[Federal Register: December 13, 2000 (Volume 65, Number 240)]
[Rules and Regulations]
[page 78030-78038]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13de00-30]

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

COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 35

RIN 3038-AB58


Exemption for Bilateral Transactions

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rules.

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

SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is adopting final rules to clarify the operation of the current swaps
exemption. In addition, in a companion notice of final rulemaking
published in this edition of the Federal Register, the Commission is
adopting rules that provide for the clearing of transactions under the
revised exemption. The Commission, in other companion releases, also is
adopting a new regulatory framework to apply to multilateral
transaction execution facilities and to market intermediaries. This new
framework establishes a number of new market categories, including a
category of exempt multilateral transaction execution facility. Nothing
in these releases, however, affects the continued vitality of the
Commission's exemption for swaps transactions in effect before December
13, 2000, or any of its other existing exemptions, policy statements or
interpretations.

EFFECTIVE DATE: February 12, 2001.

FOR FURTHER INFORMATION CONTACT: Paul M. Architzel, Chief Counsel, or
Nancy E. Yanofsky, Assistant Chief Counsel, Division of Economic
Analysis, Commodity Futures Trading Commission, Three Lafayette Centre,
1155 21st Street, NW., Washington, DC 20581. Telephone: (202) 418-5260.
E-mail: [email protected] or [email protected].

SUPPLEMENTARY INFORMATION:

I. The Proposed Rules

    On June 22, 2000, the Commission published proposed amendments to
its part 35 swaps exemption to expand and to clarify its operation,
including the availability of clearing for these transactions.\1\ These
amendments were proposed in order to provide greater legal certainty to
the over-the-counter (OTC) markets and to reduce systemic risk. The
President's Working Group on Financial Markets (PWG) \2\ and the
chairmen of the Commission's Congressional oversight committees
encouraged the Commission in this undertaking.
---------------------------------------------------------------------------

    \1\ 65 FR 39033 (June 22, 2000).
    \2\ Recognizing the importance of the OTC derivatives markets,
the chairmen of the Senate and House Agriculture Committees
requested that the PWG conduct a study of OTC derivatives markets.
After studying the existing regulatory framework of OTC derivatives,
recent innovations, and the potential for future developments, the
PWG on November 9, 1999, reported to Congress its recommendations.
See Over-the-Counter Derivatives Markets and the Commodity Exchange
Act, Report of the President's Working Group on Financial Markets
(PWG Report). The PWG Report focused on promoting innovation,
competition, efficiency, and transparency in OTC derivatives markets
and in reducing systemic risk.
---------------------------------------------------------------------------

    The Commission proposed the amendments to part 35 in light of the
changes that have occurred in the OTC markets since the Commission
adopted its Swaps Policy Statement in 1989, and its subsequent part 35
swaps exemption in 1993. In the intervening years, the OTC derivatives
markets have experienced dramatic and sustained growth. During this
period, OTC financial derivatives have developed into global markets
having outstanding contracts with a total notional value of over $90
trillion.\3\ OTC derivatives have transformed finance, increasing the
range of financial products available for managing risk.
---------------------------------------------------------------------------

    \3\ See Our Estimates of Global Size Market (visited Oct. 10,
2000), http://www.swapsmonitor.com.
---------------------------------------------------------------------------

    The Commission proposed making several changes to part 35. First,
the Commission proposed deleting specific reference to ``swaps'' within
the exemption itself. Instead, the rule would refer to a ``contract,
agreement or transaction'' that meets the requisite exemptive
conditions. Moreover, as suggested by the PWG Report, the Commission
proposed to delete the requirement that exempt transactions not be
fungible or standardized and to make clear that insofar as such exempt
transactions may be cleared, creditworthiness of the counterparty is
not a condition of the exemption. PWG Report at 17. In addition, the
Commission proposed, through an exemption from the private right of
action provision of section 22 of the Act, that transactions entered
into in reliance on the part 35 swaps exemption would not be subject to
a claim for rescission solely due to a violation of the exemption's
requirements. See id. at 18.
    In proposing the rules, the Commission affirmed the continuing
vitality of the exemptive relief that it had previously granted to
transactions in the OTC market, including the part 35 exemption, the
Policy Statement Concerning Swap Transactions (54 FR 30694 (July 21,
1989)) (Swaps Policy Statement), the Statutory Interpretation
Concerning Forward Transactions (55 FR 39188 (Sept. 25, 1990)) (Energy
Interpretation), and the Exemption for Certain Contracts Involving
Energy Products (58 FR 21286 (April 20, 1993)) (Energy Exemption).
Moreover, in recognition of its continuing vitality and to assist the
public in locating it, the Commission proposed publishing the Swaps
Policy Statement as Appendix A to part 35.

II. Comments Received

    The Commission received 31 comment letters on the proposed
rulemaking.\4\ The commenters included

[[page 78031]]

nine trade associations,\5\ three future exchanges,\6\ two brokerage
firms,\7\ a coalition of commercial and investment banks,\8\ four law
firms,\9\ four representatives of the energy services community,\10\ an
agricultural firm \11\ and others.\12\
---------------------------------------------------------------------------

    \4\ In addition to these 31, a significant number of letters
commenting on aspects of the regulatory framework in companion
notices were also submitted to the Commission. In this and three
companion Notices of Final Rulemaking which are being published in
this edition of the Federal Register, comment letters (CLs) are
referenced by file number, letter number and page. Comments filed in
response to the notice of proposed rulemaking on multilateral
transaction execution facilities, parts 36-38, are contained in file
No. 21, on the notice of proposed rulemaking on intermediaries in
file No. 22, on the notice of proposed rulemaking on clearing
organizations in file No. 23 and on the notice of proposed
rulemaking on the part 35 exemption in file No. 24. These letters
are available through the Commission's internet web site, http://www.cftc.gov.
    \5\ The associations that filed comment letters are the Managed
Funds Association, the International Swaps and Derivatives
Association, Inc., the National Grain and Feed Association, the
Futures Industry Association, the Commodity Floor Brokers & Traders
Association, the Silver Users Association, the Weather Risk
Management Association, the Association for Investment Management
and Research, Advocacy Advisory Committee, Derivatives Subcommittee,
and the Securities Industry Association, OTC Derivatives Products
Committee.
    \6\ The futures exchanges that filed comment letters are the
Chicago Board of Trade, the New York Mercantile Exchange and the
Chicago Mercantile Exchange.
    \7\ The brokerage firms that filed comment letters are Merrill
Lynch & Co. Inc. and J.P. Morgan Securities Inc.
    \8\ The coalition of commercial and investment banks (the
Coalition) consists of the following financial institutions: The
Chase Manhattan Bank, Citigroup Inc., Credit Suisse First Boston
Inc., Goldman Sachs & Co., Merrill Lynch & Co., Inc. and Morgan
Stanley Dean Witter & Co.
    \9\ The law firms that filed comment letters are Covington &
Burling, McDermott, Will & Emery, on behalf of Virginia Electric &
Power Company, Vinson and Elkins, and Gardner, Carter and Douglas.
    \10\ The representatives of the energy services community that
filed comment letters are Williams Energy Marketing and Trading
Company, the California Power Exchange, Oxy Energy Services, Inc.
and Petrocosm Corporation.
    \11\ The agricultural firm that filed a comment letter is
Cargill.
    \12\ The others filing comment letters are the National Futures
Association, the Financial Markets Lawyers Group, the Federal
Reserve Bank of Chicago, the U.S. Department of the Treasury, the
Regulatory Studies Program of the Mercatus Center, Reuters Group
PLC, and The EBS Partnership.
---------------------------------------------------------------------------

    The majority of commenters strongly supported the Commission's
proposed amendments and expressed the view that the amendments, among
other things, would increase legal certainty for the OTC market. Two
commenters took the opposite view, expressing jurisdictional concerns.
The commenters also raised a number of technical issues concerning the
operation of the exemption, the definition of ``eligible participant''
and other matters. The comments are addressed in the final rules
section below.

III. The Final Rules

A. The Exemption

    Except for certain technical changes, the Commission is adopting
the proposed rules expanding and clarifying the operation of the swaps
exemption as final rules. As noted above, the majority of commenters
strongly supported the amendments, expressing the view that they will
increase legal certainty for the OTC market and reduce systemic risk.
See, e.g., CL 24-6; CL 24-8; CL 24-25; CL 24-29; CL 24-30; CL 24-31; CL
24-34; CL 24-36. The International Swaps and Derivatives Association
(ISDA) views the proposed amendments as necessary to ensuring that new
and evolving risk management tools will enjoy legal certainty
comparable to that which has been available to transactions covered by
the Commission's swaps exemption since 1993. CL 24-8 at 2. See also CL
24-6 at 3; CL 24-29 at 3-4. ISDA specifically commented that: The
proposed expansion of the exemption to cover all bilateral agreements
would ``enable market participants to focus on legal and economic
substance rather than labels'' (CL 24-8 at 3); that the elimination of
the requirement that exempt transactions not be standardized or
fungible would ``eliminate a potential source of uncertainty with
respect to the scope of the exemption'' (id.); that the authorization
of clearing would ``eliminate the `Hobson's Choice' that now exists
between legal certainty and the use of clearing to reduce systemic
risk'' (id.); and that the nonrepudiation provisions would deal
directly with the ``main source of legal risk under the CEA'' (id. at
5). As ISDA noted, the substantial growth of the OTC swaps market since
the Commission first promulgated part 35 in 1993:

did not occur in a vacuum. It was fostered by this Commission in an
earlier regulatory initiative commencing with the release of the
Swaps Policy Statement in 1989 and continuing with the promulgation
of the Swaps Exemption * * * and the Hybrids Exemption * * * These
latter actions were of course entirely consistent with the intent of
Congress, as reflected in the enactment of the Futures Trading
Practices Act of 1992. * * * The pivotal role that OTC derivatives
transaction [sic] now play in our economy is an outgrowth of these
earlier policies of the Commission and the continuing expressions of
support for those policies by Congress. ISDA believes that the
proposed regulatory initiative now under consideration can and
should be viewed as a vital and positive step in carrying out the
Commission's long-standing policy with respect to OTC derivatives.
    ISDA believes that * * * the proposed regulatory initiative is
an important change for the better. We applaud the sensitivity of
both the Commission and its professional staff to the need to avoid
structuring the proposals in ways that could result in legal
uncertainty, and we believe that the proposals will not have this
effect. We likewise applaud the decision of the Commission to
propose specific actions intended to increase, within the parameters
of the CEA, legal certainty and we believe the proposals will have
this effect. * * *

(CL 24-8 at 2; emphasis in original).
    One commenter, however, the Regulatory Studies Program of the
Mercatus Center (Mercatus), expressed the view that, by expanding the
category of products to which the exemption applies, the Commission may
exacerbate rather than reduce legal uncertainty. CL 24-21 at 4-5.
Mercatus is concerned about the ``implications'' of the broad
definitions used, commenting that, if adopted as proposed, the
Commission could attempt to exercise its antifraud authority over
contracts, agreements and transactions as to which it has no
jurisdiction. Id. Mercatus suggests that the Commission instead limit
the scope of part 35 to instruments over which the Act vests the
Commission with jurisdiction, such as ``contracts of sale of a
commodity for future delivery.'' Id. at 9.\13\
---------------------------------------------------------------------------

    \13\ J.P. Morgan Securities Inc. (J.P. Morgan) raises
jurisdictional issues similar to those raised by Mercatus, while
specifically focusing on the Commission's proposed rules concerning
exempt multilateral transaction execution facilities and recognized
clearing organizations. CL 24-19 at 2-5. The Commission is
responding to those comments more thoroughly in its companion
releases on those matters.
---------------------------------------------------------------------------

    These amendments, however, do not expand the Commission's
jurisdiction. To the contrary, the substance of part 35's scope
provision remains unchanged from the current part 35 exemption.\14\
Furthermore, the Commission's antifraud authority in rule 35.3, as
proposed and as being adopted herein, is limited to ``transactions and
persons otherwise subject to those [antifraud] provisions'' (emphasis
added). Thus, the antifraud provisions will continue to apply only to
those transactions already covered by them. The Commission's approach
is consistent with how Congress intended the Commission to exercise its
exemptive authority.\15\
---------------------------------------------------------------------------

    \14\ Commission rule 35.1(a) provides that the provisions of the
exemption apply to any transaction ``which may be subject to the
Act'' (emphasis added). The final rules amend this scope provision
to incorporate a technical amendment which substitutes the phrase
``any contract, agreement or transaction'' for ``any swap
agreement.'' This change merely conforms the formal statement of
scope in rule 35.1(a) to the substantive provisions of the rule.
    \15\ When it adopted section 4(c) in 1992, the Conferees of the
Congress stated:
    The Conferees do not intend that the exercise of exemptive
authority by the Commission [under section 4(c)] would require any
determination beforehand that the agreement, instrument, or
transaction for which an exemption is sought is subject to the Act.
Rather, this provision provides flexibility for the Commission to
provide legal certainty to novel instruments where the determination
as to jurisdiction is not straightforward.
    H.R. Rep. No. 978, 102d Cong., 2d Sess. 82-83 (1992). The
Commission did not make a determination in 1993 that the
transactions that it was exempting under part 35 were or were not
subject to its jurisdiction. The Commission similarly declined to
make any such determination in proposing the current amendments to
part 35 and will not make any such determination now.

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

[[page 78032]]

    Moreover, the contract nonrepudiation provision that the Commission
is adopting today further removes any potential legal uncertainty. As
one commenter, McDermott, Will & Emery, on behalf of Virginia Electric
& Power Company, noted, this provision ``would prevent economically
disappointed counterparties from bringing a private cause of action
seeking to void the contract on the theory that it is illegal.'' CL 24-
25 at 2. This provision, as ISDA commented, will reduce legal
uncertainty because ``[it] deal[s] directly with the main source of
legal risk under the CEA.'' CL 24-8 at 5.
    The expansion of the exemption to cover all bilateral ``contracts,
agreements and transactions'' was endorsed by most other commenters. As
one commenter, Reuters Group PLC, noted, this amendment should permit a
``substantially broader range of transactions to enjoy a new level of
legal certainty.'' CL 24-30 at 2. In this regard, the Commission
believes that certain pending matters may now be considered within the
context of the new regulatory framework.
    Two commenters, a coalition of commercial and investment banks (the
Coalition)\16\ and the OTC Derivatives Products Committee of the
Securities Industry Association (SIA), recommended two changes
regarding the operation of the exemption. CL 24-31; CL 24-36. First,
they suggested that the Commission delete the requirement of the
exemption that, in cases where a transaction is not submitted for
clearing,\17\ the creditworthiness of the counterparty be a material
consideration in entering into the transaction. These commenters
believe that retention of the creditworthiness requirement for non-
cleared transactions will create uncertainty and confusion as to what
types of non-cleared transactions are permissible. The Commission
agrees and has deleted the creditworthiness requirement from part 35.
---------------------------------------------------------------------------

    \16\ See note 8, supra.
    \17\ For rules pertaining to clearing, see part 39 which the
Commission is adopting in a companion release in this edition of the
Federal Register.
---------------------------------------------------------------------------

    The Coalition and SIA also recommended that rule 35.2(d) be amended
to authorize explicitly the netting of deliveries or delivery
obligations in connection with transactions pursuant to part 35.
Currently, part 35 permits bilateral arrangements for the netting of
payment obligations. It also permits multilateral arrangements for the
netting of payments ``provided that the underlying gross obligations
among the parties are not extinguished until all netted obligations are
fully performed.'' 58 FR at 5591. SIA commented that many categories of
OTC derivatives require or permit settlement by delivery, that it can
see no policy reason for excluding netting of such deliveries while
permitting netting of payments, and that permitting such netting would
be consistent with the goal of reducing systemic risk for OTC
derivatives. CL 24-36 at 10. In light of these comments, the Commission
is clarifying that the types of netting agreements that are permissible
under part 35 include arrangements for the netting of delivery
obligations or deliveries, respectively. As is currently the case for
multilateral netting of payments, multilateral netting of deliveries
would be permitted provided that the underlying gross obligations among
the parties are not extinguished until all netted obligations are fully
performed.
    ISDA, the Coalition and SIA suggested that the Commission clarify
that the determination whether a party is an eligible participant is to
be determined by whether there was a reasonable belief at the time the
transaction was entered into that a party was an eligible participant.
CL 24-8 at 3; CL 24-31 at 8; CL 24-36 at 8. The language of the
exemption currently tracks the language of the statute, which provides
that the Commission shall not grant an exemption under section 4(c) of
the Act unless the Commission determines that the exempted transaction
``will be entered into solely between appropriate persons.'' 7 U.S.C.
6(c)(2)(B)(i). However, as the Commission noted when it adopted the
swaps exemption in 1993 (58 FR at 5589; footnotes omitted):

    As the Act specifies that the swap agreement may only be
``entered into'' by appropriate persons, this determination is to be
made at the inception of the transaction. Further, it is sufficient
that the parties have a reasonable basis to believe that the other
party is an eligible swap participant at such time.

Furthermore, the Commission notes that the nonrepudiation provision
specifically exempts a party from a rescission action based solely on
the failure of the agreement to comply with the terms of the exemption
when that party entered into the agreement with an eligible participant
or with a counterparty ``reasonably believed by such party at the time
the transaction was entered into'' to be an eligible counterparty.\18\
---------------------------------------------------------------------------

    \18\ The Commission has made a technical change to the
nonrepudiation provision in rule 35.3(b) to make clear that the
reasonable belief is to exist at the time the transaction is entered
into. In addition, the Commission has reorganized the nonrepudiation
provisions of section 35.3.
---------------------------------------------------------------------------

    As part of its proposed amendments to part 35, the Commission
proposed to publish its Swaps Policy Statement as Appendix A to part 35
and to include its Swaps Policy Statement and its Statutory
Interpretation Concerning Certain Hybrid Instruments (55 FR 13582
(April 11, 1990)) (Hybrid Interpretation) within the nonrepudiation
provision. The commenters generally supported these proposals, but
recommended that the Commission update the Swaps Policy Statement,
provide additional relief regarding the Treasury Amendment (7 U.S.C.
2(ii)) and revise and update the Hybrid Interpretation. CL 24-31 at 14-
16; CL 24-36 at 3-7. As the Commission has noted, nothing in these
rules affects the continuing vitality of the Commission's existing
exemptions, policy statements or interpretations. The Commission is
persuaded, however, that these commenters have raised important issues
which, although outside the scope of this rulemaking, should be
addressed expeditiously. The Commission plans to address these issues
through a separate rulemaking or other appropriate action.

B. Eligible Participants

    A number of commenters suggested changes to the definition of
``eligible participant'' in rule 35.1. The Commission proposed applying
the definition of eligible participant set forth in the 1993 swaps
exemption\19\ to the revised and amended bilateral transaction
exemption in part 35. Two commenters, the Managed Funds Association
(MFA) and the Futures

[[page 78033]]

Industry Association (FIA), suggested that the Commission create a new
category of eligible participant that would include certain large
commodity trading advisors. CL 24-4 at 4; CL 24-12 at 11. Specifically,
MFA and FIA suggested that commodity trading advisors (CTAs) with at
least $25 million in assets under management be permitted to trade in
all exempt markets on behalf of their customers, without regard to the
individual customers' financial qualifications. FIA also suggested that
registered investment advisers (IAs) with at least $25 million in
assets under management be included in this category of eligible
participant.
---------------------------------------------------------------------------

    \19\ That definition generally uses the list of ``appropriate
persons'' set forth in section 4(c)(3)(A) through (J) of the Act,
and utilizes the authority granted by section 4(c)(3)(K) to
determine other persons to be appropriate persons (specifically,
natural persons with total assets exceeding at least $10 million).
The Commission placed certain financial and other limitations on
various categories of appropriate persons, consistent with Congress'
intent that the Commission may limit the terms of an exemption to
some, but not all, of the listed categories of appropriate persons.
See H.R. Rep. No. 978, 102nd Cong., 2d Sess. 79 (1992).
---------------------------------------------------------------------------

    Several other commenters suggested additional modifications to the
definition of eligible participant. ISDA, the Coalition, The EBS
Partnership and SIA recommended that the definition of eligible
participant be expanded to include several additional categories of
financial institutions and to include agency transactions by eligible
participants on behalf of other eligible participants. CL 24-8; CL 24-
31; CL 24-34; CL 24-36. Certain commenters, including the California
Power Exchange, the National Grain and Feed Association (NGFA) and the
Weather Risk Management Association, suggested that the financial
thresholds for corporations and other entities were too restrictive. CL
24-5; CL 24-10; CL 24-28. Other commenters, including the FIA, the
Coalition and SIA, commented that the financial threshold for natural
persons who enter into exempt transactions for risk management purposes
should be reduced from a total asset test of $10 million to a total
asset test of $5 million. CL 24-12; CL 24-31; CL 24-36. Finally, the
National Futures Association suggested that the Commission impose a $5
million asset test on investment companies to conform the standard for
those collective investment vehicles to that which applies to commodity
pools. CL 24-4.\20\
---------------------------------------------------------------------------

    \20\ Many commenters also suggested modifications to the
Commission's proposed definition of ``multilateral transaction
execution facility'' in part 36. These comments are addressed in a
companion release being issued by the Commission today adopting
final rules governing multilateral transaction execution facilities.
In this regard, the Commission notes that the use of the term
``bilateral'' in the title of part 35 does not import any
independent requirements regarding the exemption. Taken together,
however, part 35 governing bilateral transactions and parts 36
through 38 governing multilateral transactions execution facilities
are intended to be seamless in the sense that transactions that do
not fall within the definition of multilateral transaction execution
facility in part 36 will be considered to be bilateral.
---------------------------------------------------------------------------

    After careful consideration of these comments, the Commission is
modifying the definition of eligible participant to permit agency
transactions by eligible participants on behalf of other eligible
participants,\21\ to include foreign banks and their U.S. branches and
agencies and the regulated subsidiaries and affiliates of insurance
companies within that definition and to include a $5 million asset test
for investment companies (as is required for investment companies under
the current part 36). The Commission will consider MFA's and NFA's
suggestion that a new category of eligible participant be added for
registered CTAs and IAs with at least $25 million in assets under
management in conjunction with its subsequent review of relief for CPOs
and CTAs.\22\
---------------------------------------------------------------------------

    \21\ In light of this general agency authorization by eligible
participants on behalf of other eligible participants, the
Commission is deleting the language in paragraphs 35.1(b)(2)(i),
(ix) and (x) which specifically authorizes certain entities such as
banks and futures commission merchants that are eligible
participants to act in an agency capacity on behalf of other
eligible participants. See 7 U.S.C. 6(c)(3)(A), (I) and (J). This
specific authorization is now unnecessary.
    \22\ In a companion release being issued in this edition of the
Federal Register, however, the Commission has modified the access
standards for CTAs to provide that CTAs with at least $25 million
under management may trade on a recognized derivatives transaction
facility through any registered futures commission merchant.
Moreover, in response to the comments of the futures exchanges, in
the same companion release being issued today, the Commission has
modified the eligibility standards for recognized derivatives
transaction facilities to include certain registered floor brokers
and floor traders. The Commission, however, is retaining the
existing eligibility standards for floor brokers and floor traders
when entering into bilateral transactions under part 35 (and when
trading on exempt multilateral transaction execution facilities).
---------------------------------------------------------------------------

    In response to the comments regarding expanding the categories of
eligible financial institutions and reducing the financial thresholds
for corporations and other entities, the Commission notes that the
current definition of eligible participant contains a general corporate
category, which itself contains alternative means of qualifying, and
that this general corporate category enables many different types and
sizes of entities (including financial institutions) to qualify as
eligible participants under part 35. As the Coalition acknowledges (CL
24-31 at 6), many financial institutions that are not specifically
encompassed by the definition of eligible participant fall within this
general corporate category. The Commission believes that this general
corporate category is an appropriate standard to determine corporate
eligibility.\23\
---------------------------------------------------------------------------

    \23\ Furthermore, with regard to the comments suggesting that
some of the financial thresholds in the definition are too
restrictive, the Commission notes that the part 35 definition of
eligible participant has worked well over the years and that the
amounts in real terms are less restrictive than when the exemption
was first adopted.
---------------------------------------------------------------------------

C. Agricultural Trade Options

    Finally, the NGFA and Cargill opined that the bilateral transaction
exemption should be available for all transactions in the agricultural
commodities enumerated in section 1a(3) of the Act, including
agricultural trade options. CL 24-10 at 3; CL 24-15 at 1-2. The
Commission is retaining in part 35 its reservation of rule 32.13 which
governs trading in certain agricultural trade options at this time.\24\
The Commission has not yet had sufficient experience with rule 32.13,
which the Commission recently reconsidered and adopted (64 FR 68011
(December 6, 1999)), to determine whether the $10 million net worth
level should be modified. Furthermore, at the time the Commission
adopted that exemptive level it noted the lack of industry consensus on
the issue. Id. at 68015. The Commission has no reason to believe that a
greater level of consensus has been reached since that time.
---------------------------------------------------------------------------

    \24\ Rule 32.13 includes its own exemption which imposes a
different financial threshold than part 35. Under rule 32.13(g), an
option is exempt from various regulatory requirements if, among
other things, each party to the option has a net worth of not less
than $10 million. The Commission has reserved the application of
rule 32.13 in part 35, see rule 35.3(a), and it is that reservation
to which NGFA and Cargill object.
---------------------------------------------------------------------------

    The Commission reiterates that these amendments to the part 35
exemption are designed to enhance legal certainty. In adopting these
amendments to part 35, the Commission is not making any determination
that the exempted transactions are or are not subject to its
jurisdiction. When it adopted section 4(c) in 1992, the Conferees of
the Congress stated:

    The Conferees do not intend that the exercise of exemptive
authority by the Commission [under section 4(c)] would require any
determination beforehand that the agreement, instrument, or
transaction for which an exemption is sought is subject to the Act.
Rather, this provision provides flexibility for the Commission to
provide legal certainty to novel instruments where the determination
as to jurisdiction is not straightforward.\25\

    \25\ H.R. Rep. No. 978, 102d Cong., 2d Sess. 82-83 (1992).

    Moreover, these changes in no way call into question any
transaction undertaken under part 35 before the adoption of these
amendments. In recognition of its continuing vitality and to assist the
public in locating it, the Commission as proposed is incorporating its
1989 Swaps Policy

[[page 78034]]

Statement as Appendix A to part 35.\26\ Finally, the Commission again
affirms the continuing applicability of its Energy Interpretation and
its Energy Exemption which are not being changed or altered in any way
by these part 35 amendments.
---------------------------------------------------------------------------

    \26\ The Swaps Policy Statement originally was published at 54
FR 30694 (July 21, 1989). In this republication, the Commission has
corrected certain typographical errors that appeared in the original
publication.
---------------------------------------------------------------------------

III. Section 4(c) Findings

    These rule amendments are being promulgated under section 4(c) of
the Act, which grants the Commission broad exemptive authority. Section
4(c) of the Act provides that, in order to promote responsible economic
or financial innovation and fair competition, the Commission may by
rule, regulation or order exempt any class of agreements, contracts or
transactions, either unconditionally or on stated terms or conditions
from any of the requirements of any provision of the Act. For any
exemption granted pursuant to section 4(c), the Commission must find
that the exemption would be consistent with the public interest. For
any exemption granted pursuant to section 4(c) from the requirements of
section 4(a), the Commission must further find that the section 4(a)
requirements should not be applied to the agreement, contract or
transaction to be exempted, that the exemption would be consistent with
the public interest and the purposes of the Act, that the agreement,
contract or transaction to be exempted would be entered into solely
between appropriate persons and that the exemption would not have a
material adverse effect on the ability of the Commission or any
contract market to discharge its regulatory or self-regulatory duties
under the Act.\27\
---------------------------------------------------------------------------

    \27\ See 7 U.S.C. 6(c).
---------------------------------------------------------------------------

    No one commented directly on the Commission's section 4(c)
findings. Two U.S. futures exchanges, the Chicago Board of Trade and
the Chicago Mercantile Exchange, however, cautioned the Commission to
ensure that traditional exchange markets would not be put at an unfair
competitive disadvantage within this new regulatory regime contemplated
by this and the Commission's companion Federal Register releases. CL
24-7 at 12-13; CL 24-17 at 13-14. In this regard, the Commission
believes that the regulatory lines that it has drawn are necessary and
appropriate to protect the public interests embodied in the Act. Under
the framework as a whole, the degree of regulation will turn on whether
the market is multilateral, whether the market participants are
eligible and whether or not the commodity is susceptible to
manipulation. The Commission believes that these are appropriate
factors on which to base regulatory differences and that, within the
framework, the exchanges will be able to fairly compete with the OTC
market.
    The proposed exemption for bilateral transactions is available only
to appropriate persons. Moreover, these amendments to part 35 will
promote financial innovation and fair competition and reduce systemic
risk. The Commission further finds that these proposed amendments would
have no adverse effect on any of the regulatory or self-regulatory
responsibilities imposed by the Act. Finally, the Commission finds that
these amendments are consistent with the public interest.

IV. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA), 5 U.S.C. 601 et seq.,
requires that agencies, in promulgating rules, consider the impact of
these rules on small entities. A small entity is defined to include,
inter alia, a ``small business'' and a ``small organization.'' 5 U.S.C.
601(6).\28\ The Commission previously has formulated its own standards
of what constitutes a small business with respect to the types of
entities regulated by it. The Commission has determined that contract
markets, futures commission merchants, registered commodity pool
operators, and large traders should not be considered small entities
for purposes of the RFA.\29\
---------------------------------------------------------------------------

    \28\ ``Small organization,'' as used in the RFA, means ``any
not-for-profit enterprise which is independently owned and operated
and is not dominant in its field * * *.'' 5 U.S.C. 601(4). The RFA
does not incorporate the size standards of the Small Business
Administration for small organizations. Agencies are expressly
authorized to establish their own definition of small organization.
Id.
    \29\ 47 FR 18618-20 (Apr. 20, 1982).
---------------------------------------------------------------------------

    The Commission believes that it is unlikely that firms defined as
small businesses under Section 3 of the Small Business Act could offer
or be offered transactions subject to the part 35 exemption and thus be
affected by the rules exempting such transactions. See 58 FR 5587, 5593
(January 22, 1993). Further, the amendments to part 35 that the
Commission is adopting today remove the requirement that the exempt
transactions not be fungible or standardized as to their material
economic terms and makes the expanded relief available to a broader
category of transactions.
    Accordingly, the Chairman, on behalf of the Commission, certifies
pursuant to section 3(a) of the RFA, 5 U.S.C. 605(b), that the
amendments to part 35 will not have a significant economic impact on a
substantial number of small entities. In this regard, the Commission
notes that it did not receive any comments regarding the RFA
implications of the amendments to part 35.

B. Paperwork Reduction Act

    The Paperwork Reduction Act (PRA) of 1995 (44 U.S.C. 3507(d))
imposes certain requirements on federal agencies (including the
Commission) in connection with their conducting or sponsoring any
collection of information as defined by the PRA. As the Commission
noted in proposing these amendments, it has determined that the PRA
does not apply to these amendments because they do not contain
information collection requirements which require the approval of the
Office of Management and Budget. No comments were received concerning
the Commission's determination in this regard.

List of Subjects in 17 CFR Part 35

    Commodity futures, Commodity Futures Trading Commission.

    In consideration of the foregoing, and pursuant to the authority
contained in the Commodity Exchange Act and, in particular, sections 2,
4, 4c, and 8a thereof, 7 U.S.C. 2, 6, 6c, and 12a, the Commission
hereby revises part 35 of title 17 of the Code of Federal Regulations
to read as follows:

PART 35--EXEMPTION OF BILATERAL AGREEMENTS

Sec.
35.1  Scope and definitions.
35.2  Exemption.
35.3  Enforceability.
Appendix A to Part 35--Policy Statement Concerning Swap Transactions

    Authority: 7 U.S.C. 2, 6, 6c, and 12a.


Sec. 35.1  Scope and definitions.

    (a) Scope. The provisions of this part shall apply to any contract,
agreement or transaction which may be subject to the Act, and which has
been entered into on or after October 23, 1974.
    (b) Definition. As used in this part, ``eligible participant''
means, and shall be limited to, the following persons or classes of
persons, either trading for their own account or through another
eligible participant:
    (1) A bank or trust company or a foreign bank or a branch or agency
of a

[[page 78035]]

foreign bank (as defined in section 1(b) of the International Bank Act
of 1978 (12 U.S.C. 3101(b));
    (2) A savings association or credit union;
    (3) An insurance company that is regulated by a State or that is
regulated by a foreign government and is subject to comparable
regulation (including a regulated subsidiary or affiliate of such an
insurance company);
    (4) An investment company subject to regulation under the
Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) or a foreign
person performing a similar role or function subject as such to foreign
regulation, provided that such investment company or foreign person is
not formed solely for the specific purpose of constituting an eligible
participant and has total assets exceeding $5,000,000;
    (5) A commodity pool formed and operated by a person subject to
regulation under the Act or a foreign person performing a similar role
or function subject as such to foreign regulation, provided that such
commodity pool or foreign person is not formed solely for the specific
purpose of constituting an eligible participant and has total assets
exceeding $5,000,000;
    (6) A corporation, partnership, proprietorship, organization,
trust, or other entity not formed solely for the specific purpose of
constituting an eligible participant:
    (i) Which has total assets exceeding $10,000,000, or
    (ii) The obligations of which under the contract, agreement or
transaction are guaranteed or otherwise supported by a letter of credit
or keepwell, support, or other agreement by any such entity referenced
in paragraph (b)(6) of this section or by an entity referred to in
paragraph (b)(1), (2), (3), (4), (5), (6) or (8) of this section; or
    (iii) Which has a net worth of $1,000,000 and enters into the
agreement in connection with the conduct of its business; or which has
a net worth of $1,000,000 and enters into the agreement to manage the
risk of an asset or liability owned or incurred in the conduct of its
business or reasonably likely to be owned or incurred in the conduct of
its business;
    (7) An employee benefit plan subject to the Employee Retirement
Income Security Act of 1974 or a foreign person performing a similar
role or function subject as such to foreign regulation with total
assets exceeding $5,000,000, or whose investment decisions are made by
a bank, trust company, insurance company, investment adviser subject to
regulation under the Investment Advisers Act of 1940 (15 U.S.C. 80a-1
et seq.), or a commodity trading advisor subject to regulation under
the Act;
    (8) Any governmental entity (including the United States, any
state, or any foreign government) or political subdivision thereof, or
any multinational or supranational entity or any instrumentality,
agency, or department of any of the foregoing;
    (9) A broker-dealer subject to regulation under the Securities
Exchange Act of 1934 (15 U.S.C. 78a et seq.) or a foreign person
performing a similar role or function subject as such to foreign
regulation: Provided, however, that if such broker-dealer is a natural
person or proprietorship, the broker-dealer must also meet the
requirements of either paragraph (b)(6) or (11) of this section;
    (10) A futures commission merchant, floor broker, or floor trader
subject to regulation under the Act or a foreign person performing a
similar role or function subject as such to foreign regulation:
Provided, however, that if such futures commission merchant, floor
broker, or floor trader is a natural person or proprietorship, the
futures commission merchant, floor broker, or floor trader must also
meet the requirements of paragraph (b)(6) or (b)(11) of this section;
or
    (11) Any natural person with total assets exceeding at least
$10,000,000.


Sec. 35.2  Exemption.

    A contract, agreement or transaction is exempt from all provisions
of the Act and any person or class of persons offering, entering into,
rendering advice, or rendering other services with respect to such
contract, agreement or transaction, is exempt for such activity from
all provisions of the Act (except in each case the provisions
enumerated in Sec. 35.3(a)) provided the following terms and conditions
are met:
    (a) The contract, agreement or transaction is entered into solely
between eligible participants either trading for their own account or
through another eligible participant;
    (b) The contract, agreement or transaction is not entered into and
traded on or through a multilateral transaction execution facility as
defined in Sec. 36.1 of this chapter; and
    (c) The contract, agreement or transaction, if cleared, is
submitted for clearance or settlement to a clearinghouse that is
authorized under Sec. 39.2 of this chapter.
    (d) The provisions of paragraphs (b) and (c) of this section shall
not be deemed to preclude:
    (1) Arrangements or facilities between parties to such contracts,
agreements or transactions that provide for netting of payment or
delivery obligations resulting from such contracts, agreements or
transactions;
    (2) Arrangements or facilities among parties to such contracts,
agreements or transactions that provide for netting of payments or
deliveries resulting from such contracts, agreements or transactions;
or
    (3) The use of an electronic or non-electronic market or similar
facility used solely as a means of communicating bids or offers by
market participants or the use of such a market or facility by a single
counterparty to offer to enter into or to enter into bilateral
transactions with multiple counterparties.
    (e) Any person may apply to the Commission for exemption from any
of the provisions of the Act (except section 2(a)(1)(B)) for other
arrangements or facilities, on such terms and conditions as the
Commission deems appropriate, including but not limited thereto, the
applicability of other regulatory regimes.


Sec. 35.3  Enforceability.

    (a) Notwithstanding the exemption in Sec. 35.2, sections
2(a)(1)(B), 4b, and 4o of the Act, Sec. 32.9 of this chapter as adopted
under section 4c(b) of the Act, Sec. 32.13 of this chapter, and
sections 6(c) and 9(a)(2) of the Act to the extent that they prohibit
manipulation of the market price of any commodity in interstate
commerce or for future delivery on or subject to the rules of any
contract market, continue to apply to transactions and persons
otherwise subject to those provisions.
    (b) A party to a contract, agreement or transaction that is with a
counterparty that is an eligible participant (or counterparty
reasonably believed by such party at the time the contract, agreement
or transaction was entered into to be an eligible participant) shall be
exempt from any claim, counterclaim or affirmative defense by such
counterparty under section 22(a)(1) of the Act or any other provision
of the Act:
    (1) That such contract, agreement or transaction is void, voidable
or unenforceable, or
    (2) To rescind, or recover any payment made in respect of, such
contract, agreement or transaction, based solely on the failure of such
party or such contract, agreement or transaction to comply with the
terms or conditions of the exemption under this part.
    (c) A party to a contract, agreement or transaction that is entered
into pursuant to the Statement of Policy Concerning Swap Transactions
in appendix A to

[[page 78036]]

this part 35 or the Statutory Interpretation Concerning Certain Hybrid
Instruments, as the same may be revised by the Commission from time to
time, shall be exempt from any claim under section 22(a)(1) of the Act
or any other provision of the Act:
    (1) That such contract, agreement or transaction is void, voidable
or unenforceable, or
    (2) To rescind, or recover any payment made in respect of, such
contract, agreement or transaction, based solely on the failure of such
party, or such contract, agreement or transaction, to comply with the
Statement of Policy Concerning Swap Transactions in appendix A to this
part 35 or the Statutory Interpretation Concerning Certain Hybrid
Instruments, as the same may be revised by the Commission from time to
time, respectively, or with any provision of the Act or other
Commission rule or exemption, excluding, in the case of this paragraph,
any claim for manipulation or fraud arising under a provision of the
Act or Commission rules applicable by its terms to a contract,
agreement or transaction that is not otherwise subject to regulation
under the Act.

Appendix A to Part 35--Policy Statement Concerning Swap Transactions

    (a) Background.
    (1) Section 2(a)(1)(A) of the Commodity Exchange Act (CEA or
Act) grants the Commission exclusive jurisdiction over ``accounts,
agreements (including any transaction which is of the character of *
* * an `option' * * *), and transactions involving contracts of sale
of a commodity for future delivery traded or executed on a contract
market * * * or any other board of trade, exchange, or market. * *
*'' 7 U.S.C. 2. The CEA and Commission regulations require that
transactions in commodity futures contracts and commodity option
contracts, with narrowly defined exceptions, occur on or subject to
the rules of contract markets designated by the CFTC.\1\ In several
recent releases \2\ and in response to requests for case-by-case
review of various proposed offerings,\3\ the Commission has
addressed the applicability of the Act and Commission regulations to
various forms of commodity-related instruments offered and sold
other than on designated contract markets. An overview of off-
exchange transactions and issues was commenced by issuance in
December 1987 of an Advance Notice of Proposed Rulemaking (Advance
Notice). The Advance Notice requested comment concerning, among
other things, a proposed no-action position concerning certain
commercial transactions, which, as described, would have extended to
certain categories of swap transactions.
---------------------------------------------------------------------------

    \1\ 7 U.S.C. 6(a), 6c(b), 6c(c). Section 4(a) of the CEA
provides, inter alia, that it is unlawful to enter into a commodity
futures contract that is not made ``on or subject to the rules of a
board of trade which has been designated by the Commission as a
`contract market' for such commodity.'' 7 U.S.C. 6(a). This
prohibition does not apply to futures contracts made on or subject
to the rules of a foreign board of trade, exchange or market. 7
U.S.C. 6(a). The exchange trading requirement reflects Congress's
view that such an environment would control speculation and promote
hedging. H.R. Rep. No. 44, 67th Cong., 1st Sess. 2 (1921). See also
7 U.S.C. 5 (Congressional findings concerning necessity for
regulation of futures and commodity option transactions). Pursuant
to sections 4c(b) and 4c(d), 7 U.S.C. 6c(b) and 6c(d), of the CEA,
the Commission has authority to permit transactions in commodity
options which do not take place on contract markets. Currently, only
two narrow categories of such option transactions exist: trade
options (in which the offeree is a ``commercial user'' of the
underlying commodity) and dealer options (in which the grantor
fulfills the criteria of section 4c(d)(1) of the CEA). See also 54
FR 1128 (January 11, 1989) (Proposed Rules Concerning Regulation of
Hybrid Instruments). Final Rules Concerning Regulation of Hybrid
Instruments.
    \2\ 52 FR 47022 (December 11, 1987) (Advance Notice of Proposed
Rulemaking); 54 FR 1139 (January 11, 1989) (Statutory Interpretation
Concerning Certain Hybrid Instruments); 54 FR 1128 (January 11,
1989) (Proposed Rules Concerning Regulation of Hybrid Instruments).
See also 50 FR 42963 (October 23, 1985) (Statutory Interpretation
and Request for Comments Concerning Trading in Foreign Currencies
for Future Delivery).
    \3\ The Commission staff's Task Force on Off-Exchange
Instruments has addressed a number of proposed offerings of hybrid
instruments in a series of published ``no-action'' letters. See,
e.g., CFTC Advisory No. 39-88, June 23, 1988 [Interpretative Letter
No. 88-10, June 20, 1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,262]
(notes indexed to dollar/Yen exchange rate); CFTC Advisory No. 45-
88, July 19, 1988 [Interpretative Letter No. 88-11, July 13, 1988, 2
Comm. Fut. L. Rep. (CCH) para. 24,284] (notes indexed to dollar/Yen
exchange rate); CFTC Advisory No. 48-88, July 26, 1988
[Interpretative Letter No. 88-12, July 22, 1988, 2 Comm. Fut. L.
Rep. (CCH) para. 24,285] (notes indexed to dollar/foreign currency
exchange rate); CFTC Advisory No. 58-88, August 30, 1988
[Interpretative Letter No. 88-16, August 26, 1988, 2 Comm. Fut. L.
Rep. (CCH) para. 24,312] (federally-chartered corporation issuing
notes indexed to nationally disseminated measure of inflation
published by a U.S. government agency); CFTC Advisory No. 63-88,
September 21, 1988 [Interpretative Letter No. 88-17, September 6,
1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,320] (fixed-rate
debentures with additional payments indexed to the price of natural
gas over an established base price); CFTC Advisory No. 66-88,
September 23, 1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,321
(certificates of deposit with interest payable at maturity indexed
in part to the spot price of gold). See also CFTC Advisory No. 18-
19, March 17, 1989 (letter dated November 23, 1988, concerning
proposed sale of hay for delayed delivery).
---------------------------------------------------------------------------

    (2) Based upon careful review of the comments received in
response to the Advance Notice, indicating generally a need for
greater clarity in this area, representations from market users, and
consultations with other federal regulators concerning the issues
raised by swap transactions, the Commission is issuing this policy
statement to clarify its view of the regulatory status of certain
swap transactions. This statement reflects the Commission'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 Act and regulations. This policy
statement is intended to recognize a non-exclusive safe harbor for
transactions satisfying the requirements set forth in this Appendix.
    (b) Safe harbor standards. (1) In determining whether a
transaction constitutes a futures contract, the Commission and the
courts have assessed the transaction ``as a whole with a critical
eye toward its underlying purpose.'' \4\ Such an assessment entails
a review of the ``overall effect'' of the transaction as well as a
determination as to ``what the parties intended.'' \5\ Although
there is no definitive list of the elements of futures contracts,
the CFTC and the courts recognize certain elements as common to such
contracts.\6\ Futures contracts are contracts for the purchase or
sale of a commodity for delivery in the future at a price that is
established when the contract is initiated, with both parties to the
transaction obligated to fulfill the contract at the specified
price. In addition, futures contracts are undertaken principally to
assume or shift price risk without transferring the underlying
commodity. As a result, futures contracts providing for delivery may
be satisfied either by delivery or offset.
---------------------------------------------------------------------------

    \4\ CFTC v. Co Petro Marketing Group, Inc., 680 F.2d 573, 581
(9th Cir. 1982).
    \5\ CFTC v. Trinity Metals Exchange, No. 85-1482-CV-W-3 (W.D.
Mo. January 21, 1986] [citing CFTC v. National Coal Exchange, Inc.
[1980-1982 Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 21,424 at
26,046 (W.D. Tenn. 1982)].
    \6\ See generally, 52 FR 47022, 47023 (December 11, 1987)
(citing In the Matter of First National Monetary Corp., [1984-1986
Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 22,698 (CFTC 1985));
Letter to the Honorable Patrick Leahy and the Honorable Richard
Lugar, Committee on Agriculture, Nutrition and Forestry, United
States Senate, from Wendy L. Gramm, Chairman, Commodity Futures
Trading Commission, dated May 16, 1989 (Attachment at 7-8). The
Commission has explained that this does not mean that ``all
commodity futures contracts must have all of these elements * * *''
In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH)
para. 20,941 (CFTC 1979). To hold otherwise would permit ready
evasion of the CEA.
---------------------------------------------------------------------------

    (2) In addition to these necessary elements, the CFTC and the
courts also recognize certain additional elements common to
exchange-traded futures contracts, including standardized commodity
units, margin requirements related to price movements, clearing
organizations which guarantee counterparty performance, open and
competitive trading in centralized markets, and public price
dissemination.\7\ These additional elements facilitate the trading
of futures contracts on exchanges and historically have developed in
conjunction with the growth of organized contract

[[page 78037]]

markets. The presence or absence of these additional elements,
however, is not dispositive of whether a transaction is a futures
contract.\8\
---------------------------------------------------------------------------

    \7\ E.g., Advance Notice, 52 FR 47023; Letter to the Honorable
Patrick Leahy and the Honorable Richard Lugar, Committee on
Agriculture, Nutrition and Forestry, United States Senate, from
Wendy L. Gramm, Chairman, Commodity Futures Trading Commission,
dated May 16, 1989 (Attachment at 8); OGC Statutory and Regulatory
Interpretation (Regulation of Leverage Transactions and Other Off-
Exchange Future Delivery-Type Instruments), 50 FR 11656, 11657, n.2
(March 25, 1985); CFTC v. Co Petro Marketing Group, Inc., 680 F.2d
573 (9th Cir. 1982).
    \8\ In addition, the Commission and the courts have consistently
recognized that ``the requirement that a futures contract be
executed on a designated contract market is what makes the contract
legal, not what makes it a futures contract.'' In the Matter of
First National Monetary Corp., [1984-1986 Transfer Binder] Comm.
Fut. L. Rep. (CCH) para. 22,698 at 30,975 (CFTC 1985); In re
Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) para.
20,941 at 23,776 (CFTC 1979). See, also, Interpretative Statement,
``The Regulation of Leverage Transactions and Other Off-Exchange
Future Delivery Type Investments-Statutory Interpretation,'' 50 FR
11656 (March 25, 1985).
---------------------------------------------------------------------------

    (3) In general, a swap may be characterized as an agreement
between two parties to exchange a series of cash flows measured by
different interest rates, exchange rates, or prices with payments
calculated by reference to a principal base (notional amount).\9\
Commenters have described the swap market as one in which the
customary large transaction size effectively limits the market to
institutional participants rather than the retail public.\10\ Market
participants also have noted that swaps typically involve long-term
contracts, with maturities ranging up to twelve years.\11\ In
addition to these characteristics, many comparisons between swaps
and futures contracts have stressed the tailored, non-standardized
nature of swap terms; the necessity for particularized credit
determinations in connection with each swap transaction (or series
of transactions between the same counterparties); the lack of public
participation in the swap markets; and the predominantly
institutional and commercial nature of swap participants. Other
commenters have stressed that, despite these distinctions in the
manner of trading of swaps and exchange products, the economic
reality of swaps nevertheless resembles that of futures contracts.
---------------------------------------------------------------------------

    \9\ See generally, Bank for International Settlements, Recent
Innovations in International Banking at 37-60 (April 1986); S.K.
Henderson, ``Swap Credit Risk: A Multi-Perspective Analysis,'' 44
Business Lawyer 365 (1989). Interest rate swaps have been described
as having three primary forms: coupon swaps (fixed rate to floating
rate swaps); basis swaps (swap of one floating rate for another
floating rate); and cross-currency interest rate swaps (swaps of
fixed rate payments in one currency to floating rate payments in
another currency). Currency swap transactions involve agreements
between two parties providing for exchanges of amounts in different
currencies which are calculated on the basis of a pre-established
interest rate, a specified exchange rate, and a specified notional
amount. Commodity swaps generally include swap transactions similar
in structure to interest rate swaps, except that payments are
calculated by reference to the price of a specified commodity, such
as oil.
    \10\ The average notional amount for swaps has been estimated at
$24 million. Letter from the New York Clearing House to CFTC, dated
April 6, 1989, commenting on Proposed Rule and Statutory
Interpretation Concerning Certain Hybrid and Related Instruments.
    \11\ E.g., Letter to CFTC from the International Swap Dealers
Association, Inc., dated April 8, 1988, concerning Advance Notice;
letter to CFTC from Morgan Guaranty Trust Company of New York, dated
April 11, 1988, concerning Advance Notice.
---------------------------------------------------------------------------

    (4) The Commission recognizes that swaps generally have
characteristics, such as individually-tailored terms, predominantly
commercial and institutional participants, and expectation of being
held to maturity, rather than offset during the term of the
agreement, that may warrant distinguishing them from futures
contracts. The criteria set forth in this Appendix identify certain
swaps for which regulation under the CEA and Commission regulations
is unnecessary. These safe harbor standards are consistent with
policies reflected in the CEA's jurisdictional exclusion for forward
contracts,\12\ the Treasury Amendment,\13\ and the trade option
exemption,\14\ and are otherwise consistent with section 2(a)(1)(A)
of the CEA. Although these jurisdictional and exemptive or
exclusionary provisions are not sufficiently broad to provide clear
exemptive boundaries for many swaps, they reflect policies relevant
to the safe harbor policy set forth in this Appendix and may
encompass certain swap transactions.\15\
---------------------------------------------------------------------------

    \12\ Section 2(a)(1)(A) of the CEA provides that the term
``future delivery'' does not include sales of any cash commodity for
deferred shipment or delivery. 7 U.S.C. 2. Sales of cash commodities
for deferred delivery, or forward contracts, generally have been
recognized to be commercial, merchandising transactions in physical
commodities entered into by commercial counterparties who have the
capacity to make or take delivery of the underlying commodity but in
which delivery ``may be deferred for purposes of convenience or
necessity.'' 52 FR 47027; In re Stovall, [1977-1980 Transfer Binder]
Comm. Fut. L. Rep. (CCH) para. 20,941 at 23,777-78 (CFTC 1979). The
forward contract exclusion may apply to certain types of swap
transactions.
    \13\ The Treasury Amendment provides that ``[n]othing in this
Act shall be deemed to govern or in any way be applicable to
transactions in foreign currency, security warrants, security
rights, resales of installment loan contracts, repurchase options,
government securities, or mortgages and mortgage purchase
commitments, unless such transactions involve the sale thereof for
future delivery conducted on a board of trade.'' 7 U.S.C. 2. See
generally, 50 FR 42963 (October 23, 1985) (CFTC Statutory
Interpretation). See also, Commodity Futures Trading Commission v.
American Board of Trade, 473 F. Supp. 117 (S.D.N.Y. 1979), aff'd,
803 F.2d 1242 (2d Cir. 1986). The Treasury Amendment may apply to
some types of transactions also characterized as swaps.
    \14\ The trade option exemption, which is set forth in Rule
32.4(a), 17 CFR 32.4(a) (1988), authorizes commodity option
transactions, other than those on commodities specified in rule
32.2(a), that are not executed on a designated contract market and
that are:
    Offered by a person which has a reasonable basis to believe that
the option is offered to a producer, processor, or commercial user
of, or a merchant handling the commodity which is the subject of the
commodity option transaction, or the products or byproducts thereof,
and that such producer, processor, commercial user or merchant is
offered or enters into the commodity option transaction solely for
purposes related to its business as such. It should be noted that
under Rule 32.4(a), only the offeree of the trade option need
qualify as a ``commercial user'' or ``merchant.'' Rule 32.4(a) is
silent concerning which party to a trade option may be the option
buyer of a put or call or ``long,'' and which party may be the
option seller of a put or call or ``short.'' As a result, provided
that the qualifying commercial offeree is entering the trade option
transaction solely for non-speculative purposes demonstrably related
to its commercial business in the commodity which is the subject of
the option transaction, the requirements of Rule 32.4(a) are met.
    \15\ The forward contract exclusion facilitates commodity
transactions within the commercial merchandising chain. The trade
option exemption similarly may be viewed as facilitating principal-
to-principal transactions in which the offeree is a commercial party
with respect to the underlying commodity. The Treasury Amendment
reflects Congressional intent to avoid duplicative regulation of
foreign currency transactions and other transactions in the
interbank market supervised by bank regulatory agencies.
---------------------------------------------------------------------------

    (5) Consequently, the Commission has determined that a greater
degree of clarity may be achieved through safe harbor guidelines
establishing specific criteria for swap transactions to which the
Commission's regulatory framework will not be applied. Swaps
satisfying the requirements set forth in this Appendix will not be
subject to regulation as futures or commodity option transactions
under the Act and regulations. This policy statement addresses only
swaps settled in cash, with foreign currencies considered to be
cash.\16\
---------------------------------------------------------------------------

    \16\ As noted previously, certain categories of swap
transactions may be subject to the forward contract exclusion, the
Treasury Amendment and the trade option exemption. The safe harbor
criteria set forth in this Appendix apply equally to options on
swaps.
---------------------------------------------------------------------------

    (i) Individually-tailored terms. (A) Individual tailoring of the
terms of swap agreements is frequently cited as indispensable to the
operation of the swap market. Commenters have indicated that swap
agreements are based upon individualized credit determinations and
are tailored to reflect the particular business objectives of the
counterparties. Tailoring occurs through private negotiations
between the parties and may involve not only financial terms but
issues such as representations, covenants, events of default, term
to maturity, and any requirement for the posting of collateral or
other credit enhancement. Such tailoring and counterparty credit
assessment distinguish swap transactions from exchange transactions,
where the contract terms are standardized and the counterparty is
unknown. In addition, the tailoring of swap terms means that, unlike
exchange contracts, which are fungible, swap agreements are not
fully standardized.
    (B) To qualify for safe harbor treatment, swaps must be
negotiated by the parties as to their material terms, based upon
individualized credit determinations, and documented by the parties
in an agreement or series of agreements that is not fully
standardized.\17\ This requirement is intended to exclude from safe
harbor treatment instruments which are fungible and therefore may be
readily transferred and traded.
---------------------------------------------------------------------------

    \17\ Formation of swaps pursuant to a master agreement between
two counterparties that establishes some or all contract terms for
one or more individual swap transactions between those
counterparties is not precluded by this requirement, provided that
material terms of the master agreement and transaction
specifications are individually tailored by the parties.
---------------------------------------------------------------------------

    (ii) Absence of exchange-style offset. (A) Exchange-traded
futures contracts generally

[[page 78038]]

may be terminated by offset,\18\ that is, liquidated through
establishment of an equal and opposite position. For exchange-traded
futures contracts, the universal counterparty to each cleared
position is the clearing organization. Prior consent of the clearing
organization, as counterparty, is unnecessary to offset.\19\
---------------------------------------------------------------------------

    \18\ In the context of exchange-traded futures, offset refers to
the liquidation of a futures position through the acquisition of an
opposite position. Availability of such offset, resulting in the
liquidation of the position, typically is established by exchange
rules governing exchange members' relationships with the clearing
house. See, e.g., Chicago Mercantile Exchange Rule 808 (``a clearing
member long or short any commodity to the Clearing House as a result
of substitution may liquidate the position by acquiring an opposite
position for its principal''); Board of Trade Clearing Corporation
Regulation 705.00 (``Where a member buys and sells the same
commodity for the same delivery, and such contracts are cleared
through the Clearing House, the purchases and sales shall be offset
to the extent of their equality, and the member shall be deemed a
buyer from the Clearing House to the extent that his purchases
exceed his sales, or a seller to the Clearing House to the extent
that his sales exceed his purchases''); New York Futures Exchange
Rule 3-4 (``As between the Clearing Corporation and the original
parties to futures contracts and option contracts, such contracts
shall be binding upon the original parties until liquidated by
offset, delivery, exercise or expiration, as the case may be''). Of
course, the ability to offset in any given case depends upon the
availability of a counterparty to enter into an offsetting
transaction at an acceptable price.
    \19\ However, the ability to liquidate contractual positions
through offset is established by clearing organization rules to
which all clearing members consent.
---------------------------------------------------------------------------

    (B) In contrast, swap transactions have been described as
transactions which create performance obligations terminable only
with counterparty consent and which generally are expected to be
maintained to maturity. A swap counterparty who seeks to eliminate
the economic effect of a swap agreement may enter into a reverse
swap agreement, that is, a second swap with the same maturity and
payment requirements, with the same or a new counterparty, but in
which the party seeking to eliminate its economic exposure assumes
the reverse position (in this case the obligations of each party to
both transactions continue to maturity). A swap counterparty who
seeks to terminate, absent default, its obligations under a swap
agreement may: Undertake a swap sale in which, based upon consent of
the counterparty, it assigns its rights and obligations under the
swap to a third party or negotiate an early termination of the
transaction, or swap ``closeout,'' in which it negotiates a lump-sum
payment with its counterparty to terminate the swap.\20\ In the
latter two cases, termination of the obligations created by a swap
is dependent upon consent of the counterparty.
---------------------------------------------------------------------------

    \20\ Swap parties may agree in advance upon a termination
formula or price for the swap.
---------------------------------------------------------------------------

    (C) To qualify for safe harbor treatment, the swap must create
obligations that are terminable, absent default, only with the
consent of the counterparty. If consent to termination is given at
the outset of the agreement and a termination formula or price
fixed, the consent provision must be privately negotiated. This
requirement is intended to confine safe harbor treatment to
instruments that are not readily used as trading vehicles, that are
entered into with the expectation of performance, and that are
terminated as well as entered into based upon private negotiation.
    (iii) Absence of clearing organization or margin system. (A) As
noted in paragraph (b)(5)(ii) of this Appendix, the necessity for
individualized credit determinations has been described as a
hallmark of swap transactions. A number of commenters have stressed
both the dependence of the current swap market on such
determinations and the absence of a multilateral ``credit support''
mechanism, such as a clearing organization, for swaps. In accordance
with the concept of swaps as dependent upon private negotiation and
individualized credit determinations as to the capacity of certain
parties to perform, this safe harbor is applicable only to swap
transactions that are not supported by the credit of a clearing
organization and that are not primarily or routinely supported by a
marked-to-market margin and variation settlement system designed to
eliminate individualized credit risk.\21\ The ability to impose
individualized credit enhancement requirements to secure either
changes in the credit risk of a counterparty or increases in the
credit exposure between two counterparties consistent with the
criteria in paragraph (b)(5)(ii) would not be affected.
---------------------------------------------------------------------------

    \21\ Several commenters urged the Commission to adopt a safe
harbor for swaps that would be conditioned upon, among other things,
the absence of a credit support mechanism. See Letter to CFTC from
Sullivan & Cromwell, dated April 8, 1988, concerning Advance Notice,
at 41-42; Letter to CFTC from Manufacturers Hanover, dated April 11,
1988, concerning Advance Notice, at 4. The safe harbor standard is
based upon individualized credit determinations at the outset and
during the pendency of the contract.
---------------------------------------------------------------------------

    (B) [Reserved]
    (iv) The Transaction is Undertaken in Conjunction With a Line of
Business.
    (A) The absence of public participation in the swaps market has
frequently been cited as a factor supporting different regulatory
treatment of swaps and futures contracts. Swap market participants
are predominantly institutional and commercial entities such as
corporations, commercial and investment banks, thrift institutions,
insurance companies, governments, and government-sponsored or
chartered entities.\22\
---------------------------------------------------------------------------

    \22\ Letter dated April 8, 1988, to CFTC from International Swap
Dealers Associations, Inc. concerning Advance Notice.
---------------------------------------------------------------------------

    (B) The safe harbor set forth in this Appendix is limited to
swap transactions undertaken in conjunction with the parties' line
of business.\23\ This restriction is intended to preclude public
participation in qualifying swap transactions and to limit
qualifying transactions to those based upon individualized credit
determinations. This restriction does not preclude dealer
transactions in swaps undertaken in conjunction with a line of
business, including financial intermediation services.
---------------------------------------------------------------------------

    \23\ Swap transactions entered into with respect to exchange
rate, interest rate, or other price exposure arising from a
participant's line of business or the financing of its business
would be consistent with this standard.
---------------------------------------------------------------------------

    (v) Prohibition Against Marketing to the Public. Swap
transactions eligible for safe harbor treatment may not be marketed
to the public. This restriction reflects the institutional and
commercial nature of the existing swap market and the Commission's
intention to restrict qualifying swap transactions to those
undertaken as an adjunct of the participant's line of business.
    (c) Conclusion. This policy statement is intended to clarify the
regulatory treatment of certain transactions in order to facilitate
legitimate market transactions in a field distinguished by
innovation and rapid growth. Consequently, the Commission proposes
to continue to review on a case-by-case basis transactions that do
not meet the criteria set out in this Appendix and that are not
otherwise excluded from Commission regulation.

    Issued in Washington, DC, this 21st day of November, 2000, by
the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 00-30270 Filed 12-12-00; 8:45 am]
BILLING CODE 6351-01-P

======== RETURN TO INDEX ========