section 1a(49)(A), 7 U.S.C. 1a(49)(A). Therefore, a dissonance still
exists between the CFTC Entities Rule and the SEC Entities Rule.
\39\ See supra note 24. The Commission could have focused on
differences in market composition. Unfortunately, such focus could
have raised other issues with Commission construction of CEA section
1a(49), 7 U.S.C. 1a(49).
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[cir] Interim Final Rule on Hedging
In the CFTC Entities Rule, the Commission has included an
interim final rule excepting certain hedging transactions from the
``swap dealer'' definition (i.e., Regulation 1.3(ggg)(6)(iii)).\40\
I agree that hedging is not dealing. However, I find the interim
final rule excessively narrow. First, the interim final rule only
applies to a limited set of physical commodity hedges. I am not sure
why the Commission does not wish to allow commercial end-users to
hedge financial risks (e.g., through interest rate swaps) without
fearing that they could be deemed ``swap dealers.'' \41\ Permitting
such hedging would be consonant with Congressional intent, as
expressed in the letters from members of Congress.\42\ Conversely, I
am not sure why the Commission wants to encourage, e.g., banking
entities--like Barclays--to own physical commodities and claim the
hedge exception.
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\40\ See Section II(A)(4)(e) of the CFTC Entities Rule.
\41\ The Commission relies on its misconstruction of the
statutory ``swap dealer'' definition to justify such a narrow
exclusion. In Section II(A)(4)(e) of the CFTC Entities Rule, the
Commission states: ``In terms of the statutory definition of the
term `swap dealer,' the CFTC notes as an initial matter that there
is no specific provision addressing hedging activity. Thus, the
statutory definition leaves the treatment of hedging swaps to the
CFTC's discretion; it neither precludes consideration of a swap's
hedging purpose, nor does it require an absolute exclusion of all
swaps used for hedging.'' As noted above, whereas CEA section 1a(49)
does not specifically refer to ``hedging,'' CEA section 1a(49)(C), 7
U.S.C. 1a(49)(C), (as well as CEA section 1a(49)(B), 7 U.S.C.
1a(49)(B))--as properly construed--would have excluded commercial
end-users that engage in swaps for purposes of hedging. It is
interesting that the SEC did not endorse these specific sentences.
\42\ As mentioned above, the Commission contorts itself in the
CFTC Entities Rule to provide an interim hedging exception that
applies only to physical commodity risks. This approach runs
contrary to the Dodd-Lincoln Letter (as well as the Stabenow-Lucas
Letter). Both letters emphasize exclusions for entities--such as
commercial end-users--so that they could freely hedge their risks--
whether financial or physical.
The Dodd-Lincoln Letter begins by referencing hedging of
interest rate risk. It specifically states: ``Whether swaps are used
by an airline hedging its fuel costs or a global manufacturing
company hedging interest rate risk, derivatives are an important
tool businesses use to manage costs and market volatility. This
legislation will preserve that tool.'' Moreover, the Dodd-Lincoln
Letter states: ``The end user exemption may also apply to our
smaller financial entities--credit unions, community banks, and farm
credit institutions.'' If such institutions could be categorized as
``swap dealers,'' then they would be prohibited from relying on the
end-user exception. Such institutions would likely seek to hedge
financial risk.
As mentioned above, the Stabenow-Lucas Letter states: ``The
Commission's final rulemaking further defining `swap dealing' should
clearly distinguish swap activities that end-users engage in to
hedge or mitigate the commercial risks associated with their
businesses, including swaps entered into by end-users to hedge
physical commodity price risk, from swap dealing.'' In using the
term ``including,'' the Stabenow-Lucas Letter acknowledges that end-
users may use swaps to hedge or mitigate risks--such as financial
risks--other than those related to physical commodities.
By focusing only physical commodity risks, therefore, the
interim hedging exception fails to fully satisfy Congressional
intent.
---------------------------------------------------------------------------

Second, there are four other hedging definitions that are either
(i) currently effective or (ii) the subject of a Dodd-Frank Act
proposal.\43\ Given the call by President Obama to simplify
regulation,\44\ I would have expected the Commission to refrain from
proposing a fifth hedging definition, unless strictly necessary. In
the CFTC Entities Rule, the Commission does not cogently explain the
necessity for a fifth hedging exception. For example, the Commission
spends a considerable amount of effort to differentiate the interim
final rule from bona fide hedging in Regulations 1.3(z) and
151.5(a)(1). The Commission's rationale may be distilled into one
circular sentence: the Commission believes that certain bona fide
hedging transactions may constitute swap dealing, due to reasons
that the Commission declines to fully explain.\45\ Additionally, the
Commission spends one paragraph attempting to differentiate between
the interim final rule and the ``major swap participant'' definition
(which contains a hedging or mitigating commercial risk exception).
In that paragraph, the central argument appears to be that the
``swap dealer'' definition determines the parameters of the ``major
swap participant'' definition--but not also vice versa.\46\
Preliminarily, the Commission declines to cite where exactly the
Dodd-Frank Act states that the ``swap dealer'' definition is
determinative. Secondarily, even assuming that the Commission is
correct in characterizing the interconnection, the Commission does
not clearly explain why it thinks that those transactions (i)
falling outside the interim final rule but (ii) falling within
hedging or mitigating commercial risk are more likely to constitute
swap dealing.
---------------------------------------------------------------------------

\43\ See Regulation 1.3(z), 17 CFR 1.3(z); (ii) Regulation
151.5(a)(1) (in Position Limits in Futures and Swaps; Final Rule, 76
FR 71626, 71688 (Nov. 18, 2011) (to be codified at 17 CFR parts 1,
150, and 151)); (iii) Regulation 1.3(hhh) (as set forth in the CFTC
Entities Rule); and (iv) Regulation 39.6(c) (in End-User Exception
to Mandatory Clearing of Swaps; Proposed Rule, 75 FR 80747, 80757
(Dec. 23, 2010)).
\44\ See Exec. Order No. 13563, 76 FR 3821, Jan. 21, 2011; see
also Exec. Order No. 13579, 76 FR 41587, July 14, 2011.
\45\ In Section II(A)(4)(e) of the CFTC Entities Rule, the
Commission attempts to distinguish between ``purpose'' and
``effect.'' Market participants may find such an attempt to be less
than clear.
\46\ Section II(A)(4)(e) of the CFTC Entities Rule (stating ``*
* *The definition of the term ``major swap participant,'' which
applies only to persons who are not swap dealers, is premised on the
prior identification, by the swap dealer definition, of persons who
accommodate demand for swaps, make a market in swaps, or otherwise
engage in swap dealing activity. The major swap participant
definition performs the subsequent function of identifying persons
that are not swap dealers, but hold swap positions that create an
especially high level of risk that could significantly impact the
U.S. financial system.'').
---------------------------------------------------------------------------

Finally, the Commission is silent on the manner in which the
interim final rule interacts with the proposed Regulation 39.6
(detailing hedging or mitigating commercial risk for the end-user
exception). If an entity is a ``swap dealer,'' then it cannot rely
on the end-user exception to clearing.\47\ Therefore, if the
Commission overreaches in defining ``swap dealer,'' it may narrow
the end-user exception in a way not congruent with Congressional
intent.\48\
---------------------------------------------------------------------------

\47\ See CEA section 2(h)(7), 7 U.S.C. 2(h)(7). See also supra
note 43.
\48\ See supra note 42.
---------------------------------------------------------------------------

Other Provisions of the Dodd-Frank Act and the CEA: Further
Misconstructions

As mentioned above, the Commission fails to properly construe
the various clauses of CEA section 1a(49). As detailed in this
section, the Commission also fails to consider other provisions of
the CEA or the Dodd-Frank Act in determining the parameters of
``swap dealer.'' The Commission appears to assume that the ``swap
dealer'' definition is determinative for all such provisions, rather
than also vice versa. The Commission does not provide much (if any)
rationale for this assumption. Removing this assumption, it becomes
clear that other provisions of the CEA or the Dodd-Frank Act may
suggest further limitations on ``swap dealer.'' \49\
---------------------------------------------------------------------------

\49\ As mentioned above, the Commission has authority to
discretionarily exclude certain entities pursuant to CEA section
1a(49)(B), 7 U.S.C. 1a(49)(B).
---------------------------------------------------------------------------

End-User Exemption: Who can take advantage of it?

CEA section 2(h)(7) sets forth what is commonly known as the
``end-user clearing exception.'' As mentioned above, the ``swap
dealer'' definition is crucial to determining which entities could
use the end-user clearing exception. That is because CEA section
2(h)(7) only applies if one counterparty to a swap is not a
``financial entity.'' \50\ CEA section 2(h)(7)(C) defines

[[Page 30763]]

``financial entity'' as including a ``swap dealer.'' \51\ Therefore,
if the Commission defines ``swap dealer'' expansively, then the
Commission will limit the number and types of end-users that may use
the clearing exception.
---------------------------------------------------------------------------

\50\ CEA section 2(h)(7)(A), 7 U.S.C. 2(h)(7)(A), states: ``In
General.--The requirements of paragraph (1)(A) shall not apply to a
swap if 1 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.''
\51\ Notably, CEA section 2(h)(7)(C)(i), 7 U.S.C. 2(h)(7)(C)(i),
also lists commodity pools, certain private funds, certain employee
benefit plans, and certain banking and financial entities separately
from ``swap dealer.'' Does this separate listing imply that those
entities are not ``swap dealers''? Why or why not?
---------------------------------------------------------------------------

Given the importance of the interconnections between the ``swap
dealer'' definition and the end-user clearing exception, I would
have expected the Commission to discuss such interconnections in
great detail. Surprisingly, in that portion of the CFTC Entities
Rule defining ``swap dealer,'' the Commission only discusses end-
user clearing in a footnote.\52\
---------------------------------------------------------------------------

\52\ The Commission discusses the end-user clearing exception
more fully in that portion of the CFTC Entities Rule defining
``major swap participant.''
---------------------------------------------------------------------------

Footnote 213 illustrates in a particularly poignant manner the
Commission's failure to properly consider the interaction between
the ``swap dealer'' definition and the end-user exception. In that
footnote, the Commission attempts to dismiss the argument that the
``swap dealer'' definition should only apply to financial entities.
The Commission states:
Similarly, the absence of any limitation in the statutory
definition of the term ``swap dealer'' to financial entities, when
such limitation is included elsewhere in Title VII, indicates that
no such limitation applies to the swap dealer definition. CEA
section 2(h)(7), 7 U.S.C. 2(h)(7), specifically limits the
application of the clearing mandate, in certain circumstances, to
only ``financial entities.'' That section also provides a detailed
definition of the term ``financial entity.'' See CEA section
2(h)(7)(C), 7 U.S.C. 2(h)(7)(C). That such a limitation is included
in this section, but not in the swap dealer definition, does not
support the view that the statutory definition of the term ``swap
dealer'' should encompass only financial entities.
In actuality, Footnote 213 raises more questions than it
answers. In Footnote 213, the Commission presumes that the
interaction between the ``swap dealer'' definition and the end-user
exception only goes one way--namely, that the ``swap dealer''
definition fixes the scope of the end-user exception, but not also
vice versa. The Commission provides no basis for this presumption,
especially since a basic canon of statutory is that the Commission
should construe a statute as a ``harmonious whole.'' From that
perspective, it becomes clear that Footnote 213 raises a series of
fundamental questions. Why did Congress use the term ``financial
entity'' in CEA section 2(h)(7)(C)? Does use of this term imply in
any way that Congress presumed that the ``swap dealer'' definition
would exclude commercial entities? Why or why not? Surely, Congress
need not have specified financial entity in CEA section 2(h)(7)(C)
if it had intended to permit the Commission to vitiate the reference
to financial by simply defining ``swap dealers'' to include
commercial entities. If Congress intended to so permit, then
Congress could have simply used the term ``entity'' in CEA section
2(h)(7)(C).

Employee Benefit Plans: ``Swap Dealers?''

In Section II(A)(2)(f) of the CFTC Entities Rule, the Commission
describes comments requesting categorical exclusions from the ``swap
dealer'' definition. One such comment was from American Benefits
Council (``ABC'') and the Committee on the Investment of Employee
Benefit Assets (``CIEBA'').\53\ In their comments, ABC/CIEBA
requested that the Commission exclude (or interpret CEA section
1a(49) to exclude) certain employee benefit plans from the ``swap
dealer'' definition. In Section II(A)(6) of the CFTC Entities Rule,
the Commission denies this request, mainly on the basis of its
misguided construction of CEA section 1a(49).
---------------------------------------------------------------------------

\53\ Comment from ABC/CIEBA, dated February 22, 2011, available
at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27944&SearchText=American%20Benefits%20Council.
---------------------------------------------------------------------------

In so denying, the Commission fails to consider CEA section
4s(h). Specifically, CEA sections 4s(h)(2), (4), and (5) prescribe
heightened business conduct standards for ``swap dealers''
interacting with ``special entities.'' In fact, the Commission
recently promulgated a final rulemaking on these standards.\54\ CEA
section 4s(h)(2)(C) defines ``special entity'' as, among other
things, ``any employee benefit plan, as defined in section 3 of the
Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002).''
CEA section 4s(h) raises another series of fundamental questions.
Did Congress presume that employee benefit plans would not
constitute ``swap dealers''? \55\ Why or why not? Indeed, how does
the Commission reconcile its denial of the ABC/CIEBA request with
its own de minimis requirement, which seems to recognize a per se
difference between a ``special entity'' and a ``swap dealer''? \56\
---------------------------------------------------------------------------

\54\ Business Conduct Standards for Swap Dealers and Major Swap
Participants with Counterparties; Final Rule, 77 FR 9734 (Feb. 17,
2012).
\55\ See supra note 51.
\56\ See Section II(D) of the Entities Rule.
---------------------------------------------------------------------------

Internal Business Conduct Standards: Indication of the
Scope of ``Swap Dealer?''

In addition to failing to account for external business conduct
standards, the Commission fails to account for certain internal
business conduct standards in defining ``swap dealer.'' For example,
CEA section 4s(j)(5) requires ``swap dealers'' to have systems and
procedures to mitigate conflicts of interest resulting from
interactions between (i)(A) any person engaged in ``research or
analysis of the price or market for any commodity or swap'' or (B)
any person ``acting in a role of providing clearing activities or
making determinations as to accepting clearing customers'' and (ii)
certain persons involved in ``pricing, trading, or clearing
activities.'' The Commission recently promulgated a final rulemaking
on this requirement.\57\ CEA section 4s(j)(5) raises another
fundamental question. Did Congress presume that ``swap dealers''
generally engage in either ``research or analysis'' or ``providing
clearing activities or making determinations'' and ``pricing,
trading, or clearing activities''? Why or why not?
---------------------------------------------------------------------------

\57\ Swap Dealer and Major Swap Participant Recordkeeping,
Reporting, and Duties Rules; Futures Commission Merchant and
Introducing Broker Conflicts of Interest Rules; and Chief Compliance
Officer Rules for Swap Dealers, Major Swap Participants, and Futures
Commission Merchants; Final Rule, 77 FR 20128 (Apr. 3, 2012).
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Volcker: How does the CFTC Entities Rule Fit?

As I have noted previously, the ``Volcker Rule'' \58\ sets forth
detailed metrics to differentiate between (i) market-making and (ii)
proprietary trading. To say that the CFTC Entities Rule does not
replicate such detail would be an understatement. Worse, the CFTC
Entities Rule does not even attempt to explain why the metrics in
the Volcker Rule are inapplicable to the ``swap dealer'' definition.
In fact, the Commission addresses the interaction between the
Volcker Rule and the CFTC Entities Rule only in one footnote. This
footnote states in relevant part:
---------------------------------------------------------------------------

\58\ Prohibitions and Restrictions on Proprietary Trading and
Certain Interests in, and Relationships With, Hedge Funds and
Covered Funds; Proposed Rule, 77 FR 8332 (Feb. 14, 2012).
---------------------------------------------------------------------------

The Commissions have proposed an approach to the Volcker Rule
under which a person could seek to avoid the Volcker Rule in
connection with swap activities by asserting the availability of
that market making exception * * * Under this approach, such a
person would likely also be required to register as a swap dealer
(unless the person is excluded from the swap dealer definition, such
as by the exclusion of certain swaps entered into in connection with
the origination of a loan).\59\
---------------------------------------------------------------------------

\59\ Section II(A)(4)(c) of the CFTC Entities Rule.
---------------------------------------------------------------------------

Of course, this footnote provides no useful clarification, since
the operative question is whether an entity engaging in activities
that would not be ``market-making'' under the Volcker Rule could
nonetheless be engaging in ``market-making'' under the CFTC Entities
Rule (and, solely by virtue of such characterization, be required to
register as a ``swap dealer'').

[[Page 30764]]

Conclusion

In the CFTC Entities Rule, the Commission has made many positive
policy changes. To enable these changes, however, the Commission
engages in a series of statutory contortions. Moreover, the
Commission ignores a number of important questions. Witnessing these
statutory gymnastics, I am reminded of the Robert Frost poem, ``The
Road Not Taken.'' In its eagerness to adopt the CFTC Entities Rule,
the Commission opted for one road. Specifically, the Commission
opted for providing more relief to market participants, without
contradicting the fundamental premises of the Proposal. However,
once market participants have examined the rulemaking, will the
Commission have wished that it had properly construed CEA section
1a(49) instead? Given the Proposal and the final CFTC Entities Rule
(and their respective differences), the Commission may well conclude
that ``* * * it took the one less traveled by * * * And that has
made all the difference.'' \60\
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\60\ Generally, because the vast body of administrative law
provides guideposts to the road more traveled.

[FR Doc. 2012-10562 Filed 5-22-12; 8:45 am]
BILLING CODE 6351-01-P

2012-10562

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