2012 Capital Markets Symposium Event Materials - Herrick ...

CURRENT DEVELOPMENTS IN
FEDERAL REGULATION OF
THE CAPITAL MARKETS
LOCATION
Herrick, Feinstein LLP
2 Park Avenue (between 32nd and 33rd)
14th Floor
New York, NY

HERRICK, FEINSTEIN LLP’s
SIXTH ANNUAL CAPITAL MARKETS SYMPOSIUM
OCTOBER 2, 2012
CURRENT
DEVELOPMENTS
IN FEDERAL REGULATION
OF THE CAPITAL MARKETS
A distinguished panel of financial and legal
experts, including representatives of
JPMorgan Chase, Barclays, Grant Thornton,
Riverside Risk Advisors LLC and Herrick,
Feinstein LLP will assess the current regulatory
developments in federal regulation of capital
markets, including the implementation of the
Volcker Rule, ramifications of the JOBS Act,
and ongoing regulatory developments in the
derivatives markets.
KEYNOTE SPEAKER
JAMES E. GLASSMAN
MANAGING DIRECTOR AND SENIOR ECONOMIST,
JPMORGAN CHASE & CO.
EMMA BAILEY
Director, Barclays Capital
JOYCE A. FROST
Partner, Riverside Risk Advisors LLC
JAMES E. GLASSMAN
Managing Director & Senior Economist, JPMorgan Chase & Co.
DAVID WEILD
Chairman & CEO, Capital Markets Advisory Partners
SYMPOSIUM FACULTY
STEPHEN E. FOX
Partner, Herrick, Feinstein LLP
RICHARD M. MORRIS
Partner, Herrick, Feinstein LLP
PATRICK D. SWEENEY
Partner, Herrick, Feinstein LLP

CONTENTS
SPEAKER BIOS...........................................................................................................................................................................1
KEYNOTE SPEECH
BIG LESSONS FROM THE HOUSING DEBACLE...............................................................................................................7
By James E. Glassman
Managing Director & Senior Economist at JPMorgan Chase & Co.
THE REGULATORY OBJECTIVE AND PERSPECTIVE OF THE VOLCKER RULE......................................................15
By Richard M. Morris and Natalia Cavaliere
Herrick, Feinstein LLP
THE JOBS ACT.........................................................................................................................................................................41
By Stephen E. Fox, Monica Reyes-Grajales and Liliana Chang
Herrick, Feinstein LLP
TRACKING DERIVATIVES REGULATION UNDER DODD-FRANK..............................................................................61
By Patrick D. Sweeney and Julie Albinsky
Herrick, Feinstein LLP

SPEAKER BIOS
JAMES E. GLASSMAN
MANAGING DIRECTOR & SENIOR ECONOMIST, JPMORGAN CHASE & CO.
Mr. James E. Glassman is a Managing Director with JPMorgan Chase & Co. and is the
Head Economist for the Commercial Bank where he serves the Company’s bankers and
the Commercial Bank’s clients. He also works closely with the firm’s chief investment
officer, investment banking, and government relations groups. He publishes
independent research on the principal forces shaping the economy and financial
markets and is a long-standing participant in the widely-followed Federal Reserve Bank
of Philadelphia Survey of Professional Forecasters and the National Association of
Business Economists panel of macroeconomic forecasters.
From 1979 through 1988, Mr. Glassman served as a senior economist in the Research &
Statistics and Monetary Affairs divisions at the Federal Reserve Board in Washington
D.C. His responsibilities at the Federal Reserve ranged from analysis and forecasting of
inflation and labor market developments, to analysis of the Federal Reserve’s operating
strategies and interest rate markets, and to development of monetary and reserves
projections. He joined Morgan Guaranty in 1988 and Chemical Bank in 1993 that
through a combination of mergers became JPMorgan Chase & Co.
Mr. Glassman earned a bachelors degree from the University of Illinois,
Champaign-Urbana, Illinois. Subsequently, he was awarded a Ph.D. in economics from
Northwestern University.
1

SPEAKER BIOS
EMMA BAILEY
DIRECTOR, BARCLAYS CAPITAL
JOYCE A. FROST
PARTNER, RIVERSIDE RISK ADVISORS LLC
Joyce Frost is the co-founder of Riverside Risk Advisors, a boutique, independent derivatives advisory firm
located in New York City. Joyce has over twenty-five years of experience in the interest rate, currency and
credit derivatives markets starting her career when the swap market was in its infancy. Between 1986 and
1995 Joyce was responsible for marketing fixed income derivatives to corporate, project finance, real estate
and other end users for The Northern Trust Company, Chase Manhattan Bank and Sumitomo Bank Capital
Markets in New York. She executed hundreds of transactions ranging from plain vanilla swaps to the most
complex crossborder project finance transactions in Latin America. In this capacity, she worked closely with
all areas of the bank including investment banking, credit, risk management, capital markets and trading.
In 1995, Joyce became Head of Marketing for Chase’s newly formed Credit Derivatives Group. Ms. Frost
contributed to the development and execution of the bank’s first credit derivatives transactions, including
total return swaps, credit default swaps, off balance sheet financing vehicles and the market’s first synthetic
CLO. Clients ranged from banks, insurance companies, hedge funds and corporations. As new products
developed, Joyce worked with nearly every department within Chase coordinating and approving all
products and activities with risk management, credit, legal, accounting, treasury, corporate finance and
capital markets. Chase’s Credit Derivatives group was rated “Best in Credit Derivatives for 1997” by Global
Finance Magazine and “Best in Credit Derivatives for 1998” by Derivatives Strategies Magazine in addition
to other premier industry recognitions.
Joyce retired in 2001, but returned to the market in 2006 as Senior Vice President of Cournot Capital Inc, the
management company of Cournot Financial Products, LLC (“CFP”), a credit derivatives product company
sponsored by Morgan Stanley. CFP was a highly successful seller of credit protection on senior tranches of
synthetic CDOs that was successfully sold in November 2008. She completed her transition responsibilities
in March, 2009 and formally launched Riverside Risk Advisors in October, 2009.
Joyce is Co-Editor of the Handbook of Credit Derivatives (McGraw Hill, 1999) and author of many articles
published on the use of derivatives by corporations and other end-users. She has spoken at dozens of
industry conferences throughout North and South America and Europe. Joyce earned a B.S. in Finance from
Indiana University Kelly School of Business and an MBA from the University of Chicago Booth School of
Business.
She currently is Chair, Board of Trustees of the Bronx Charter School for Excellence, the highest performing
charter school in New York State, and Secretary of the Board of Directors of New York Cares. She has three
children and lives on the Upper West Side.
Emma Bailey is a Director at Barclays Capital in New York and is responsible for legal coverage of all Barclays Capital’s principal M&A and
private equity activities in the Americas. Prior to joining Barclays Capital in 2008, Ms. Bailey was a senior vice president at Lehman Brothers,
and before that she was an associate at Fried Frank Harris Shriver & Jacobson, where she represented financial institutions in capital markets
and merchant banking transactions, and public M&A clients.
Ms. Bailey has worked on the sale of Lehman Brothers to Barclays Capital, Barclays Capital’s exit from the mortgage servicing business,
and is coordinating the firm’s response to the Volcker Rule.
2

DAVID WEILD
CHAIRMAN & CEO, CAPITAL MARKETS ADVISORY PARTNERS
David is Chairman and CEO of Capital Markets Advisory Partners, the firm that works with issuers to
significantly improve the size and quality of institutional demand for their offerings. David also oversees
Capital Markets at Grant Thornton, the ‘Global Six’ Audit, Tax and Advisory firm and is a former Vice
Chairman and executive committee member of The NASDAQ Stock. He is a noted expert on how stock
market structure impacts capital formation and job creation. He has testified in Congress and at the SEC
on this and other stock market structure issues (e.g., The Flash Crash). Together with Ed Kim, their work
created the rationale that gave rise to The JOBS Act.
David and co-author Ed Kim’s written work was the first to identify how changes in stock market structure
are harming capital formation and job growth in the United States. Their studies (Why are IPOs in the
ICU; Market structure is causing the IPO crisis – and more; A wake up call for America) have been cited in
over 100 articles including The Economist, The Wall Street Journal, The New York Times and The Financial
Times. These studies have also been cited by Congressmen, Senators and the Executive Branch of the U.S.
Government, including most recently in the Interim Report of the White House’s Job Council led by Jeffrey
Immelt, CEO of General Electric, and the IPO Task Force report to the U.S. Treasury led by Kate Mitchell,
former Chairman of the National Venture Capital Association. David was also a member of the NYSE and
NVCA’s (National Venture Capital Association) Blue Ribbon Panel to restore liquidity in the US venture
capital industry and his work was cited in the NVCA’s final report. David has testified in Congress and at
the CFTC-SEC Joint Panel on Emerging Regulatory Issues and his studies served as the impetus for the The
JOBS Act (HR 3606). David attended the signing of The JOBS Act by President Obama in the Rose Garden
of the White House on April 5, 2012.
While at NASDAQ, David created the “Market Intelligence Desk” and the “Corporate Client Services Network”
which are the two core services offerings that NASDAQ continues to rely on to serve its listed companies.
He spent 14 years at Prudential Securities in senior management roles, including President of
PrudentialSecurities.com, Head of Corporate Finance (where he tripled revenue and doubled productivity
per investment banker over three years), Head of Technology Investment Banking and Head of Global
Equity Capital Markets (where his department ranked #1 in a poll of other equity syndicate professionals
for two years running). He oversaw more than 1,000 IPO's, Follow-on offerings and convertible transactions
and was an innovator in new issue systems and transaction structures and was behind a number of
innovations in the equity capital markets including, “Capped jump-ball” institutional pots, incentive
underwriting structures, the “Evergreen” diligence process that underlies most modern follow-on offerings,
the first use of algorithms to improve the quality of retail distribution on new issues and the first
“Accelerated book build” transaction.
David holds an MBA from the Stern School of Business and a BA from Wesleyan University. He studied on
exchange at The Sorbonne, Ecole des Haute Etudes Commerciales and The Stockholm School of Economics.
He is Chairman of the Board of Tuesday’s Children, the pre-eminent charity providing services to 9/11
families and first responders and has served on that board since shortly after 9/11.
3

SPEAKER BIOS
STEPHEN E. FOX
PARTNER, HERRICK, FEINSTEIN LLP
Stephen's practice focuses on advising domestic and foreign public and private entities on corporate and
securities matters, with a particular emphasis on public company securities law compliance, securities
offerings and mergers and acquisitions (including reverse mergers into public shells). Stephen also
represents private investment funds and their managers with respect to fund formation and compliance,
and strategic investments on behalf of private investment funds. Stephen frequently serves as outside
corporate counsel to his clients, managing all aspects of a company's legal needs.
Stephen represents emerging growth and middle market clients in their ongoing securities law compliance
and corporate governance matters, including the preparation and review of periodic reports, proxy
statements and other documents filed with the Securities and Exchange Commission. He also represents
issuers in all kinds of registered and unregistered offerings of debt and equity securities, including initial
and secondary public offerings, alternative public offerings and PIPEs offerings, and private placements
pursuant to Regulation D and Rule 144A.
Stephen also represents individual and institutional fund managers in establishing and operating hedge
funds and private equity funds, both domestic and offshore, as well as structuring and negotiating seed
investor agreements, derivative transactions and other corporate transactions associated with establishing,
operating and winding up private investment funds.
RICHARD M. MORRIS
PARTNER, HERRICK, FEINSTEIN LLP
Richard Morris works closely with the executive management of middle market companies and funds to
enhance and implement acquisition, financing, operation and exit strategies and to solve a broad range
of commercial and regulatory issues. Financial institutions, investment funds, and investment management
professionals have the benefit of Richard's more than 25 years of transactional experience in such areas as
corporate finance, institutional investment, mergers and acquisitions, hedge fund investment, corporate
governance, and executive employment and benefits.
Richard applies his "Wall Street" certified public accountant and operations experience to our clients'
problems, providing practical solutions that improve operations and risk management. He speaks on a
variety of subjects, including fiduciary duties of board members and investment professionals, improving
company risk management environments and commercial workout and exit strategies. Richard works
closely with the New York State Society of CPAs Committee on Anti-Money Laundering and Counter
Terrorist Financing, focusing on the Bank Secrecy Act and related issues.
Prior to joining Herrick, Richard was a corporate associate with Schulte Roth & Zabel. He began his legal
career as a tax, then corporate, associate at Shearman & Sterling. Prior to becoming a lawyer, Richard was a
regulatory auditor with the Commodities Exchange in New York and specialized in operations and financial
management at Kidder Peabody. He also was the U.S. Audit Manager for the financial division for a
diversified Australian company.
4

PATRICK D. SWEENEY
PARTNER, HERRICK, FEINSTEIN LLP
Patrick D. Sweeney is Chairperson of Herrick's Investment Management Practice Group. He represents
investment managers, investment funds and investment fund fiduciaries in a wide range of corporate,
regulatory and transactional matters. Pat also represents major institutional investors in corporate debt
restructuring and non-U.S. investors in inbound investments.
Prior to joining Herrick, Pat practiced investment management law in-house for more than 10 years, first
as senior investment counsel for Merrill Lynch Asset Management and then as General Counsel to Nomura
Corporate Research and Asset Management. He began practicing law in association with Shearman &
Sterling in the 1980's, where he represented financial institutions in corporate, securities and finance
transactions.
Pat has been an active member of the New York City Bar Investment Management Committee and the
Investment Company and Investment Adviser Subcommittee of the American Bar Association's Business
Law Section, and has participated for many years in committees, conferences and panel presentations of
the Investment Company Institute, the Loan Syndications and Trading Association, the Mutual Fund
Directors Forum and many other investment management industry organizations.
5

HERRICK, FEINSTEIN LLP’s
SIXTH ANNUAL CAPITAL MARKETS SYMPOSIUM
OCTOBER 2, 2012
KEYNOTE:
BIG LESSONS FROM
THE HOUSING DEBACLE
BY JAMES E. GLASSMAN

The Housing Debacle
The speculative frenzy that drove house prices far beyond anything we’ve ever seen by 2006,
referring to fundamental benchmarks of affordability and customary standards used to
qualify borrowers for a mortgage loan, did considerable damage to the economy. We are still
recovering from that traumatic event four years later and it may take the rest of the decade
for the economy to fully regain its health. Business cycles are a common feature of modern
economies: this one is the 48 th the US economy has suffered since George Washington was
inaugurated on Wall Street on April 30, 1989, according to the National Bureau of Economic
Research (the referee of such events). Business downturns usually are triggered by unique
events and so are hard to predict. But this one was tragic, because it could have been
avoided. Observers should have known, and many claimed they did, that something was
amiss, when from 2003 to 2008 the national level of house prices rose to levels that were 55
percent higher than anything we had ever seen relative to income.
The speculative debacle damaged our economy and it also tarnished the reputation of
market systems and our particular that of the United States. It would be a shame if we
condemned the system, which works because it has many checks and balances, rather than
the human failings for the crisis. Our market-based system has lifted America’s living standard
far above most others. And it would be a shame if we blame the economic liberalization of
recent decades that has pushed us ahead of all of our competition except the sleeping giants
who catching up with us only because they are stepping out of the Middle Ages.
Congress has passed sweeping reform initiatives and international regulators have pushed for
new guidelines. Their efforts likely will make our financial system stronger, although they
come at a cost. But the most important steps will come from the mistakes we made.
A Dispassionate Taxonomy of the Housing Debacle
Take a minute to recall the key features of the housing crisis. There were many culprits,
beyond those that work on Wall Street.
(1) The usual (and unusual) suspects:
Lax lending standards and the innovative tools Wall Street created to meet global
investors’ appetites for yield, which they found in housing-backed vehicles, gave the
housing industry easy access to cheap credit, even when valuations climbed to
unprecedented levels. So, of course, Wall Street deserves its fair share of criticism. But
Wall Street had many willing partners.
The rating agencies, with their top ratings assigned to subprime CDOs, for example,
opened the door to investor groups whose charters limit their risk exposures. Did the
rating agencies not think about what would happen to those ratings if house prices
dropped
9

Speculators were important actors. Did the folks who put little of their own money in a
house transaction, or who used home equity credit lines to spend the equity in their
houses, really not know what was going on
The builders likely knew what was going on. They claimed they had adequate rules in
place to limit purchases by speculators who had no intention of living in the places
they were buying. But cautious builders benefit little by holding back in a housing
boom, because there will be little business for them to pick up in the subsequent bust.
At the end of the day, investors are the ultimate check and balance, because it is their
funds that are on the line. The appetite for risk assets at small spreads surely was the
ultimate enabler of the housing debacle.
(2) Collateralized lending: “Liar loans”—low-doc, no-doc, and stated loans by any
other name—are the poster child of lax lending. But such products come with the
territory, as the popularity of NIV loans—the acronym for “No Income
Verification”—during the 1980s real estate bubble demonstrates. It is easier to
ignore the creditworthiness of the borrower when the outlook for collateral is
strong. This is unique to real estate lending, because lenders make no assumptions
about car prices when they underwrite subprime car loans.
(3) National housing policies strongly favor homeownership. The unspoken
assumption appears to be that homeownership promotes social cohesion.
Housing policies generously treat capital gains accruing to primary residences
(Taxpayer Relief Act of 1997), provide tax deductions for mortgage financing costs
and property taxes, and support several government sponsored agencies that can
raise funds at Treasury-like rates to provide default insurance and invest in
portfolios of mortgage backed securities.
(4) Regulatory policy, in contrast to lean-against-the-wind monetary policy, is procyclical
and that tends to amplify credit cycles. The financial system needs a
safeguard when times are good, not when times are tough and financial
institutions are vigilant. Regulators talk about macro-prudential policies, to temper
this pro-cyclical bias, but in truth this is a daunting challenge.
(5) Credit default swaps, which enable risk takers to hedge specific credit exposures,
are a highly beneficial innovation. Their role in the AIG losses were the result of
faulty management of risk exposure at that company and the absence of a
backstop, like a clearinghouse, to cover their losses not faulty financial
instruments.
(6) The failure of the market to price “strategic defaults” as prices rose to
unprecedented levels surely fueled the speculative fury. The market failed because
investors had no history of strategic defaults of the scale we saw. Indeed, the
historical absence of a decline in the national level of house prices was cited as a
justification for optimism even in the face of extraordinary rises in prices. If market
10

participants had understood what could happen when the music stopped,
mortgage rates would have climbed as house prices rose to reflect a risk premium
for strategic defaults.
On the other hand, popular opinions about what went wrong often include arguments that in
my opinion are red herrings.
(1) You can’t have a conversation about the housing debacle without getting into
arguments about moral hazard and the danger of financial institutions that are too
big to fail. That assumption underpins the Basle III additional capital buffers for
systemically important financial institutions. Moral hazard is a red herring: the
wealth of the financial industry’s risk takers is heavily concentrated in the equity of
their companies; they are first in line when an institution fails. No one takes risks on
the assumption that the regulators will bail them out, because they know that, by
the time the regulators have to step in, their own financial stake will suffer. And, of
course, large financial institutions are key for the economy and the financial
system, given the complex interconnectedness of the system, but, because they
are generally better diversified than small financial institutions, they pose less
danger to the economy than if they were carved up into smaller units that are not
well diversified. And fears of “big” ignore the complex needs of global business
customers and the benefits associated with scale economies in risk management.
(2) Some claim the housing crisis was caused by monetary policy in the last cycle,
keeping interest rates too low for too long. Monday Morning Quarterbacks who
make this claim forget the frightening events the Fed was dealing with at the time,
including the fears around the Y2K drama, the telecom bust that destroyed $100
billion of bond wealth, the 9/11 shock, the earnings fiascos that led to Sarbanes-
Oxley, and the Iraq War. These criticisms are off base, because countercyclical
monetary policy, what comes in bad times, doesn’t fuel speculative bubbles. Those
are born in optimistic times. Apparently, the Fed disagrees, based on what we see
now. Moreover, if easy Fed policy was the culprit, where was the bond market
Bond investors are free to make up their own mind about the risks. In fact, longterm
interest rates remained low even as the Fed tightened back then, prompting
comments that bond yields were a “conundrum”.
(3) Many believe the absence of “skin in the game” makes the financial system
vulnerable to speculative bouts. This is an exaggeration. If everyone is minding
their store, acting in our own self interest in fact serves the interests of our
customers, our shareholders, our creditors, our employers, the broad economy.
That is a fundamental underpinning of a competitive market economy. Market
economies aren’t perfect. They fail in the presence of externalities—when property
rights don’t fully capture the indirect effects of our activity on others. But they
don’t fail just because we have no “skin in the game”. Everyone has “skin in the
game” if they hope to provide services that customers will use.
11

The Dodd-Frank/Basle III Financial Reform Effort
Regulatory reforms introduced by the Dodd-Frank financial reform bill and new guidelines for
capital buffers and liquidity coming from the Basle III group of international bank regulators
addresses some of these weaknesses in the banking system.
The key initiatives call for bigger capital buffers to absorb losses, greater attention to liquidity,
and tighter rules on activities some believe contributed to the financial crisis. (1) Capital
cushions have been raised, with Tier 1 tangible common equity bumped up from 4% to 7% of
assets. (2) Systemically important financial institutions are to hold additional buffers
depending on their size. (3) A larger proportion of bank assets will have to be held in liquid
forms (Liquidity Coverage Ratios are still in flux). (4) Banks are required to maintain “living
wills” to provide for an orderly unwind in the event of a failures (the Financial Stability
Oversight Council will oversee this and will have some say over nonbank institutions and
regulators will have the authority to manage an orderly liquidation modeled on the FDIC
process that can take failing institutions into receivership and restructure them without
significant disruption to the broader financial system, force creditors and shareholders to bear
all losses, replace management, and do this without using taxpayer funds). (5) The law
created a consumer regulator. And (7) the Dodd-Frank reform bill requires financial firms to
use derivatives clearinghouses where traders post capital—the requirements are higher for
firms with larger positions that could pose a greater systemic risk—once a contract is open to
cover potential losses. This limits a firm’s exposure (most derivatives that go through a
clearinghouse must be traded through a regulated exchange or on a trading platform that
meets specific requirements in order to make the pricing more transparent). Nonfinancial
firms that use derivatives to hedge business risks—like an airline that buys oil swaps to limit
its exposure to fluctuating prices—are typically exempt from the above regulations. (8) The
Dodd-Frank bill limits proprietary trading by deposit-taking institutions (the Gramm-Leach-
Bliley Act of 1999 repealed the Glass-Steagall Act’s prohibition of proprietary trading by
deposit-taking institutions but the proposed Volcker rule provides that financial firms backed
by government deposit insurance, even if the costs of that insurance are born by banks and
its depositors, should not be permitted to trade speculatively for their own benefit).
Surely, the financial reform effort will strengthen the financial system. Nonetheless, it focuses
solely on the banking industry. To the extent that other factors contributed to the housing
debacle, it does not address those weaknesses.
Conclusion: Learning From Mistakes, the Best Reforms
The sponsors and architects of the financial reform effort have pushed through sweeping
financial reform measures, hoping to avoid a repeat of the housing debacle that did so much
damage to the economy. It remains to be seen how well it will work. Past efforts to “fix”
problems have a mixed record. Take the Glass-Steagall Act that was passed in response to the
1930s banking crisis. It separated commercial banking from investment banking on the
12

assumption that the system would be safer if the riskier parts of the financial services industry
were partitioned from the deposit-taking business. In fact, many blame the breakdown of
Glass-Steagall barriers for the housing crisis. The opposite may be the case: Glass-Steagall Act
may have enabled the housing crisis by creating a class of financial service companies—
investment banks—that could operate at twice the leverage of the commercial banks and
were regulated by the Securities Exchange Commission, out of sight of the Federal Reserve
System. That is one reason why there was a run on the investment banks in the wake of
Lehman Brothers’ collapse. Commercial banks, which operate at much lower levels of
leverage, fared relatively well and today are generously cushioned today.
It is unrealistic to assume that we can draft regulations that will any prevent speculative
excesses and that can regulate safety. And it is doubtful that Congress will radically alter our
national housing policies, which many blame for some of the excesses of the housing
debacle. That would face a high political hurdle, in part, because the value of the nation’s
stock of housing reflects the existing tax treatment of housing. To alter that would cause
substantial real estate losses. And it is doubtful that we can or will find ways to prevent
financial institutions from thinking about the outlook for collateral when underwriting loans.
In truth, that doesn’t matter, because the best protection we have against a repeat of the
housing debacle is the lessons we have learned from the mistakes we make, the “fool me
once …” idea. Never again will market participants, investors, risk managers, financial
engineers, and rating agencies be able to assume that house prices do not fall at the national
level. Now we will have to be mindful of the potential for mortgage borrowers to accept
strategic defaults should prices fall and drive them under water. If financial markets have
learned their lessons, and that seems like a reasonable assumption, mortgage spreads would
widen to reflect the risk of strategic defaults should house prices ever rise out of line with
customary benchmarks of affordability. Markets should bring a discipline that was absent in
the last decade’s housing debacle.
(c) 2012 JPMorgan Chase & Co. All rights reserved. The material contained herein is intended as a general
market commentary. Opinions expressed herein are those of James Glassman and may differ from those of other
J.P. Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research and should not
be treated as such. Further, the views expressed herein may differ from that contained in J.P. Morgan research
reports. The above summary/prices/quotes/statistics have been obtained from sources deemed to be reliable,
but we do not guarantee their accuracy or completeness.
13

HERRICK, FEINSTEIN LLP’s
SIXTH ANNUAL CAPITAL MARKETS SYMPOSIUM
OCTOBER 2, 2012
THE REGULATORY OBJECTIVE AND
PERSPECTIVE OF THE VOLCKER RULE
BY RICHARD M. MORRIS AND NATALIA CAVALIERE

I. Introduction
The part of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(the “Dodd-Frank Act”) commonly referred to as the Volcker Rule is the latest component of a
comprehensive U.S. bank regulatory regime designed to reduce specified risk exposure of
banks and related financial institutions. The fundamental purpose of the Volcker Rule is to
implement the Congressional directives under Title VI of the Dodd-Frank Act, referred to as
the Bank and Savings Association Holding Company and Depository Institution Regulatory
Improvements Act of 2010, which are intended to: (i) eliminate certain proprietary trading
and investment activities by depository institutions and certain specified affiliates; and (ii)
implement additional limitations to mitigate the risks associated with such activities in other
specified entities. The Dodd-Frank Act provides a two-prong approach to restrict permitted
operations of banks and other nonbank financial institutions that are subject to the
regulatory oversight of the Board of Governors of the Federal Reserve System.
Except as otherwise permitted:
Banking entities shall not “(A) engage in proprietary trading; or (B) acquire
or retain any equity, partnership, or other ownership interest in or sponsor a
hedge fund or a private equity fund”; and
Nonbank financial institutions supervised by the Federal Reserve Board
shall be subject to additional capital requirements and additional
quantitative limits that will be specified by the applicable regulatory
agency with respect to their proprietary trading operations or investments
in hedge funds or private equity funds.
The statute broadly defines “banking entity”. The definition includes the
depository institution (what is commonly thought of as the bank), the bank holding company
and their respective subsidiaries and affiliates. Accordingly, a separate entity organized to
conduct proprietary trading that is a subsidiary or otherwise an affiliate of a bank would be
included in the scope of the statute.
The regulatory objective was summarized by The Hon. Paul Volcker, former
Chairman of the Board of Governors of the Federal Reserve System, in his testimony to the
Senate Banking Committee when he urged the adoption of this provision:
What we can do, what we should do, is recognize that curbing the
proprietary interests of commercial banks is in the interest of fair
and open competition as well as protecting the provision of
essential financial services. Recurrent pressures, volatility and
uncertainties are inherent in our market-oriented, profit-seeking
financial system. By appropriately defining the business of
commercial banks . . . we can go a long way toward promoting the
17

combination of competition, innovation, and underlying stability
that we seek. (emphasis added)
In many respects, the Volcker Rule evokes the objectives of the Glass-Steagall
Act (formally named the Banking Act of 1933) that formed the Federal Deposit Insurance
Corporation and prohibited commercial banks from specified investment banking activities.
Both the Glass-Steagall Act and the Dodd-Frank Act re-defined the scope of permitted
activities of commercial banks to require a more stable institution with a core business model
of taking deposits and making loans. The Glass-Steagall Act was substantially modified by in
1999 by the Gramm-Leach-Bliley Act, which permits certain bank holding companies to
promote their regulatory status to a financial holding company, thereby allowing non-bank
business activities, such as investment banking and insurance activities. It is the Gramm-
Leach-Bliley Act that created the concept that certain financial institutions are “too big to fail”.
Both the Glass-Steagall Act and the Dodd-Frank Act were enacted after an unprecedented
and unforeseen collapse of the financial markets, wide-spread unemployment and significant
loss in public confidence in the ability and integrity of the financial markets and commercial
banking industry; and both statutes sought to restore the public’s confidence in the ability
and integrity of the commercial banking industry by limiting permitted activities by specified
financial institutions, eliminating or mitigating risks deemed to be unnecessary and otherwise
promoting (and, to a certain extent, mandating) safe and sound banking practices.
The Volcker Rule became effective on July 21, 2012, notwithstanding that the
final rules that will interpret many of its core elements were not, and have not yet been,
issued. Adopting the final rules has taken considerably longer than the timeline envisioned
by Congress under the Dodd-Frank Act, which was:
Scheduled Date
January 21, 2011 or six months
after the date on which the
Dodd-Frank Act was enacted.
Nine months after the
Council’s recommendations
are provided (which should
have been no later than
October 21, 2011).
July 21, 2014.
Action
Council study and recommendations for the
implementation of the Volcker Rule. The
recommendations were released on January
18, 2011. See
http://www.treasury.gov/initiatives/docume
nts/volcker%20sec%20%20619%20study%2
0final%201%2018%2011%20rg.pdf
Adoption of the final rules by the Agencies
to implement the Volcker Rule.
Expiration of the conformance period for
entities to comply with the Volcker Rule.
18

July 21, 2015
July 21, 2016
July 21, 2017
Expiration of the separate three one-year
extensions of the conformance period for
entities to comply with the Volcker Rule.
Each extension is granted to an entity at the
discretion of the Federal Reserve.
Regulatory guidance on the scope of the restrictions applicable to banks and
other specified covered financial institutions under the Volcker Rule is provided mostly by the
proposed rules (“Proposed Rules”) that were jointly issued on October 11 and 12, 2011 by the
Office of the Comptroller of the Currency (which is part of the U.S. Department of the
Treasury), the Board of Governors of the Federal Reserve System, the Federal Deposit
Insurance Corporation and the Securities Exchange Commission. These agencies, together
with the Commodity Futures Trading Commission (or CFTC), which provided substantively
identical proposed rules on January 11, 2012, are the federal “Agencies” that are tasked with
developing and enforcing the appropriate rules and regulations to implement the Volcker
Rule.
The Agencies are now considering more than 18,000 comments received to the
Proposed Rules. Some commentators expect that the final Volcker Rule will be adopted later
this year. Adopting the final rules has proved difficult for the Agencies who must navigate
through competing influences, including those at senior levels of our Federal government,
numerous industry participants, and a variety of industry and special interest groups.
Congressional actions that seek to modify, the Volcker Rule create additional complications
to the development of the final rules. House Financial Services Committee Chairman Spencer
Bachus (R-Ala.) has announced that this Committee will hold hearings and is considering
introducing legislation to make substantial changes to the Volcker Rule. Representative
Bachus has publicly stated that the current version of the Volcker Rule will deal “devastating”
repercussions to the economy and said he is anxious to hear from investors and other
members of the public on how the rule should be changed to create a less “burdensome”
alternative to the regulatory standards proposed by the Agencies. On the other end of the
spectrum, Senators Carl Levin (D-Mich.) and Jeff Merkley (D-Ore.), who authored the Volcker
Rule language in the Dodd-Frank Act, have advocated that the Proposed Rules released by
the Agencies have left too many “loopholes” that may be exploited by banks and other
financial institutions and that there should be a more stringent standard to limit the scope of
proprietary trading and investment activities.
In light of these competing and apparently irreconcilable forces, the Agencies
are guided by the express statutory mandate and the recommendations developed by the
plain language of the statute and the Financial Stability Oversight Council (the “Council”), a
multi-federal level body that was created by the Dodd-Frank Act to assess the risks to the U.S.
financial systems, guide and coordinate regulatory rulemaking and otherwise promote safe
and sound banking and financial institutional practices. The Council is also tasked to
“promote market discipline, by eliminating expectations on the part of shareholders,
19

creditors, and counterparties of financial institutions that the U.S. government will shield
them from losses in the event of failure.” That is, change the landscape to end the era of
taxpayer bailouts for financial institutions that have been deemed “too big to fail”. The
Volcker Rule promotes the argument that reducing the proprietary trading risk of financial
institutions will promote more stable financial markets. In this regard, the Volcker Rule is not
attempting to remedy one of the driving causes of the 2007 financial markets collapse or the
“Great Recession”, a fact that was noted by Representative Barney Frank, as ranking Democrat
of the House Financial Services Committee, during his opening statements to the hearings on
the Volcker Rule. The Volcker Rule responds to a perceived systemic risk that threatens the
banking system and financial markets in order to avoid a repeat of the 2007 financial markets
collapse . Representative Frank has previously noted that proprietary trading and typical
financial industry compensation arrangements unacceptably add to the systemic risk of the
financial markets as executives are able to keep a portion of the profits from proprietary
trading (heads - they win) and the taxpayers are required to bail out the financial institutions
for proprietary trading losses (tails – we the taxpayers lose). The goal is to create more stable,
less risky (as one bank executive noted, “boring”) commercial banking operations that uses
the benefit of their unique status or bank license to prudently make loans and promote the
U.S. economy.
II.
Regulatory Perspective
An understanding of the Volcker Rule requires a review of its regulatory
perspective as well as its regulatory objective. The Volcker Rule is one of the more recent
regulatory actions that restrict the banking and financial services industry. The banking
industry is one of the more regulated businesses in the U.S. There are many types of entities
that are commonly referred to as banks. Often consumers think of a bank as an organization
with the plate glass window and tellers that accepts deposits and make loans. These entities
include commercial banks, industrial banks, EDGE corporations, savings and loan associations,
savings banks, thrifts and credit unions. For convenience, these different types of entities are
each referred to as a “bank.” The distinctions between these types of banks include the scope
of bank businesses and related activities that are permitted under their respective charters, as
well as capital structure and the applicable primary regulatory authorities. The Proposed
Rules broadly define a “banking entity” for the purposes of the Volcker Rule and the definition
includes all of these types of banks.
The statutory definition includes any insured depository institution
(other than certain limited purpose trust institutions), any company
that controls an insured depository institution [that is, a bank
holding company or financial holding company], any company that
is treated as a bank holding company for purposes of section 8 of
the International Banking Act of 1978 (12 U.S.C. 3106), and any
affiliate or subsidiary of any of the foregoing.
20

Banks are subject to the regulation and oversight of the applicable primary
regulator, such as the Office of the Comptroller of the Currency (or OCC), the Federal Deposit
Insurance Corporation (or FDIC) or state bank regulatory authorities such as the New York
State Department of Financial Institutions. Credit unions are subject to the authority of the
National Credit Union Administration or the applicable state authority. Bank holding
companies, including financial holding companies that under the Gramm-Leach-Bliley Act are
permitted to hold non-bank subsidiaries, are subject to the oversight of the Federal Reserve
Board. Non-U.S. banking institutions that have a type of banking office that is subject to U.S.
regulatory authority, such as an agency office, branch or subsidiary, are generally subject to
the applicable state bank regulatory authority unless they elect to be subject to the OCC and
oversight of the Federal Reserve Board. Additionally, banks that maintain insured deposits
are subject to regulatory oversight by an applicable agency, such as the FDIC. Additional
regulatory restrictions are provided under the Basle Accords (internationally agreed bank
standards) and banks may also be subject to oversight of non-U.S. regulators depending
upon the non-U.S. business that is conducted by the U.S. based bank and the scope of the
non-U.S. regulatory regime. Additional regulatory authority is provided under: (i) the Real
Estate Settlements Procedures Act of 1974 (or RESPA), which provides significant regulatory
policies and procedures applicable to the residential mortgage industry, including servicing
standards and consumer disclosures (which was amplified by the regulations promulgated by
the U.S. Department of Housing and Urban Development and is now enforced by the
Consumer Financial Protection Bureau); and (ii) numerous state and local laws. For example,
the New York State ATM Safety Act regulates the ATM security precautions required by banks.
One professor at a well-known New York law school compared the organization and
reporting structure between and among the bank regulatory authorities and the different
types of banks to a bowl of spaghetti. In summary, banks are accustomed to the broad
reaching and detailed policies and procedures that are mandated by governmental
authorities and agencies that affect virtually every aspect of their business operations. The
scope of the Volcker Rule, including the compliance and recordkeeping procedures, reflects
the well established regulatory influence that banking entities face in a variety of other
business operations, including lending, deposit products, information regarding depositors
and borrowers and the ownership of real estate (for example, bank ownership of real estate is
subject to specific limitation).
The history of bank regulation in the U.S. dates back to 1838 and illustrates a
pattern of intense involvement by bank regulators over banks with respect to a variety of
issues. Some of the significant bank laws are:
1838 - New York Free Banking Act, which permitted the organization of a
state bank provided certain conditions were satisfied.
1863-1864 - National Currency Act, which later was revised to the National
Bank Act of 1864, which formalized the creation of national banks.
21

1927 - McFadden Act of 1927, which prohibited interstate branching by
national banks and permitted intrastate branching by a national bank to
the same extent permitted under applicable state banking law.
1932 - Federal Home Loan Bank Act, which enabled greater home
ownership through the establishment of the Federal Home Loan Bank
System, the Federal Home Loan Bank Board and twelve Federal Home Loan
Banks.
1933 - The “second” Glass-Steagall Act (formally named the Banking Act of
1933), which formed the FDIC, and separated the investment banking and
commercial banking industries.
1935 - Banking Act of 1935, which permanently established the FDIC.
1956 - Bank Holding Company Act, which permits banks to be owned by a
regulated holding company.
1968 - Truth in Lending Act, which is part of the Consumer Credit Protection
Act and requires robust consumer disclosure standards.
1970 - Bank Holding Company Act Amendments, which further regulate
bank holding companies by better defining permitted banking activities
and increasing the oversight by the Federal Reserve Board.
1975 - Home Mortgage Disclosure Act, which requires financial institutions
to maintain and disclose data bout home purchases, preapprovals and
improvements.
1977 - Community Reinvestment Act, which prohibits the discriminatory
lending practice known as redlining.
1978 - International Banking Act, which provides for regulation of non-U.S.
banks by the Federal Reserve Board and applicable state authorities.
1980 - Depository Institutions Deregulation and Monetary Control Act,
which established reserve requirements for all banks and phased out the
limitations on interest that may be paid on deposits (Regulation Q),
permitted the issuance of bank credit cards and exempted mortgage loans
from state usury laws.
1991 - Federal Deposit Insurance Corporation Improvement Act, which
increased the powers of the FDIC and gave the FDIC better access to
liquidity through U.S. Treasury borrowings to replenish the Bank Insurance
Fund and gave greater power to the FDIC to close a failing bank.
1991 - Foreign Bank Supervision Enforcement Act, which established
federal standards for non-U.S. banks operating in the U.S. and increased the
supervisory authority of the Federal Reserve Board.
22

1994 - Riegle-Neal Interstate Banking and Branching Efficiency Act, which
permits interstate branching, reversed the limitation under the McFadden
Act, and increased permitted interstate bank mergers.
1999 - Gramm-Leach-Bliley Act, which effectively repealed the Glass-
Steagall Act with respect to bank holding companies that qualify and elect
to be a financial holding company.
2001 - U.S.A. Patriot Act, which, together with several regulations
promulgated by FinCEN (part of the U.S. Treasury Department), significantly
increased the “know your customer” and customer due diligence
requirements.
2004 - Check Clearing for the 21 st Century Act, also known as Check 21,
which significantly changed check processing and settlements.
2006 - Financial Services Regulatory Relief Act, which was intended to
reduce the regulatory burden to banks.
2008 - The Housing and Economic Recovery Act of 2008 (or HERA), which
addresses the subprime mortgage crisis by, among other provisions,
authorizing the Federal Housing Administration to guarantee up to $300
billion in new 30-year fixed rate mortgages for subprime borrowers if
lenders write-down principal loan balances to 90 percent of current
appraisal value and authorizes states to refinance subprime loans using
mortgage revenue bonds. HERA also led to the government
conservatorship of Fannie Mae and Freddie Mac.
2008 - Emergency Economic Stabilization Act of 2008, which establishes the
$700 billion Troubled Assets Relief Program (TARP).
2009 - Credit Card Act of 2009, which limits controls and limits increases on
credit card interest rates.
2009 - Fraud Enforcement and Recovery Act, which creates the Financial
Crisis Inquiry Commission, an investigative body modeled after the
Depression-era Pecora Commission, to among other matters, enhanced
criminal enforcement of federal fraud laws, especially regarding financial
institutions and mortgage fraud.
2009 - Helping Families Save Their Homes Act, which amends the Hope for
Homeowners Program, as well as provides additional provisions to help
borrowers avoid foreclosure.
2010 - Dodd-Frank Act.
A core element of the Volcker Rule is the limitations of traditional areas of a
bank’s operations to limit and mitigate specified industry risks. The Volcker Rule is one of
numerous means by which federal and state bank regulators control the scope and risk of a
23

ank’s business. The selected list of significant banking statutes noted above each provide
federal authority over a specified aspect of a bank’s business. In addition to the banking
statutes noted above, broad reaching limitations on a bank’s business are provided by
numerous bank regulations promulgated by federal and state authorities and the bank
supervision process through the uniform rating of banks under the CAMELS ratings system.
CAMELS is one of the core processes by which a bank is rated for regulatory purposes. It is a
bank’s composite rating (1 being the best and 5 representing regulatory concern) under the
Uniform Financial Institutions Rating System (UFIRS) and integrates ratings from six
component areas: Capital adequacy, Asset quality, Management, Earnings, Liquidity, and
Sensitivity to market risk. Evaluations of the component areas take into consideration the
institution’s size and sophistication, the nature and complexity of its activities, and its risk
profile. A bank with a high CAMELS rating can be deemed to be a troubled financial
institution resulting in limitations on its permitted banking activities, for example accepting
brokered deposits.
Some critics of the Volcker Rule have argued that it unnecessarily increases
detailed recordkeeping, mandates certain business practices, prohibits other business
practices, and increases a bank’s regulatory expense and burden which, together with lost
proprietary profit opportunities, may significantly reduce a bank’s profits. An argument can
be made, however, that the scope of the restrictions and entanglement in bank risk
management required under the Volcker Rule is consistent with existing bank regulatory
regime in a variety of other aspects of the business of a bank and other financial institutions.
Since the 1819 U.S. Supreme Court decision in McCulloch v. Maryland, banks are, in many
respects, effectively agents of the government that enjoy the protections and privileges set
forth in their charters or bank licenses that are issued by the applicable regulator, in large
part, in their discretion and the additional protections offered by the federal authority, such as
the insurance by the FDIC. In exchange for a bank’s ability to accept retail deposits, its access
to the discount window for advances from the Federal Reserve, the protections of the FDIC
and the general protections and privileges set forth in a bank’s charter, a bank must accept,
and comply with, the direct management and business control asserted upon a bank’s
business by various Federal and state agencies and statutes, notwithstanding the significant
costs and administrative burdens which may arise in connection with such compliance. Some
financial institutions are apparently re-computing the cost / benefit analysis of maintaining a
depositary institution and are reportedly considering selling or otherwise disposing their
depository institution in order to continue their proprietary trading activities, as a result of the
requirements of the Volcker Rule.
III.
The Volcker Rule
The Proposed Rules may be compared to the Rubik’s Cube. The rules are a
sophisticated and detailed matrix that rely on numerous defined terms. Like the Rubik’s
Cube, each time that a condition for a defined term is satisfied, it leads to another turn of the
puzzle. The analytic objective is to solve the puzzle to determine if a specified action is
24

deemed to be prohibited proprietary trading or if the specified action is permitted and, if
permitted, restricted or limited by capital or other specified requirements.
One apparent reason for the delay in developing and adopting the final rule is
that the Agencies face a daunting task to implement the seemingly straightforward objective
of the Dodd-Frank Act. This is illustrated by the debate and difficulty in defining the core
concept: proprietary trading, and the difficulty in defining the scope of the permitted
activities such as market making, hedging or customer support. The Proposed Rules admit
that “… the delineation of what constitutes a prohibited or permitted activity … often
involves subtle distinctions that are difficult both to describe comprehensively within
regulation and to evaluate in practice.” A bright-line objective standard was rejected by the
Agencies in favor of a multi-faceted approach. The multi-faceted approach offers an adaptive
approach to implement the Volcker Rule that provides an ability to fine tune the scope of the
proprietary trading restriction and permitted “carve outs”. The Proposed Rules provide a
framework that: (i) provides core elements of actions that would be deemed, and have
traditionally been indicative of, proprietary trading, and guidelines to determine the extent of
permitted or exempted activities; (ii) require a comprehensive and programmatic compliance
regime which effectively requires a robust enterprise risk management system with respect to
all trading operations, including permitted trading activities; and (iii) with respect to
proprietary trading, requires certain banking entities to calculate and report meaningful
quantitative data that will provide the Agencies with current market intelligence to identify
any particular activity that warrants additional scrutiny to distinguish prohibited proprietary
trading from otherwise permissible activities. The Proposed Rules attempt to strike the “…
appropriate balance between accommodating prudent risk management and the continued
provision of client-oriented financial services by banking entities while ensuring that such
entities do not engage in prohibited proprietary trading or restricted covered fund activities
or investments.”
The fundamental objective of the Volcker Rule is to prohibit depositary
institutions (generally, banks and their subsidiaries) and other entities that will be deemed a
“covered banking entity” from engaging in proprietary trading, except as otherwise expressly
permitted. The specific language of the Proposed Rules is: “(a) Prohibition. Except as
otherwise provided in this subpart, a covered banking entity may not engage in proprietary
trading.” The analytic and substantive guidance by the Agencies (and the current debate over
the scope of the Volcker Rule) is provided by certain key defined terms.
Covered Banking Entity
The first step of the analysis is to determine if the activity is by a “covered
banking entity”. If the institution is a covered banking entity, then it is subject to the
proprietary trading prohibition. The Proposed Rules parallel the statutory language with one
interesting difference. The statute uses the phrase banking entity (which is broadly defined,
as discussed above). The Proposed Rules change the scope (and the type of entity subject to
the restrictions) to “covered banking entity” and do not define this phrase. This definition is
25

eserved by the Agencies to their respective specific regulatory action that will be provided at
a later date.
One opportunity to tailor the scope of the Volcker Rule is to permit certain
affiliates of a depository institution to maintain proprietary trading activities that are
restricted by capital and position limits. It is clear that to accurately implement the Volcker
Rule, a covered banking entity must include the entities that could receive “taxpayer bailouts”
through FDIC insurance or similar programs and include the bank holding companies and
other affiliates of the bank to the extent that their capital could be subject to proprietary
trading losses in excess of certain limits. Bank holding companies are traditionally viewed as
organizations that are able to support the depository institutions with additional capital, even
if not subject to a firm commitment or obligation. If the liabilities of bank holding company
affiliates, excluding the bank and its subsidiaries, which are given any value on the bank’s
balance sheet were limited, for example by the limited liability of a corporate structure, then
the fundamental purpose of the Volcker Rule that the taxpayers are not required to bailout
proprietary trading firms would still be achieved. On the other hand, Agencies may provide
final rules that continue the broad reach of the statutory language which would simply define
a covered banking entity as the type of affiliates that are within the scope of the specific
regulatory Agency, such as a broker dealer (SEC) or futures commission merchant (CFTC).
The Dodd-Frank Act permits “specified other nonbank financial institutions” to
engage in proprietary trading and have investments in and other relationships with hedge
funds and private equity funds, subject to additional capital charges, quantitative limits, or
other restrictions. These entities will most likely be the hedge funds and other entities that
will be subject to oversight because of their potential systemic risk to the U.S. financial
system. The final rules promulgated by the Agencies will need to provide a meaningful
further gloss on the restrictions. In addition, further Congressional action could effectively
redefine “banking entities” to exclude certain “specified other nonbank financial institutions”.
Given the current debate over the scope of the Volcker Rule, it is difficult to accurately assess
the likelihood of such additional action.
Proprietary Trading
The next turn of the Rubik’s Cube is to determine if the activity by a covered
banking entity constitutes proprietary trading. Proprietary trading is defined simply as:
engaging as principal for the trading account of the covered banking
entity in any purchase or sale of one or more covered financial
positions. Proprietary trading does not include acting solely as agent,
broker, or custodian for an unaffiliated third party. (emphasis added)
This definition requires several more turns of our Rubik’s Cube, specifically,
defining the terms “trading account” and “covered financial position”.
26

Trading Account
In defining “trading account”, the Agencies attempted to delineate the type of
activities that are customarily part of the proprietary trading operations. A trading account
has purchases, sales and other transactions or investments for short-term gains or losses. The
Proposed Rules did not elect to use generally accepted accounting principles as the primary
definitional source. Rather the Proposed Rules borrow a variety of concepts and definitions
currently used in federal banking, securities and commodities regulations. There are certain
objective standards provided by the Proposed Rules, such as trading by dealers in their
capacity as a dealer and positions, other than specified positions, under the Market Risk
Capital Rules. The Proposed Rules mostly define trading account and other key terms with
subjective standards, which is more akin to providing guidance and not specific instructions.
Subject to specified exceptions, a trading account includes an account in which positions are
purchased and sold on a short-term basis, where the institution gains from short-term price
movements, realizes short-term arbitrage profits, or hedges another trading account position.
The lack of clear and objective standards to define “short-term” will make it
more difficult to determine if an account is a trading account. One benefit of this multifaceted
and subjective approach is that objective standards would enable an institution to
evade the fundamental purpose of the statutory restriction while complying with the literal
text of the rule. In addition, it is unlikely that any objective standard would be able to foresee
and be adoptive to future market trading strategies and financial instruments that present a
similar risk profile. If an objective set of rules were promulgated by the Agencies, there would
likely be the need to update the rules to capture additional financial instruments and
transaction structures. This would likely result in the regulatory game of “catch-up” and give
pause to even the most conservative banker, as permitted positions, strategies and structures
could be recharacterized as not permitted leaving bankers in the untenable position of
needing to liquidate a position that they thought, in good faith, complied with the Volcker
Rule when the position or trade was initiated. As such, either approach – clear, specific and
objective standards or subjective standards subject to later regulatory amplification through
no-action rulings or similar opinions, subject financial institutions to a degree of uncertainty
in these particular Dodd-Frank waters.
The Agencies note that short-term positions are generally indicative of
behavior that reflects proprietary trading. This behavior is often the quick reaction to market
inefficiencies or underlying value expectations of a particular security or trading position by
portfolio managers or people on the “trading desk” related to a trading strategy is indicative
of proprietary trading. To assist in the determination of short-term positions, the Proposed
Rules provide a 60-day rebuttable presumption. Subject to specified exceptions, positions
that are held for 60 days or less will be presumed to be “short-term” positions. The financial
institution has the opportunity to rebut this presumption “… based on all the facts and
circumstances”. It is important to note that this rebuttable presumption is not a safe-harbor
for the financial position. Positions that are held longer than 60 days may still be classified by
the regulators as “short-term” positions. Therefore, banking entities should carefully
27

document the underlying reasons for exiting or closing a position that was initiated as part of
a long-term investment strategy.
The Proposed Rules provide exemptions from the trading account definition by
describing certain positions that will not be deemed to make an account a trading account.
These are:
positions under bona fide repurchase and reverse-repurchase agreements;
positions under bona fide stock loan and stock borrow agreements;
positions taken by the institution that is a clearing organization in
connection with its obligations to clear derivatives or securities; and
the less objective exemption, positions held for bona fide liquidity
management.
The liquidity management exemption is subject to additional qualifications
which are considered by the Agencies to be indicative of positions that are purchased and
sold to manage the liquidity position of the financial institution and in which the trading
profits or losses are incidental to this primary objective. To qualify for this exemption, the
positions must have been purchased and sold pursuant to a written and authorized liquidity
management plan with specified minimum attributes, including, approval of the type of
circumstances including market conditions in which a position may be traded, that the
position is traded “principally” for managing the institution’s liquidity position and not for
short-term trading profits or hedging, that the type of the security is highly liquid and that the
positions be “consistent” with the “near-term” funding needs of the institution, including the
expected changes from estimated operations. As such, a covered banking entity may
purchase and sell highly liquid securities that are traded in an active and liquid market and
have reasonably expected price variations.
Covered Financial Positions
Another key term used in the definition of proprietary trading is “covered
financial positions”. This term is broadly defined to include a wide array of securities,
derivatives, futures and other financial products. Significantly, the following trading
positions are exempted: loans, commodities and foreign exchange or currency trading. The
need to exempt loans is self-evident. However, the necessary broad scope of the exception
for loans will make it more difficult to eliminate proprietary trading risk. A loan is defined as
“any loan, lease, extension of credit, or secured or unsecured receivable.” (emphasis added)
The phrase “extension of credit” is a term of art under the federal banking regulations that is
broadly defined. The Proposed Rules do not address the tension that will likely develop
between the more sophisticated loan (extension of credit) transactions and the need to
eliminate or substantially mitigate trading risks as well as the extent of the ancillary
transactions, if any, that may be included in this exemption. For example, transactions that
guaranty the performance of others or the ability of a special purpose entity used in CDO
28

transactions to make payments to investors are extensions of credit. In addition, excluding
“spot” or physical trading in commodities and currencies has drawn criticism from some
commentators that this provides a similar and significant “loophole” for banking institutions
as an FX trading desk exposes a financial institution to significant proprietary trading risks.
The issuance and trading (through syndication and participation and other structures) of
guarantees or credit support products may also subject an entity to significant risk, as
evidenced by recent events.
Permitted Positions
The next step of the analysis is to determine if a covered financial position that
is in a trading account is otherwise exempt from the proprietary trading restrictions of the
Volcker Rule. Each of these exemptions requires an additional turn of our Rubik’s Cube.
These exemptions are:
Underwriting activities
Market making-related activities;
Risk-mitigating hedging activity;
Trading in certain government obligations;
Trading on behalf of customers;
Investments in Small Business Investment Companies (“SBICs”) and public
interest investments;
Trading for the general account of insurance companies;
Organizing and offering a covered fund (including limited investments in
such funds); and
Foreign trading by non-U.S. banking entities and foreign covered fund
activities by non-U.S. banking entities.
Many commentators have noted that scope of underwriting activities, risk
mitigating hedging activities and customer support trading activities are overbroad and
continue to expose banking institutions to significant market risk from proprietary trading
operations.
1. Underwriting.
Underwriting activities are permitted by covered banking entities to the extent
that they are acting in their capacity as an underwriter or dealer solely with respect to the
distribution of securities provided that the institution complies with a specified internal
control and compliance program, including recordkeeping requirements and the following
other conditions:
29

The position is “designed not to exceed the reasonably expected near-term
demands of clients, customers, or counterparties” of the banking entity.
This provision restates the statutory language and does not give any
needed meaningful gloss to the elements to determine the “near term
demands”. The Agencies’ request for comments include requests for
additional criteria or methods that an institution may use to accurately
predict the “near term demands” so that securities positions undertaken to
meet bona fide underwriting obligations are appropriately distinguished
from speculative positions. The final rules may provide additional
guidance. At a minimum, financial institutions should keep detailed
records of the expected demand of the underwriting “book” including the
reason and ability to exit any additional securities purchased by exercise of
the typical overallotment option or “shoe”.
Consistent with customary operations, the primary revenue source must be
fees, commissions, underwriting spreads or other income, and not gains
from the security position, including any hedging positions. That is, profits
or losses resulting from changes in the market value, including with respect
to exercise of the overallotment option or “shoe” would be indicative of
speculative proprietary trading and not prudent underwritten offerings
with a matched “book”.
The institution’s compensation arrangements for individuals engaged in
the underwriting activities must be designed to not encourage proprietary
risk-taking, such as bonus arrangements correlated to market appreciation.
The compensation program condition is a recurring obligation for activities
to be exempt from the proprietary trading prohibition and the focus of
other parts of the Dodd-Frank Act.
The Proposed Rules provide examples of activities that would be performed by
a financial institution that are indicative of the institution acting as a bona fide underwriter
and admit that the following examples may not be sufficiently clear or that each would
necessarily be performed by an institution for it to be acting as an underwriter:
Assisting an issuer in capital raising;
Performing due diligence;
Advising the issuer on market conditions and assisting in the preparation of
a registration statement or other offering documents;
Purchasing securities from an issuer, a selling security holder, or an
underwriter for resale to the public;
Participating in or organizing a syndicate of investment banks;
Marketing securities; and
30

Transacting to provide a post-issuance secondary market and to facilitate
price discovery.
The examples of bona fide underwriting activities are provided as guidance
and are not required in all situations. For example, a member of an underwriting syndicate
may take a position as part of its obligations to the syndicate but may not be actively involved
in each aspect of the underwritten offering.
2. Market Making Activities.
There are several subjective conditions required for a financial institution to
have short term investments qualify for the market making exemption. Of the exempted
trading activities, the market making exemption may be one of the more difficult exemptions
to enforce, as the primary goal, indeed obligation, of the financial institution in its marketmaking
activities is to assume and manage proprietary trading risk. The fundamental
objective of the provisions, or their common theme, is the management and mitigation of
proprietary risk by requiring that the positions are limited to the amount necessary for the
expected demands of the market. The Proposed Rules admit the inherent limitations in
attempting to strike this balance.
Market making-related activities, like prohibited proprietary trading,
sometimes require the taking of positions as principal, and the
amount of principal risk that must be assumed by a market maker
varies considerably by asset class and differing market conditions. It
may be difficult to distinguish principal positions that appropriately
support market making-related activities from positions taken for shortterm,
speculative purposes. In particular, it may be difficult to
determine whether principal risk has been retained because (i) the
retention of such risk is necessary to provide intermediation and
liquidity services for a relevant financial instrument or (ii) the
position is part of a speculative trading strategy designed to realize
profits from price movements in retained principal risk. (emphasis
added)
Accordingly, the Agencies have adopted a multi-faceted approach that
provides guidance as to the core elements of bona fide market making operations. There are
seven specified criteria:
(i) Risk compliance program. The market making activities must comply
with the institution’s comprehensive compliance program that monitors and controls the
market making activities. Institutions should remember that the applicable Agency will
monitor adherence with their compliance program and assess whether it sufficiently
appreciates and controls the market and operational risk. Institutions should take care in
developing the scope of the compliance program and include independent testing and reevaluation
of effectiveness.
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(ii) Market Making Operations. The activities must reflect bona fide
customary market making operations, such as:
Making continuous, two sided quotes and holding oneself out as willing to
buy and sell on a continuous basis;
A pattern of trading that includes both purchases and sales in roughly
comparable amounts to provide liquidity, including taking positions that
anticipate and are designed to fill market / customer demands for the
position;
Making continuous quotations that are at or near the market on both sides;
and
Providing widely accessible and broadly disseminated quotes.
In less liquid markets, the criteria of the institution holding itself out as a market
maker and regular transactions that are consistent with customer liquidity and investment
needs will be of greater focus.
(iii) Customer Demand. The inventory positions by a financial institution
should be limited to the amount necessary to fill the “reasonably expected near-term
demands” of the institution as the maker of the specified security or position. This condition
is consistent with the existing requirements under the Bank Holding Company Act and is
intended to prevent a trading desk that is relying on the market making exemption from
taking a speculative proprietary position unrelated to customer needs as part of its purported
market making-related activities. In determining the market demands, the institution should
consider more than “simple” expected price volatility and focus on “… the unique customer
base of the banking entity’s specific market-making business lines and the near-term
demands of those customers based on particular factors beyond a general expectation of
price appreciation.”
(iv) Registration Standards. The banking entity must comply with all
applicable securities registration requirements. To the extent applicable, the institution’s
market making activities must be through a registered dealer, such as a dealer or municipal
securities dealer under the Securities Exchange Act of 1934 or swaps dealer under the
Commodity Exchange Act. If the market making activities are not subject to these
registration requirements, such as for non-U.S. operations, the operations must be subject to
the applicable local regulatory regime. This requirement effectively delegates certain
mitigation of proprietary trading risk to the specific securities and commodities regulations,
for example net capital requirements including “haircuts” and margin deposits.
(v) Revenue Source. The primary source of revenue from the operations
should be fees, commissions, and bid/ask spreads. The Proposed Rules, including Appendix
B, provide considerable attention to this element as a key distinction between bona fide
market making activities and prohibited proprietary trading. One difficulty that may be
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presented is that the trading profit for a market maker will be consistent with the bid/ask by
that institution. It may be difficult to demonstrate compliance with this criterion in illiquid
markets, where the position is held for some length of time in order to meet anticipated
market demand.
(vi) Compensation Program. Another reflection of this recurring theme is
that the institution’s compensation program, particularly for trading desk personnel, must not
reward market speculation or trading profit. The Proposed Rules note that the compensation
program may “appropriately take into account” the desk’s trading profits for personnel that
are managing the principal risk inherent in the market making operations. The primary
incentive compensation for personnel must, however, “reward customer revenues and
effective customer service.” In this regard, the institution’s compensation program should be
well documented and establish market oriented goals such as trades from existing clients,
establishing new client relationships, low number of customer complaints and disputed
trades and other indicia of exemplary customer service.
(vii) Other Criteria Set Forth in Appendix B. The Agencies provide in
Appendix B to the Proposed Rules a discussion of the various factors and customary attributes
of market making operations. The market making operations of the institution must be
consistent with these additional subjective criteria that, effectively, amplify the other factors.
3. Risk-mitigating hedging activities.
Another controversial area of the Proposed Rules is the exemption provided for
hedging activities. At first glance, the ability of a covered banking entity to reduce its
proprietary risk seems to further to goals of the Dodd-Frank Act. Many commentators,
however, have expressed concern that activities that purport to hedge risk will actually hide
speculative trading operations. The Proposed Rules provide specific conditions for a trade to
be deemed a hedge. These conditions are designed to substantially reduce the risk of
disguised speculative activities that are mischaracterized as a hedge.
(i) Risk compliance program. First, reflecting the approach for permitted
market making activities, hedge transactions must comply with an effective written internal
compliance program that provides reasonable assurance that positions in fact hedge and
mitigate existing proprietary risk. The Proposed Rules (Subpart D) provide a detailed
summary of an effective compliance program and these procedures are consistent with
robust enterprise risk management policies, which banks are obligated to have under other
applicable regulations. The compliance program must specify the positions and trading
strategies and limits for the hedging activities and include effective monitoring and
independent testing. The hedging must be consistent with prudent and stated risk
management policies.
(ii) Mitigate specific risk. The hedging activities must “… mitigate one or
more specific risks, including market risk, counterparty or other credit risk, currency or foreign
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exchange risk, interest rate risk, basis risk, or similar risks, arising in connection with …” the
institution’s business. Further, the hedging activity must be “reasonably correlated” to these
underlying business risks and positions and not increase the liquidity risk of the institution
(that is cash flows of the hedge transaction should not provide a deficit to the cash flows of
the underlying trade or risk).
(iii) No significant exposures. Measured at the inception of the hedge
transaction, the hedge cannot provide “significant exposures” to the then existing underlying
business risks and positions of the financial institution and its affiliates.
(iv) Oversight. The hedging operations must be under continuous and
effective monitoring and management oversight and be subject to independent review and
examination that detects compliance with the applicable procedures and identifies any
material weaknesses.
(v) Compensation Program. Another instance of this recurring theme is
that the compensation program for those associated with the hedging activities cannot
incentivize speculative risks.
(vi) Recordkeeping. Another significant condition is that the institution
must maintain detailed documentation, including documentation that relates to the risk that
is mitigated by the hedge, the manner in which the hedge mitigates the risk and the
operational personnel that that approved the analysis and the trade.
4. Trading in certain government obligations.
The Proposed Rules provide specific covered financial positions that are
exempt from the proprietary trading prohibition. These are:
U.S. government and agency obligations.
An obligation, participation, or other instrument of or issued by the
Government National Mortgage Association, the Federal National
Mortgage Association, the Federal Home Loan Mortgage Corporation, a
Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation or
a Farm Credit System.
Obligation of any State or political subdivision.
Some commentators have noted that the list of permitted investments should
include state agency bonds and obligations. It is interesting to note that some state agencies
have a credit rating that is superior to that of the state (or even the U.S.) bond obligations.
Other commentators have noted that non-U.S. government obligations should be permitted
while others have advocated that the list of permitted debt positions should not be expanded
to include non-U.S. obligations and note the recent failure of a large financial institution
because of its “bets” on non-U.S. sovereign debt to support their position. Another reason
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that the Agencies may elect to not expand the list of the permitted debt obligations, is that
there is considerable political appeal to continue to support active and liquid markets trading
T-Bills, T-Bonds and other permitted debt obligations.
5. Trading on behalf of customers. Riskless principal and other customer
trades are exempt from the proprietary trading prohibition. This is consistent with existing
bank regulations. Even under the Glass-Steagall Act, banks were permitted to act as brokers
and agents. This exemption includes trades conducted by institutions in their capacity as an
investment adviser, commodities trading adviser, trustee or similar capacity solely for the
benefit of customers. There are similar conditions for trading by insurance companies for the
separate accounts of the policy holder.
6. Investments in Small Business Investment Companies (“SBICs”) and public
interest investments. The Proposed Rules exempt these investments as well as a covered
banking entity sponsoring, owning or retaining an interest in a covered fund that is an SBIC or
such other entity. The Agencies noted that these investment activities are consistent with
safe and sound business practices and permit the covered banking entity to provide valuable
funding and assistance to small businesses and low-and moderate-income communities, an
important obligation of banks under the Community Reinvestment Act.
7. Trading for the general account of insurance companies. Regulated
insurance companies may generally engage in proprietary trading for their own account. To
restrict such trading would significantly disrupt the basic business model of the insurance
industry. The Proposed Rules, accordingly, focus on the following objective standards: the
entity or its affiliate is an insurance company licensed under applicable state law (or non-U.S.
insurance regulatory regime) and the trading is solely for the general account of the
insurance company in compliance with applicable laws. The Proposed Rules add a safety
provision that the appropriate federal agencies will review the applicable state and non-U.S.
laws and, upon notice, may disallow the proprietary trading activities to the extent that state
or non-U.S. law permits trading and investments by the insurance company or its affiliates are
“… insufficient to protect the safety and soundness of the banking entity or of the financial
stability of the United States.” It should be noted that this is the only area of permitted
activities where the Agencies have and will continue to place considerable reliance on the
regulatory oversight by others, specifically each of the state insurance commissioners or
similar authority. There is support for this reliance as even one of the most significant failures
of an insurance holding company still resulted in the specific insurance companies with
sufficient capital and excess to continue to actively engage in the insurance business.
8. Organizing and offering a covered fund (including limited investments in
such funds). The Proposed Rules follow the limited statutory exemption for organizing and
offering, or investing in, a covered fund. The limited exemption permits the institution to
continue to organize and offer investments in hedge funds and private equity funds if:
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the financial institution provides bona fide trust, fiduciary, or investment
advisory services;
the activities are related to, and are provided in connection with, bona fide
trust, fiduciary, or investment advisory services and only to persons that are
the institution’s customers;
the investment interest is limited to the de minimis level, which generally
limits the investment to the amount to seed the organization and operating
costs of the fund and expenses incurred for the fund to offer and attract
investments from unaffiliated investors, and which requires the institution
to have its interest in the fund reduced within one year (subject to
extension by the Federal Reserve Board for up to 2 additional years) to not
more than 3% of the total ownership interests in the fund and requires that
the institution’s investment in the fund is not more than 3% of the Tier 1
capital of the banking entity (generally, the amount under generally
accepted accounting principles equal to the par value and additional paid
in capital for the common stock and perpetual preferred stock and net
earnings);
the institution does not engage in affiliated transactions or “covered”
transactions restricted by banks with their affiliates, other than prime
brokerage services if other specified conditions are satisfied;
the institution does not have direct or contingent liabilities regarding the
fund, its obligations or performance, unless otherwise expressly permitted;
the institution is separate from the fund in other specified ways, including
the marketing of the fund (including that the fund cannot trade on the
bank’s name);
no director or employee of the institution has an ownership interest in the
fund, except as permitted for those directors or employees who are directly
engaged in providing investment advisory or other services to the hedge
fund or private equity fund; and
the institution complies with specified disclosure obligations, including that
the bank does not have any obligation for any losses in the hedge fund or
private equity fund.
This area of the Volcker Rule is one of the more significant provisions. It
mandates that covered banking institutions divest or “kick out” their capitive or sponsored
hedge funds and private equity funds prior to the expiration of the conformance period,
which is subject to extension in the discretion of the Federal Reserve Board on a per fund
basis. The ramification of this restriction, has already been evident. One market report noted
that more hedge funds were formed during the first quarter of 2012 than any other quarter as
banks wind down or divest their fund operations. The full effect of the kick out provision to
banks will likely not be seen for some time. In addition to profits, large banks were able to
36

supplement their traditional commercial bank product offerings with their affiliated funds.
Some commentators have expressed concern that limiting the product offerings will impede
a bank’s ability to assist large industrial companies through all parts of their capital structure
and may disadvantage U.S. banks to their non-U.S. counter parts. The counter argument is
that under Glass-Steagall Act, prior to the Gramm-Leach-Bliley Act, U.S. banks were able to
grow significantly and appropriately support and finance the U.S. and other economies.
Requiring the divestiture and separation of banks from hedge funds and
private equity funds has been criticized by many supporting the limitation of the Volcker Rule.
It is interesting to note a certain disconnect in the banking regulations. The loan attribution
rules for commercial banks which are designed to limit the risks of loans and other extensions
of credit, subject to certain exceptions, do not attribute the credit risk extended to a limited
liability company or partnership to the managing member if the liability is limited under
applicable law. The Volcker Rule would, by contrast, conclude the risk of the fund poses risk
(and is attributed to) the banking entity.
The Proposed Rules and the statute broadly define the terms hedge fund and
private equity fund. Similar to other parts of the Dodd-Frank Act, these terms (referred to
under the Proposed Rules as covered funds) include any entity that would be an investment
company under the Investment Company Act of 1940, as amended, but for the exemptions
under sections 3(c)(1) (100 investor rule) or 3(c)(7) (institutional investor rule). In addition, the
Proposed Rules include “or such similar funds as the Agencies may by rule determine.” The
Proposed Rules include as “similar funds” commodity pools and non-U.S. entities that are
substantively equivalent. This broad definition, subject to the regulatory discretion through
the language “similar fund,” excludes may result in private equity funds that invest in and
control portfolio companies to not qualify as an investment company. As such, the
exemptions under 3(c)(1) or 3(c)(7) are not relevant. The Investment Company Act of 1940, as
amended, provides that an investment company must have a threshold percentage of
“investment securities”, which, generally, are passive investments. A private equity fund with
portfolio investments that do not qualify as investment securities is more likely to be
excluded from the statutory definition.
9. Foreign trading by non-U.S. banking entities; and Foreign covered fund
activities by non-U.S. banking entities. This exemption reflects the inherent limitations of the
extraterritorial application of U.S. law. Trading activity by non-U.S. departments that are
entirely effected outside the U.S. with no U.S. person being part of the transactions, including
any person that is physically located in the U.S. that is making the trade for a non-U.S. entity,
will be exempt. The regulations specify in greater detail that any contact of any participant in
the trade with the U.S. would permit the application of Volcker Rule to the institution.
10. Catch All Provision. Consistent with the underlying mission of federal
banking regulations, the Proposed Rules provide that the exempted or permitted proprietary
trading transactions will nevertheless be disallowed if the transaction would:
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involve or result in a material conflict of interest between the covered
banking entity and its clients, customers, or counterparties;
result, directly or indirectly, in a material exposure by the institution to a
high-risk asset or a high-risk trading strategy; or
pose a threat to the safety and soundness of the covered banking entity or
to the financial stability of the United States.
This set of safety or catch-all provisions reflect the basic bank regulator’s tool
kit in overseeing the operations of banks and bank holding companies. The core purpose of
much of the comprehensive bank regulatory regime is the promotion of “safety and
soundness” of the banking entities. Indeed, the Volcker Rule is part of the regulatory regime
intended to promote the safety and soundness of banks by protecting them from the
perceived systemic and unnecessary risk of proprietary trading.
Recordkeeping Requirements
The Proposed Rules provide detailed recordkeeping and reporting obligations
for covered banking entities. The detailed requirements are found in Appendix A to the
Proposed Rules. These obligations are stratified in three tiers. Covered banking entities with
aggregate trading assets of less than $1 billion measured as of the last day of each of the four
prior calendar quarters, will not be subject to these enhanced reporting obligations. The
second tier is for covered banking entities with trading assets under $5 billion and the third is
for those larger banking institutions that exceed such amount. The enhanced recordkeeping
and reporting obligations provide for a wide array of quantitative measurements of the
covered trading activities of banking entities. The records must be maintained for a period of
at least 5 years.
The enhanced reporting will be used by the Agencies in their continuing
mission to evaluate the market conditions, measure systemic and banking institutional risks
and to update and enhance the regulations, as needed. Specifically, the Agencies note that
the enhanced recordkeeping and reporting will:
provide a better understanding and better process to evaluate the scope,
type, and profile of the covered banking entity’s trading activities;
assist the monitoring of the covered banking entity’s trading activities;
identify trading activities that warrant further review or examination by the
covered banking entity to verify compliance with the proprietary trading
restrictions; and
assist in evaluating whether the trading activities of trading units comply
with the Volcker Rule requirements.
IV.
Nonbank Financial Institutions
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The Volcker Rule permits nonbank financial institutions to engage in
proprietary trading subject to additional capital and other limitations. The Agencies have
deferred specifying these capital and other limitations as well as specifying the type of
entities that will be permitted to engage in proprietary trading. Quantifying the proprietary
trading restrictions will likely affect the ability of hedge fund trading operations. While
restricting such proprietary trading desk operations will likely reduce the systemic market risk,
it will also likely reduce the market liquidity. The Agencies will need to strike the appropriate
balance.
V. The Future of the Volcker Rule
It is difficult, if not impossible, to predict the future scope of the Volcker Rule. It
is reasonable to expect that the basic premise of the Volcker Rule will continue in some form.
Even if Congress overturns the Volcker Rule, the current bank regulatory regime may be
leveraged to achieve many of the Volcker Rule goals. For example, the risk of proprietary
trading positions could be more specifically assessed and banks could be required to lower
their Tier 1 capital by the updated risk assessment amount. The CAMELS rating system could
also be used to encourage or require banks to limit, disband or divest their proprietary
trading operations. Effectively, every bank has a “partner” who is the government and the
“partner” desires less risk undertaken by its commercial banks.
Bank regulators have long had the ability through a variety of methods to
apply their discretion to mandate a stable commercial banking industry that benefits the U.S.
economy. The regulators’ tool kit has been enhanced with the powers and the mandate of
the Volcker Rule. Despite the many criticisms of the broad reach and potential adverse effects
of the statutory language and the Proposed Rules, it is likely that there will continue to be
some form of significant limitations on proprietary trading.
The question is what other types of commercial banking operations will be
viewed by the bank regulators as exposing commercial banks and their affiliates to risk that
must be limited for the protection of the U.S. financial system. The Basle Accords have been
fine-tuning (some may say, overhauling) the capital levels required for banks, a significant risk
mitigating technique. The process of the government attempting to strike the perfect
balance of risk mitigation and pursuit of profit is dynamic and has been continuing for well
over a century. The regulators have an inherent dilemma that is more difficult to solve than
the Rubik’s Cube. On one hand, the economy is well served by offering every person the
ability to maintain their money in a financial institution with the guaranteed return of every
cent and a little bit more. On the other, the regulated financial institutions need to deploy
these funds in prudent activities that generate sufficient profit to fund the operating costs
and continue to attract capital and market support. Solving this dilemma is an ongoing and
improving process that considers numerous factors. One of these factors is the level of trust
that senior executives of bank entities will prudently control risk and pursue profit. A former
Chair of the Board of Governors of the Federal Reserve System admitted that he relied too
much on this basic market discipline to achieve the correct balance. In many ways the
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Volcker Rule reflects the inverse relationship between confidence and reliance on market
discipline and the scope of regulations that limit or bracket operations permitted by bank
entities. The regulatory process is continuously evolving. The limits on the operations of
banking entities, such as the Volcker Rule, will continue to reflect this process. The next step,
as recently noted by a senior official of the U.S. Treasury Department, may be the attempt to
“simplify” the Volcker Rule to achieve “smart rules that are responsive to the unique needs of
our financial system and promote economic growth”.
40

HERRICK, FEINSTEIN LLP’s
SIXTH ANNUAL CAPITAL MARKETS SYMPOSIUM
OCTOBER 2, 2012
THE JOBS ACT
BY STEPHEN E. FOX, MONICA REYES-GRAJALES and LILIANA CHANG

On April 5, 2012, President Barack Obama signed into law the “Jumpstart Our Business
Startups Act,” also known as the “JOBS Act.” The JOBS Act consists of seven unrelated titles,
each of which are ostensibly designed to aid in raising capital, ease the regulatory burdens of
smaller companies and spur an increase in the number of initial public offerings in the United
States - which has seen a dramatic decline in the last decade - all of which would presumably
culminate in job growth and economic growth in the United States. It remains to be seen if
the JOBS Act can deliver as promised, while still protecting investors. While the bills that
ultimately were signed into law as the JOBS Act were the product of bipartisan support in
both Houses of Congress and were also supported by President Obama, there are many vocal
opponents to the JOBS Act, including ranking members of Congress and former and current
members of the U.S. Securities and Exchange Commission (the “SEC”). Opponents are
concerned about the effect on investor protection due to the loosening of some longstanding
rules specifically designed to safeguard investors, including the now-overturned
ban on general solicitations and general advertising under Rule 506 of Regulation D among
others, all of which will be discussed below.
IPO ON-RAMP: REOPENING AMERICAN CAPITAL MARKETS TO EMERGING GROWTH
COMPANIES
Title I of the JOBS Act is entitled “Reopening American Capital Markets to Emerging
Growth Companies” but is known by the more catchy “IPO On-Ramp.” The IPO On-Ramp is
designed to encourage companies to go public by (a) loosening some restrictions for
companies going through the IPO process and (b) creating a phase-in period for other
obligations normally affecting public companies, providing some time for newly public
companies to grow large enough to afford the regulatory costs associated with being a public
company.
Several members of Congress and commentators have expressed concerns that the
provisions of the IPO On-Ramp (a) weaken investor protections by limiting disclosures that
must be made by emerging growth companies and the application of certain obligations of
public companies and (b) will allow more shell and blank check companies (with no
employees) and reverse merger companies based outside of the United States to go public.
Others contend that risk is part of investing. The actual effects of the IPO On-Ramp remain to
be seen.
Defining Emerging Growth Companies
The IPO On-Ramp creates a new category of issuer, called an “emerging growth
company,” which is comprised of any domestic or foreign issuer that has total annual gross
revenues of less than $1 billion during its most recently completed fiscal year. It is curious that
Congress picked $1billion as the threshold, as it encompasses an estimated 90% of all public
companies, and companies with annual gross revenues of substantially less than $1billion are
likely to be able to afford the regulatory costs associated with going public.
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An issuer will not be an emerging growth company if such issuer sold any common
equity securities pursuant to a registration statement under the Securities Act of 1933, as
amended (the “Securities Act”), on or prior to December 8, 2011. Also, while a business
development company (generally a company whose purpose is to make investments in small,
developing and financially troubled businesses) may qualify as an emerging growth
company, issuers of asset backed securities and investment companies registered under the
Investment Company Act of 1940, as amended (the “Investment Company Act”), will not
qualify as emerging growth companies.
An emerging growth company will keep that designation for each subsequent fiscal
year until the earliest of (a) the last day of the fiscal year during which it had total annual gross
revenues of at least $1 billion (indexed for inflation every five years), (b) the last day of the
fiscal year following the fifth anniversary of the date of the first sale of its common stock
pursuant to an effective registration statement, (c) the date on which it has, during the
previous three-year period, issued more than $1 billion in non-convertible debt or (d) the date
on which it meets the definition of a “large accelerated filer”, generally a company with a
public float of $700 million or more.
Modifications to assist Emerging Growth Companies in Going Public
Confidential Draft Registration Statements
The IPO On-Ramp adds a new Section 6(e) to the Securities Act which permits an
emerging growth company to submit a draft registration statement to the SEC on a
confidential basis prior to the date of first sale of common equity securities pursuant to an
effective registration statement under the Securities Act (which may be its initial public
offering). While prior to the enactment of the JOBS Act, in certain circumstances, foreign
private issuers were allowed to confidentially submit registration statements, historically a
company seeking to make an initial public offering was required to publicly file its initial
registration statement and disclose sensitive information regarding itself, often before the
offering was priced. The SEC could then issue several rounds of comments on the company’s
registration statement. Now, by making a confidential submission for registration, companies
may avoid public scrutiny and reduce potentially negative publicity. Furthermore, (a) since a
confidential submission is not considered a “filing” for liability purposes, it is not required to
be signed by the company, its directors or senior management, or to include the consent of
auditors and other experts and (b) no filing fee is due at the time of the confidential
registration’s submission. Even so, a draft registration statement must be “substantially
complete” and include a signed audit report of a registered public accounting firm with
respect to the fiscal years presented. Also, the confidential submission process is only
available for registrations under the Securities Act. Registrants under the Securities Exchange
Act of 1934, as amended (the “Exchange Act”), including registrants using Form 10 or Form
20-F registration statements, may not avail themselves of the confidential submission
process.
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In the event that an emerging growth company determines to move forward with an
offering and submits confidential submissions to the SEC, its confidential submissions and all
amendments to the confidential submissions must be included as exhibits to the publiclyavailable
“filed” registration statement at least 21 days before the issuer conducts any road
show as part of the offering or, if there is no road show, then the registration statement must
include as an exhibit the confidential submissions no later than 21 days before the
anticipated date of effectiveness of the registration statement. Due to the need to estimate
the time period for a road show or to otherwise plan the 21 day period, it is important that
any emerging growth company that avails itself of the confidential submission process
coordinate with its underwriters and other service providers to prevent non-compliance with
these timing requirements, otherwise the company’s offering could be needlessly delayed.
The SEC staff has indicated that it will publicly release comment letters and an emerging
growth company’s responses to staff comment letters on EDGAR no earlier than 20 business
days following the registration statement effective date.
The SEC has indicated that an emerging growth company which submits its draft
registration statement on a confidential basis may not rely upon the Rule 134 Safe Harbor
permitting public communications during an offering. However, after submitting a
confidential submission to the SEC but before the actual filing of the registration statement,
an emerging growth company may still publish a notice that complies with the safe harbor
provisions of Rule 135 (which lists specific information that may be published by a
prospective issuer during a public offering). While Rule 135 does not list a confidential
submission as one of its safe-harbor disclosure items, a number of companies have already
published Rule 135 compliant notices advising the public that they have confidentially
submitted draft registration statements to the SEC.
Reduced Registration Statement Disclosures
The IPO On-Ramp also reduces an emerging growth company’s disclosure obligations
in its registration statement. An emerging growth company may choose to provide only two
years of audited financial statements in its registration statement as opposed to the three
years previously required. Once public, emerging growth companies will be required to
include three years of financial statements in their subsequently filed Form 10-K’s unless they
are smaller reporting companies (generally companies with a public equity float of less than
$75 million); however, such emerging growth companies will not need to include audited
financial statements for any period prior to the earliest audited period made public in
connection with its initial public offering.
Each emerging growth company is also exempt from certain of the executive
compensation disclosures to the same extent as a smaller reporting company, the most
significant being the exemption from having to prepare and include in its initial registration
statement (and any an annual proxy statement) a compensation discussion and analysis.
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Marketing Prior to Going Public
The IPO On-Ramp loosens the limitations on brokers and dealers with respect to
publishing or distributing research reports. Brokers and dealers may now publish and
distribute research reports about an emerging growth company that is the subject of a
proposed registered public offering of its common stock without such reports being deemed
an offer to sell a security, even if such brokers or dealers are participating or will participate in
the registered offering of the securities that are the subject of the report.
The IPO On-Ramp also expands permissible communications before and after the
filing of a registration statement by permitting an emerging growth company or any person
authorized to act on its behalf to “test the waters” by engaging in oral or written
communications with potential investors that are qualified institutional buyers or institutional
accredited investors. Such mechanism allows an emerging growth company to determine
whether such investors might have an interest in the contemplated securities offering and
the likelihood of success if it decides to move forward with the offering. Prior to the JOBS Act,
non-public companies and most public companies were prohibited from communicating
with potential investors regarding a proposed offering without having filed a registration
statement; such communications are commonly known as “gun jumping.” Under the new
rules, test the waters communications are not considered gun jumping, allowing emerging
growth companies to use these communications to gain insights into the views of
institutional investors which could help them raise capital. The SEC staff has also indicated
that it will not object if an emerging growth company determines that it will not treat a test
the waters communication as a road show. It remains to be seen how popular this new
communications regime will be, in that any communications to test the waters will still be
subject to the federal securities laws’ anti-fraud rules and could raise concerns regarding
selective disclosures, which may cause some prospective issuers to think twice before availing
themselves of the opportunity.
Reduced Reporting Requirements for Public Emerging Growth Companies
Once an emerging growth company is public, such emerging growth company is
exempt from certain obligations under the Securities Act and the Exchange Act that would
otherwise apply to reporting companies, including:
Section 404(b) of the Sarbanes-Oxley Act of 2002, as amended (“SOX”) requires a
publicly-held company’s auditor to attest to, and report on, management’s
assessment of its internal controls. The IPO On-Ramp amends SOX by eliminating the
application of this requirement to emerging growth companies. This exemption was
included in the JOBS Act legislation over Chairman Shapiro’s objections.
The IPO On-Ramp further amends SOX by providing that any rules adopted by the
Public Company Accounting Oversight Board (the “PCAOB”) which require mandatory
audit firm rotation or a supplement to such auditor’s report providing additional
information will not apply to any emerging growth company. The PCAOB has
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published a concept release on the subject of audit firm rotation and its potential to
enhance auditor independence but no definitive rules have been adopted as of this
writing. Also, any additional rules adopted by the PCAOB after April 5, 2012 will not
apply to audits conducted on emerging growth companies unless the SEC finds that
the application of such rules to emerging growth companies is in the public interest,
after considering investor protection and the promotion of capital efficiency,
competition and formation. With respect to the extension of time provided by the IPO
On-Ramp to comply with new and/or revised financial accounting standards, at the
time an emerging growth company is first required to file a registration statement or
other periodic report, such emerging growth company must notify the SEC of its
choice to take advantage or opt out of the extended transition period. A decision to
opt out of the extended transition period is irrevocable and an emerging growth
company may not select to comply with some standards but not others.
Any new or revised financial accounting standard will not apply to emerging growth
companies until that date that private companies are required to comply with such
new or revised financial accounting standards;
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-
Frank”) amended the Exchange Act to require certain companies to hold shareholder
advisory votes on executive compensation and golden parachutes. The IPO On-Ramp
exempts emerging growth companies from the so called say-on-pay vote and the
advisory vote on golden parachute payments. Once a company no longer qualifies as
an emerging growth company, such company must comply with these voting rules
within one year of losing its status as an emerging growth company except that, if
such company qualified as an emerging growth company for two years or less, it must
comply with these rules within three years of losing its status.
Dodd-Frank also (a) required certain companies to disclose information that shows the
relationship between executive compensation and such companies’ financial
performance, taking into account any change in the value of the shares of stock and
any dividends or distributions and (b) required the SEC to promulgate rules requiring
companies to disclose the ratio of the median of the total annual compensation of all
employees of a company to the total annual compensation of a company’s chief
executive officer (neither of which have been promulgated by the SEC as of this
writing). The IPO On-Ramp exempts emerging growth companies from these
requirements.
Decimalization Study
The IPO On-Ramp required the SEC to conduct a study examining the transition to
trading and quoting securities of emerging growth companies in one penny increments,
known as decimalization, to (a) examine the impact that decimalization has had on the
number of initial public offerings since its implementation relative to the period before its
implementation and (b) examine the impact that the change has had on liquidity for small
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and middle cap company securities and whether there are sufficient economic incentives to
support trading operations in these securities in penny increments. If the SEC determined
that the securities of emerging growth companies should be quoted and traded using a
minimum increment of greater than one cent, the IPO On-Ramp permitted the SEC to enact
rules designating a minimum increment for the securities of emerging growth companies
that was greater than one cent but less than ten cents for use and quoting and trading of
securities in any exchange or other execution venue.
In July 2012, the SEC staff completed the decimalization study and found that the
effect of mandating an increase in the minimum tick size for smaller companies on the US
market structure and on the willingness of such companies to initiate public offerings was
uncertain. The SEC staff recommended that the SEC should not implement rules to increase
the size of the minimum price increments for trading and quoting the securities of emerging
growth companies but should consider additional steps to determine whether rulemaking
should in the future be undertaken. It remains to be seen whether Congress or the SEC
decides to further study this important matter or takes additional steps to increase the
minimum increment for trading securities of emerging growth companies.
Many commentators were disappointed with the SEC’s apparent lack of urgency on
this matter and some, including these authors, believe that the decimalization issue, if
addressed differently by the SEC, would have had important and far-reaching positive
consequences for the IPO market of smaller and middle cap companies, as allowing a greater
economic incentive to support trading operations could have helped bring back market
makers in those securities and, consequently, would have helped create liquidity and interest
in smaller and middle cap companies looking to go public.
Review of Regulation S-K
The IPO On-Ramp also requires the SEC to conduct a review of Regulation S-K to
comprehensively analyze the current registration requirements of such regulation and
determine how the requirements could be updated to modernize and simplify the
registration process and reduce the costs and other burdens associated with these
requirements for issuers who are emerging growth companies. The SEC’s report to Congress
regarding Regulation S-K is due at the beginning of October 2012.
ACCESS TO CAPITAL FOR JOB CREATORS
Title II of the JOBS Act, entitled “Access to Capital for Job Creators,” required the SEC to
revised its rules relating to the prohibition against general solicitation and general advertising
(contained in Section 502(c) of Regulation D promulgated under the Securities Act) in
connection with a private offering of securities.
Revisions Relating to Offerings Pursuant to Rule 506 of Regulation D
Title II requires the SEC to revise Rule 506 of Regulation D so that the prohibition
against general solicitation and general advertising would not apply to offers and sales of
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securities made pursuant to such rule when all purchasers of such securities are accredited
investors. It also provides that the revised SEC rules must require issuers to take reasonable
steps to verify that purchasers of the securities are accredited investors, using methods to be
determined by the SEC.
Rule 506 provides a non-exclusive safe harbor from registration for any private
offering of securities for any amount so long as all investors in such securities are accredited
investors (subject to a 35 person non-accredited investor limit so long as certain statutory
information is provided to the potential investors). The restrictions on general solicitations
and general advertising have forced issuers seeking to rely on Regulation D to take a cautious
approach and strictly limit communications about their business and the offering. Proponents
of the change argued that the new SEC rules will improve transparency and provide
substantial benefit to investors, regulators and the public, by providing more accurate and
complete information to the public, increasing communications between the entity and
investors, and allowing regulatory agencies and the media to better monitor industry trends
and activities.
Title II of the JOBS Act also amends the Securities Act to provide that any person who
offers securities for sale pursuant to Rule 506 of Regulation D or permits general solicitations,
general advertisements, or similar or related activities shall not be deemed a broker or dealer
so long as (a) such person receives no compensation in connection with the purchase or sale
of the securities, (b) such person and any person associated with that person does not
possess customer funds or securities in connection with the purchase or sale of such
securities and (c) such person and any person associated with such person is not subject to a
statutory disqualification under the Securities Act. This amendment encourages the
formation of online platforms and forums that would assist in matching investors with
companies seeking capital. Such online platforms and forums are playing an increasingly
important role in facilitating capital formation in small companies.
Revisions Relating to Secondary Sales Pursuant to Rule 144A
Title II also provides for a similar lifting of the ban on general solicitation and general
advertising under Rule 144A with respect to secondary sales of securities so long as securities
sold under Rule 144A are sold only to persons that the seller and any person acting on the
seller’s behalf reasonably believes is a qualified institutional buyer.
Proposed SEC Rules
As directed by the JOBS Act, on August 29, 2012, the SEC released proposed rules
designed to eliminate the prohibition against general solicitation and advertising under Rule
506 of Regulation D and Rule 144A of the Securities Act.
Under the proposed new Rule 506(c), companies issuing securities pursuant to Rule
506 of Regulation D would be able to offer securities using general solicitation and general
advertising provided that (a) the issuer takes reasonable steps to verify that purchasers are
accredited investors, (b) the purchasers come within one of the categories of accredited
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investors under Rule 501 or the issuer reasonably believes that each of the purchasers meets
one of the categories of accredited investors at the time of the sale of securities and (c) all
terms and conditions of Rule 501, Rule 502(a) and Rule 502(d) are met. The SEC declined to
provide a bright-line rule to determine whether “reasonable steps” have been taken by an
issuer. Rather, to determine that an issuer took reasonable steps to verify that a purchaser is
an accredited investor, the facts and circumstances of the transaction should be considered,
including the following factors:
The type of accredited investor and purchaser that the purchaser claims to be;
The information relating to the purchaser obtained by the issuer, including the
amount and type; and
The offering’s nature, including the way in which the purchaser was solicited, and
the offering terms, including the minimum investment amount.
The proposed rules would also allow an issuer to comply with the existing Rule 506
and not engage in general solicitation or general advertising. Such an issuer would then not
need to comply with the new purchaser verification rules. Also, Form D would be amended to
add a separate box for an issuer to check in the event that it intends to claim the new
exemption permitting general solicitation and advertising.
Within the release containing the proposed amendments to Rule 506, the SEC also
discussed the JOBS Act amendment to Section 4 of the Securities Act and its effects on
privately offered funds such as hedge funds and private equity funds. Privately offered funds
routinely rely on the Rule 506 safe harbor to offer their securities without registering pursuant
to the Securities Act. In addition, these privately offered funds generally avoid the regulatory
provisions of the Investment Company Act by availing themselves of the exemptions from
the definition of “investment company” under Section 3(c)(1) and Section 3(c)(7) of the
Investment Company Act. Section 3(c)(1) of the Investment Company Act exempts from the
definition of “investment company” issuers whose securities are beneficially owned by not
more than 100 beneficial owners and who are not making or proposing to make a public
offering of securities. Additionally, Section 3(c)(7) of the Investment Company Act exempts
from the definition of “investment company” issuers whose securities are exclusively owned
by “qualified purchasers” and who are not making or proposing to make a public offering of
securities. The JOBS Act amends Section 4 of the Securities Act to state that offers and sales of
securities exempt from registration under the Securities Act pursuant to Rule 506 are not
public offerings as a result of general advertising and solicitation permitted pursuant to the
amended Rule 506. In the proposed rules, the SEC staff acknowledged that the amendment to
Section 4 of the Securities Act permits privately offered funds to make general solicitations
pursuant to the revised Rule 506 without losing their exemption from the definition of
“investment company” under the Investment Company Act.
The proposed SEC rules would amend Rule 144A to permit parties engaging in a
secondary sale of securities pursuant to Rule 144A to offer such securities by means of general
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solicitation to persons, whether or not such persons are qualified institutional buyers,
provided that such securities are sold only to persons whom the seller reasonably believes are
qualified institutional buyers.
The SEC also addressed integration of Rule 506 and Rule 144A offerings with
transactions made in compliance with Regulation S. Regulation S provides an exclusion from
the registration requirements of the Securities Act for offerings made outside the United
States by both U.S. and foreign issuers. The SEC clarified that, in accordance with the historical
treatment of simultaneous Regulation S and Rule 144A or Rule 506 offerings by an issuer,
offshore offerings that comply with Regulation S requirements would not be integrated with
onshore offerings that comply with Rule 506 or Rule 144A, each, as amended by the proposed
rules.
Comments to the newly proposed rules may be received by the SEC within 30 days
after publication of the proposed rules in the Federal Register. It remains to be seen whether
the proposed rules are further amended prior to their adoption.
CROWDFUND ACT
Title III of the JOBS Act is entitled “Capital Raising Online While Deterring Fraud and
Unethical Non-Disclosure Act of 2012” or the “CROWDFUND Act.” “Crowdfunding”
colloquially refers to raising capital from a “crowd” of small investors, generally through the
internet. The crowdfunding provision, one of the most controversial parts of the JOBS Act,
provides an exemption from registration under the Securities Act for any transaction
involving the offer or sale of securities provided that (a) the aggregate amount sold to all
investors during the twelve-month period preceding the date of the transaction is not more
than $1.0 million, (b) the aggregate amount sold to any investor does not exceed (i) the
greater of $2,000 or 5% of the annual income or net worth of the investor (if either the annual
income or the net worth of the investor is less than $100,000) and (ii) 10% of the annual
income or net worth of the investor (if either of the annual income or net worth of the
investor equal to or more than $100,000), not to exceed a maximum aggregate amount sold
of $100,000, (c) the transaction is conducted through an SEC registered broker or funding
portal who complies with new Section 4A(a) (discussed further below) and (d) the issuer
complies with the requirements under new Section 4A(b) (discussed further below).
A registered funding portal is any person that acts as an intermediary in a transaction
involving the offer or sale of securities for the account of others, solely pursuant to the
crowdfunding exemption and that does not (a) offer investment advice or recommendations,
(b) solicit purchases, sales, or offers to buy the securities offered or displayed on its website or
portal, (c) compensate employees, agents, or other persons for such solicitation or based on
the sale of securities displayed or referenced on its website or portal, (d) hold, manage,
possess, or otherwise handle investor funds or securities or (e) engage in such other activities
as the SEC, by rule, determines appropriate. Subject to rulemaking by the SEC, a funding
portal shall be exempt from the requirement to register as a broker or dealer, provided that it
registers with the SEC as a funding portal and (x) remains subject to the examination,
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enforcement, and other rulemaking authority of the SEC, (y) is a member of a national
securities association registered under Section 15A of the Exchange Act and (z) is subject to
such other requirements as the SEC determines appropriate. As of this writing, the Financial
Industry Regulatory Authority (FINRA) is the only existing national securities association
registered under Section 15A of the Exchange Act.
Section 4A(a) provides that the SEC registered broker or funding portal must:
Provide such disclosures, including disclosures relating to risks and other investor
education materials, as the SEC by rule deems appropriate.
Ensure that each investor (a) reviews investor education information in accordance
with SEC standards, (b) positively affirms that the investor understands that the
investor is risking the loss of the entire investment and that the investor could bear
such a loss and (c) answers questions demonstrating an understanding of the level of
risks generally applicable to investments in start-ups, emerging businesses and small
issuers, an understanding of the risk of liquidity and an understanding of such other
matters as the SEC determines appropriate by rule.
Take such measures to reduce the risk of fraud with respect to the transactions as
established by the SEC by rule, including obtaining a background and securities
enforcement regulatory history check on each officer, director and person holding
more than 20% of the outstanding equity of every issuer whose securities are offered
by such person under the crowdfunding exemption.
Not later than 21 days prior to the first day on which securities are sold to any investor
or such other period as the SEC may establish, make available to the SEC and potential
investors any information provided by the issuer pursuant to this rule (as described
below).
Ensure that all offering proceeds are only provided to the issuer when the aggregate
capital raised from all investors is equal to or greater than the target offering amount
and allow all investors to cancel their commitments to invest as the SEC shall by rule
determine appropriate.
Make such efforts as the SEC determines appropriate by rule to ensure that no investor
in a twelve-month period has purchased securities pursuant to this section that in the
aggregate from all issuers exceed the crowdfunding offering investment limits.
Take such steps to protect the privacy of information collected from investors as the
SEC shall by rule determine appropriate.
Not compensate brokers, finders, or lead generators for providing the broker or
funding portal with personal identifying information of any potential investor.
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Prohibit its directors, officers, or partners from having any financial interest in an issuer
using its services.
Meet such other requirements as the SEC may by rule prescribe for the protection of
investors and in the public interest.
The crowdfunding exemption is limited to domestic issuers that are not SEC reporting
companies, investment companies or certain companies exempt from the definition of
investment companies. The Crowdfund Act also permits the SEC to establish additional
limitations on the types of issuers that may use the crowdfunding exemption. Section 4A(b)
provides that any issuer of securities availing itself of the crowdfunding exemption:
Will be required to file with the SEC and provide to investors and the relevant broker
or funding portal, and make available to potential investors:
o the name, legal status, physical address, and website address of the issuer;
o the names of the directors, officers and each person holding more than 20% of the
shares of the issuer;
o a description of the business of the issuer and the anticipated business plan of the
issuer;
o a description of the financial condition of the issuer, including the income tax
returns filed by the issuer for the most recently completed year (if any) and
financial statements of the issuer certified by the principal executive officer of the
issuer to be true and complete in all material respects for targeted offerings of
$100,000 or less, financial statements reviewed by an independent public
accountant, using professional standards and procedures for such review or
standards and procedures established by the SEC by rule, for such purpose for
targeted offerings of more than $100,000 but not more than $500,000, and audited
financial statements for targeted offerings of more than $500,000;
o a description of the stated purpose and intended use of the proceeds of the
offering;
o the target offering amount, the deadline to reach the target offering amount, and
regular updates regarding the progress of the issuer in meeting the target offering
amount;
o the price to the public of the securities or the method for determining the price,
provided that, prior to sale, each investor shall be provided in writing the final
price and all required disclosures, with a reasonable opportunity to rescind the
commitment to purchase the securities; and
o a detailed description of the ownership and capital structure of the issuer.
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May not advertise the terms of the offering, except for notices which direct investors
to the funding portal or broker.
May not compensate or commit to compensate any person to promote its offerings
through a broker or funding portal without taking steps to ensure that such person
discloses the past or prospective receipt of such compensation.
Not less than annually, file with the SEC and provide to investors reports of the results
of operations and financial statements of the issuer.
The crowdfunding rules provide that any person who purchases a security in a
crowdfunding transaction may bring a rescission action against an issuer to recover the
consideration paid for such security (with interest, but less the amount of any income
received thereon), or for damages if such person no longer owns the security, in the event the
issuer violates the antifraud provisions of the securities laws, provided that the purchaser did
not know of such untruth or omission.
Securities issued pursuant to a crowdfunding transaction may not be transferred by
the purchaser of such securities for one year from the date of purchase, unless such securities
are transferred to the issuer of the securities, to an accredited investor, as part of an offering
registered with the SEC, to a member of the family of the purchaser, or in connection with the
death or divorce of the purchaser or, at the SEC’s discretion, other similar circumstances. The
SEC may, by rule, establish further transfer limitations.
Not later than 270 days after April 5, 2012, the SEC is required to issue such rules as it
determines may be necessary or appropriate for the protection of investors to carry out the
crowdfunding exemption, including to establish disqualification provisions under which an
issuer shall not be eligible to offer securities pursuant to the crowdfunding exemption and a
broker or funding portal shall not be eligible to effect or participate in transactions pursuant
to the exemption.
The SEC is also mandated, by rule not later than 270 days after April 5, 2012, to exempt
securities acquired pursuant to a crowdfunding offering from the provisions of Section 12(g)
of the Exchange Act.
Although offerings relying on the crowdfunding exemptions and funding portals are
generally exempt under state blue sky law, states will still have antifraud oversight with
respect to any such offerings, and under certain circumstances are permitted to require
notice filings and fees in relation thereto.
The crowdfunding rules have received a lot of press, in part because of its novelty
when compared to historic securities offering alternatives, in part because of the fear of abuse
by bad actors and in part because of the success of similar business models that do not sell
securities such as Kickstarter, Inc., a funding platform for creative projects. Regardless of the
amount of press, there is still much uncertainty about crowdfunding and whether it will take
its place as a legitimate form of capital formation. The SEC has publicly stated that no person
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may rely on the crowdfunding rules and no person may act as a crowdfunding intermediary,
even if they are a registered broker, until the SEC has adopted the rules mandated by the
JOBS Act, which will not be at least until the end of 2012. Furthermore, in the quest to protect
investors, it is likely that the SEC will include in the new rules additional safeguards not
otherwise contemplated by the JOBS Act but not impermissible, which may have the effect of
stifling a crowdfunding market that would otherwise develop. There is also the possibility
that crowdfunding as it is currently proposed will not work as well as it is intended, similar to
the original Regulation A (discussed below), because the threshold of $1.0 million is too low
for broad-based use by issuers, there may be significant costs to implement a crowdfunding
offering, there may not be enough financial incentive to attract the intermediaries that are
required to facilitate the offerings, and issuers who otherwise would use crowdfunding will
instead rely on more customary ways to raise money, such as Regulation D.
We can only hope that any rules adopted by the SEC are sensible and attempt to strike
the right balance between capital formation and investor protection, and not a reaction
against what the SEC may consider an unfamiliar or suspicious funding alternative.
SMALL COMPANY CAPITAL FORMATION
Title IV of the JOBS Act, entitled “Small Company Capital Formation,” is designed to
breathe new life into the existing limited offering exemption known as Regulation A. As
initially codified, Regulation A provided an exemption from the Securities Act registration
requirements for US and Canadian issuers (other than SEC reporting companies, development
stage companies, registered investment companies and certain other categories of
companies) who intended to raise not more than $5 million in a rolling twelve month period.
Such issuers were required to go through a federal filing and review process beginning with
the filing of an offering statement pursuant to Form 1-A. Also, unlike offerings under
Regulation D, Regulation A offering were generally subject to state securities laws. Primarily
due to the expense in preparing the required Form 1-A, the relatively limiting $5 million cap
on the amount that may be raised, and the added expense of having to register the offering
under blue sky laws, Regulation A was infrequently used as an offering alternative. According
to one report from the U.S. Government Accountability Office, Regulation A offerings filed
with the SEC decreased from 116 in 1997 to 19 in 2011.
Title IV changes the existing paradigm by amending the Securities Act to require that
the SEC enact rules and regulations (a) increasing the offering limit from $5 million to $50
million and (b) making the securities sold pursuant to Regulation A “covered securities,” thus
exempting them from most blue sky laws if the securities are offered and sold on a national
securities exchange or to qualified purchasers. The amendments also codify the following:
The securities sold in any Regulation A offering are not “restricted” securities and
instead may be offered and sold publicly.
The civil liability provision in Section 12(a)(2) of the Securities Act applies to any
person offering or selling such securities.
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The issuer may solicit interest in the offering prior to filing any offering statement, on
such terms and conditions as the SEC may prescribe in the public interest or for the
protection of investors.
The SEC, by rule or regulation, shall require the issuer to annually file audited financial
statements with the SEC and may require the issuer to make available to investors and
file with the SEC, periodic disclosures relating to such issuer’s business operations,
finances, corporate governance, use of investor funds and other matters deemed
appropriate by the SEC. The SEC may also choose to suspend and/or terminate any
such reporting requirement for an issuer.
Such other terms, conditions, or requirements as the SEC may determine necessary in
the public interest and for the protection of investors.
Only equity securities, debt securities, and debt securities convertible or exchangeable
to equity interests, including any guarantees of such securities, may be offered and sold
pursuant to the revised exemption.
It remains to be seen whether, pursuant to its rulemaking, the SEC will create a set of
two exemptions, a $5 million Regulation A offering and alternate $50 million Regulation A
offering, or one integrated Regulation A offering reflecting the new $50 million cap. Every two
years, the SEC is required to review the $50 million offering amount limitation and increase
such amount as the SEC determines appropriate. If the SEC determines not to increase such
amount, it is required to report its reasons for not increasing the amount to the Committee on
Financial Services of the House of Representatives and the Committee on Banking, Housing
and Urban Affairs of the Senate.
Though the crowdfunding exemption described above has received a lot of press,
many commentators believe that the revised Regulation A will be the biggest boon to small
capitalization companies. Such companies may now choose to forgo an initial public offering
and instead pursue a private offering pursuant to Regulation A because, unlike offerings
pursuant to the crowdfunding exemption and Rule 506, the securities issued are not
restricted and, upon their issuance, are freely tradable. As a result, securities issued pursuant
to Regulation A offer more liquidity to investors and could result in the creation of a healthy
secondary market in such securities. Also, unlike the crowdfunding exemption, companies
issuing securities pursuant to Regulation A are not capped at $1 million and, unlike offerings
pursuant to Rule 506, the accredited investor requirements are not applicable to such sales of
securities. In addition, similar to the new Rule 506(c), an issuer may publish or deliver to
prospective purchasers a written document or make scripted radio or television broadcasts to
determine whether there is any interest in a contemplated securities offering, following
submission of the written document or script of the broadcast to the SEC.
The JOBS Act does not contain a deadline by which the SEC must promulgate rules
applying the provisions of the Small Company Formation title. Therefore, it is not yet known
when issuers may begin to enjoy the benefits of the revised Regulation A.
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PRIVATE COMPANY FLEXIBILITY AND GROWTH
Title V of the JOBS Act is entitled “Private Company Flexibility and Growth” and is
designed to address the issue of a private company being forced to go public prematurely
due to the company reaching the 500 stockholder limit under Section 12(g) of the Exchange
Act. A company that is registered under Section 12(g) of the Exchange Act is required to file
with the SEC periodic reports such as annual reports on Form 10-K, quarterly reports on Form
10-Q and current reports on Form 8-K and be subject to the proxy rules. This title amends
Section 12(g) to increase the thresholds pursuant to which a company would be required to
register under Section 12(g) from 500 record holders to either 2,000 record holders or 500
record holders who are not accredited investors.
This title also revises the definition of “held of record” set forth in Section 12(g)(5) of
the Exchange Act to exclude securities held by persons who received such securities pursuant
to an employee compensation plan in a transaction exempt from registration under Section 5
of the Securities Act. The SEC is required to adopt rules implementing this change in the
definition, as well as to adopt safe harbor provisions that issuers can follow when determining
whether holders of their securities received the securities pursuant to an employee
compensation plan in transactions that were exempt from the registration requirements of
Section 5 of the Securities Act. These rules will therefore be very important to companies that
need to monitor their record holders because they are approaching the thresholds for Section
12(g) registration, as mistakes in counting could potentially cause a company to inadvertently
become a reporting company. As of this writing, the SEC has not adopted these rules;
however, according to certain frequently asked questions issued by the SEC, the absence of
the safe harbor rule does not preclude reliance on the amendment to Section 12(g)(5) of the
Exchange Act and, therefore, as of April 5, 2012, an issuer may exclude persons who received
securities pursuant to an exempt employee compensation plan regardless of whether or not
the person is a current employee of such issuer.
The determination of who is a record holder or holder of record would be made within
120 days after the last day of the first fiscal year ended on which an issuer has total assets
exceeding $10 million. The amendments to the Exchange Act required by Title V of the JOBS
Act will likely make it more complicated and difficult to determine the number of
shareholders of record a particular company has at any given point. It is also not clear how to
treat these exempted shares if they are subsequently sold by or otherwise transferred from
the original holder.
As widely reported in the press in the lead-up to Facebook’s IPO, some private
companies who were not yet ready to go public were in any event forced to do so due to
pushing up against the 500 record holder limit, as a result of the companies granting equity
compensation to their employees or otherwise privately issuing securities to investors, or as a
result of private secondary market trading. Other private companies, in order to avoid going
public, were forced to structure their equity compensation plans in such a way to avoid their
employees from being counted towards the 500 record holder limit, but which limited the
form of equity compensation the companies were permitted to grant. This title puts some
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common sense back into Section 12(g) and the SEC’s interpretations of Section 12(g), by
allowing companies to remain private while retaining flexibility with respect to equity
compensation grants to employees, as well as encouraging the growth of private secondary
markets of securities by enabling the easing of restrictions on transfer of company stock by
employees and other stockholders. It is ironic, though, that the same act that created the IPO
On-Ramp to facilitate IPOs also provides a method to delay companies from being forced to
go public by increasing the record holder threshold for registration under Section 12(g) of the
Exchange Act.
Title V of the JOBS Act also requires the SEC to examine its authority to enforce Rule
12g5–1 (relating to the definition of securities “held of record”), to determine if new
enforcement tools are needed to enforce the anti-evasion provision contained in subsection
(b)(3) of that rule. Rule 12g5-1(b)(3) provides that if an issuer knows or has reason to know
that the form of holding securities of record is used primarily to circumvent the registration
requirements of the Exchange Act, the beneficial owners of such securities shall be deemed
to be the record owners thereof. The JOBS Act required the SEC to transmit its
recommendations on this topic to Congress not later than 120 days after April 5, 2012.
CAPITAL EXPANSION
Title VI of the JOBS Act is entitled “Capital Expansion.” The title assists banks and bank
holding companies by amending Section 12(g) of the Exchange Act to increase the threshold
for registration and deregistration under the Exchange Act. Prior to the passage of Title VI,
companies with 500 or more shareholders of record were required to register with SEC. Also, a
company could not “go dark” and cease filing periodic reports with the SEC until such
company had less than 300 holders of record. As a result of Title VI a bank or a bank holding
company will not need to register with the SEC pursuant to Section 12(g) until it has total
assets exceeding $10 million and a class of equity security (other than an exempted security)
held of record by 2,000 or more persons. Such bank or bank holding company may deregister
(or “go dark”) and suspend its reporting obligations under Section 15(d) of the Exchange Act if
the number of record holders falls below 1,200 persons. The SEC has indicated that if a bank
or bank holding company has less than 1,200 holders of record for a class of securities, such
bank or bank holding company may file a Form 15 to terminate the Section 12(g) registration
of that class. Form 15 has not yet been amended to reflect the change to Exchange Act
Section 12(g)(4). Therefore, the SEC has directed such bank or bank holding company to
include an explanatory note in its Form 15 indicating that it is relying on Exchange Act
Section 12(g)(4) to terminate its duty to file reports with respect to that class of equity
security.
The SEC is required to issue final regulations to implement Title VI of the JOBS Act and
the amendments made by such title within one year of enactment. It is anticipated that this
title will result in greater flexibility for banks and bank holding companies with respect to
their capital raising efforts.
58

OUTREACH ON CHANGES TO THE LAW
Title VII of the JOBS Act, entitled “Outreach on Changes to the Law,” is the shortest title
of the JOBS Act. Pursuant to the title, the SEC is directed to provide online information and
conduct outreach to inform small and medium sized businesses, women owned businesses,
veteran owned businesses, and minority owned businesses of the changes made by the JOBS
Act.
CONCLUSION
Congress ostensibly enacted the JOBS Act to spur job creation and economic growth
in the United States by improving access by emerging growth companies to the public capital
markets. They reasoned that public offerings contribute to job growth because they give
companies access to capital thus allowing them to grow and that growing companies hire
more employees. Others point out that there is nothing in the JOBS Act that actually requires
the creation of jobs. Also, many are concerned that the JOBS Act will not invigorate the public
markets and will instead result in boosting the private markets instead. They note that, while
Title I of the JOBS Act aims to encourage economic growth by decreasing the disclosure and
reporting requirements for emerging growth companies that seek to engage in a public
offering, on the other hand, Title II through Title VI strive to encourage economic grow by
eliminating restrictions against general solicitation and advertising for Rule 506 of Regulation
D, creating an exemption from registration for crowdfunding, creating new exempt securities
under Regulation A and raising the thresholds for mandatory registration. These provisions
operate to offer alternatives to going public for companies attempting to raise capital.
Only time will tell if the JOBS Act has the intended effect envisioned by Congress, in
part because we must still await substantial rulemaking from the SEC before issuers and their
advisers can take full advantage of the opportunities that the JOBS Act has to offer.
Unfortunately, these authors are already seeing some set-backs since enactment, with the
SEC declining to address the fundamental problems resulting from decimalization, in its July
2012 study on the topic. It is uncertain as to when the SEC will complete its rulemaking and
implementation under the JOBS Act. The SEC still has not completed all rulemaking initiatives
called for under the Dodd-Frank Act, and SEC Chairman Shapiro has publicly stated that some
of the time limits set forth in the JOBS Act are aggressive and may not be achievable within
the indicated time limits. Furthermore, SEC Chairman Shapiro has made no secret of her belief
that much of the JOBS Act weakens investor protection, and the jury is still out as to whether
any SEC rulemaking will shift away from Congressional intent for the sake of protecting
investors, by adding regulations to the extend the SEC has the authority to do so. It will also
take time to see if the loudest critics of the JOBS Act will be vindicated as a result of any
scandals stemming from the loosening of existing regulations to protect investors. We at
Herrick, Feinstein LLP believe that the JOBS Act includes some very good ideas to balance
what has arguably been over-regulation and the requirements for over-disclosure (and the
resulting costs) over the past ten years, but are not certain as to whether any of the provisions
of the JOBS Act or the resulting rules will truly spur an IPO boom or assist companies to more
easily obtain capital.
59

HERRICK, FEINSTEIN LLP’s
SIXTH ANNUAL CAPITAL MARKETS SYMPOSIUM
OCTOBER 2, 2012
TRACKING DERIVATIVES REGULATION
UNDER DODD-FRANK
BY PATRICK D. SWEENEY and JULIE ALBINSKY

TABLE OF CONTENTS
Page
I. INTRODUCTION ...................................................................................................................................... 65
II. DEFINITIONS ............................................................................................................................................ 65
1. Swaps, Security Based Swaps and Mixed Swaps. ...................................................... 66
2. Swap Dealers and Security Based Swap Dealers. ...................................................... 72
3. Major Swap Participants and Major Security-Based Swap Participants. .......... 77
4. Eligible Contract Participant ("ECP")............................................................................... 79
5. Effective Dates and Compliance Dates. ........................................................................ 79
III.
REPORTING AND RECORDKEEPING OF SWAP TRANSACTION DATA;
REGISTRATION AND REGULATION OF SWAP DATA REPOSITORIES ................................... 80
1. Reporting and Recordkeeping Requirements. ........................................................... 80
2. Reporting and Recordkeeping Requirements for Pre-Enactment
Swaps ......................................................................................................................................... 82
3. Registration and Regulation of SDRs ............................................................................. 83
IV. MANDATORY CLEARING ..................................................................................................................... 86
1. Proposed Rules Regarding the Clearing Requirement ........................................... 87
2. Compliance Schedule for Mandatory Clearing .......................................................... 88
3. End-User and Other Exemptions ..................................................................................... 88
4. Process for Review of Swaps for Mandatory Clearing ............................................. 91
5. Customer Clearing Documentation, Timing of Acceptance for
Clearing and Clearing Member Risk ............................................................................... 92
6. Protection of Cleared Swaps Customer Contracts and Collateral ...................... 94
7. Core Principles for DCOs ..................................................................................................... 95
8. Proposed Rules Regarding SBS CA Standards for Operation and
Governance ............................................................................................................................. 98
9. Proposed Rules Regarding Mitigating Conflicts of Interest for
DCOs/CAs, DCMs, SEFs and SBS Exchanges ..............................................................100
V. REGISTRATION AND REGULATION OF SWAP DEALERS AND MAJOR SWAP
PARTICIPANTS ......................................................................................................................................102
1. Registration of Swap Dealers and Major Swap Participants ...............................102
2. Business Conduct Standards for Swap Dealers and Major Swap
Participants ............................................................................................................................104
3. Duties of Swap Dealers and Major Swap Participants ...........................................110
4. Recordkeeping Rules for Swap Dealers and Major Swap Participants ............115

5. Proposed Rules Regarding Margin Requirements for Uncleared Swaps
for Swap Dealers and Major Swap Participants .......................................................117
6. Proposed Rules Regarding Capital Requirements for Uncleared Swaps
for Swap Dealers and Major Swap Participants .......................................................119
VI.
MANDATORY TRADE EXECUTION REQUIREMENT; REGULATION OF SWAP
EXECUTION FACILITIES AND DESIGNATED CONTRACT MARKETS....................................120
1. Confirmation; Portfolio Reconciliation; Portfolio Compression; and
Trading Relationship Documentation .........................................................................120
2. Proposed Rules Regarding Position Limits ................................................................125
3. Registration of Foreign Boards of Trade .....................................................................130
4. Proposed Rules Regarding Core Principles for SEFs and SBS SEFs ...................130
5. Proposed Rules Regarding Core Principles for DCMs ............................................134
VII. CROSS-BORDER APPLICATION OF SWAPS RULES ...................................................................135
1. Cross-Border Framework ..................................................................................................135
2. Registration and Regulation of Non-U.S. SDs and MSPs ......................................136
3. Regulation of Other Non-U.S. Market Participants .................................................137
4. Compliance Phase-In .........................................................................................................137
VIII. SUMMARY OF COMPLIANCE DATES ............................................................................................138

I. INTRODUCTION
TRACKING DERIVATIVES REGULATION UNDER DODD-FRANK 1
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
(the "Dodd-Frank Act") mandated the comprehensive regulation of derivatives trading in the
U.S. financial markets, no later than July 2011. Clearly there has been some slippage in this
targeted date. Notwithstanding, the Commodity Futures Trading Commission (the "CFTC")
and the Securities and Exchange Commission (the "SEC"), which will jointly regulate the
derivatives markets, 2 have made considerable headway in formulating the regulations and in
laying down a rational plan for their implementation.
In June 2012, the SEC released a general policy statement (the "General Policy
Statement") with regard to the sequencing of compliance dates for its rules applicable to
security-based swaps. Although the CFTC has not issued a similar statement with respect to
swap regulations, it is evident from the manner in which the CFTC has categorized its
principal rulemaking endeavors, and related compliance dates, that it generally shares the
SEC’s view on the appropriate phasing of compliance dates.
The SEC proposes that the derivatives regulations for swaps be implemented in five,
principal, sequential groups of regulations: (i) definitional and cross-border rules, (ii) swap
data repository ("SDR") registration and transaction reporting, (iii) mandatory clearing, (iv)
swap dealer ("SD") and major swap participant ("MSP") registration and regulation, and (v)
swap execution facility ("SEF") registration and regulation and the mandatory trade execution
requirement.
This article will outline actual and anticipated developments in derivatives regulation
on the basis of the groupings of regulations set forth in the General Policy Statement.
II.
DEFINITIONS
The definition of key terms is the core of derivatives regulation, not only because these
definitions impact which products and persons will be subject to the new regulations, but
also because the compliance dates for much of the derivatives regulation are tied to the
compliance dates for the definitional rules. The Dodd-Frank Act set out the basic definitions
for the products (e.g., swaps, security-based swaps, mixed swaps) and the players (e.g., swap
dealers, major security-based swap participants), and further mandated that the Commissions
clarify the statutory definitions and craft appropriate exclusions. Acting on this mandate, in
the spring of 2012, the Commissions jointly enacted two final rules (the "Definition Rules")
1 This article is current as of September 15, 2012.
2 Jurisdiction of the CFTC and the SEC over derivatives regulation is determined primarily with reference to the
terms "swap" and "security‐based swap". See Section II.1 for the regulatory definitions of these terms. For ease of
reference, this article will refer generally to swaps, except where the distinctions between the two terms are
germane to the discussion.
65

further defining and interpreting the derivatives definitions set forth in Dodd-Frank Act and
laying out various exclusions.
1. Swaps, Security Based Swaps and Mixed Swaps.
(a) Definition of Swap. "Swap" is defined broadly by the Dodd-Frank Act to
include most over-the-counter ("OTC") derivatives. The Dodd-Frank Act specifically
enumerates various types of swaps included in the definition (interest rate swaps, rate
floor/cap/collar, cross-currency rate swap, equity/debt index swap) and also contains a broad
catch-all clause including any agreement, contract or transaction that is, or in the future,
becomes known in the trade as a swap. Rate swaps, currency swaps, equity swaps, credit
default swaps and commodity swaps are all included in the definition. Excluded from the
definition of swap are futures traded on an exchange; futures that will be physically settled;
calls, options and straddles on securities that are subject to the Securities Act of 1933 (the
"Securities Act") and the Securities Exchange Act of 1934 (the "Exchange Act"); foreign
currency swaps entered into on an SEC registered exchange; transactions based on a security
entered into for capital raising purposes; and any sale of a nonfinancial commodity or any
security for deferred shipment or delivery, so long as the transaction is physically settled. The
Definition Rules do not supplement the statutory definition of "swap"; however, they do
clarify the treatment under this definition of certain types of agreements, contracts and
transactions, as discussed in Section II.1(d) below.
(b) Definition of Security-Based Swap. A "security-based swap" is defined in
the Dodd-Frank Act as a swap that is based on a narrow-based security index, a single security
or loan, or on the occurrence (or nonoccurrence or extent of occurrence) of an event relating
to an issuer or issuers in a narrow-based security index, which event directly affects the
financial statements, financial condition or financial obligation of the issuer or issuers.
Excluded from the definition is any agreement, contract or transaction that meets the
definition only because it references, is based on, or settles through the transfer or delivery of
an exempted security 3 under the Exchange Act (unless the transaction is a put, call or other
option). As with the definition of "swap", the Definition Rules do not supplement the
statutory definition of "security-based swap"; however, they do clarify the treatment under
this definition of certain types of agreements, contracts and transactions, as discussed in
Section II.1(d) below.
(c) Mixed Swap. A mixed swap is a security-based swap which is also based
on the value of one or more interest or other rates, currencies, commodities, instruments of
3 "Exempted securities" are defined in Section 3(a)(12) of the Exchange Act to include (i) government and
municipal securities, (ii) any interest or participation in any common trust fund or similar fund that is not an
"investment company" under the Investment Company Act of 1940, (iii) any interest or participation in a single or
collective trust fund maintained by a bank, (iv) any security issued by or any interest or participation in a pooled
income fund, collective trust fund, or similar fund that is not an "investment company" under the Investment
Company Act of 1940, (v) for certain purposes under the Exchange Act only, any security issued by any interest or
participation in any church plan, company or account that is not an "investment company" under the Investment
Company Act of 1940, (vi) other securities as the SEC may specify.
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indebtedness, indices, quantitative measures, other financial or economic interest or property
of any kind (other than a single security or a narrow-based security index) or the occurrence
of certain events. The category of mixed swaps is very narrow and is intended solely to insure
that there are no gaps in the regulation of swaps and security-based swaps. A bilateral,
uncleared mixed swap will be a transaction that is both a swap and a security-based swap. An
example of a mixed swap is an instrument in which the underlying reference is a portfolio of
both securities (assuming the portfolio is not an index or, if it is an index, that the index is
narrow-based) and commodities. Mixed swaps with dealers and major participants registered
with both the CFTC and SEC as counterparty will be subject to CFTC rules and requirements of
federal securities laws. All other mixed swaps will be regulated either pursuant to a joint
order from the Commissions determining whether the mixed swap will be governed by the
Commodity Exchange Act ("CEA") and/or the Exchange Act, or by parallel requirements of
both the CEA and the Exchange Act.
(d) Additional Exclusions and Clarifications Regarding the Definitions of
"Swap" and "Security-Based Swap".
(i) Insurance. The Definition Rules clarify that traditional insurance
products that otherwise fall within the definition of swap or security-based swap will not be
considered swaps or security-based swaps so long as they satisfy the requirements of the
insurance safe harbor. In order to qualify for the insurance safe harbor and thereby not be
considered a swap or security-based swap, an agreement, contract or transaction must (i)
either (A) satisfy the "product test" (which contains four elements: (1) the beneficiary must
have an insurable interest and thereby continuously carry the risk of loss; (2) loss must occur
and be proved, which will ensure that the beneficiary has a stake in the insurable interest; (3)
the insurance product must not be traded separately from the insured interest on an
organized market or over the counter; and (4) in the case of financial guaranty insurance
policies (i.e. bond insurance or bond wraps), any acceleration of payment under the policy
must be at the sole discretion of the insurance provider) or (B) be an "enumerated product",
which includes surety and fidelity bonds, various types of insurance (life insurance, health,
long-term care, title, property and casualty, annuities, disability, private mortgage,
reinsurance (including retrocession) of any of the foregoing; and (ii) satisfy one prong of the
"provider test" (which includes providers regulated by federal and state insurance authorities
where the product is regulated as insurance under applicable federal or state law; federal,
state and local governments and agencies where the product is regulated as insurance under
applicable state or federal law; providers under statutorily authorized programs; certain
reinsurers of products which satisfy the product test or are enumerated products; and certain
non-admitted insurers). The Definition Rules state that the product test, the enumerated
products and the provider test represent a non-exclusive safe harbor; that is, if a product does
not satisfy the insurance safe harbor as set forth in the Definition Rules, such product will
require further analysis of the facts and circumstances, including the form and substance of
such product.
(ii) Guarantees. The CFTC has stated that the definition of "swap"
includes any guarantee of a swap, to the extent that a counterparty to the guaranteed swap
67

would have recourse against the guarantor; i.e. a guarantee of a swap is a term of the swap.
In contrast, the SEC will treat guarantees of security-based swaps as separate securities, which
is consistent with the SEC’s historical approach to the treatment of guarantees of securities.
Guarantees of security-based swaps will therefore be regulated as separate securities.
(iii) Forward Contracts. The definition of "swap" as set forth in the
Dodd-Frank Act excludes forward contracts with respect to nonfinancial commodities for
deferred shipment or delivery, so long as the transaction is intended to be physically settled.
In the Definition Rules, the CFTC has stated that it will interpret the forward contract exclusion
in a manner consistent with its historical interpretation of the existing forward exclusion with
respect to futures contracts. The CFTC’s historical interpretation has been that forward
contracts with respect to nonfinancial commodities are commercial merchandising
transactions, and therefore intent to deliver has historically been an element of the CFTC’s
analysis of whether a contract is a forward contract. Accordingly, the CFTC will look at
whether a contract is intended to be physically settled in order to determine if it is a forward
contract of a swap.
Whether a forward contract will lose its exclusion in the event of a "book-out"
transaction has long been the subject of consideration under CFTC regulations. A "book-out"
is a cancellation agreement entered into by two counterparties who have multiple, offsetting
positions with each other in order to terminate their contracts and forego deliveries and
instead to agree on payment of differences. The CFTC has stated that it will employ the Brent
Interpretation, 4 which concluded that forward contracts for oil commodities retain their
character as commercial merchandising transactions (and therefore as forward contracts)
notwithstanding the practice of terminating delivery obligations via book-outs. The new
interpretation effectively extends the Brent Interpretation to cover all nonfinancial
commodities, rather than only oil commodities. Oral book outs will be permissible so long as
they are followed in a commercially reasonable timeframe by a written or electronic
confirmation.
(iv) Consumer and Commercial Agreements, Contracts and
Transactions. Various agreements, contracts and transactions entered into by consumers for
personal, family or household purposes, which may have attributes of swaps or securitybased
swaps, will not be considered swaps or security-based swaps. Such consumer
agreements include real estate lease, purchase and mortgage transactions, product or service
agreements for personal, family or household purposes, interest rate caps or locks or variable
interest rate options for consumer loans or mortgages, consumer product warranties,
extended service plans and buyer protection plans.
Similarly, business agreements, contracts and transactions which are part of a
business’ operations relating to acquisitions and sales of property, provisions of services,
employment of individuals and other matters will not be considered swaps or security-based
swaps.
4 Statutory Interpretation Concerning Forward Transactions, 55 FR 39188 (Sept. 25, 1990).
68

(v) Loan Participations. A loan participation is the transfer, by a
lender to an investor, of a participation in the economic risks and benefits of all or a portion of
a loan or commitment it has entered into with a borrower. Loan participations are not swaps
or security-based swaps if the participation reflects a current or future direct or indirect
ownership interest in the underlying loan or commitment. In evaluating this ownership
interest, the Commissions have set out a four-part test: (1) the grantor of the participation
must be a lender of or participant in the loan or commitment, (2) the aggregate participation
amount does not exceed the principal amount of the loan or commitment, (3) the entire
purchase price for the loan participation is paid in full when acquired and not financed and (4)
the participation provides the participant all of the economic benefit and risk of the whole or
part of the loan or commitment. Also, a loan participation does not have to be a "true
participation" (that is, does not have to result in the underlying assets being totally isolated
form a transferor’s creditors for U.S. bankruptcy law purposes) in order to fall outside the
definition of swap or security-based swap.
(vi) Foreign Exchange Products. The CEA as amended by the Dodd-
Frank Act provides that foreign exchange forwards and foreign exchange swaps will be
considered swaps unless the U.S. Treasury Secretary determines otherwise. In April 2011, the
U.S. Treasury Secretary published a Notice of Proposed Determination to exempt foreign
exchange forwards and foreign exchange from the definition of "swap". 5
A "foreign exchange forward" is defined in the CEA as a transaction that solely involves
the exchange of two different currencies on a specific future date at a fixed rate agreed upon
on the inception of the contract covering exchange. A "foreign exchange swap" is defined in
the CEA as a transaction that solely involves an exchange of 2 different currencies on a
specific date at a fixed rate that is agreed upon on the inception of the contract covering the
exchange; and a reverse exchange of the 2 currencies described above at a later date and at a
fixed rate that is agreed upon on the inception of the contract covering the exchange. Even if
foreign exchange forwards and foreign exchange swaps are excluded from the definition of
swap, such transactions will still be subject to certain requirements for reporting swaps, and
SDs and MSPs engaging in such transactions still would be subject to certain business
conduct standards. Pending a final determination by the U.S. Treasury Secretary, the CFTC is
including these products in the definition of swaps.
Other foreign exchange products are not subject to a determination by the U.S.
Treasury Secretary and therefore are considered swaps. These products include forward
currency options, non-deliverable forwards, currency swaps and cross-currency swaps.
The CFTC interprets the Dodd Frank Act to exclude bona fide spot transactions from
the definition of "swap". Retail foreign currency options are also excluded.
(vii) Forward Rate Agreements ("FRAs"). The Definition Rules state
that FRAs will be deemed swaps. An FRA is an over-the-counter contract for a single cash
5 "Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange
Act", issued by the Department of Treasury in April 2011.
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payment, due on the settlement date of a trade, based on a spot rate (determined by the
parties) and a pre-specified forward rate. The notional amount itself is not exchanged. The
Commissions determined that FRAs will be deemed swaps because they provide for a future
payment based on the transfer of interest rate risk between the parties as opposed to
transferring an ownership interest in any asset or liability. The CFTC distinguished FRAs from
forward contracts, because FRAs do not involve nonfinancial commodities and are not
commercial merchandising transactions.
(viii) Combinations and Permutations of, or Options on, Swaps and
Security-Based Swaps. The Dodd-Frank Act provides that any combination or permutation of,
or option on, any agreement, contract, or transaction described in any of clauses (i) through
(v) of the definition of swap is a swap or security-based swap, as applicable. The Commissions
have interpreted this to mean that, among other things, an option on a swap (a "swaption")
and a forward swap are swaps. The Commissions reserved the right to include other, more
esoteric transactions in this category as swap products evolve.
(ix) Contracts for Differences ("CFDs"). The Definition Rules clarified
that CFDs, unless otherwise excluded, fall within the scope of the swap and security-based
swap definitions, as applicable. A CFD is generally an agreement to exchange the difference
in value of an underlying asset between the time at which a CFD position is established and
the time at which it is terminated. If the value increases, the seller pays the buyer the
difference; if the value decreases, the buyer pays the seller the difference.
(x) Interpretive Rules. The Commissions have stated that regardless
of whether agreements, contracts or transactions are labeled by the parties thereto as
"swaps" or "security-based swaps", or whether the documentation used is the industry
standard form typically used for swaps and security-based swaps, the key question for
determination of swap status is whether the agreement, contract or transaction falls within
the statutory definition of swap or security-based swap (though the documentation used may
be a relevant factor).
(xi) Relationship between Swaps and Security-Based Swaps. The
determination whether a transaction is a swap or security-based swap should be made, based
on the facts and circumstances of the transaction, prior to execution, but no later than when
the parties offer to enter into the transaction. So long as the transaction is not amended by
the parties, it will retain its characterization as a swap or a security-based swap for the life of
the transaction, regardless of changes in external factors. The Commissions 6 have provided
specific characterization guidance with respect to some derivative products discussed below.
(A) Instruments Based on Interest Rate, other Monetary Rates or
Yield. Instruments based solely on levels of certain interest rates or other monetary rates that
are not themselves based on one or more securities are swaps. Except in the case of certain
exempted securities, when one of the underlying references of an instrument is the yield of a
6 As used in this article, "Commissions" refers to the SEC and CFTC, collectively.
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debt security, loan, or narrow-based security index, the instrument is a security-based swap.
In this sense, "yield" means a proxy for the price or value of a debt security, loan, or narrowbased
security index. However, when the only underlying reference involving securities is US
Treasuries or other exempted securities, 7 the instrument is a swap.
(B) Total Return Swaps ("TRS"). In a TRS, one counterparty (the
seller) makes a payment that is based on the price appreciation and income from an
underlying security or loan or security index, while the other counterparty (the buyer) makes
a financing payment that is often based on variable interest rates (e.g., LIBOR), as well as a
payment based on the price depreciation of the underlying reference. The "total return"
consists of the price appreciation or depreciation, plus any interest or income payments.
The Commissions have stated that where the TRS is based on single security or loan or
narrow-based security index, the TRS would be a security-based swap. Where the TRS is
based upon more than one loan, or a broader-based security index, the TRS is a swap.
Generally, the use of a variable interest rate to determine the buyer’s payment obligations is
incidental to the terms of the TRS and does not result in the characterization of the TRS as a
mixed swap. However, where such payments incorporate additional elements that create
additional interest rate or currency exposures unrelated to the financing of the TRS, or
otherwise shift or limit risks related to the financing of the TRS, the TRS would be a mixed
swap. Quanto equity swaps, which provide currency-protected exposure to a non-U.S. equity
index, are subject to a similar analysis.
(C) Security-Based Swaps Based on a Single Security or Loan
and Single-Name Credit Default Swaps ("CDS"). A single-name CDS that is based on a single
reference obligation will be considered a security-based swap because it is based on a single
security or loan (or any interest therein or on the value thereof). Also, event triggered swap
contracts, including CDS, are security-based swaps if the event relates to a single issuer of a
security. The Commissions are also of the view that each transaction executed under an ISDA
Master Agreement needs to be analyzed separately to determine whether it is a securitybased
swap or a swap.
(D) Futures. An instrument that is based on a futures contract
will be either a swap or a security based swap, or both (i.e,. a mixed swap), depending on the
nature of the futures contract, including the underlying reference of the futures contract.
Generally, an instrument where the underlying reference is a security future is a securitybased
swap. Similarly, an instrument where the underlying reference is a futures contract
that is not a security future is a swap. There is a special rule for references consisting of
certain foreign government debt securities which provides that such instruments will be
swaps, rather than security-based swaps.
(E) Narrow-Based Security Index. The definition of narrowbased
security index is critical to the distinction between swaps and security-based swaps
7 See footnote 3 above.
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which are based upon security indices. The Commissions have finalized a number of
interpretations and rules addressing this complex definition, including such aspects as the
treatment of index CDS, the definition of "index", and market movements which transform
narrow-based security indices to broad-based securities indices, and vice versa. As a general
rule, a narrow based security index is one which meets any one of the following four criteria:
(1) it has nine or fewer component securities; (2) a component security comprises more than
30% of the index’s weighting; (3) the five highest weighted component securities comprise in
the aggregate more than 60% of the index’s weighting or (4) the average daily trading
volume of the lowest weighted component securities comprising 25% of the index’s
weighting is, generally, less than $50,000,000.
(e) Security-Based Swap Agreements. Security-based swap agreements are
swaps over which the CFTC has regulatory and enforcement authority but for which the SEC
also has antifraud and certain other authority. A "security-based swap agreement" is a swap
agreement 8 of which a material term is based on the price, yield, value or volatility of any
security or any group or index of securities, including any interest therein, but does not
include a security-based swap. The Commissions have stated that it is not possible to provide
a bright line test to define security-based swap agreement, but it is possible to clarify certain
types of swaps that are clearly within the definition of security-based swap agreement,
including (i) a swap that is based on an index of securities that is not a narrow-based security
index, (ii) an index CDS that is not based on a narrow-based security index or on the issuers of
securities in a narrow-based security index, and (iii) a swap based on U.S. Treasury securities
or on certain other exempted securities (other than municipal securities).
2. Swap Dealers and Security Based Swap Dealers.
(a) Definitions of Swap Dealer and Security Based Swap Dealer. Swap dealer
is defined in the Dodd-Frank Act as anyone (i) who holds itself out as a dealer in swaps, (ii) is a
market-maker in swaps, (iii) regularly engages in purchases and re-sales of swaps in the
ordinary course of business for its own account, or (iv) engages in activities causing the
person to be commonly known in the trade as a dealer or market maker in swaps. Securitybased
swap dealer has a parallel definition with respect to dealings in security-based swaps.
A person may be designated as a swap dealer for a single type or single class or category of
swap or activities and not considered a swap dealer for others.
The Dodd-Frank Act stated that the swap dealer definition 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 Dodd-Frank Act also directs the CFTC
and SEC to promulgate rules establishing a de minimis exception.
8 Section 206A of the Gramm‐Leach‐Bliley Act defines "swap agreements" as any individually negotiated contract,
agreement, warrant, note, or option that is based, in whole or in part, on the value of, any interest in, or any
quantitative measure or the occurrence of any event relating to, one or more commodities, securities, currencies,
interest or other rates, indices, or other assets, but does not include any other identified banking product.
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Further, the statutory definition of swap dealer (but not the definition of securitybased
swap dealer) provides that an insured depository institution ("IDI"), such as a bank, is 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.
The Definition Rules further define the terms swap dealer and security-based swap
dealer and set out the exceptions to those definitions.
(b) Dealer-Trader Distinction. The Definition Rules state that the dealertrader
distinction, which already forms a basis for identifying which persons fall within the
longstanding Exchange Act definition of "dealer", will generally provide a framework for
interpreting the definition of swap dealer and security-based swap dealer. The SEC has
previously 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). 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. The Commissions have created a list of
dealing activities. In addition, the Commissions have clarified that "market making" means
routinely standing ready to enter into swaps at the request or demand of a counterparty
(routinely being more frequently than occasionally, though there is no requirement that the
person do so continuously). Likewise, the Commissions have created a list of activities that
constitute market making.
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 statutory definitions of dealer and swap dealer: (i) because swap markets are
less active than most securities markets, the concept of "regularity" will be relative to the
swap dealer’s activities as a portion of total market activity; (ii) since each counterparty to a
swap is in essence the "issuer" of that instrument, the concept of maintaining an inventory of
securities is inapposite to the context of swaps, and moreover the concept of two-sided
markets would generally be less relevant for identifying swap dealers than dealers; (iii) since
swaps are thus far not significantly traded on exchanges or other trading systems, the
concept of what it means to make a market must be construed flexibly; and (iv) the ongoing
mutuality of swap obligations in swap transactions leads to the characterization of swap
parties as "counterparties" rather than "customers".
(c) Indicia of Holding Oneself Out as a Dealer in Swaps or Being Commonly
Known in the Trade as a Dealer in Swaps. In the release finalizing the Definition Rules, the
Commissions set out various indicia of holding oneself out as a dealer in swaps or being
commonly known in the trade as a dealer in swaps; however, the CFTC and SEC stated that
these should not be considered in a vacuum, but should instead be considered in a facts and
circumstances analysis and in the context of all activities of the swap participant. The indicia
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are not conclusive, and could be countered by other factors indicating that the person is not a
swap dealer. These indicia include: (i) contacting potential counterparties to solicit interest in
swaps; (ii) developing new types of swaps and informing potential counterparties of the
availability of such swaps; (iii) membership in a swap association in a category reserved for
dealers; (iv) providing marketing materials that describe the types of swaps that one is willing
to enter into with other parties; or (v) generally expressing a willingness to offer or provide a
range of financial products that would include swaps. The Commissions also state that the
test for being "commonly known in the trade" as a swap dealer may appropriately reflect,
among other factors, the perspective of persons with substantial experience with and
knowledge of swap markets. The indicia were not codified in the Definition Rules in order to
allow for a flexible facts and circumstances analysis.
(d) Market Making. The Definition Rules set out four factors indicative of
market making in swaps; however this list is not exhaustive: (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 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. The Commissions also stated that the dealer-trader
interpretive framework should be applied to the market maker analysis, thus in applying the
four factors described above, 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. Market makers may make either a two-way or one-way market in swaps.
(e) Exception for Activities Not Part of a "Regular Business". The Definition
Rules clarify that "regular business" and "ordinary course of business" are synonymous for
purposes of the definition of swap dealer. The Commissions interpret these phrases to focus
on the 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 through a dedicated subsidiary, division, department or
trading desk, or whether such activities are the person’s "primary" business or an "ancillary"
business. The determination whether a person regularly enters into swaps as an ordinary
course of business will be a facts and circumstances determination and the Definition Rules
list several factors that the regulators will consider: (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.
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(f) Hedging Activity. Swaps and security-based swaps entered into to
hedge commercial risk or otherwise to hedge risks unrelated to activities that constitute
dealing under the dealer-trader distinction will not be considered swap dealing activity. The
CFTC has stated that it will use its definition of bona fide hedging and will focus on the
purpose for which the person enters into a swap, as opposed to the effect or consequences of
the swap. The SEC has made this a final rule, while the CFTC has made this an interim final
rule, stating that since the manner in which persons negotiate, execute and use swaps is likely
to evolve in response to the requirements of the Dodd-Frank Act, crafting exclusions from the
swap dealer definition at this time is inappropriate.
The determination of whether a person is a swap dealer will not consider a swap that
the person enters into 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 (x) assets that the person owns, produces, manufactures, processes or merchandises,
or anticipates owning, producing, manufacturing, processing or merchandising; (y) liabilities
that the person owns or anticipates incurring; or (z) 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.
(g) Swaps Entered Into by Persons Registered as Floor Traders. The Dodd-
Frank Act amended the CEA definition of "floor trader" to encompass activities involving
swaps, and so in order to avoid duplicative regulation, if floor traders engage in swaps in their
capacity as floor traders they will not be considered swap dealers; provided, that the person:
(i) is registered with the CFTC as a floor trader; (ii) enters into swaps solely with proprietary
funds for the trader’s own account on or subject to the rules of a designated contract market
or swap execution facility, and submits each swap for clearing with a designated clearing
organization; (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 the price
and quantity or to participate in a request for quote process; (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 or hedging or mitigating commercial risk (with the exceptions of swaps
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
designated contract market or swap execution facility; and (viii) complies with the record
keeping and risk management requirements of the CFTC with respect to each such swap as if
it were a swap dealer.
(h) Treatment of Insured Depository Institutions. The statutory definition of
swap dealer excludes an IDI to the extent it offers to enter into a swap with a customer in
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connection with originating a loan with that customer. This exclusion does not appear in the
statutory definition of security-based swap dealer.
In the Definition Rules, the CFTC clarified that only swap activity with a customer in
connection with originating a loan are part of the exclusion, not all swaps entered into
between the IDI and a borrower at any time during the duration of the loan. In order to fall
within this exclusion, the following conditions must be satisfied:
(i) the term of the swap between the IDI and the borrower may not
extend beyond the termination of the loan;
(ii) the swap must be connected to the financial terms of the loan or
is required by 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;
(iii)
the loan cannot be a sham or synthetic loan;
(iv) the IDI must (directly or indirectly such as by purchasing a
participation) be the source of funds for at least 10% of the maximum principal amount;
(v) the IDI must enter into the swap with the borrower no more
than 90 days before or 180 days after any transfer of principal to the borrower from the IDI
pursuant to the loan; and
(vi) the aggregate notional amount of all swaps entered into by the
IDI and the borrower cannot exceed the notional principal amount of the loan at any time
during the term of the loan.
(i) Application of Dealer Definitions to Legal Persons and Inter-Affiliate Swaps
and Security-Based Swaps. The Commissions have clarified that they interpret the word
"person" in the swap dealer and security-based dealer definitions to mean a legal person,
which means that a legal person will be deemed to be performing dealing activities even if
those activities are limited to a trading desk or discrete business unit. The Commissions also
clarified that the dealer analysis will not apply to swaps between majority-owned affiliates.
Neither will the analysis be applied between a cooperative and its members so long as the
swaps in question are reported to the relevant swap data repository and are subject to the
cooperative’s risk management policies and procedures.
(j) De Minimis Exception. Persons who engage in a de minimis quantity of
swap/security-based swap dealing are not swap dealers/security-based swap dealers.
A person will not be deemed to be a swap dealer as a result of swap dealing activity
that meets the following conditions: over the preceding 12 months: (i) an aggregate gross
notional amount of no more than $3 billion (subject to a phase-in level of $8 billion); and (iii)
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an aggregate gross notional amount of no more than $25 million with regard to all securitybased
swaps in which the counterparty is a special entity 9 .
A person will not be deemed to be a security-based swap dealer as a result of securitybased
swap dealing activity that meets the following conditions: over the preceding 12
months: (i) an aggregate gross notional amount of no more than $3 billion (subject to a
phase-in level of $8 billion) 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 $400 million) with regard to all other security-based swaps; and (iii) an
aggregate gross notional amount of no more than $25 million with regard to all securitybased
swaps in which the counterparty is a special entity.
3. Major Swap Participants and Major Security-Based Swap Participants.
(a) Definition of Major Swap Participants and Majority Security-Based Swap
Participants. Major swap participants are defined in the Dodd-Frank Act as any person who is
not a swap dealer and (i) who maintains a substantial position in swaps for any of the major
swap categories (excluding positions held for hedging or mitigating commercial risk or
maintained by any employee benefit plan for the primary purpose of hedging or mitigating
risk associated with the operation of the plan), (ii) whose outstanding swaps create
substantial counterparty exposure that could have serious adverse effect on the financial
stability of the U.S. banking system or financial markets, or (iii) who is a financial entity that is
highly leveraged and maintains a substantial position in outstanding derivatives in any major
swap category. There is a parallel definition for security-based swap participants with respect
to dealings in swap-based securities.
(b) Major Swaps. The Definition Rules establish 4 "major" categories of
swaps as rate swaps, credit swaps, equity swaps and other commodity swaps, and 2 "major"
categories of security-based swaps as debt security-based swaps and other security-based
swaps.
(c) Substantial Position. The guiding principle set forth in the Definition
Rules for determining "substantial position" is a 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 order for a person to have a "substantial position" in a major swaps or securitybased
swaps category, it must have (i) a daily average aggregate uncollateralized outward
exposure of at least $1 billion (or $3 billion for the rate swap category), or (ii) a daily average
aggregate uncollateralized outward exposure plus daily average aggregate potential outward
exposure of $2 billion (or $6 billion for the rate swap category).
9 "Special entity" means (i) a federal agency, (ii) a state, state agency, city, county, municipality, other political
subdivision of a state, or any instrumentality, department or corporation of or established by a state or political
subdivision of a state, (iii) any employee benefit plan subject to ERISA, (iv) any government plan as defined by
ERISA, and (v) any endowment.
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"Aggregate uncollateralized outward exposure" is defined as the sum of those
uncollateralized amounts over all counterparties with which the person has entered into
swaps or security-based swaps in a major category.
(d) Hedging or Mitigating Commercial Risk. The first test of the major
participant definitions excludes positions held for hedging or mitigating commercial risk from
the substantial position analysis. The exclusion is predicated 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 substantial position. The Definition Rules clarify that this
exclusion applies regardless of the nature of the entity involved (e.g., whether the entity is
financial, such as a bank) or the organizational status of the entity involved (e.g., whether the
entity is a governmental or non-profit entity). The Definition Rules also clarify that the
exclusion is available to positions that hedge "financial" or "balance sheet" risk and extends to
hedging the risks of a person’s majority-owned affiliates. Whether a person hedges or
mitigates commercial risk should be determined by the facts and circumstances at the time of
entry into the swap and should take into account overall hedging and risk mitigation
strategies of such person. However, a swap cannot be held for the purpose of speculation,
investing or trading and its terms must be economically appropriate for managing risk.
(e) Exclusion for Positions Held by Certain ERISA Plans. The first test of the
major participant definitions excludes hedging by ERISA-covered plans 10 . The Definition
Rules clarify the scope of this exclusion, stating that the swap positions will be deemed to
have a primary purpose of hedging or mitigating risks directly associated with the operation
of an ERISA plan of the applicable type when those positions are intended to reduce
disruption 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. In addition
the Definition Rules clarified that positions "maintained" by an ERISA plan include those in
which such a plan is a counterparty and also positions in which the counterparty is a trust or
pooled vehicle that holds plan assets.
(f) Substantial Counterparty Exposure. The second test of the major
participant definitions encompasses persons whose outstanding swaps or security-based
swaps create substantial counterparty exposure. Substantial counterparty exposure will be
determined based on the same current uncollateralized exposure and potential future
exposure tests that are used to identify "substantial position". However, it should be noted
that the substantial counterparty exposure analysis addresses all of person’s swap positions in
the aggregate, rather than being limited to positions in a "major" category. It should also be
noted that substantial counterparty exposure analysis does not exclude commercial hedging
risk or ERISA hedging positions.
10 "ERISA" is the Employee Retirement Income Security Act of 1974, which is a federal law that was enacted to
protect the interests of employee benefit plan participants and their beneficiaries. ERISA establishes minimum
standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of
transactions associated with employee benefit plans.
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For a major swap participant the thresholds for substantial counterparty exposure are
current uncollateralized exposure of $5 billion or current uncollateralized exposure and future
exposure of $8 billion across all of the person’s swap positions. For a major security-based
swap participant, the thresholds are $2 billion and $4 billion, respectively.
(g) Highly Leveraged and Financial Entity. For purposes of the third test of
the major participant definitions, a "financial entity" includes commodity pools, private funds,
ERISA plans, and persons predominantly engaged in activities that are in the business of
banking or financial in nature, as well as certain dealers or major participants. "Highly
leveraged" generally means a ratio of liabilities to equity in excess of 12 to 1.
4. Eligible Contract Participant ("ECP"). 11
The Dodd-Frank Act makes it unlawful for a person that is not an ECP to enter into a
swap other than on or subject to the rules of a designated contract market (and in the case of
a security-based swap, a national securities exchange registered with the SEC). The Dodd-
Frank Act also amended the CEA definition of ECP to provide that (i) ECP does not include (i) 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, (iii)
replacing the "total asset" standard for individuals to qualify as an ECP with an "amounts
invested on a discretionary basis" standard.
In addition, the Definition Rules added the terms swap dealer, security-based swap
dealer, major swap participant and major security-based swap participant to the definition of
ECP.
5. Effective Dates and Compliance Dates.
The Definition Rules for the product definitions become effective on October 12, 2012,
and the compliance date for these rules will also be October 12, 2012 (with certain
exceptions).
The Definition Rules for the player definitions became effective on July 23, 2012
(except that the effective date for certain commodity pools that are deemed eligible contract
participants will be December 31, 2012). There are various phase-in periods for compliance
11 "Eligible Contract Participant" is defined in Section 1(a)(12) of the CEA and generally means: (i) financial
institutions, (ii) insurance companies, (iii) investment companies regulated under the Investment Company Act of
1940, (iv) certain commodity pools with $5 million or more of assets, (v) certain organizations with, generally, $10
million or more of assets, (vi) ERISA plans with $5 million or more of assets, (vii) certain governmental entities with
over $50 million or more in investments, (viii) certain broker‐dealers and investment banks, (ix) futures
commission merchants, (x) floor brokers, (xi) an individual with, generally, $10 million or more of assets invested
on a discretionary basis or $5 million invested on a discretionary basis and who 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 the individual, and (xii) certain brokers and investment advisers.
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y persons that will be deemed swap dealers/security-based swap dealers, major swap
participants/major security-based swap participants and eligible contract participants.
III.
REPORTING AND RECORDKEEPING OF SWAP TRANSACTION DATA; REGISTRATION AND
REGULATION OF SWAP DATA REPOSITORIES
The Dodd-Frank Act requires every swap transaction (whether cleared or uncleared) to
be recorded, and to be reported in two ways: (i) on a comprehensive basis to a data
warehouse known as a swap data repository (SDR), which information will be treated
confidentially but made available to regulators and (ii) on a selective basis (i.e. price, volume
and asset type, but excluding the names of the parties) to the public. SDRs will play a key role
in the dissemination of swap transaction data and will themselves be subject to regulation.
The CFTC has enacted regulation regarding reporting and recordkeeping of swap
transaction data and registration and regulation of SDRs, while the SEC has proposed rules
but has not yet enacted final regulation.
CFTC REGULATION
1. Reporting and Recordkeeping Requirements.
The fundamental goal of the CFTC’s rulemaking regarding reporting and
recordkeeping requirements for swap transactions is to ensure that complete data
concerning all swaps subject to the CFTC’s jurisdiction is maintained in SDRs, where it would
be available to the CFTC and other financial regulators for fulfillment of their various
regulatory mandates, including systemic risk mitigation, market monitoring and market
abuse prevention.
(a) Records Required; Retention Periods. Sophisticated parties (including
SEFs, designated contract markets ("DCMs"), derivatives clearing organizations ("DCOs"), swap
dealers and major swap participants) will be required to keep full, complete and systematic
records of all activities relating to their business with respect to swaps. Non-swap
dealer/major swap participant counterparties will be subject to lesser recordkeeping
requirements; they must only keep full and complete records relating to swaps to which they
are counterparties, as opposed to their entire business relating to swaps. All such records
must be kept throughout the existence of the swap and for 5 years following final termination
of the swap. Sophisticated parties must keep the data readily accessible (meaning retrievable
in real time or at least on the same day) throughout the life of the swap and for the first two of
the five years of the post-termination retention period, while non-swap dealer/major swap
participant counterparties must make the records retrievable within 5 business days through
the life of the swap and the post-termination retention period. SDRs are subject to additional
requirements, as their records must be (i) readily accessible and available to the CFTC via real
time electronic access during the life of the swap and for five years thereafter and (ii) kept in
archival storage for an additional 10 year period, during which time they must be retrievable
by the SDR within 3 business days.
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(b) Data To Be Reported. Swap data must be reported to a registered SDR
at the creation of the swap and over the existence of the swap. Continuing data regarding a
swap must be reported to the same SDR that received the initial creation data.
(i) Creation Data. In connection with the creation of the swap, two
categories of data must be reported: primary economic terms data ("PET" data), which is all of
the terms of the swap verified or matched by the counterparties at or shortly after the
execution of the swap; and confirmation data, which is all of the terms of a swap matched and
agreed upon by the counterparties in confirming the swap.
Initial creation data will be reported to an SDR by the registered entity or reporting
counterparty that the CFTC believes has the easiest and fastest access to the data required.
Counterparties to swaps are generally subject to reporting requirements; however: (i) if only
one counterparty is a swap dealer or major swap participant, such swap dealer or major swap
participant will be the reporting party; (ii) if one counterparty is a swap dealer and the other a
major swap participant, the swap dealer will be the reporting party; (iii) if both counterparties
are swap dealers or major swap participants, they must agree between themselves who will
be the reporting party; (iv) if neither counterparty is a swap dealer or major swap participant,
but one of them is a financial entity (as defined in the CEA), the financial entity will be the
reporting party; (v) if neither counterparty is a swap dealer or major swap participant, but one
of the counterparties is a U.S. person and the other is not, then the U.S. person will be the
reporting party; and (vi) if neither counterparty is a swap dealer or major swap participant, a
financial entity or a non-U.S. person, they must agree between themselves who will be the
reporting party. SEFs, DCMs and DCOs will also participate in the reporting process,
depending upon where the trade occurs and whether it is cleared. For example, if a swap is
executed on an SEF or DCM and not cleared, the swap dealer or major swap participant must
report continuation data and daily valuation data (as discussed below), while the DCM/SEF
will report the creation data. If a swap is executed on an SEF or DCM and is cleared, then the
swap dealer or major swap participant must report only daily valuation data, while the
DCM/SEF will report the creation data and the DCO will report continuation data.
If there is no SDR that will accept swap data for a certain swap transaction (e.g., where
a novel product does not fit into any existing asset class), the reporting counterparty must
report data regarding such swap to the CFTC.
(A) Mixed Swaps; Multi-Asset Swaps. Mixed swaps must be
reported to both an SDR registered with the CFTC and one registered with the SEC (a dual
registered SDR is acceptable, but not required). Multi-asset swaps must be reported to a
single SDR accepting swaps data for the asset class determined by the reporting counterparty
to be the first or primary asset.
(B) International Swaps. International swaps (that is, swaps
that may be required by U.S. law and the law of another jurisdiction to be reported both to an
SDR registered with the CFTC and to a different trade repository registered with the other
jurisdiction), must be reported to a U.S. registered SDR, together with the identity of the
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foreign trade repository and the swap identifier used by that foreign trade repository for that
swap.
(ii) Continuation Data. Registered entities and reporting
counterparties must report continuation data in a manner sufficient to ensure that the
information in the SDR concerning the swap is current and accurate, and includes all changes
to the PET of the swap. The CFTC has left it to the SDR, registered entities and reporting
counterparties to choose the method of reporting. Relevant changes must be reported on
the same day they occur (for non-swap dealers/major swap participants, during the 1-year
phase-in period, they have 2 business days to report, and after the phase-in period, they must
report no later than the next business day). Corporate events of both the reporting and nonreporting
counterparties must also be reported.
Valuation data for each swap must be reported daily. For cleared swaps in all asset
classes, DCOs will be the sole reporters of continuation data, other than valuation data, which
will be reported daily by both the DCO and the reporting counterparty (unless the reporting
party is not a swap dealer or major swap participant, in which case only the DCO will report
valuation data). For uncleared swaps, the reporting party must report the daily valuation
information (regardless of whether the reporting party is a swap dealer or major swap
participant).
(c) Third-Party Facilitation of Swap Data Reporting. Registered entities and
reporting counterparties may contract with third-party service providers to facilitate
reporting, but, nonetheless, remain fully responsible for the reporting required.
(d) Voluntary Reporting. Voluntary supplemental reporting by nonreporting
counterparties is permitted.
(e) Format of Reported Data. The CFTC rules do not impose a uniform
reporting format or a single data standard. However, SDRs must maintain and transmit all
data reported to it in a format acceptable to the CFTC.
(f) Compliance Dates. The compliance dates for the CFTC regulations
regarding reporting and recordkeeping of swap data are: (i) for credit swaps and interest rate
swaps, October 12, 2012; (ii) for equity swaps, foreign exchange swaps and other commodity
swaps, January 10, 2013; and (iii) for non-swap dealers/major swap participants, April 10,
2013.
2. Reporting and Recordkeeping Requirements for Pre-Enactment Swaps
The above-summarized rules regarding reporting and recordkeeping (the "R&R Rules")
apply only to swaps executed on or after the compliance dates for such rules. The CFTC
adopted separate rules for recordkeeping and reporting of "historical swaps". Historical
Swaps include "pre-enactment swaps", which are swaps entered into before the enactment of
the Dodd-Frank Act on July 21, 2010 but not terminated or expired as of that date, and
"transition swaps", which are swaps entered into between July 21, 2010 and October 12, 2012.
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On October 14, 2010 the CFTC adopted an interim final rule related to recordkeeping
and reporting for pre-enactment swaps, and on December 17, 2010 the CFTC also adopted an
interim final rule related to recordkeeping and reporting for transition swaps. These interim
final rules required market participants to retain information about swap transactions for
future reporting.
(a)
Recordkeeping for Historical Swaps.
(i) Historical Swaps Terminated or Expired Before April 25, 2011.
For historical swaps terminated or expired before April 25, 2011, all counterparties to those
swaps will be required to retain information and documents in their possession on or after the
date of the relevant interim final rule. The retention period is the life of the swap plus 5 years.
The data must be retrievable within 5 business days throughout the retention period.
(ii) Historical Swaps Not Terminated or Expired Before April 25,
2011. For historical swaps not terminated or expired before April 25, 2011, all counterparties
will be required to retain (i) minimum PET data (as specified by CFTC regulations) in such
party’s possession on April 25, 2011, (ii) records of confirmation terms and master or credit
support agreements and modifications in such party’s possession on April 25, 2011, and (iii)
and all records required under the R&R rules, to the extent such information is created or
becomes available after the compliance date for the historical swap reporting rules (see
below). The retention period is the life of the swap plus 5 years. The data must be readily
accessible via real time electronic access for the life of the swap plus 2 years, and then
retrievable within 3 business days through the remainder of the retention period (for nonswap
dealer/major swap participant counterparties, the date must only be retrievable within
5 business days throughout the retention period).
(b) Reporting of Historical Swaps. Counterparties to historical swaps must
report to SDRs minimum PET data, execution dates (if known), as well as whether one or both
of the counterparties is a swap dealer or major swap participant. Counterparties to uncleared
swaps will also be required to report continuation data (to the same extent required under
the R&R Rules) for changes occurring after the compliance dates for the historical/transition
swap rules. The reporting counterparty will be determined using the same hierarchy
established by the R&R Rules.
(c) Compliance Dates. The compliance dates for recordkeeping and
reporting for historical swaps will be the same as those for the R&R Rules.
3. Registration and Regulation of SDRs
Under the Dodd-Frank Act, SDRs are intended to play a key role in enhancing
transparency of the swap market by retaining complete records of swap transactions and
providing effective access to those records to the relevant authorities and to the public. The
SDRs also have the potential to reduce operational risk and enhance efficiency by maintaining
data that is accessible by both counterparties to a swap.
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(a) Registration of SDRs. The Dodd-Frank Act required the creation of SDRs,
which must be registered with and subject to regulation by the CFTC. The CFTC has enacted
rules setting forth registration procedures for SDRs, which require an applicant to submit to
the CFTC detailed information about its business, the asset classes it will serve, its financial
resources, technological capabilities and accessibility of its services.
(b) Duties of Registered SDRs. The CFTC has enacted minimum duties that
an SDR is required to perform to become registered and maintain registration: (i) accept
swap data as prescribed by the CFTC; (ii) confirm with both counterparties to a swap the
accuracy of the data; (iii) maintain the data submitted; (iv) provide the CFTC and other U.S.
and foreign regulators with access to the data; (v) comply with the public reporting
requirements, (vi) establish automated systems for monitoring, screening and analyzing swap
data; (vii) maintain confidentiality and privacy of all swap data; (viii) maintain sufficient
financial resources; (ix) establish emergency data recovery plans; and (x) provide fair and
open access, and fees and charges that are equitable and non-discriminatory.
(c) Core Principles Applicable to SDRs. The Dodd-Frank Act amended the
CEA to establish four statutory core principles that all SDRs must comply with in order to
register and maintain registration. The CFTC has since clarified these core principles through
regulation:
(i) Anti-trust considerations. Unless necessary or appropriate to
achieve the purposes of the Dodd-Frank Act, an SDR must avoid adopting any rule or taking
any action that results in any unreasonable restraint on trade, or imposing any material anticompetitive
burden on trading, clearing or reporting swaps.
(ii) Transparent Governance Arrangements. SDRs must have
transparent governance arrangements. SDRs must publicly describe its decision-making
process (including board member nominations and assignments), its significant decisions
implicating public interest (e.g., decisions regarding pricing, access to data, and the use of
otherwise protected customer information and trade secrets), and how its board considers an
"independent perspective"; i.e. a viewpoint that is impartial regarding competitive,
commercial or industry concerns and contemplates the effect of a decision on all constituents
involved. In addition, the compensation of non-executive board members may not be linked
to the business performance of the SDR.
(iii) Conflicts of Interest. SDRs must establish and implement internal
rules to minimize conflicts of interest and establish a process for resolving conflicts that arise.
(iv) Additional Principles. The CFTC was given rule-making authority
to establish additional duties for SDRs and the CFTC has created 3 duties to further minimize
conflicts of interest, protect data, ensure compliance and guaranty the safety and security of
SDRs:
(A) SDRs must maintain financial resources sufficient to cover
operating expenses for at least 1 year (calculated on a rolling basis), including unencumbered
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liquid assets equal to at least 6 months' operating costs. Financial resources must be
separately dedicated for this purpose and if the SDRs’ financial resources are not sufficiently
liquid, committed lines of credit may be counted.
(B) SDRs must furnish to market participants a disclosure
document setting forth the risks and costs associated with using the services of SDR, which
must include, among other things, the SDR’s criteria for providing others with access to the
data maintained by the SDR, a description of policies and procedures regarding safeguarding
data and confidentiality, and a description of all services provided by the SDR.
(C) SDRs must provide fair and open access to all market
participants. Fees must be equitable (e.g., no volume discounts may be offered) and ancillary
services may not be bundled with mandated regulatory services.
(d) Use of Data; Confidentiality. CFTC rules prohibit SDRs from using swap
data for commercial purposes (other than data that is publicly disseminated), unless the
persons submitting the data consent to such use. SDRs must have policies and procedures to
protect privacy and confidentiality of all swap information they receive that is not subject to
real-time public reporting requirements.
(e) Chief Compliance Officer. An SDR must have a chief compliance officer
who is appointed by its board of directors and is not a member of its legal department or its
general counsel. The chief compliance officer must report directly to the board or senior
officer of the SDR and can only be removed with board approval. The CFTC has enacted rules
that outline the CCO's major duties, which include taking reasonable steps to ensure
compliance with rules and regulations and developing procedures for corrective actions for
noncompliance.
(f) Compliance Dates. The registration and regulation of SDRs rules became
effective on October 31, 2011. The CFTC noted, however, that while SDRs can register, they
will not otherwise be fully operational on such effective date but instead will require a
compliance period based on the R&R rules and the real-time reporting rules.
SEC PROPOSED RULES
The SEC proposed rules on November 19, 2010 regarding reporting and
recordkeeping of security-based swap transaction data and the regulation of SDRs (the "R&R
Proposed Rules") which are very similar to the regulations enacted by the CFTC. Some of the
differences include: (i) the SEC proposes to mandate a uniform electronic format for
reporting of security-based swap data (unlike the CFTC, which has left the format and
reporting methodology to the SDRs); (ii) regarding historical security-based swaps, the SEC
proposes to collect data only for those security-based swaps that have not expired prior to
the date of enactment of the final historical swap data reporting rules; and (iii) the SEC
proposes to make SDRs the sole disseminators of real-time public security-based swap data
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(as opposed to the CFTC rules which permit certain third-party service providers to have
public dissemination responsibility).
The Dodd-Frank Act mandated that in enacting its real-time reporting rules, the SEC
take into account whether the public disclosure will materially reduce market liquidity. In the
R&R Proposed Rules the SEC addressed this, stating that by reducing information
asymmetries, transparency has the potential to lower transaction costs, improve confidence
in the markets, encourage participation by a larger number of participants and increase the
liquidity of the security-based swap markets. The SEC noted that the current markets are
opaque and even market participants such as dealers lack an effective mechanism to learn
the prices at which other market participants transact. Since the security-based swaps are
complex derivative instruments, there exists no single accepted way to model pricing. Public
information would allow for valuation models to be adjusted to reflect how other market
participants have valued security-based swap instruments at a specific time.
IV.
MANDATORY CLEARING
The 2008 financial crisis illustrated the significant risks that an uncleared, OTC
derivatives market can pose to the financial system. The Financial Crisis Inquiry Commission
explained that the scale and nature of the OTC derivatives market created significant systemic
risk throughout the financial system and helped fuel the panic in the fall of 2008; millions of
contracts in this opaque and deregulated market created interconnections among a vast web
of financial institutions through counterparty credit risk, thus exposing the system to
contagion of spreading losses and defaults. The President’s Working Group on Financial
Policy ("PWG") noted shortcomings in the OTC derivatives market as a whole during the crisis.
The PWG identified the need for an improved integrated operational structure supporting
OTC derivatives, specifically highlighting the need for an enhanced ability to manage
counterparty risk through netting and collateral agreements by promoting portfolio
reconciliation and accurate valuation of trades. These issues were exposed in part by the
surge in collateral required between counterparties in 2008 when the ISDA reported an 86%
increase in the collateral in use for OTC derivatives, indicating not only increased risk but also
circumstances in which positions may not have been collateralized.
In the preamble to its proposed rules regarding mandatory clearing, the CFTC stated
that with only limited checks on the amount of risk that a market participant could incur,
great uncertainty was created among market participants. A market participant did not know
the extent of its counterparty’s exposure, whether its counterparty was appropriately hedged,
or if its counterparty was dangerously exposed to adverse market movements. Without
central clearing, a market participant bore the risk that its counterparty would not fulfill its
obligations pursuant to a swap’s terms. As the financial crises deepened, this risk made
market participants wary of trading with each other. As a result, markets quickly became
illiquid and trading volumes plummeted.
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One of the primary objectives of the Dodd-Frank Act was to promote the central
clearing of swaps and to establish the regulatory infrastructure for the clearing of swaps. 12
The Dodd-Frank Act requires (i) swaps and security-based swaps to be cleared through (x) in
the case of swaps, a DCO if the CFTC determines such swaps are required to be cleared or (x)
in the case of security-based swaps, a registered security-based swap clearing agency ("SBS
CA") if the SEC determines such swaps are required to be cleared (in each case, unless an
exemption from mandatory clearing applies), (ii) swaps and security-based swaps must be
reported to a registered SDR, (iii) if the swap is subject to a clearing requirement, it must be
traded on a DCM or SEF (unless no DCM or SEF has made the swap available to trade), and (iv)
if a security-based swap is subject to a clearing requirement, it must be traded on a registered
exchange or a registered or exempt SEF (unless no facility makes such security-based swap
available for trading).
1. Proposed Rules Regarding the Clearing Requirement
The CFTC has proposed but has not yet finalized rules regarding the mandatory
clearing requirement (the "Proposed Clearing Rules"), while the SEC has not yet made a
proposal.
(a) Timing of Submission for Clearing. The Proposed Clearing Rules would
require all persons executing a swap that is subject to the mandatory clearing requirement to
submit such swap to a DCO for clearing as soon as technologically practicable after execution,
but in any event by the end of the day of execution. Each person subject to this requirement
would be required to undertake reasonable efforts to verify whether a swap is required to be
cleared.
(b) Public Information Regarding Clearing Requirement. The Proposed
Clearing Rules would require each DCO to make publicly available on its website a list of all
swaps that it will accept for clearing and identify which swaps on the list are required to be
cleared. The CFTC will also be required to maintain on its website a current list of all swaps
that are required to be cleared and all DCOs that are eligible to clear such swaps.
(c) Swaps Required to be Cleared. The Proposed Clearing Rules specify two
classes of swaps that would be required to be cleared: (i) interest rate swaps, including those
in the fixed-to-floating swap class, basis swap class, forward rate agreement class and
overnight index swap class, that meet specifications set by the CFTC and (ii) untranched credit
default swaps on certain North American indices and European indices.
12 Clearing is the process by which transactions in derivatives are processed, guaranteed and settled by a central
counterparty defined by the CFTC as a DCO. The DCO becomes the seller to every buyer, and the buyer to every
seller. More specifically, the DCO novates swap transactions initially entered into between various market
participants (e.g., swap dealers and end users) and clears either directly, or indirectly through a futures
commission merchant ("FCM"). The contractual obligations between the original parties ("A" and "B") are replaced
by sets of equivalent obligations between the FCM acting for the original parties and the DCO, and between the
FCM and its individual customers. In economic effect, the DCO serves as a guarantor that every clearing member
party to a cleared swap receives performance according to the terms of the swap, while the FCM serves a
guarantor of its customers’ swaps obligations to the DCO.
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(d) Clearing Transition Rules. The Proposed Clearing Rules would exempt
from the clearing requirement (i) swaps entered into before July 21, 2010 (the date of
enactment of the Dodd-Frank Act) and (ii) swaps entered into before the application of the
clearing requirement for a particular class of swaps, in each case if reported to an SDR.
(e) Anti-Evasion. The Proposed Clearing Rules provide that it would be
unlawful for any person to: (i) knowingly or recklessly evade or participate in or facilitate the
evasion of the clearing requirements, or (ii) abuse the exceptions to the clearing requirement.
2. Compliance Schedule for Mandatory Clearing
The CFTC has established a phase-in compliance schedule for the mandatory clearing
requirement. The SEC has not yet proposed a compliance schedule for the mandatory
clearing requirement.
The compliance schedule for the clearing requirement is based on the type of market
participants entering into the relevant swap: (i) category 1 participants (swap dealers,
security-based swap dealers, major swap participants, major security-based swap
participants, and "active funds" 13 ) must comply with the clearing requirement no later than 90
days after the publication of the final rules regarding the clearing requirement ("Final CR
Rules"), (ii) category 2 participants (commodity pools, private funds, and persons
predominantly engaged in activities that are in the business of banking, or in activities that
are financial in nature according to Section 4(k) of the Bank Holding Company Act, provided
that such participants are not third-party subaccounts 14 ) must comply within 180 days after
publication of the Final CR Rules, and (iii) all other counterparties must comply within 270
days after publication of the Final CR Rules. Each swap is subject to the latest compliance
date for one of the counterparties.
3. End-User and Other Exemptions
The Dodd-Frank Act provides that the clearing requirement will not apply to a swap or
security-based swap if one of the counterparties is (i) not a financial entity 15 , (ii) is using swaps
13 An "active fund" is defined as any private fund under Section 202(a) of the Investment Advisers Act of 1940 that
is not a third‐party subaccount and which executes 200 or more swaps per month on average over the course of
the 12 months preceding a final clearing determination by the CFTC.
14 A "third‐part subaccount" is a managed account where the managed is unaffiliated with the account’s beneficial
owner and is responsible for the documentation necessary for the account’s beneficial owner to clear swaps.
15 A "financial entity" for purposes of the End‐User Exemption in general includes swap dealers, security‐based
swap dealers, major swap participants, major security‐based swap participants, commodity pools, private funds as
defined in Section 202(a) of the Investment Advisers Act of 1940, employee benefit plans as defined in ERISA, and
persons predominantly engaged in activities that are in the business of banking, or activities that are financial in
nature, as defined in Section 4(k) of the Bank Holding Company Act of 1956. Excluded from the definition of
"financial entity" for purposes of the End‐User Exemption are persons (i) organized as a bank (as defined in Section
3(a) of the Federal Deposit Insurance Act) the deposits of which are insured by the FDIC, or a savings association
(as defined in Section 3(b) of the Federal Deposit Insurance Act) the deposits of which are insured by the FDIC, or a
farm credit system institution chartered under the Farm Credit Act of 1971, or an insured Federal credit union or
State‐chartered credit union under the Federal Credit Union Act, and (ii) that have total assets of $10 billion or less
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or security-based swaps to hedge or mitigate commercial risk, and (iii) notifies the CFTC (in
the case of swaps) or the SEC (in the case of security-based swaps) how it generally meets its
financial obligations associated with entering into non-cleared swaps (if there is more than
one electing counterparty, both must provide this information) (the "End-User Exemption").
The CFTC has promulgated final rules regarding the End-User Exemption, while the
SEC has proposed but has not yet finalized rules regarding the End-User Exemption ("SEC
Proposed End-User Exemption Rules").
(a) Hedging or Mitigating Commercial Risk. The CFTC and SEC stated their
intent to use the same definition for "hedging or mitigating commercial risk". The CFTC has
stated that the counterparties should look to the facts and circumstances that exist at the
time the swap is executed to determine whether the swap hedges or mitigates commercial
risk. The CFTC has also stated that whether the risk is "commercial" will be based on the
underlying activity to which the risk relates, not on the type of entity claiming the End-User
Exemption.
A swap is used to "hedging or mitigating commercial risk" if such swap (i) is not used
for a purpose that is in the nature of speculation, investing or trading 16 , and (ii) is not used to
hedge or mitigate the risk of another swap or security-based swap position (unless that other
position itself is used to hedge or mitigate commercial risk):
(i) is economically appropriate 17 to the reduction of risks in the
conduct and management of a commercial enterprise where the risks arise from;
(ii) qualifies as a bona fide hedging for purposes of an exemption
from position limits under the CEA; or
(iii) qualifies for hedging treatment under (a) FASB Topic 815
(Derivatives and Hedging), or (b) GASB Statement 53 (Accounting and Financial Reporting for
Derivative Instruments).
on the last day of such person’s most recent fiscal year. Also excluded from the definition of "financial entity" for
purposes of the End‐User Exemption are "captive finance companies", defined as 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% or more of which arise from financing that facilitates the
purchase or lease of products, 90% or more of which are manufactured by the parent company or another
subsidiary of the parent company.
16 The CFTC has not designed a test to determine the difference between hedging or mitigating commercial risk
and speculation, investing or trading; however, the CFTC has stated that positions for the purpose of speculation,
investing or trading are, generally speaking, being executed primarily for the purpose of taking an outright view on
market direction or to obtain an appreciation in value of the swap position itself, and are not primarily for the
hedging or mitigating of the underlying commercial risks.
17 The CFTC has stated that facts and circumstances will determine whether the swap is economically appropriate
to hedge or mitigate risk. The CFTC believes this flexible approach is needed given the wide variety of swaps,
potential electing counterparties, and hedging strategies to which the clearing requirement applies.
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(b) Reporting. When a counterparty elects to use the End-User Exemption,
CFTC regulations require one of the counterparties to report to an SDR (or if no registered
SDR is available to receive the information, to the CFTC) certain information, including:
(i)
(ii)
(iii)
following information:
notice of the election of the exemption,
the identity of the electing counterparty to the swap,
unless previously included in an annual report (see below), the
A. whether the electing counterparty is a financial entity or
is exempt from the definition of financial entity;
B. whether the swaps for which the electing counterparty is
electing the End-User Exemption are being used to
hedge or mitigate commercial risk;
C. how the electing counterparty generally meets its
financial obligations associated with entering into noncleared
swaps; and
D. whether the electing entity is a public company (if so,
additional information must be reported).
An entity that qualifies for the End-User Exemption may report the information listed
in clause (3) above annually in anticipating of electing the End-User Exemption for one or
more swaps.
The reporting counterparty will be determined in accordance with the hierarchy set
forth in the R&R Rules. CFTC regulations require each reporting counterparty to have a
reasonable basis to believe that the electing counterparty meets the requirements of the End-
User Exemption. The SEC Proposed End-User Exemption Rules propose similar reporting
requirements.
(c)
Other Exemptions From the Mandatory Clearing Requirement.
(i) Foreign Governments, Foreign Central Banks and International
Financial Institutions. The CFTC has clarified that the clearing requirement does not apply to
foreign governments, foreign central banks, and international financial institutions; however,
if such an entity enters into a non-cleared swap with a counterparty who is subject to the
clearing requirement, then the counterparty still must comply with the CEA and CFTC
regulations pertaining to non-cleared swaps. The SEC has not addressed this topic.
(ii) Inter-Affiliate Swaps. The CFTC has proposed rules that would
exempt swaps between certain affiliated entities within a corporate group from the clearing
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equirement. Under the proposed rules, the inter-affiliate swap exemption would be
available if one counterparty directly or indirectly holds a majority ownership interest in the
other, or if a third party directly or indirectly holds a majority ownership interest in both
counterparties, and the financial statements of both counterparties are reported on a
consolidated basis. The proposed rules detail specific conditions counterparties must satisfy
in order to qualify for the inter-affiliate swap exemption. The SEC has not addressed this
topic.
(iii) Cooperatives. The CFTC has proposed rules that would permit
cooperatives that meet certain qualifications to elect not to clear certain swaps that are
otherwise required to be cleared. This exemption is being proposed because certain
cooperatives that execute swaps on behalf of their members for the benefit of their members
may be considered "financial entities" with assets greater than $10 billion. The SEC has not
addressed this topic.
(d) Compliance Dates. The End-User Exemption becomes effective on
September 17, 2012. However, compliance will not be necessary or possible until swaps
become subject to the clearing requirement and those rules have not yet been finalized.
4. Process for Review of Swaps for Mandatory Clearing
The CFTC and SEC have each issued final rules regarding the process for review of
swaps and security-based swaps for mandatory clearing. For purposes of convenience, the
CFTC rules are summarized below and, unless otherwise noted, the SEC rules are substantially
similar, including the SEC’s rules regarding CA’s which are substantially similar to the CFTC’s
rules regarding DCOs.
(a) DCO Eligibility to Clear Swaps. CFTC regulations state that each DCO will
be presumed eligible to accept for clearing any swap that is within a group, category, type or
class of swaps that the DCO already clears; however, this presumption of eligibility is subject
to review by the CFTC. If a DCO wishes to accept for clearing any other swaps, it must request
a determination of eligibility from the CFTC and such request must include information such
as the sufficiency of the DCO’s financial resources and its ability to manage the risk associated
with clearing the swap.
(b) Swap Submissions. A DCO will be required to submit to the CFTC each
swap or any group, category, type or class of swaps that it plans to accept for clearing
(submissions may be aggregated in the DCO’s discretion). Each submission must include a
statement that the DCO is eligible to accept the swap or group, category, type or class of
swaps and must also include information that will assist the CFTC in making quantitative and
qualitative assessments of the following factors: (i) existence of significant outstanding
notional exposures, trading liquidity, and adequate pricing data; (ii) availability of rule
framework, capacity, operational expertise and resources, and credit support infrastructure to
clear the contract on terms that are consistent with the material terms and trading
conventions on which the contract is then traded; (iii) the effect on the mitigation of systemic
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isk (taking into account the size of the market for such contract and the resources of the DCO
available to clear the contract); (iv) the effect on competition (including appropriate fees and
charges applied to clearing); and (v) the existence of reasonable legal certainty in the event of
the insolvency of the DCO or one or more of its clearing members with regard to the
treatment of customer and swap counterparty positions, funds and property. Each
submission must also include pricing sources, models and procedures demonstrating an
ability to obtain sufficient data to measure credit exposures in a timely and accurate manner.
In addition, each submission must include risk management procedures. The submissions
will be made available to the public and posted on a CFTC website for a 30-day public
comment period (a DCO may request confidential treatment for portions of its submission).
The CFTC will make a determination of eligibility no later than 90 days after receipt of a
complete submission. SEC rules require (in addition to requirements similar to those
summarized above) SBS CAs to post all their submissions on their website within 2 days of
making the submission to the SEC.
(c) CFTC-Initiated Reviews. The CFTC will, on an ongoing basis, review
swaps that have not been accepted for clearing by a DCO to make a determination as to
whether the swaps should be required to be cleared. If no DCO has accepted for clearing a
particular swap, group, category, type or class of swap that the CFTC finds would otherwise
be subject to a clearing requirement, the CFTC may take such actions as it determines to be
necessary and in the public interest, including requiring retaining of adequate margin or
capital by parties to such swap, group, category, type or class of swaps.
(d) Stay of Clearing Requirement. A counterparty may apply to stay the
clearing requirement pending the CFTC’s review of the terms of the swap, group, category,
type or class of swaps and the clearing arrangement. CFTC regulations require the CFTC to
complete its review no later than 90 days after issuance of the stay and will determine either
that the swap, group, category, type or class of swaps must be cleared, or that the clearing
requirement will not apply but clearing may continue on a non-mandatory basis.
(e) Effective Date. On September 29, 2011, the CFTC rules regarding the
process for review of swaps for mandatory clearing became effective. The SEC rules regarding
the process for review of security-based swaps for mandatory clearing will become effective
30 days after the publication of such rules in the Federal Register; however, the compliance
date for SBS CA submissions is 60 days after the SEC issues its first written determination on
whether a security-based swap (or group, category, type or class of security-based swap) is
subject to mandatory clearing.
5. Customer Clearing Documentation, Timing of Acceptance for Clearing and
Clearing Member Risk
The CFTC has enacted final rules regarding customer clearing documentation, timing
of acceptance for clearing and clearing member risk, while the SEC has not yet proposed rules
on this topic.
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(a) Customer Clearing Documentation. CFTC rules prohibit futures
commission merchants ("FCMs") that provide clearing services to customers from entering
into an arrangement that (i) discloses to the FCM or any swap dealer or major swap
participant the identity of a customer’s original executing counterparty, (ii) limits the number
of counterparties with whom a customer may enter into a trade, (iii) restricts the size of the
position a customer may take with any individual counterparty, apart from an overall limit for
all positions held by the customer at the FCM, (iv) impairs a customer’s access to execution of
a trade on terms that have a reasonable relationship to the best terms available, or (v)
prevents compliance with the timeframes for acceptance of trades into clearing. CFTC rules
impose similar prohibitions on swap dealers and major swap participants entering into a
swap to be submitted for clearing with a counterparty that is a customer of an FCM.
(b) Time Frames for Acceptance Into Clearing. The CFTC’s stated goal is to
expand access to, and strengthen the financial integrity of, the swap markets by providing for
prompt processing, submission and acceptance of swaps eligible for clearing by a DCO.
With respect to each swap that is not executed on a SEF or DCM, each swap dealer and
major swap participant shall, (i) if such swap is subject to mandatory clearing, submit such
swap for clearing to a DCO as soon as technologically practicable after execution of the swap,
but no later than the close of business on the day of execution and (ii) if such swap is not
subject to mandatory clearing but is accepted for clearing by any DCO and such swap
dealer/major swap participant and its counterparty agree that such swap will be submitted
for clearing, submit such swap for clearing not later than the next business day after
execution of the swap, or the agreement to clear, if later than execution.
Each FCM, swap dealer and major swap participant that is a clearing member of a DCO
must coordinate with each DCO with which it clears to establish systems that enable the
clearing member, or the DCO acting on its behalf, to accept or reject each trade submitted to
the DCO for clearing by or for the clearing member as quickly as would be technologically
practicable if fully automated systems were used. In addition, each FCM, swap dealer and
major swap participant that is a clearing member of a DCO shall accept or reject each trade
submitted by or for it as quickly as would be technologically practicable if fully automated
systems were used.
(c) Clearing Member Risk Management. One of the purposes of the CEA is to
ensure the financial integrity of all transactions subject to the CEA and to avoid systemic risk.
The CFTC has determined that risk management systems are critical to the avoidance of
systemic risk.
CFTC regulations require each FCM that is a clearing member of a DCO and each swap
dealer and major swap participant that is a clearing member of a DCO (only with respect to
clearing activities in futures, security futures products, swaps, agreements, commodity
options, or leveraged transactions) to:
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(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
establish risk-based limits based on position size, order size,
margin requirements or similar factors,
screen orders for compliance with the risk-based limits,
monitor for adherence to the risk-based limits intra-day and
overnight,
conduct stress tests under extreme but plausible conditions for
all positions at least once per week,
evaluate its ability to meet initial margin requirements at least
once per week,
evaluate its ability to meet variation margin requirements in cash
at least once per week,
evaluate its ability to liquidate the positions it clears in an orderly
manner, and estimate the cost of liquidation, and
test all lines of credit at least once per year.
In addition, each FCM, swap dealer and major swap participant that is a clearing
member of a DCO must have written procedures to comply with these risk management
regulations and keep full, complete and systematic records documenting its compliance
(such records must be available promptly upon request to the CFTC or other regulators).
(d) Swap Processing and Clearing. CFTC rules require each swap dealer and
major swap participant to ensure that it has the capacity to route swaps not executed on an
SEF of DCM to a DCO (swaps that are executed on an SEF or DCM will be routed to the DCO by
such SEF or DCM). Each swap dealer and major swap participant will be required to
coordinate with each DCO to which it or its clearing member submits transactions for clearing
to facilitate prompt and efficient swap processing.
(e) Effective Dates. The rules regarding customer clearing documentation,
timing of acceptance for clearing and clearing member risk (i) became effective on March 19,
2012 for swap dealers and major swap participants, (ii) will become effective on October 1,
2012 for FCMs, DCMs and DCOs, and (iii) will become effective on the later of October 1, 2012
and the effective date of rules implementing the core principles for SEFs (such rules have
been proposed by the CFTC but not yet finalized).
6. Protection of Cleared Swaps Customer Contracts and Collateral
The CFTC has enacted final rules regarding protection of cleared swaps customer
contracts and collateral, while the SEC has not yet proposed rules on this topic.
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Clearing members that clear swaps for customers must be registered as FCMs. In the
clearing process for each swap transaction, the DCO is interposed as the counterparty for
each FCM, which is acting for its customer. In a typical swap transaction, a DCO novates the
swap transaction initially entered into between various market participants and cleared
through FCMs that are clearing members of a DCO. Contractual obligations between the
original counterparties are replaced by equivalent obligations between (i) the FCMs (acting
on behalf of the original counterparties) and the DCO and (ii) between the FCMs and their
individual customers. At any given moment, a DCO may owe funds to an FCM, an FCM may
owe funds to the DCO, and an FCM and its customers may also owe funds to each other
based upon daily marking-to-market of the swap contracts, which result in margin calls. All of
these obligations are secured by collateral.
Under the current system, a customer’s collateral is potentially exposed to risks
unrelated to the underlying swap obligation, including (i) the insolvency of the FCM, (ii) that
an FCM would need to access the collateral of a non-defaulting customer to cure a significant
loss of a defaulting customer (this would occur if a customer defaulted and the FCM did not
have sufficient resources to cover the loss, which would result in a default by the FCM to the
DCO and the FCM filing for bankruptcy; in this case, the DCO would have the right to cover its
loss from the FCM’s customer account without regard to which customer’s assets it uses).
The Dodd-Frank Act sought to ameliorate these risks by mandating segregation of
customer collateral. The CFTC has implemented the Dodd-Frank mandate by adopting the
"complete legal segregation model". Under this rule,
FCMs and DCOs must treat and deal with cleared swaps of customers and associated
collateral as belonging to such customer; specifically: (i) FCMs and DCOs are required to
segregate all cleared swaps customer collateral that they receive, and either hold it physically
separate from their own assets or hold it in an account with a permitted depository; (ii) FCMs
and DCOs are prohibited from commingling cleared swaps customer collateral with their own
assets (with certain exceptions); however, the funds of different cleared customers may be
commingled; (iii) FCMs are prohibited from using cleared swaps customer collateral of one
customer to purchase, margin or settle the cleared swaps of any other trade or contract of, or
to secure or extent the credit of, any person other than such customer; (iv) FCMs are
prohibited from imposing or permitting the imposition of a lien on any cleared swaps
customer collateral; (v) FCMs are prohibited from including in cleared swaps customer
collateral money invested in the equity interests or obligations of any DCO, DCM, SEF or SDR
or any money, securities or other property that any DCO holds and may use for purposes
other than customer collateral; and (vi) FCMs are required to maintain in segregated customer
accounts(s) an amount equal to the sum of any credit balances (minus any debits) that the
cleared swaps customers of such FCM have in their accounts.
7. Core Principles for DCOs
The CFTC has enacted final rules regarding 15 out of the 18 core principles established
by the Dodd-Frank Act for DCOs. The remaining core principles regarding governance and
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fitness standards, conflicts of interest and composition of governing boards will be addressed
in future rulemaking.
(a) Chief Compliance Officer. The Dodd-Frank Act requires each DCO to
appoint a chief compliance officer who will be responsible for developing and enforcing, in
consultation with senior officers and the board, appropriate compliance policies and
procedures. The chief compliance officer must meet with the board of directors and senior
officers annually.
(b) Financial Resources. The Dodd-Frank Act requires each DCO to possess
financial resources that, at a minimum, exceed the total amount that would enable the DCO
to (i) meet its financial obligations to its clearing members (notwithstanding a default by the
clearing member creating the largest financial exposure for the DCO in extreme but plausible
market conditions) and (ii) cover its operating costs for a one year period, as calculated on a
rolling basis. CFTC rulemaking has clarified that a DCO may allocate a financial resource, in
whole or in part, to satisfy the requirement in either clause (i) or (ii) above, but not both
simultaneously. CFTC regulations set forth a list of financial resources that may be included
and also require that such financial resources be sufficiently liquid to enable the DCO to fulfill
its obligations as a central counterparty during a one-day settlement cycle (liquid means cash,
U.S. treasury obligations, or high quality, liquid, general obligations of a sovereign nation).
(c) Participant and Product Eligibility. The Dodd-Frank Act requires each
DCO to establish appropriate admission and continuing eligibility standards for members of
and participants in DCOs, including sufficient financial resources and operational capacity to
meet the obligations arising from participation. Such standards must be publicly disclosed
and must permit fair and open access. The CFTC has clarified that DCOs cannot: (i) require
the clearing members to be swap dealers; (ii) adopt restrictive clearing standards if less
restrictive standards that achieve the same objective would not materially increase risk to the
DCO or clearing members if adopted; or (iii) require clearing members to maintain a swap
portfolio of any particular size or that clearing members meet swap transaction volume
thresholds.
The Dodd-Frank Act also requires each DCO to establish appropriate standards for
determining the eligibility of products submitted to such DCO for clearing. The CFTC has
prescribed factors to be considered in determining product eligibility, including trading
volume, liquidity, availability of reliable prices and ability of the DCO and clearing members to
address any unique risk characteristics of a product.
(d) Risk Management. The Dodd-Frank Act requires each DCO to (i) ensure
that it possesses the ability to manage risks associated with discharging the responsibilities of
the DCO, (ii) measure its credit exposure to each clearing member not less than one per
business day and monitor each such exposure periodically during the business day, and (iii)
through margin requirements and other risk control mechanisms limit its exposure to
potential losses from defaults by clearing members to ensure that (A) its operations would
not be disrupted and (B) non-defaulting clearing members would not be exposed to losses
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that non-defaulting clearing members cannot anticipate or control. Each DCO must establish
and maintain written policies, procedures and controls approved by its board of directors
which establish a risk-management framework. CFTC regulations set out procedures for
determining margin requirements for clearing members, but allow DCOs flexibility in making
this determination.
CFTC regulations will also require DCOs to conduct stress tests as follows: (i) on a daily
basis for each large trader who poses significant risk to a clearing member or the DCO (DCOs
will have reasonable discretion in determining which traders to test and what methodology
to use); and (ii) on at least a weekly basis for each clearing member account.
(e) Settlement. The Dodd-Frank Act prescribed rules for DCOs regarding
settlements 18 , including requirements to (i) effect a settlement with each clearing member at
least once each business day, and (ii) employ settlement arrangements that eliminate or
strictly limit its exposure to settlement bank risks, including credit and liquidity risks arising
from the use of such banks to effect settlements with its clearing members.
(f) Treatment of Funds. The Dodd-Frank Act required each DCO to (i)
establish standards and procedures that are designed to protect and ensure the safety of its
clearing members’ funds and assets; (ii) hold such funds and assets in a manner by which to
minimize the risk of loss or of delay in the DCO’s access to the assets and funds; and (iii) only
invest such funds and assets in instruments with minimal credit, market and liquidity risks.
CFTC regulations require that each DCO hold funds and assets belonging to clearing
members and its customers in a manner that minimizes the risk of loss or of delay in the
DCO’s access to those funds and assets.
DCOs will also be required to limit the assets they accept as initial margin to those that
have minimal credit, market and liquidity risks, and will be prohibited from accepting letters
of credit as initial margin for swaps (but not as initial margin for futures and options on
futures). In addition DCOs will be required to use prudent valuation practices to value assets
posted as initial margin, including evaluating the appropriateness of haircuts at least on a
quarterly basis. Concentration limits will also be imposed on assets posted as initial margin as
necessary to ensure the DCO’s ability to liquidate those assets quickly with minimal adverse
price effects.
DCOs will be required to have rules providing that they will promptly transfer all or a
portion of a customer’s portfolio of positions and related funds at the same time from the
carrying clearing members of the DCOs to other clearing members without requiring closeout
and re-booking of the positions.
18 "Settlement" is defined to include (i) payment and receipt of variation margin for futures, options and swap
positions, (ii) payment receipt of option premiums, (iii) deposit and withdrawal of initial margin for futures, options
and swap positions, (iv) all payments due in final settlement of futures, options and swap positions on the final
settlement date with respect to such positions, (v) all other cash flows collected from or paid to each clearing
member, including but not limited to payments related to swaps such as coupon amounts.
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(g) Default Rules and Procedures. The Dodd-Frank Act requires each DCO to
have rules and procedures designed to allow for the efficient, fair and safe management of
events during which clearing members become insolvent or otherwise default on their
obligations to the DCO. These rules and procedures must be publicly available. CFTC
regulations set forth certain procedures which must be adopted by each DCO to contain
losses and liquidity pressures and to continue meeting its obligations in the event of a
default, including the actions that the DCO may take upon default, which include prompt
transfer, liquidation or hedging of customer or house positions of the defaulting clearing
member.
(h) Rule Enforcement. The Dodd-Frank Act requires DCOs to maintain
adequate arrangements and resources for the effective monitoring and enforcement of
compliance with its rules and resolution of disputes.
(i) System Safeguards. The Dodd-Frank Act requires DCOs to establish and
maintain controls and procedures designed to minimize sources of operational risk.
(j) Reporting Requirements. The Dodd-Frank Act requires DCOs to provide
the CFTC with all information that the CFTC determines to be necessary to conduct oversight
of the DCO. Under CFTC regulations DCOs will be subject to periodic reports (daily, quarterly
and annually), reporting of significant events and provision of information upon the CFTC’s
request.
(k) Recordkeeping. The Dodd-Frank Act requires DCOs to maintain records
of all activities related to the business of the DCO as a DCO in form and manner acceptable to
the DCO for not less than 5 years. However, recordkeeping with respect to swap data is
subject to separate rules summarized in Section III of this article.
(l) Public Information. The Dodd-Frank Act requires DCOs to provide
market participants sufficient information to enable them to identify and evaluate accurately
the risks and costs associated with using the DCO’s services, including information regarding
its operating and default procedures and its procedures governing clearing and settlement.
(m) Compliance Dates. DCOs must comply with certain rules by May 6, 2012,
and with certain other rules by November 8, 2012.
8. Proposed Rules Regarding SBS CA Standards for Operation and
Governance
The SEC has existing authority over SBS CAs pursuant to the Exchange Act. SBS CAs
are required to register with the SEC prior to performing the functions of a CA, and the SEC is
not permitted to grant registration unless an SBS CA meets set statutory standards. If a SBS
CA is granted registration, the SEC oversees the SBS CA through on-site examinations by SEC
staff. The Dodd-Frank Act tasked the SEC with adopting additional rules to govern SBS CAs
that clear security-based swaps. Accordingly, the SEC has proposed rule regarding operation
and governance standards for registered SBS CAs (the "Proposed SBS CA Rules").
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(a) Which SBS CAs Would be Subject to New Standards for Operation and
Governance. The types of SBS CAs that are subject to the Proposed SBS CA Rules will be: (i)
SBS CAs that offer central counterparty ("CCP") services for transactions in securities that are
not security-based swaps and those that are security-based swaps, and (ii) SBS CAs that
provide non-CCP services for transactions in securities that are not security-based swaps and
those that are security-based swaps. SBS CAs that offer only non-CCP services would only be
subject to certain of the proposed rules.
(b) Policies and Procedures. Each SBS CA that performs CCP services would
be required to establish, maintain and enforce written policies and procedures reasonably
designed to, among other things:
(i) measure its credit exposures to its participants at least once a
day and limit its exposures to potential losses from defaults by its participants in normal
market conditions so that its operations would not be disrupted and non-defaulting
participants would not be exposed to losses that they cannot anticipate or control;
(ii) use margin requirements and collateral requirements to limit its
credit exposures to participants in normal market conditions and use risk-based models and
parameters to set margin requirements and review them at least monthly;
(iii) maintain sufficient financial resources and robust operational
capacity to meet obligations arising from participation in the clearing agency;
(iv) identify sources of operational risk and minimize them through
development of controls and business continuity plans;
(v)
have governance arrangements that are clear and transparent;
(vi) provide market participants with sufficient information for them
to identify and evaluate the risks and costs associated with using its services;
participants; and
(vii)
(viii)
protect the confidentiality of trading information of the CA’s
address conflicts of interest.
(c) Dissemination of Pricing and Valuation Information. Each SBS CA that
performs CCP services would be required to make publicly available (on terms that are fair
and reasonable and not unreasonably discriminatory) all end-of-day settlement prices and
any other prices with respect to security-based swaps that the clearing agency may establish
to calculate mark-to-market margin requirements for its participants and any other pricing or
valuation information with respect to security-based swaps as is published or distributed by
the SBS CA to its participants.
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(d) Registration of CAs. Registration of a SBS CA would only be effective for
24 months. Not later than 15 months from the date of registration, the SEC will either grant
continued registration or will institute proceedings to determine whether the SBS CA should
be denied continued registration at the expiration of the previous registration period.
(e) Chief Compliance Officer. Each SBS CA would be required to designate a
Chief Compliance Officer who will report directly to the board of directors or senior officers of
the SBS CA and who will be responsible for administering the policies and procedures
required to be adopted by the CA.
9. Proposed Rules Regarding Mitigating Conflicts of Interest for DCOs/CAs,
DCMs, SEFs and SBS Exchanges
On August 20, 2010 the Commissions held a joint public roundtable to discuss sources
of conflicts of interest at DCOs, CAs, DCMs, SEFs and securities-based national stock
exchanges ("SBS Exchanges"). The CFTC and SEC believe the most significant conflicts of
interest are those that arise when a small number of participants exercise undue control or
influence over a DCO/CA, potentially causing a limitation on open access to the DCO/CA, a
limitation on the scope of products eligible for clearing and reduced risk management
controls. Undue control may be exercised by participants either through voting interests in
the DCO/CA) or through governance of the DCO/CA (e.g., a participant selecting directors of
the DCO/CA). Likewise, similar conflicts of interest arise for DCMs, SEFs and SBS Exchanges.
The CFTC has proposed rules to address conflicts of interest for DCOs, DCMs and SEFs ("CFTC
Proposed COI Rules"), and the SEC in its turn has also proposed rules to address conflicts of
interest for CAs, securities-based SEFs ("SBS SEFs") and SBS Exchanges ("SEC Proposed COI
Rules").
(a) Structural Governance Requirements. The CFTC Proposed COI Rules
would require the governing boards of DCOs, DCMs and SEFs (i) to maintain at least 35%
public directors 19 , and no less than 2 public directors, (ii) not to be operated 20 by another
entity, unless such entity agrees to comport with the board composition requirement and (iii)
to be composed entirely of members with sufficient expertise in financial services, risk
management and clearing services, as applicable. In general, the CFTC’s structural
governance requirements are designed to mitigate conflicts of interest at a DCO, DCM or SEF
by introducing a perspective independent of competitive, commercial or industry
considerations to their governing bodies (e.g., board of directors).
19 "Public Director" is one that has no "material relationship" with the DCO, DCM or SEF. A "material relationship"
exists if (i) the director is an officer or employee of the DCO, DCM or SEF or any of its affiliates, (ii) the director is a
member of the DCO, DCM or SEF or an officer or director of a member of the DCO, DCM or SEF, (iii) the director, or
a firm with which the director is an officer, director or partner, receives more than $100,000 combined annual
payments from the DCO, DCM or SEF, or (iv) any of these relationships apply to a member of the director’s
immediate family (i.e., spouse, parents, children and siblings.)
20 "Operated" means to directly exercise control (including through the exercise of veto power) over the day‐today
business operations of a DCO, DCM or SEF by the sole or majority shareholder or such entity, either through
ownership of voting equity, by contract or otherwise.
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The CFTC Proposed COI Rules would also require that the governing board of a DCO,
DCM or SEF clearly articulate rules and responsibilities for ensuring regulatory compliance
and to review its performance and the performance of its members at least annually. In
addition, the proposed CFTC Proposed COI Rules would require that each DCO, DCM and SEF
establish a nominating committee and disciplinary panel(s). DCOs would also be required to
establish a risk management committee.
The SEC Proposed COI Rules likewise require CA’s to (i) clearly articulate rules and
responsibilities for ensuring regulatory compliance, (ii) review its performance and the
performance of its members periodically and (iii) have board members with the requisite
expertise. In addition, CA’s are required to have standards for its board of directors and
committee members that set out disqualifying factors concerning serious legal misconduct.
(b) Ownership and Voting Limits. The CFTC Proposed COI Rules would
impose equity ownership limits on DCOs, DCMs and SEFs. Likewise the SEC Proposed COI
Rules would impose equity ownership limits on CAs, security-based SEFs and national
securities exchanges with respect to security-based swaps.
(i) CFTC Proposed COI Rules. The CFTC Proposed COI Rules would
allow DCOs to choose between two alternative ownership limits (and also provide for the
possibility of a waiver of these ownership limits). Under the first alternative, no single
member of a DCO (and related persons) may own more than 20% of the equity interest of the
DCO and no more than 40% of the voting equity of the DCO may be held by enumerated
entities 21 . Under the second alternative, no more than 5% of the voting equity in the DCO
may be owned by any DCO member or enumerated entity and the related persons thereof.
The CFTC Proposed COI Rules would limit DCM or SEF members from (i) beneficially owning
more than 20% of any class of voting equity in the DCM or SEF or (ii) directly or indirectly
voting (e.g., through proxy or shareholder agreement) an interest exceeding 20% of the
voting power of any class of equity interests in the DCM or SEF. DCMs and SEFs would, on the
other hand, be subject to a 20% limitation on the voting equity that any single member (and
related persons) may own.
(ii) SEC Proposed COI Rules. The SEC Proposed COI Rules would
allow SBS CAs to choose between two alternative ownership limits. Under the first
alternative, (i) no single member (and related persons) may own more than 20% of the equity
interest of the SBS CA (ii) no more than 40% of the voting equity of the SBS CA may be held by
participants and their related persons 22 , (iii) the SBS CA would have to establish rules for
divesture of voting interests in excess of the 20%/40% limitations and a mechanism not to
give effect to the portion of any voting interest held by a participant in excess of the 20%/40%
limitations, (iv) at least 35% of board of directors of the SBS CA must be comprised of
21 "Enumerated Entities" include (i) bank holding companies with over $50 billion in total consolidated assets, (ii)
nonbank financial companies supervised by the Federal Reserve and affiliates of such entities, and (iii) swap
dealers, major swap participants and their associated persons.
22 The percentages of ownership in the first alternative pertain to beneficial ownership of any class of voting equity
and also to direct or indirect voting (e.g., through proxy or shareholder agreement).
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independent directors 23 , and (v) the SBS CA would be required to have a nominating
committee and disciplinary panels.
Under the second alternative, (i) no single member (and related persons) may own
more than 5% of the equity interest of the CA, (ii) the SBS CA would have to establish rules for
divesture of voting interests in excess of the 5% limitation and a mechanism not to give effect
to the portion of any voting interest held by a participant in excess of the 5% limitation, (iii) at
least a majority of the board of directors of the SBS CA must be comprised of independent
directors, and (iv) the SBS CA would be required to have a nominating committee and
disciplinary panels. 24
The SEC Proposed COI Rules would require that SB SEFs and SBS Exchanges not permit
any of their participants or members, as applicable, either alone or together with their related
persons, to (i) beneficially own, directly or indirectly, any interest in such entity that exceeds
20% of any class of securities in such entity, or (ii) directly or indirectly vote, cause the voting
of, or give any consent or proxy with respect to the voting of any interest in such entity that
exceeds 20% of the voting power of any class of securities in such entity. In addition, SEC
Proposed COI Rules would require that the boards of directors of SB SEFs and SBS Exchanges
be comprised of a majority of independent directors.
V. REGISTRATION AND REGULATION OF SWAP DEALERS AND MAJOR SWAP
PARTICIPANTS
1. Registration of Swap Dealers and Major Swap Participants
The CFTC has issued final rules regarding registration of SDs and MSPs, while the SEC
has proposed but not yet finalized rules regarding registration of security-based swap dealers
("SBS SDs") and major security-based swap participants ("SBS MSPs"). The CFTC’s and SEC’s
registration regimes are very similar.
(a) Registration Requirement. The Dodd-Frank Act provided that it shall be
unlawful for any person to act as an SD, SBS SD, MSP, or SDS MSP (collectively, "Swap Entities")
unless such person is registered (i) in the case of SDs and MSPs, the CFTC and (ii) in the case of
SBS SDs and SDS MSPs, with the SEC. In order to become registered, a Swap Entity must file
an application with the CFTC or SEC, as applicable. There is an extensive list of matters that
constitute grounds pursuant to which the CFTC or SEC may refuse to register a person,
including, without limitation, felony conviction, commodities or securities law violations, and
bars or other adverse actions taken by financial regulators. CFTC regulations also require
each SD and SMP to be a registered member of a registered futures association.
23 As with the CFTC "public director" concept, the "independent director" concept focuses on material
relationships with certain entities.
24 The percentages of ownership in the first and second alternatives pertain to beneficial ownership of any class of
voting equity and also to direct or indirect voting (e.g., through proxy or shareholder agreement.
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(b) Statutory Disqualification. The Dodd-Frank Act makes it unlawful for a
Swap Entity to permit any person associated 25 with it who is subject to a statutory
disqualification to effect or be involved in effecting swaps on behalf of the Swap Entity, if the
Swap Entity knew, or in the exercise of reasonable care should have known, of the statutory
disqualification; however, this prohibition does not apply to any person listed as principal or
registered as an associated person of an FCM, retail foreign exchange dealer, introducing
broker, commodity pool operator, commodity trading advisor, or leverage transaction
merchant, or any person registered as a floor broker or floor trader, notwithstanding that the
person is subject to disqualification from registration.
(c) Duration of Registration. Under the CFTC’s final rules and the SEC’s
proposed rules, a Swap Entity would continue to be registered until the effective date of any
cancellation, revocation or withdrawal of registration or any other event the CFTC or SEC
determines should trigger expiration. The SEC’s proposed rules also address succession: if an
SBS SD or SBS MSP succeeds to and continues the business of another SBS SD or SBS MSP, the
registration of the predecessor will remain effective as the registration of the successor if the
successor files an application for registration within 30 days after such succession and the
predecessor files a notice of withdrawal from registration.
(d) Non-U.S. Entities. Under the SEC’s proposed rules, nonresident SBS SDs
and SBS MSPs that are required to register with the SEC would be required to (i) appoint an
agent for service of process in the U.S. and provide the SEC with the identity and address of
such agent, and (ii) certify that the firm can, as a matter of law, provide the SEC with prompt
access to its books and records and can submit to onsite inspection and examination by the
SEC, and provide a legal opinion as to the foregoing. The CFTC has not yet addressed this
topic.
(e) Compliance Dates. An SD will be required to register on the earlier of (i)
December 31, 2012 or (ii) within 2 months following the end of the month in which it exceeds
the applicable de minimis threshold of aggregate notional amount of swaps executed 26 . An
MSP will be required to register no later than February 28, 2013. 27 SDs and MSPs may
25 "Associated person" means a natural person associated with a Swap Entity as a partner, officer, employee or
agent (or functionally similar role) in a capacity that involves solicitation or acceptance of swaps, or the supervision
of persons so engaged.
26 The definition of "swap dealer" provides an exemption from such definition where the aggregate notional
amounts of a person’s positions connected with its dealing activity over a specified period of time do not exceed
certain thresholds.
27 Under the rules defining "major swap participant", a person that meets the criteria for being an MSP as a result
of its swap activities in a fiscal quarter but who has not registered as an MSP will not be deemed to be an MSP until
the earlier of (i) the date on which it submits a complete application for registration as an MSP or (ii) 2 months
after the end of that fiscal quarter. A person will have to start its MSP calculations based on all outstanding swaps
on and after October 12, 2012. This means that the first fiscal quarter for the MSP determination is the one that
ends on December 31, 2012 and any person whose swap activities for that quarter exceed any applicable MSP
threshold by more than 20% will have to submit an application for registration as an MSP within 2 months of
December 31, 2012, which is February 28, 2013.
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voluntary register prior to these deadlines. SBS SDs and SBS MSPs will be permitted to
register as soon as final registration rules are adopted by the SEC.
2. Business Conduct Standards for Swap Dealers and Major Swap
Participants
The CFTC has issued final rules (the "CFTC Business Conduct Rules") regarding business
conduct standards for SDs and MSPs, while the SEC has proposed but not yet finalized rules
regarding business conduct standards for SDS SDs and SDS MSPs (the "SEC Proposed Business
Conduct Rules"). The CFTC and SEC worked closely together to establish consistent
requirements for CFTC and SEC registrants to the extent practicable. For purposes of
convenience, the CFTC Business Conduct Rules are summarized below and, unless otherwise
indicated, the SEC Proposed Business Conduct Rules are substantially similar.
(a) Scope. The CFTC Business Conduct Rules apply in connection with
transactions in swaps as well as in connection with swaps that are offered 28 but not entered
into. The CFTC’s business conduct rules generally do not distinguish between SDs and MSPs;
however, rules for MSPs do not include the suitability duty, pay-to-play, "known your
counterparty" and scenario analysis provisions (each of these rules are summarized below). In
addition, the CFTC has determined not to require that SDs provide MSPs with the same
protection afforded to other counterparties. Nor is the CFTC requiring SDs to allow MSPs to
opt in to receive certain protections, such as daily mark, suitability or scenario analysis, that
are afforded to counterparties generally. SDs and MSPs will not need to comply with the
CFTC business conduct rules for swaps entered into with their affiliates where the transaction
would not be a publicly reportable transaction. 29
As summarized below, certain of the CFTC’s business conduct rules will not apply
when (i) a transaction is initiated by a special entity on a DCM or SEF and (ii) the SD or MSP
does not know the identity of the counterparty to the transaction.
The CFTC has confirmed that the business conduct standards will not apply to
unexpired swaps executed before the effective date of the CFTC Business Conduct Rules.
(b) Policies and Procedures. Each SD and MSP is required to establish
written policies and procedures reasonably designed to ensure compliance with the CFTC
Business Conduct Rules, and prevent the SD or MSP from evading or participating in or
facilitating an evasion of any provision of the CFTC Business Conduct Rules. However, each
SD or MSP may consider the nature of its particular business in developing its policies and
procedures and tailor them accordingly.
28 "Offer" has the same meaning as in contract law, such that, if accepted, the terms of the offer would form a
binding contract.
29 A "publicly reportable transaction" means, among other things, any executed swap that is an arm’s length
transaction between two parties that results in a corresponding change in the market risk position between the
two parties.
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(c)
Information Regarding Counterparties.
(i) Know Your Counterparty. Each SD must implement policies and
procedures reasonably designed to obtain and retain a record of the essential facts 30
concerning each counterparty whose identity is known to the SD prior to the execution of the
transaction that are necessary for conducting business with the counterparty. MSPs are
excluded from this requirement.
(ii) True Name and Owner. Each SD and MSP must obtain and retain
a record of the true name and address of each counterparty whose identity is known to the
SD or MSP prior to the execution of the swap, the principal occupation or business of such
counterparty, as well as the name and address of any other person guaranteeing the
performance of such counterparty and any person exercising any control with respect to the
positions of such counterparty.
(d) Prohibition on Fraud, Manipulation and Other Abusive Practices. CFTC
Business Conduct Rules make it unlawful for an SD or MSP to engage in any act, practice or
course of business that is fraudulent, deceptive or manipulative. This prohibition imposes a
non-scienter standard (that is, intent does not have to be proven); however, an affirmative
defense is available: an SD or MSP can establish that (i) it did not act intentionally or
recklessly in connection with the alleged violation, and (ii) it complied in good faith with its
written policies and procedures designed to avoid such a violation.
(e) Communications; Fair Dealing. With respect to any communications
between an SD or MSP and any counterparty, the SD or MSP must communicate in a fair and
balanced manner based on principles of fair dealing and good faith. This requirement works
in tandem with the anti-fraud rules. This requirement is meant to address the findings in the
Senate report titled "Wall Street and the Financial Crises: Anatomy of a Financial Collapse",
issued April 13, 2011, that swap transactions which included structured CDOs were
problematic because they were designed to fail and the disclosures omitted and/or
misrepresented the material risks, characteristics, incentives and conflicts of interest.
(f) Confidential Treatment of Counterparty Information. The CFTC Business
Conduct Rules make it unlawful for an SD or MSP to (i) disclose to any other person any
material confidential information provided by or on behalf of a counterparty to the SD or
MSP, or (ii) use for its own purposes in any way that would tend to be materially adverse to
the interests of a counterparty, any material confidential information provided by or on behalf
of a counterparty to the SD or MSP; however, an SD or MSP may disclose or use material
confidential information provided by or on behalf of a counterparty to the SD or MSP if such
disclosure or use is authorized in writing by such counterparty or is necessary for the effective
30 "Essential facts" include (i) facts necessary to comply with applicable laws, regulations and rules, (ii) facts
necessary to effectuate the SD’s credit and operational risk management policies in connection with transactions
entered into with such counterparty, (iii) information regarding the authority of any person acting for such
counterparty, and (iv) if the counterparty is a special entity, such background information regarding the
independent representative as the SD reasonably deems appropriate.
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execution of any swap for or with such counterparty, to hedge or mitigate any exposure
created by such swap, or to comply with a request from the SEC, Department of Justice, any
self-regulatory organization designated by the CFTC, or an applicable prudential regulator, or
is otherwise required by law. Each SD and MSP must implement written policies and
procedures reasonably designed to protect material confidential information provided by or
on behalf of a counterparty to the SD or MSP.
(g) Verification of Counterparty Eligibility. SDs and MSPs must verify, prior to
offering to enter into or entering into a swap, (i) that a counterparty meets the eligibility
standards for an eligible contract participant (ECP) and (ii) whether the counterparty is a
special entity (if so, the SD or MSP must notify such entity of its right to make an election to be
treated as a special entity). In making this verification, SDs and MSPs may rely on written
representations of a counterparty in the absence of red flags. The verification requirement
will not apply with respect to (i) a transaction that is initiated on a DCM or (ii) a transaction
that is initiated on an SEF, if the SD or MSP does not know the identity of the counterparty to
the transaction prior to execution.
(h)
Disclosure of Material Information.
(i) Disclosure of Material Information. At a reasonably sufficient
time prior to entering into a swap, an SD or MSP must disclose to any counterparty to the
swap (other than an SD, SBS SD, MSP, or SBS MSP) material information 31 concerning the swap
in a manner reasonably designed to allow the counterparty to assess (i) the material risks of
the particular swap, which may include market, credit, liquidity, foreign currency, legal
operational, and any other applicable risks (this requirement will be interpreted consistently
with industry best practice regarding disclosure of material risks), (ii) the material
characteristics of the particular swap, which shall include the material economic terms of the
swap, the terms relating to the operation of the swap, and the rights and obligations of the
parties during the term of the swap, and (iii) the material incentives and conflicts of interest
that the SD or MSP may have in connection with the particular swap, which shall include the
price of the swap and the mid-market mark of the swap, and any compensation or other
incentive from any source other than the counterparty that the SD or MSP may receive in
connection with the swap.
(ii) Scenario Analysis. Prior to entering into a swap with a
counterparty (other than an SD, SBS SD, MSP, or SBS MSP) that is not available for trading on a
DCM or SEF, an SD must (i) notify the counterparty that it can request and consult on the
design of a scenario analysis to allow the counterparty to assess its potential exposure in
connection with the swap, (ii) upon request of the counterparty, provide a scenario analysis,
which is designed in consultation with the counterparty and done over a range of
assumptions, including severe downside stress scenarios that would result in significant loss,
(iii) disclose all material assumptions and explain the calculation methodologies used to
31 Information is "material" if there is a substantial likelihood that a reasonable investor would consider the
information to be important in making an investment decision.
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perform any requested scenario analysis (provided, however, that the SD is not required to
disclose confidential, proprietary information), and (iv) in designing any requested scenario
analysis, consider any relevant analysis that the SD undertakes for its own risk management
purposes. Regarding the parameters of the scenario analysis, the CFTC directed SDs and
MSPs to use industry best practices for scenario analysis for high-risk complex financial
instruments. The scenario analysis requirements will not apply with respect to with respect to
(i) a transaction that is initiated on a DCM or (ii) a transaction that is initiated on an SEF, if the
SD does not know the identity of the counterparty to the transaction prior to execution. The
SEC Proposed Business Conduct Rules do not include a scenario analysis requirement, but the
SEC requested comments regarding whether such requirement should be implemented.
(iii) Daily Mark. Each SD and MSP must (i) for cleared swaps, notify a
counterparty (other than an SD, SBS SD, MSP, or SBS MSP) of the counterparty’s right to
receive, upon request, the daily mark 32 from the appropriate DCO, (ii) for uncleared swaps,
provide a counterparty (other than an SD, SBS SD, MSP, or SBS MSP) with a daily mark, which
shall be in the mid-market mark of the swap 33 , during the term of the swap as of the close of
business or such other time as the parties agree in writing, (iii) for uncleared swaps, disclose
to the counterparty (A) the methodology and assumptions used to prepare the daily mark
and any material changes during the term of the swap (provided, however, that the SD is not
required to disclose confidential, proprietary information), and (B) additional information
concerning the daily mark to ensure a fair and balanced communication 34 . According to the
SEC Proposed Business Conduct Rules, the daily mark is intended to provide a counterparty
with a useful and meaningful reference point against which to assess, among other things,
the calculation of variation margin for a swap or portfolio of swaps, and otherwise inform the
counterparty’s understanding of its financial relationship with the Swap Entity.
(iv) No Fiduciary Capacity. The CFTC confirmed that compliance
with the requirements of the CFTC Business Conduct Rules alone do not cause an SD or MSP
to assume advisory responsibilities or become a fiduciary. Moreover, the Department of
Labor has confirmed that SDs and MSPs acting as counterparties to ERISA plans will not be
considered to be ERISA fiduciaries.
(v) Clearing Disclosures. Each SD and MSP must notify any
counterparty (other than an SD, SBS SD, MSP, or SBS MSP) with which it entered into a swap
that is subject to mandatory clearing that the counterparty has the sole right to select the
DCO at which the swap will be cleared. For swaps not subject to a mandatory clearing
32 The daily mark is the end‐of‐day settlement price, which is the value of any given swap used by the DCO/CA that
forms the basis of subsequent margin calculations for clearing participants.
33 The mid‐market mark of the swap shall not include amounts for profit, credit reserve, hedging, funding, liquidity
, or any other costs or adjustments. The mid‐market mark can be determined through mark‐to‐model calculations
when a liquid market does not exist.
34 Additional information may include (i) the daily mark may not necessarily be a price at which either the
counterparty or the SD or MSP would agree to replace or terminate the swap, (ii) depending upon the agreement
of the parties, calls for margin may be based on considerations other than the daily mark provided to the
counterparty, and (iii) the daily mark may not necessarily be the value of the swap that is marked on the books of
the SD or MSP.
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equirement, each SD and MSP must notify any counterparty (other than an SD, SBS SD, MSP,
or SBS MSP) with which it entered into a swap that the counterparty may elect to require the
clearing of the swap and will have the sole right to select the DCO at which the swap will be
cleared.
(i) Recommendations to Counterparties - Institutional Suitability. An SD that
recommends 35 a swap or trading strategy involving a swap to a counterparty (other than an
SD, SBS SD, MSP, or SBS MSP) must undertake reasonable diligence to understand the
potential risks and rewards associated with the recommended swap or trading strategy, and
have a reasonable basis to believe that the recommended swap or trading strategy is suitable
for the counterparty (to establish a reasonable basis for a recommendation, an SD must have
or obtain information about the counterparty, including its investment profile, trading
objectives, and ability to absorb potential losses). The CFTC Business Conduct Rules provide
for a safe harbor: an SD can fulfill these obligations if (i) the SD reasonably determines that
the counterparty (or an agent to which it has delegated decision-making authority) is capable
of independently evaluating investment risks with regard to the relevant swap or trading
strategy involving a swap, (ii) the counterparty or its agent represents in writing that it is
exercising independent judgment in evaluating the recommendations of the SD with regard
to the relevant swap or trading strategy involving a swap, (iii) the SD discloses in writing that
it is acting in its capacity as a counterparty and is not undertaking to assess the suitability of
the swap or trading strategy involving a swap for the counterparty, and (iv) in the case of a
counterparty that is a special entity, the SD has notified the entity that it can elect to be
treated as a special entity. An SD may rely on representations of the counterparty to make
the determinations necessary to use the safe harbor.
(j) Requirements for SDs Acting as Advisors to Special Entities. An SD that acts
as an advisor to a special entity 36 will have a duty to make a reasonable determination that
any swap or trading strategy involving a swap recommended by the SD is in the best interests
of the special entity, and must make reasonable efforts to obtain such information as is
necessary to make such reasonable determination, including information relating to the
financial status and future funding needs of the special entity, its tax status, the special
entity’s experience with swaps generally and swaps of the complexity being recommended
and whether the special entity has the financial capability to withstand changes in market
35 The determination of whether a "recommendation" has been made is an objective rather than a subjective
inquiry. An important factor is whether , given its content, context and manner of presentation, a particular
communication from an SD to a counterparty reasonably would be viewed as a "call to action" or suggestion that
the counterparty enter into a swap. An analysis of the content, context and manner of presentation of a
communication requires examination of the underlying substantive information transmitted to the counterparty
and consideration of any other facts and circumstances, such as any accompanying explanatory message from the
SD. Additionally, the more individually tailored a communication to a specific counterparty or a targeted group of
counterparties about a swap, group of swaps or trading strategy involving the use of a swap, the greater the
likelihood that the communication may be viewed as a "recommendation".
36 An SD "acts as an advisor to a special entity" when it recommends a swap or trading strategy involving a swap
that is tailored to the particular needs or characteristics of the special entity. The CFTC Business Conduct Rules
provide safe harbors detailing when an SD will not be deemed to be acting as an advisor.
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conditions. An SD may rely on written representations of the special entity to satisfy the
requirements to make reasonable efforts to obtain necessary information.
(i) Requirements for SDs and MSPs Acting As Counterparties to Special
Entities. Any SD or MSP that offers to enter or enters into a swap with a special entity (other
than an employee benefit plan subject to Title I of ERISA) must have a reasonable basis to
believe that the special entity has a representative that (i) has sufficient knowledge to
evaluate the transaction and risks, (ii) is not subject to statutory disqualification, (iii) is
independent 37 of the SD or MSP, (iv) undertakes a duty to act in the best interests of the
special entity, (v) makes appropriate and timely disclosures to the special entity and (vi)
evaluates, consistent with any guidelines provided by the special entity, fair pricing and the
appropriateness of the swap. An SD or MSP will be deemed to have reasonable basis to
believe that the special entity has a representative that meets the requirements set forth
above if it reasonably relies on (i) written representations of the special entity that it has
complied in good faith with written policies and procedures regarding selection of qualified
representatives and (ii) written representations of the representative that it meets the
requirements set forth above.
If the SD or MSP determines that it has no reasonable basis to believe that the
representative of the special entity meets the above criteria, the SD or MSP must make a
written record of its basis for such determination and submit such determination to its chief
compliance officer for review to ensure that the SD or MSP has a substantial, unbiased basis
for the determination.
Prior to the initiation of a swap, an SD or MSP must disclose to a special entity in
writing the capacity in which it is acting in connection with the swap, and if it engages in
business with the special entity in more than one capacity, disclose the material differences
between such capacities
The above requirements do not apply if the transaction is (i) initiated on a DCM or SEF
and (ii) one in which the SD or MSP does not know the identity of the counterparty to the
transaction prior to execution.
(k) Political Contributions by Certain SDs ("Pay to Play Rules"). In order to
prevent fraud, the CFTC Business Conduct Rules prohibit SDs from offering to enter into or
entering into a swap or trading strategy involving a swap with a governmental special entity
within 2 years after any contribution (other than a de minimis contribution) to an official of
37 A representative is "independent" of the SD or MSP if (i) it is not, and within 1 year of representing the special
entity in connection with the swap was not, an associated person of the SD or MSP, (ii) the SD or MSP is not a
principal of the representative, (iii) the representative provides timely and effective disclosures to the special
entity of all material conflicts of interest that could reasonably affect the judgment or decision making of the
representative with respect to its obligations to the special entity, (iv) the representative complies with policies
and procedures designed to mitigate conflicts of interest, (v) the representative is not directly or indirectly,
through one or more persons, controlled by, in control of, or under common control with the SD or MSP, and (vi)
the SD or MSP did not refer, recommend or introduce the representative to the special entity within 1 year of the
representative’s representation of the special entity in connection with the swap.
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such governmental special entity was made by the SD or any covered associates 38 of the SD.
The CFTC Business Conduct Rules provide for certain exceptions to this prohibition. This
prohibition does not apply if the transactions is (i) initiated on a DCM or SEF and (ii) one in
which the SD or MSP does not know the identity of the counterparty to the transaction prior
to execution. The CFTC Business Conduct Rules also prohibit an SD from paying a third party
to solicit any government special entity to enter into swaps, unless such party is also subject
to "pay to play" regulations.
The CFTC Business Conduct Rules also contain a non-circumvention provision,
prohibiting SDs from directly or indirectly doing any act that would result in a violation of the
prohibition on political contributions.
An SD can apply to the CFTC for an exemption under certain circumstances.
(l) Record Retention. SDs and MSPs must create a record of their
compliance with the business conduct requirements and retain these records and make them
available to regulators upon request.
(m) Chief Compliance Officer. Each SD, MSP and FCM must have a chief
compliance officer that is appointed by and reports directly to the board of directors or senior
management of such SD, MSP or FCM. Unlike the chief compliance officer of an SDR, the chief
compliance officer of an SD, MSP or FCM may be the general counsel or part of the legal
department. The chief compliance officer must be responsible for, among other things,
administering policies and procedures reasonably designed to ensure compliance with the
CEA and CFTC regulations, resolve any conflicts of interest in consultation with the board of
directors or senior management, developing procedures for correcting actions for
noncompliance and conducting an annual review, and preparing and furnishing to the CFTC
an annual compliance report.
(n) Compliance Dates. SDs and MSPs must comply with the business
conduct rules by the later of (i) October 14, 2012 and (ii) the date on which SDs and MSPs are
required to apply for registration with the CFTC.
3. Duties of Swap Dealers and Major Swap Participants
The CFTC has issued final rules regarding duties of SDs and MSPs, while the SEC has
not yet proposed rules on this topic for SDS SDs and SDS MSPs.
(a) Risk Management Program. Each SD and MSP must establish, document,
maintain and enforce a system of risk management policies and procedures designed to
monitor and manage the risks associated with the swaps activities of the SD or MSP (the "Risk
38 "Covered associates" include (i) any general partner, managing member, or executive officer, or other person
with a similar status or function, (ii) any employee who solicits a governmental special entity for the SD and any
person who supervises, directly or indirectly, such employee, and (iii) any political action committee (PAC)
controlled by the SD or by any person described in clauses (i) or (ii) above.
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Management Program"). The Risk Management Program must be written, approved by the
governing board of the SD or MSP, and a copy must be furnished to the CFTC.
Each SD and MSP must establish and maintain a risk management unit with sufficient
authority, qualified personnel and financial, operational, and other resources to carry out the
Risk Management Program. This unit must report directly to senior management and must
be independent from the SD’s or MSP’s business trading unit 39 .
The Risk Management Program must be reviewed and tested at least annually and
upon any material change in the business of the SD or MSP that is reasonably likely to alter its
risk profile. Each SD and MSP must document all internal and external reviews and testing of
the Risk Management Program including the dates of each test, the results, any deficiencies
identified and corrective action taken, which documentation must be provided to the CFTC
upon request.
The Risk Management Program must contain the following elements:
(i) Identification of Risks and Risk Tolerance Limits. The Risk
Management Program should take into account market, credit, liquidity, foreign currency,
legal, operational, settlement, risks posed by affiliates and any other applicable risks together
with a description of the risk tolerance limits set by the SD or MSP and the underlying
methodology. The risk tolerance limits must be approved quarterly by senior management
and annually by the governing body of the SD or MSP. The Risk Management Program must
include policies and procedures for detecting breaches of risk tolerance limits.
(ii) Periodic Risk Exposure Reports. The risk management unit of
each SD and MSP must prepare quarterly written reports for senior management and the
governing body (copies of which must be provided to the CFTC) setting forth risk exposure of
the SD or MSP and any recommended changes to the Risk Management Program.
(iii) New Product Policy. The Risk Management Program must
include a new product policy designed to identify and take into account the risks of any new
product prior to engaging in transactions involving such new product.
(iv) Use of Central Counterparties. The Risk Management Program
must include policies and procedures relating to its use of central counterparties, which must
require use of central counterparties when required under CFTC regulations (unless an
exemption has been obtained), set forth conditions for voluntary use of central
counterparties, and require diligent investigation into the adequacy of financial resources and
risk management procedures of any central counterparties through which the SD or MSP
clears.
39 "Business trading unit" means any department, division, group or personnel of an SD or MSP or any of its
affiliates, whether or not identified as such, that performs, or personnel exercising direct supervisory authority
over the performance of, any pricing (excluding price verification for risk management purposes), trading, sales,
marketing, advertising, solicitation, structuring or brokerage activities on behalf of the SD or MSP.
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(v) Compliance With Margin and Capital Requirements. Each SD
and MSP must satisfy all statutory capital and margin requirements.
(vi) Monitoring of Compliance with the Risk Management Program.
The Risk Management Program must include policies and procedures to detect violations of
the Risk Management Program and to encourage employees to report such violations.
(b) Business Trading Unit. Each SD and MSP must establish policies and
procedures that, at a minimum (i) require all trading policies to be approved by its governing
body, (ii) require that traders execute transactions only with counterparties for whom credit
limits have been established, (iii) provide specific quantitative or qualitative limits for traders
and personnel able to commit the capital of the SD or MSP, (iv) monitor each trader
throughout the day to prevent them from exceeding any limits and from otherwise incurring
unauthorized risk, (v) require each trader to follow established policies and procedures for
executing and confirming transactions, (vi) establish means to detect unauthorized trading
activities or any other violations of policies and procedures, (vii) ensure that all material trade
discrepancies are documented and brought to the attention to management, (viii) ensure
that broker statements and payments to brokers are periodically audited by persons
independent of the business trading unit, (ix) ensure that use of trading programs is subject
to policies and procedures governing use, supervision, maintenance, testing and inspection
of the program, and (x) require the separation of personnel in the business trading unit from
personnel in the risk management unit.
(c) Monitoring of Position Limits. Each SD and MSP must establish and
enforce written policies and procedures that are reasonably designed to monitor for and
prevent violations of applicable position limits established by the CFTC, a DCM or SEF, and to
monitor for and prevent improper reliance upon any exemptions or exclusion from such
limits. These policies and procedures must be audited on an annual basis by the SD or MSP.
Training must be provided to all relevant personnel on applicable position limits on an annual
basis, as well as notifications of any change in position limits.
Each SD and MSP must diligently monitor its trading activities and diligently supervise
the actions of its partners, officers, employees and agents to ensure compliance with position
limits. In addition, each SD and MSP must implement an early warning system designed to
detect and alert its senior management when position limits are in danger of being breached.
Any detected violation must be reported promptly to the SD’s or MSP’s governing body and
to the CFTC. Records must be maintained of any early warning received, any position limit
violation detected, any action taken as a result of either, and the date action was taken.
Position limits must be tested by each SD and MSP for adequacy and effectiveness at
least once each calendar quarter. Records must be maintained of such tests, the results
thereof, any action taken as a result thereof, and any recommended changes to the Risk
Management Program as a result thereof.
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Compliance with position limits must be documented and quarterly reports on
compliance must be reviewed by each SD’s or MSP’s chief compliance officer, senior
management and governing body.
(d) Diligent Supervision. Each SD and MSP must establish and maintain a
system to supervise, and shall diligently supervise, all activities relating to its business
performed by its partners, members, officers, employees and agents (or persons occupying a
similar status or performing a similar function). Such system must be reasonably designed to
achieve compliance with the CEA and CFTC regulations. The supervisory system must
provide for the designation of at least one person with authority to carry out the supervisory
responsibilities of the SD or MSP. In addition, the supervisory system must require for use of
reasonable efforts to determine that all supervisors are appropriately qualified.
(e) Business Continuity and Disaster Recovery. Each SD and MSP must
establish and maintain a written business continuity and disaster recovery plan that outlines
the procedures to be followed in the event of an emergency or other disruption of its normal
business activities. The plan must be designed to enable the SD or MSP to continue or
resume any operations by the next business day with minimal disturbance to its
counterparties and the market, and to recover all documentation and data required to be
maintained by applicable law and regulation. CFTC rules set forth essential components to be
included in each business continuity and disaster recovery plan. Copies of the plan must be
provided to all relevant employees and such relevant employees must receive training in
connection with the plan.
If any emergency or other disruption occurs that may affect the ability of the SD or
MSP to fulfill its regulatory obligations or would have a significant adverse effect on the SD or
MSP, its counterparties or the market, the SD or MSP must notify the CFTC.
Each SD and MSP must provide to the CFTC the name and contact information of 2
employees who will be emergency contacts in the event of any disruption. These individuals
must be authorized to make key decisions on behalf of the SD or MSP and have knowledge of
the firm’s business continuity and disaster recovery plan.
The business continuity and disaster recovery plan must be reviewed annually or upon
any material change to the business of the SD or MSP by its senior management and also by
qualified, independent internal personnel or a qualified third party service. In addition,
business continuity and disaster recovery plan must be reviewed by a qualified third party
service at least once every 3 years. The reviews must be documented, together with any
deficiencies found and corrections undertaken.
(f) Conflicts of Interest. Each SD and MSP must establish and implement
written policies and procedures to ensure such SD’s or MSP’s compliance with the conflicts of
interest rules summarized below.
(i) Restrictions on Relationship With Research Department.
Personnel from the business trading unit or clearing unit of an SD or MSP cannot have any
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influence or control over the decisions of any research analyst, the content of any research
reports, or the compensation of any research analyst. Any written communication between
non-research personnel and the research department concerning the content of a research
report must be made either through authorized legal or compliance personnel of the SD or
MSP, and any such oral communication must be documented and made either through
authorized legal or compliance personnel of the SD or MSP. In determining the
compensation of research analysts, an SD or MSP may not consider as a factor his/her
contributions to the SD’s or MSP’s trading or clearing business.
(ii) Prohibition of Promise of Favorable Research. SDs or MSPs are
prohibited from directly or indirectly offering favorable research, or threatening to change
research, to an existing or prospective counterparty as consideration or inducement for the
receipt of business of compensation.
(iii) Disclosure Requirements. An SD or MSP must disclose in
research reports and a research analyst must disclose in public appearances 40 (i) whether the
research analyst maintains a financial interest in any derivative of a type, class or category that
the research analyst follows, and the general nature of such financial interest and (ii) any
other actual, material conflicts of interest of the research analyst or SD or MSP of which the
research analyst has knowledge at the time of publication of the report or the time of the
public appearance. Records must be maintained regarding all public appearances to
document compliance with these disclosure requirements.
(iv) Third Party Research Reports. If an SD or MSP distributes or
makes available any independent third-party research report, it must accompany the research
report with the current applicable disclosures pertaining to such SD or MSP. This requirement
shall not apply to third-party reports made available by an SD or MSP to its customers upon
request or through a website maintained by the SD or MSP.
(v) Prohibition of Retaliation Against Research Analysts. SDs and
MSPs and their employees are prohibited from directly or indirectly retaliating against or
threatening to retaliate against any research analyst of such SD or MSP or any of their affiliates
as a result of an adverse, negative, or otherwise unfavorable research report or public
appearance written or made in good faith by the research analyst.
(vi) Clearing Activities. SDs and MSPs are prohibited from directly or
indirectly interfering with or attempting to influence the decision of the clearing unit of any
affiliated CA or DCO to provide clearing services and activities to a particular customer. In
40 "Public appearance" includes any participation in a conference call, seminar, forum (including interactive
electronic forum) or other public speaking activity before 15 or more persons, or interview or appearance before
one or more representatives of the media, in which a research analyst makes a recommendation or offers an
opinion concerning derivatives transactions. The term "public appearance" does not include a conference call,
webcast or similar event with existing customers, provided that all event participants received the most current
research report or other documentation that contains all required applicable disclosures and that the analyst
updates any such disclosures as necessary during the event.
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order to reasonably ensure compliance with this prohibition, each SD and MSP must create
and maintain an appropriate informational partition between business trading units of the SD
or MSP and clearing units of any affiliated CA or DCO.
(vii) Undue Influence On Counterparties. Each SD and MSP must
adopt and implement written policies and procedures that mandate the disclosure to its
counterparties of any material incentives and any material conflicts of interest regarding the
decision of a counterparty whether to execute a derivative on a SEF or DCM or whether to
clear a derivative through a DCO.
(g) General Information: Availability for Disclosure and Inspection. Each SD
and MSP must make available for disclosure and inspection by the CFTC and other prudential
regulators all information required by or related to the CEA and CFTC regulations. Such
information must be available promptly upon request. In addition, each SD and MSP must
establish and maintain reliable internal data capture, processing, storage and other
operational systems sufficient to satisfy its duties under the CEA and CFTC regulations.
(h) Antitrust Considerations. SDs and MSPs are prohibited from taking any
action that results in any unreasonable restraint on trade, or imposes any material
anticompetitive burden on trading or clearing, unless necessary or appropriate to achieve the
purposes of the CEA. Each SD and MSP must adopt policies and procedures to ensure
compliance with this requirement.
4. Recordkeeping Rules for Swap Dealers and Major Swap Participants
The CFTC has issued final rules regarding recordkeeping for SDs and MSPs, while the
SEC has not yet proposed rules on this topic for SDS SDs and SDS MSPs.
(a) Transaction and Position Records. Each SD and MSP must keep full,
complete and systematic records (together with all pertinent data and memoranda) of all its
swaps activities, including (i) records of each transaction, including all transaction documents,
(ii) records of each position held by such SD or MSP, identified by product and counterparty,
and including records reflecting whether each position is "long" or "short" and whether the
position is cleared, (iii) records of each transaction executed on an SEF or DCM or cleared by a
DCO.
(b) Business Records. Each SD and MSP must keep full, complete and
systematic records of all activities related to its business as an SD or MSP, including (i)
governance documents, such as minutes of board meetings, organizational charts, job
descriptions for managers, officers and directors, business and strategic plans for the business
trading unit, and internal and external audit, risk, management, compliance and consulting
reports, (ii) financial records, (iii) a record of each complaint received by the SD or MSP
concerning any partner, member, officer employee or agent, and (iv) marketing and sales
materials.
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(c) Records of Data Reported to SDR. With respect to each swap, each SD and
MSP must retain and produce for inspection all data reported to an SDR, including the date
and time the report was made.
(d) Records of Real-Time Reporting Data. Each SD and MSP must retain and
produce for inspection all information and data reported pursuant to the real-time reporting
requirements summarized in Section III above, including the date and time the report was
made.
(e) Daily Trading Records. Each SD and MSP must make and keep daily
trading records of all swaps it executes (including all documentation), which records must
include all information necessary to conduct a comprehensive and accurate trade
reconstruction. The records must be searchable by transaction and counterparty and must
include:
(i) pre-execution trade information including, at a minimum,
records of all oral and written communications provided or received concerning quotes,
solicitations, bids, offers, instructions, trading and prices that lead to the execution of a swap;
(ii) execution trade information including, all terms of each swap
(including terms regarding payment or settlement instructions, initial and variation margin
requirements, option premiums, payment dates and any other cash flows), the trade ticket for
each swap, the name of the counterparty, the date and title of each swap agreement, the
price of the swap, the fees or commissions and other expenses, and any other relevant
information;
(iii) post-execution trade information including confirmation,
termination, novation, amendment, assignment, netting, compression, reconciliation,
valuation, margining, collateralization, and central clearing;
(iv) ledgers reflecting payments and interest received, moneys
borrowed and loans, daily calculations of current and potential future exposure for each
counterparty, daily calculations of initial margin to be posed by the SD or MSP for the
counterparty and by the counterparty, all transfers/substitutions of collateral, and all charges
against and credits to each counterparty’s account; and
(v) daily trading records for related cash and forward transactions,
including all documentation.
(f) Record Retention and Inspection. All records required to be kept by
each SD and MSP must be kept at its principal place of business or another principal office
designated by such SD or MSP. If such principal place of business is outside the U.S., then the
SD or MSP must be able to provide the records to the CFTC within 72 hours of receiving a
request. All records must be kept for the life of the swap plus for 5 years, and must be readily
accessible. Thereafter, records must be archived for an additional 10 year period, during
which they must be retrievable within 3 business days. In response to commenters, the CFTC
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educed the record retention period for voice recordings to 1 year. Records will be open to
inspection by the CFTC, the Department of Justice and other prudential regulators.
(g) Compliance Dates. SDs and MSPs must comply with the recordkeeping
rules by the later of (i) (A) in the case of SDs and MSPs that are currently regulated by a U.S.
prudential regulator or are registered with the SEC, June 1, 2012 and (B) in the case of SDs and
MSPs that are not currently regulated by a U.S. prudential regulator and are not registered
with the SEC, August 30, 2012, and (ii) the date on which SDs and MSPs are required to apply
for registration.
5. Proposed Rules Regarding Margin Requirements for Uncleared Swaps for
Swap Dealers and Major Swap Participants
The CFTC has proposed rules regarding margin requirements for uncleared swaps for
SDs and MSPs, while the SEC has not yet proposed rules regarding margin requirements for
uncleared swaps for SDS SDs and SDS MSPs .
The rationale for margin requirements is to offset the greater risk to SDs and MSPs and
the financial system arising from the use of swaps that are not cleared. The CFTC’s proposing
release pointed out that during the 2008 financial crisis, DCOs met all their obligations with
any financial infusion from the government, while significant sums were expended as the
result of losses incurred in connection with uncleared swaps, most notably at AIG. A key
reason for this difference is that DCOs all use variation margin and initial margin as the
centerpiece of their risk management programs while these tools were often not used in
connection with uncleared swaps. Consequently, in designing the proposed margin rules for
uncleared swaps, the CFTC has built upon the sound practices for risk management
employed by central counterparties for decades.
Variation margin entails marking open positions to their current market value each
day and transferring funds between the parties to reflect any change in value since the
previous time the positions were marked. This process prevents losses from accumulating
over time and thereby reduces both the change of default and the size of any default should
one occur.
Initial margin serves as a performance bond against potential future losses. If a party
fails to meet its obligations to pay variation margin, resulting in a default, the other party may
use initial margin to cover most or all of any loss based on the need to replace the open
position.
The proposed regulations would impose requirements on SDs and MSPs for which
there is no prudential regulator ("Covered Swaps Entities"), and the requirements would vary
depending on the category of counterparty since different counterparties may pose different
levels of risk. The proposed regulations would not impose margin requirements on nonfinancial
end users.
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(a) Documentation. Each Covered Swaps Entity would be required to
execute credit support documentation that would specify in advance material terms such as
how margin would be calculated, what types of assets would be permitted to be posted, what
margin thresholds, if any, would apply, and where margin would be held.
(b) Initial Margin. On or before the date of execution of an uncleared swap
between a Covered Swaps Entity and an SD or MSP, each Covered Swaps Entity must require
that the counterparty post initial margin calculated as provided in the CFTC proposed rules
(or if the credit support documentation requires a greater amount, such greater amount).
Such initial margin must be maintained until the swap is liquidated. The CFTC proposed rules
contain substantially similar initial margin requirements (with a different calculation of
margin) for uncleared swaps between a Covered Swaps Entity and a financial entity.
Initial Margin must be calculated using either (i) a risk based model or (ii) the
alternative model. A risk based model is one that meets requirements set forth in the CFTC
rules including: (i) the model is approved by the CFTC and is either currently used by a DCO
for margining or cleared swaps, or is currently used by an entity subject to regular assessment
by prudential regulators for margining uncleared swaps, or is made available for licensing to
any market participant by a vendor, (ii) the model must have a sound theoretical basis and
significant empirical support, and must use factors sufficient to measure all material risks, (iii)
the model must use at least 1 year of historic price data and must incorporate a period of
significant financial stress appropriate to the uncleared swaps to which the model applies, (iv)
at least 99% of price changes by product and by portfolio over at least a 10-day liquidation
time horizon must be covered, (v) the Covered Swaps Entity must monitor margin coverage
daily, and (vi) the Covered Swaps Entity must stress test at least monthly. An alternative
model may be used, which is created with reference to one used by a DCO for a similar asset
class.
Each Covered Swaps Entity must apply for approval from the CFTC for each model it
uses. The application must include an explanation of the manner in which the model meets
the regulatory requirements, the mechanics of the model, the theoretical basis of the model
and empirical support for the model, and any independent third party validation of the
model. The CFTC may approve or deny any such application.
(c) Variation Margin. For each uncleared swap between a Covered Swaps
Entity and an SD or MSP, each Covered Swaps Entity must require the counterparty to pay
variation margin calculated as provided in the CFTC proposed rules. Such payment shall start
on the business day after the swap is executed and continue on each business day until the
swap is liquidated. The CFTC proposed rules contain substantially similar variation margin
requirements (with a different calculation of margin) for uncleared swaps between a Covered
Swaps Entity and a financial entity.
Variation margin must be calculated using methodology that conforms to the
following standards: (i) the valuation of each swap must be determined consistent with CFTC
rules and (ii) the variation methodology must be stated with sufficient specificity to allow the
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counterparty, the CFTC and any applicable prudential regulator to calculate the margin
requirements independently. The CFTC may at any time require a Covered Swaps Entity to
modify its methodology to address potential vulnerabilities.
(d) Forms of Margin. If the counterparty is an SD, MSP or financial entity, the
Covered Swaps Entity shall post and accept only the following assets as initial margin: (i)
immediately available cash funds denominated in U.S. dollars or the currency in which
payment obligations under the swap are required to be settled, (ii) any obligation which is a
direct obligation of, or fully guaranteed as to principal and interest, by the U.S. or an agency
of the U.S., or (iii) any senior debt obligation of the Federal National Mortgage Association, the
Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal
Agricultural Mortgage Corporation, or any obligation that is an "insured obligation" of a Farm
Credit System bank, and only the following assets as variation margin: cash or U.S. Treasury
securities. If the counterparty is a non-financial entity, the Covered Swaps Entity shall post
and accept only the following assets as initial margin and variation margin: any asset for
which the value is reasonably ascertainable on a periodic basis in a manner agreed by the
parties in the credit support documentation.
Covered Swaps Entities are prohibited from collecting as initial or variation margin any
asset that is an obligation of the counterparty providing such asset.
Covered Swaps Entities must apply haircuts to any asset received as margin that
reflect the credit and liquidity characteristics of the asset. The CFTC’s proposed rules set forth
minimum haircuts that must be applied to assets received as margin if the counterparty is an
SD, MSP or financial entity.
The CFTC may, at any time, require a Covered Swaps Entity to replace a margin asset
posted to a counterparty with a different asset to address potential risks posed by the asset,
or to require a Covered Swaps Entity to require a counterparty that is an SD, MSP or financial
entity to do so. The CFTC may also require modification of haircuts to address potential risks
posed by the asset.
6. Proposed Rules Regarding Capital Requirements for Uncleared Swaps for
Swap Dealers and Major Swap Participants
The CFTC has proposed rules regarding capital requirements for SDs and MSPs, while
the SEC has not yet proposed rules regarding capital requirements for SDS SDs and SDS MSPs.
Each SD and MSP must meet or exceed the greatest of the following regulatory capital
requirements (there are modified requirements for SDs and MSPs that are subsidiaries of a
U.S. bank holding company):
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(a) tangible net equity 41 in an amount equal to $20 million plus the
amounts calculated for the swap dealer’s market risk exposure requirement and its OTC
derivatives credit risk requirement associated with swap positions and related hedge
positions that are part of the swap activities; or
(b) the amount of capital required by a registered futures association of
which the SD or MSP is a member.
Excluded from the CFTC’s capital requirements is any SD or MSP that is subject to
regulation by prudential regulators, designated by the Financial Stability Oversight Council as
a systemically important institution and subject to the supervision by the Federal Reserve
Board or a registered FCM.
VI.
MANDATORY TRADE EXECUTION REQUIREMENT; REGULATION OF SWAP EXECUTION
FACILITIES AND DESIGNATED CONTRACT MARKETS
The Dodd-Frank Act aimed to reduce risk, increase transparency and promote market
integrity within the financial system by, among other things (i) providing for registration and
comprehensive regulation of SDs and MSPs, (ii) imposing clearing and trade execution
requirements on standardized derivatives products, (iii) creating robust recordkeeping and
real-time reporting regimes and (iv) enhancing the CFTC’s rulemaking and enforcement
authorities with respect to registered entities and intermediaries.
1. Confirmation; Portfolio Reconciliation; Portfolio Compression; and
Trading Relationship Documentation
(a) Regulatory Overview. In commenting on the overall regulatory
approach to these rules, the CFTC rejected the notion that principle-based rules should apply,
insisting that the Dodd Frank Act mandated the CFTC to adopt rules that necessarily affect
SDs, MSPs and their counterparties. The CFTC agreed, however, that the rules would not be
applied retrospectively to swaps entered before the applicable compliance dates. The CFTC
also clarified that it is not the intent of the rules to provide a basis for a counterparty to void a
transaction.
(b) Swap Confirmation. The CFTC has finalized rules regarding swap
confirmations, while the SEC has proposed but not yet finalized rules on this topic.
The President’s Working Group on Financial Markets and the U.S. Government
Accountability Office have found that if new transactions are left unconfirmed, there is no
definitive record of the contract terms. Thus, in the event of a dispute, the terms of an
agreement must be reconstructed from other evidence, such as email trails or recorded trader
conversations. This process is cumbersome and may not be wholly accurate. Disputes may
41 "Tangible net equity" is determined under U.S. GAAP and excludes goodwill and other intangible assets. The
CFTC proposed rules regarding capital requirements for SDs and MSPs contain rules regarding calculating tangible
net equity.
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arise as to which parties are entitled to benefits and subject to burdens of any transaction,
and these circumstances create significant legal and operational risk for market participants.
Confirmation means the consummation of legally binding documentation (including
electronic documentation) that memorializes the agreement of the counterparties to all of
the terms of a swap transaction. Each SD and MSP will be required to execute a confirmation
(in the case of a swap with another SD or MSP) or send an acknowledgement of such swap (in
the case of a swap with a counterparty that is not an SD or MSP) as soon technologically
practicable, but in any event by the end of the first business day following the day of
execution. Each swap executed on an SEF or DCM will be deemed to satisfy these
requirements, provided that the rules of the SEF or DCM establish that confirmation of all
terms of the transaction will take place simultaneously with execution. Each swap submitted
for clearing by a DCO will be deemed to satisfy these requirements, provided that the swap is
submitted for clearing as soon as technologically practicable, but in any event no later than
the times established for confirmations above, and confirmation of all terms takes place
simultaneously with the acceptance of the swap for clearing. The CFTC confirmed that "longform
confirmations", made in the absence of an executed master agreement, would be
acceptable so long as the confirmation includes all terms of the trading relationship
documented in writing prior to or contemporaneously with the assumption of risk arising
from the swap transaction.
Each SD and MSP must establish, maintain and follow written policies and procedures
to ensure compliance with these requirements, which procedures must include that, upon a
request by a prospective counterparty prior to the execution of any swap, the SD or MSP
furnish a draft acknowledgment specifying all terms of the swap (other than the applicable
pricing and other relevant terms to be agreed at execution). SDs and MSPs must conduct
periodic audits sufficient to identify material weaknesses in their documentation policies and
procedures.
Each SD and MSP must make and retain a record of the date and time of transmission
or receipt of any acknowledgment or confirmation. All records must be made available
promptly upon request to the CFTC or any applicable prudential regulator.
The CFTC confirmation rules provide for phase-in compliance periods of up to three
years in which swap participants receive a limited degree of relief (up to seven business days
for some participants) from the one business day requirement.
The SEC’s proposed confirmation rules would require SBS SDs and SBS MSPs to
provide their counterparties a trade acknowledgment, to provide prompt verification of the
terms provided in a trade acknowledgement and to establish, maintain and enforce policies
and procedures that are reasonably designed to obtain prompt verification of the terms
provided in a trade acknowledgment.
(c) Portfolio Reconciliation. Portfolio reconciliation is a post-execution
processing and risk-management technique by which two parties to one or more swaps
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exchange the terms of all swaps in the swap portfolio between the counterparties, exchange
each counterparty’s valuation of each swap in the swap portfolio and resolve any discrepancy
in material terms and valuations. Portfolio reconciliation is designed to (i) identify and
resolve discrepancies between the counterparties regarding the terms of a swap (either
immediately after execution or during the life of the swap), (ii) ensure effective confirmation
of all terms of the swap, and (iii) identify and resolve discrepancies between the
counterparties regarding the valuation of the swap or the collateral held as margin. The CFTC
has finalized rules regarding portfolio reconciliation, while the SEC has not yet proposed rules
on this topic. The CFTC believes that for the swap market to operate efficiently and to reduce
systemic risk, portfolio reconciliation should be a proactive process that delivers a
consolidated view of counterparty exposure at the transaction level.
Each SD and MSP must agree in writing with each of its counterparties on the terms of
portfolio reconciliation. The portfolio reconciliation may be performed on a bilateral basis by
the counterparties or by a qualified third party. With regard to transactions between SDs and
MSPs, portfolio reconciliation must be performed no less frequently than (i) once each
business day for each swap portfolio that includes 500 or more swaps, (ii) once each week for
each swap portfolio that includes more than 50 but fewer than 500 swaps at any time during
the calendar quarter, and (iii) once each calendar quarter for each swap portfolio that includes
less than 50 swaps at any time during the calendar quarter. The requirements for swaps
between an SD or MSP and a non-SD/MSP are different; a portfolio reconciliation must be
performed no less frequently than (i) once each calendar quarter for each swap portfolio that
includes more than 100 swaps at any time during the calendar quarter and (ii) once annually
for each swap portfolio that includes less than 100 swaps at any time during the calendar
year.
Any discrepancy in a material term must be resolved immediately. Each SD and MSP
must establish, maintain and follow policies and procedures reasonably designed to resolve
any discrepancy in valuation as soon as possible, but in any event within 5 business days. A
less than 10% valuation difference need not be deemed a discrepancy.
SDs and MSPs will be required to promptly notify the CFTC or any other prudential
regulator of any swap valuation dispute in excess of $20 million (or its equivalent in any
currency) that is not resolved within 3 business days (if the dispute is with a counterparty that
is an SD or MSP) or 5 business days (if the dispute is with a counterparty that is not an SD or
MSP).
DCO.
The above portfolio reconciliation requirements do not apply to swaps cleared by a
(d) Portfolio Compression. The Dodd-Frank Act tasked the CFTC with
implementing regulations for the timely and accurate processing and netting of all swaps
entered into by SDs and MSPs. Portfolio compression is a post-trade processing and netting
mechanism whereby substantially similar transactions among two or more counterparties are
terminated and replaced with a smaller number of transactions where combined notional
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value is less than the combined notional value of the terminated swaps. Portfolio
compression requirements have been adopted in an effort to reduce the risk, cost and
inefficiency of maintaining unnecessary transactions on the counterparties’ books. The use of
portfolio compression as a risk management tool has been widely acknowledged. The
President’s Working Group on Financial Policy identified frequent portfolio compression of
outstanding trades a key policy objective in the effort to strengthen OTC derivatives market
infrastructure. The CFTC has finalized rules regarding portfolio compression, while the SEC
has not yet proposed rules on this topic.
Each SD and MSP must establish, maintain and follow written policies and procedures
pertaining to counterparties that are also SDs and MSPs (i) for terminating each fully
offsetting swap in a timely fashion, when appropriate, and (ii) for periodically engaging in
bilateral and multilateral portfolio compression exercises, when appropriate; and pertaining
to non-SD/MSP counterparties, (y) for periodically terminating fully offsetting swaps and (z)
for engaging in portfolio compression exercises to the extent requested by any counterparty.
Each SD and MSP must maintain complete and accurate records of each bilateral offset and
each bilateral or multilateral portfolio compression exercise in which it participates, and such
records must be available upon request to the CFTC and other prudential regulators.
The portfolio compression requirements do not apply to any swap that is cleared with
a DCO.
(e) Trading Relationship Documentation. The Dodd-Frank Act tasked the
CFTC with enacting regulations relating to the trading relationship documentation that SDs
and MSPs must enter into with their counterparties in order to establish a swap trading
relationship and document the swap transactions that occur pursuant to that relationship.
Accordingly, the CFTC has enacted rules on this topic (the SEC has not yet proposed rules on
this topic). In addition to swap confirmations, the trading relationship documentation shall
be executed prior to or contemporaneously with a swap transaction.
As explained in the preamble to the CFTC’s proposal regarding trade documentation
rules, the OTC derivatives markets traditionally have been characterized by privately
negotiated transactions entered into by two counterparties, in which each party assumes and
manages the credit risk of the other. Because a relatively small number of dealers are the
most significantly active participants in the derivatives market, the default of such a dealer
may result in significant losses for the counterparties of that dealer, either from the
counterparty exposure to the defaulting dealer or from the cost of replacing the defaulted
trades in times of market stress. One important method of addressing the credit risk that
arises from OTC derivatives transactions is the use of bilateral close-out netting. Following
the occurrence of a default by one of the counterparties (such as bankruptcy or insolvency),
the exposures from individual transactions between the two parties are netted and
consolidated into a single net "lump sum" obligation. That exposure then may be offset by
the available collateral previously provided. Therefore, it is important that netting provisions
are legally enforceable and collateral may be used to meet the netting exposure. There is also
a risk that inadequate documentation of open swap transactions could result in collateral and
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legal disputes, thereby exposing counterparties to significant counterparty risk. In addition,
according to the regulators, increasing standardization of swap documentation should
improve the market in a number of ways, including: facilitating automated processing of
transactions; increasing the fungibility of the contracts; improving valuation and risk
management; increasing the reliability of price information; reducing the number of
problems in matching trades; and facilitating reporting of data to SDRs. Product and process
standardization are also key conditions for increased automation and central clearing of OTC
derivatives.
OTC derivatives market participants typically use industry standard documentation,
such as the ISDA Master Agreement. In large part, the CFTC’s rules reflect existing trading
relationship documentation between counterparties, such as the widely-used ISDA Master
Agreement, but do contain additional documentation requirements.
Each SD and MSP must establish, maintain and follow written policies and procedures
reasonably designed to ensure that the SD or MSP executes written swap trading relationship
documentation with its counterparty that complies with the CFTC’s requirements
summarized below. These policies and procedures must be approved in writing by senior
management of the SD or MSP.
The trading relationship documentation must be in writing and must include:
(i) all terms governing the trading relationship, including terms
addressing payment obligations, netting of payments, events of default or other termination
events, calculation and netting of obligations upon termination, transfer of rights and
obligations, governing law, valuation and dispute resolution;
(ii) credit support arrangements, including initial and variation
margin requirements, the types of assets that may be used as margin and asset valuation
haircuts, investment and rehypothecation terms for assets used as margin for uncleared
swaps, if any, and custodial arrangements for margin assets;
(iii) the process for determining the value of each swap at the time
of execution to termination, maturity or expiration of such swap;
(iv) a provision that confirms both parties’ understanding of how the
new orderly liquidation authority under Title II of the Dodd-Frank Act and the Federal Deposit
Insurance Act may affect their portfolios of uncleared, bilateral swaps; and
(v) notice that (i) upon acceptance of a swap by a DCO, the original
swap is extinguished and replaced by equal and opposite swaps with the DCO and (ii) all
terms of the swap must confirm to the product specifications established by the DCO.
The trading relationship documentation policies and procedures of each SD and MSP
must be periodically audited by an independent internal or external auditor to identify any
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material weakness. A record of each audit must be retained and must be available upon
request to the CFTC and other applicable prudential regulators.
The trading relationship documentation requirements do not apply to swaps executed
prior to October 15, 2012. The trade documentation requirements also do not apply to any
swap that is traded on a DCM or executed on an SEF, if such swap is also cleared with a DCO
and all terms of the swap conform to the rules of the DCO for futures and option contracts.
2. Proposed Rules Regarding Position Limits
The Dodd-Frank Act tasked the CFTC with establishing position limits (that is,
thresholds that restrict the number of speculative positions that a person may hold) for
exempt commodities 42 and for agricultural commodities traded on a DCM, as well as swaps
that are economically equivalent to such futures or options traded on a DCM. In addition, the
CFTC was tasked with establishing aggregate position limits for contracts based on the same
underlying commodity that include, in addition to futures and options contracts (i) contracts
listed by DCMs, (ii) swaps that are not traded on a registered entity but which are determined
to perform or affect a "significant price discovery function", and (iii) foreign board of trade
("FBOT") contracts that are price-linked to a DCM or SEF contract and made available for
trading on the FBOT by direct access from within the U.S. The CFTC has issued final rules
regarding position limits (the "Position Limits Rules").
(a) Position Limits. The Position Limits Rules set limits for net speculative
positions (long or short) that a trader may hold (even on an intraday basis) of (i) 28 specified
physical commodity futures contracts (the "Core Referenced Futures Contracts"), (ii) options
on those futures contracts, and (iii) economically equivalent 43 swaps (collectively, the
"Referenced Contracts"). The CFTC has selected those 28 futures contracts as Core Referenced
Futures Contracts because they are have high levels of open interest and significant notional
value or serve as a reference price for a significant number of cash market transactions. 44 The
42 A commodity is a product, which is of uniform quality and traded across various markets. There are generally
two types of commodities, ‘hard commodities’ and ‘soft commodities’. Hard commodities include crude oil, iron
ore, gold, and silver and have a long shelf life. Agricultural products such as soybean, rice or wheat, are considered
‘soft commodities’ since they have a limited shelf life. These commodities have to be similar and interchangeable
or ‘fungible’.
43 A swap will be deemed "economically equivalent" if it is (i) a "look‐alike" contract (i.e., it settles off of the Core
Referenced Futures Contract or contracts that are based on the same commodity for the same delivery location as
the Core Referenced Futures Contract), (ii) a contract with a reference price based on only the combination of at
least one Referenced Contract price and one or more prices in the same or substantially the same commodity as
that underlying the relevant Core Referenced Futures Contract, provided that such a contract is not a locational
basis swap, (iii) an intercommodity spread contract with two reference price components, one or both of which
are based on Referenced Contracts, or (iv) priced at a fixed differential to a Core Referenced Futures Contract.
44 The commodities subject to the position limits rules include: (i) nine agricultural legacy products with existing
limits (corn, cotton, oats, soybeans, soybean meal, soybean oil) and three wheat contracts that are traded in
Chicago, Kansas City and Minneapolis; (ii) ten additional agricultural products (milk, feeder cattle, live cattle, lean
hogs, rough rice, cocoa, coffee, frozen concentrate orange juice and two sugar contracts); (iii) four energy products
(crude oil, gasoline, heating oil, and Henry Hub natural gas; and (iv) five metals (copper, gold, silver, palladium and
platinum). Excluded from the definition of "Referenced Contracts" are (i) basis contracts (i.e., contracts based on
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Position Limits Rules also mandate that DCMs and SEFs set position limits for agricultural
commodity contracts and permit the establishment of position limits for excluded
commodities.
(b) Spot-Month Position Limits and Non- Spot-Month Position Limits.
Speculative position limits will apply in two types: (i) spot-month position limits and (ii) nonspot
month position limits. Traders will be required to comply with both types of limits on an
intra-day basis.
Spot-month limits apply in the last days of trading immediately preceding the delivery
period. The length of this trading period (or "spot month") varies depending on the contract.
Spot-month limits for physically-delivered and cash-settled contracts will be based on 25% of
estimated deliverable supply for a Core Referenced Futures Contract in the same commodity.
This is consistent with long-standing practices of DCMs. The CFTC has set initial spot-month
limits for physically-delivered Core Referenced Futures Contracts at the same levels as are
now set by the DCMs with cash-settled Referenced Contracts subject to equivalent limits.
These initial spot-month limits will go into effect on December 11, 2012. The initial spotmonth
limits rules for cash-settled contracts have been adopted on an interim basis in order
for the CFTC to solicit additional comments on the appropriate level of spot-month limits for
cash-settled contracts. Spot-month limits will be updated annually for agricultural contracts
and every 2 years for energy and metals contracts, based on the estimates of deliverable
supply that DCMs will be required to submit on specific staggered dates for each Core
Referenced Futures Contract.
Non-spot-month position limits apply to positions held by an individual market
participant in all contract months combined or in a single contract month and will generally
be set at 10% of open interest in the first 25,000 contracts and 2.5% of the open interest
thereafter. 45 This is consistent with the CFTC’s historical approach to setting non-spot-month
speculative position limits for certain agricultural commodity futures and options. The CFTC
expects that the formula will yield limits capable of preventing a speculative trader from
acquiring excessively large positions while ensuring sufficient liquidity for bona fide hedgers
and avoiding disruption to the price discovery process. The CFTC did not adopt separate
limits for different classes of transactions (i.e., swaps, futures, options on futures), so
compliance with non-spot month position limits will be determined using a trader’s net
speculative position with respect to a particular commodity across its aggregate positions in
Core Referenced Futures Contracts and economically equivalent options on futures and
swaps.
the difference in the price of a commodity (or substantially the same commodity) at different delivery locations)
and (ii) commodity index contracts, which are indexes comprised of prices of commodities that are not the same or
substantially the same. This means that diversified commodity index positions are not subject to the position
limits, but single commodity index contracts are subject to the position limits.
45 The Position Limit Rules establish a different approach for setting non‐spot‐month limits in "legacy" agricultural
Referenced Contracts that are currently subject to CFTC limits.
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The initial non-spot-month limits (single-month and all-months-combined) will be
imposed within 1 month of the CFTC’s receipt of 1 year of swaps open interest data under the
CFTC’s new swaps large trader reporting rules (which went into effect on November 21, 2011).
The non-spot-month limits will be adjusted every 2 years by applying the 10/2.5% formula to
the higher of (i) the average open interest level in the most recent calendar year (ii) the
average open interest level in the most recent 2 calendar years.
(c) Netting. For purposes of determining compliance with the spot-month
class limits, traders are permitted to net within each class of contract, but may not net across
physical-delivery and cash-settled contracts. For example, if the spot-month-limit (applying
separately to physically-delivered and cash-settled contracts) is 100 contracts and a trader
holds 50 long cash-settled contracts, 100 short cash-settled contracts and 100 long
physically-delivered contracts, then the trader could net the long and short cash-settled
contracts.
For purposes of determining compliance with the non-spot-month class limits, market
participants will be permitted to net futures/options positions against economically
equivalent swaps.
(d) Exemption from Position Limits for "Bona Fide Hedges". Contracts that are
"bona fide hedges" are exempt from the position limits, provided that a trader files notice
with the CFTC to claim the exemption. The CFTC has narrowed the definition of bona fide
hedging for purposes of the Position Limits Rules. Bona fide hedging is limited to positions (i)
that represent a substitute for transactions made or to be made or positions taken or to be
taken at a later time in a physical marketing channel, (ii) that are economically appropriate to
the reduction of risks in the conduct and management of a commercial enterprise and (iii)
that arise from a potential change in value in assets, liabilities or services, or (iv) reduce risk
attendant to a position resulting from a swap executed opposite a counterparty for which the
transaction qualifies as a bona fide hedging transaction under the preceding criteria. These
bona fide hedging rules are limited to enumerated hedging transactions and positions set
forth in the rule.
The CFTC’s pre-existing and broader definition of bona fide hedging in Regulation
1.3(z) will continue to apply only to excluded commodities.
(e) Exemption for Preexisting Positions. The Positions Limits Rules provide a
limited exemption from compliance with non-spot-month limits (but not spot-month for
preexisting positions that are in excess of the established limits, provided that they were
established in good faith prior to January 17, 2012 (the effective date of the Positions Limits
Rules). A trader would not be allowed to enter into new, additional contracts in the same
direction, but could enter into offsetting positions and thus reduce its net position. The
Positions Limits Rules also permit SDs to continue to rely on the regulatory exemption (now
repealed) for open swaps, so that SDs may continue to manage the risk of their swap portfolio
that exists at the time of implementation of the new position limits. New swaps would need
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to comply with the new requirements for the bona fide hedging exemption in order to be
excluded from the determination of the SD’s position.
(f) Aggregation of Positions. The speculative position limits apply to a
single trader and to a group of affiliated traders. If two or more traders are acting pursuant to
an express or implied agreement or understanding then the positions held by such traders
will be treated the same as if held by a single trader. Each trader will be required to aggregate
all positions in accounts for which the trader (i) directly or indirectly holds an ownership or
equity interest of 10% or greater, (ii) controls trading, by power of attorney or otherwise, or
(iii) has any interest and such accounts use identical trading strategies to those other owned
or controlled accounts.
(i) Commodity Pools. Position limits related to interests in
commodity pools are exempt from the aggregation requirement. This means that, except for
a pool’s commodity pool operator, a participant in a commodity pool need not aggregate the
commodity pool’s positions with the participant’s own positions held outside the pool, as
long as the participant does not control the commodity pool’s trading decisions and the
participant and the pool do not use identical trading strategies. This also applies for a trader
who is a principal or affiliate of a pool’s commodity pool operator, so long as the trader does
not control or supervise the commodity pool’s trading and the commodity pool operator has
proper informational barriers between the commodity pool’s trading and the trader.
However, participants with a 25% interest in a commodity pool operated by the exempt
commodity pool operator must aggregate the pool accounts or positions.
(ii) Independent Account Controllers. An "eligible entity" (which
includes mutual funds, banks, commodity pool operators, commodity trading advisors and
insurance companies or affiliates of the foregoing) is not required to aggregate with its
proprietary positions those client positions that are managed by an independent account
controller ("IAC"), provided that the eligible entity has "minimum control" over the trading
and the IAC must: (i) trade independently 46 of the eligible entity and of any other IAC trading
for the eligible entity, (ii) have no knowledge of the trading decisions by any other IAC, and
(iii) be registered as a futures commission merchant, introducing broker, commodity trading
advisor, or as an associated person of any of the foregoing, or be a general partner of a
commodity pool whose operator is exempt from commodity pool operator exemption.
However, the positions of all IACs must be aggregated during the spot month in a physicaldelivery
Referenced Contract. If the IAC is an affiliate of the eligible entity, additional
requirements apply, including blocking procedures and independent trading systems.
46 In determining whether an IAC "trades independently", the CFTC will consider the degree to which there is a
functional separation (i) between the proprietary trading desk of the eligible entity and the IAC’s trading
operations and (ii) between the research functions supporting an eligible entity’s proprietary trading desk and
those supporting the IAC’s trading decisions. Additional requirements apply if the IAC is affiliated with the eligible
entity or another IAC.
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The IAC itself must aggregate, like every other trader, all of the speculative positions in
accounts in which it owns at least 10%, for which it controls trading, or in which it has any
interest and which uses identical trading strategies.
(iii) Affiliates. Generally, a trader will be required to aggregate all
accounts in which it directly or indirectly has a 10% or greater ownership or equity interest.
Two exceptions apply: a trader will not be required to so aggregate accounts if (i) such 10%
threshold is associated with underwriting securities or (ii) aggregation across commonlyowned
affiliates (above the 10% ownership threshold) would require sharing position
information that could result in the violation of federal law (use of this exemption requires
notice to the CFTC and an opinion of counsel). However, if a trader has actual knowledge of
the positions of an affiliate, the trader will be required to aggregate all such positions. This
implies that a trader relying on this provision must maintain information barriers between
itself and its affiliates.
(iv) Proposed Exemption From Aggregation Requirement. After
enacting the Position Limits Rules, the CFTC proposed revisions to the aggregation
requirement. Specifically, the proposed rules would provide an exemption from the
aggregation requirement to a person with an ownership or equity interest in an owned entity
of at least 10% but not greater than 50%, provided that an appropriate firewall exists between
the entities, including the following: (i) each must trade pursuant to separately developed,
independent trading systems, (ii) each must maintain risk management systems that do not
allow it to share trades or trading strategies with the other, (iii) neither may have knowledge
of the other’s trading decisions, (iv) each must have in place and enforce written policies and
procedures to preclude having knowledge of, gaining access to, or receiving data about the
other’s trades, (v) the person and the owned entity may not share employees that control the
trading decisions of either the person or the owned entity, (vi) the person’s ownership or
equity interests in the owned entity may not exceed 50%, and (vii) the person must make a
prior notice filing with the CFTC.
(g) Foreign Boards of Trade. The Position Limits Rules apply to a trader’s
positions in referenced contracts executed on, or pursuant to the rules of, an FBOT, if: (i) the
contract, agreement, or transaction must settle against the price of a contract executed or
cleared pursuant to the rules of a U.S. commodities exchange, and (ii) the FBOT makes such
linked contracts available to its members or other participants located in the U.S. by direct
access to its electronic trading and order matching system.
(h) Position Limits Set by Registered Entities. The Position Limits Rules require
each commodity exchange (an SEF or DCM) in the U.S. to establish hard position limits for
Referenced Contracts that are no higher than those set by the Position Limits Rules. For non-
Referenced Contracts (which would include interest rate spas and other swaps unrelated to
Referenced Contracts), exchanges may adopt the CFTC’s general formula for establishing
position limits. As an alternative to such limits, an exchange has discretion to establish
accountability levels.
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3. Registration of Foreign Boards of Trade
An FBOT, as defined in the CFTC’s rules, is any foreign board of trade, exchange or
market located outside the U.S., its territories or possessions, whether incorporated or not
incorporated. Under the CFTC’s rules, it will be unlawful for an FBOT to provide to U.S.
persons direct access to its electronic trading and order matching system unless and it is
registered with the CFTC. Only eligible 47 FBOTs may be registered.
Once an FBOT is registered with the CFTC, its members and other participants will be
able to enter trades directly into the trading and order matching system of the FBOT, to the
extent that such members or other participants are (i) entering orders for the member’s or
other participant’s proprietary accounts, (ii) registered with the CFTC as FCMs and are
submitting customer orders to the trading system for execution, or (iii) registered with the
CFTC as commodity pool operators or commodity trader advisers (or are exempt from such
registration) and are submitting orders for execution on behalf of a U.S. pool that the member
or participant operates, or an account of a U.S. customer for which the member or participant
has discretionary authority, provided that an FCM (or a firm exempt from registration as an
FCM) acts as clearing firm and guarantees, without limitation, all such trades of the
commodity pool operators or commodity trader advisers effected through submission of
orders to the trading system.
In order to continue to be registered with the CFTC, an FBOT must comply with the
U.S. regulatory requirements and international standards.
The rule regarding FBOT registration became effective on February 11, 2012. Any
FBOT that was operating under existing no-action relief as of the effective date of these rules
must now register with the CFTC in order to continue to provide direct access to its electronic
trading and order matching system.
4. Proposed Rules Regarding Core Principles for SEFs and SBS SEFs
The Dodd-Frank Act provides that no person may operate a facility for the trading or
processing of swaps, unless the facility is registered as a SEF/SBS SEF or a DCM/securities
exchange. In order to be registered and maintain registration, (x) an SEF must comply with
core principles (and any additional requirements imposed by the CFTC) and (y) an SBS SEF
must comply with core principles (and any additional requirements imposed by the SEC).
47 An FBOT is eligible for registration with the CFTC if (i) the FBOT and its clearing organization (where applicable)
satisfy certain requirements (or alternatively, the clearing organization is a registered DCO), (ii) the FBOT possesses
the attributes of an established, organized exchange, (ii) the FBOT adheres to appropriate rules prohibiting abusive
practices, (iii) the FBOT enforces appropriate rules to maintain market and financial integrity, (iv) the FBOT has
been authorized by a regulatory process that examines customer and market protections, and (v) the FBOT is
subject to continued oversight by a regulator that has power to intervene in the market and the authority to share
information with the CFTC.
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The CFTC and SEC issued proposed rules regarding core principles for SEFs and SBS
SEFs, respectively, which seek to clarify which entities may qualify as SEFs and also to codify
and clarify the core principles established by the Dodd-Frank Act.
The CFTC’s proposed rules regarding SEFs (the "CFTC Proposed SEF Rules") apply to
every SEF that is registered, has been registered or is applying to be registered with the CFTC.
The CFTC Proposed SEF Rules provide that a transaction entered into or pursuant to the rules
of a registered SEF will not be void, voidable, subject to rescission or otherwise invalidated or
rendered unenforceable if the SEF violates these rules or if any CFTC proceeding requires the
SEF to alter, supplement or adopt a specific term or condition.
(a) Prohibited Use of Data Collected. Under the CFTC Proposed SEF Rules, an
SEF will be prohibited from using for business or marketing purposes any proprietary data or
personal information it collects or receives, from or on behalf of any person, for the purposes
of fulfilling its regulatory obligations, provided however that an SEF, where necessary, may
share such information with one or more SEFs or DCMs registered with the CFTC, for
regulatory purposes.
(b) Boards of Trade Operating Both a DCM and an SEF. Under the CFTC
Proposed SEF Rules, a board of trade that operates a DCM and intends to also operate an SEF
must separately register the SEF with the CFTC and comply with the core principles for SEFs.
If such board of trade uses the same electronic trade execution system for executing and
trading swaps that uses for executed and trading swaps on the DCM, it must clearly identify
to market participants for each swap whether the execution or trading of such swap is taking
place on the DCM or on the SEF.
(c) Permitted Methods of Execution. Under the CFTC Proposed SEF Rules, an
applicant seeking registration as an SEF must, at a minimum, offer trading services for
required transactions (those that are required to be executed and are made available for
trading, and are not block trades) with the ability to post both firm and indicative quotes on a
centralized electronic system accessible to all market participants who have access to the SEF.
SEFs must require that traders who have the ability to execute against a customer’s
order or to execute 2 customers against each other be subject to a 15 second timing delay
between the entry of those two orders, such that one side of the potential transaction is
disclosed and made available to the other market participant before the second side of the
potential transaction is submitted for execution.
Transactions that are block trades, are not swaps subject to mandatory clearing and
execution requirements or are illiquid or bespoke may be executed in accordance with
methods prescribed by the CFTC in the proposed rules or any other system for trading
permitted by the CFTC.
(d) Swaps Available for Trading. Under the CFTC Proposed SEF Rules, an SEF
must conduct an annual review of whether it has made a swap product available for trading.
When conducting reviews, the SEF may consider the frequency of transactions in this or
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similar swaps, the open interest in this or similar swaps, and any other factors requested by
the CFTC. If at least one SEF has made the same or an economically equivalent swap available
for trading, all SEFs will be required to treat the swap as made available for trading.
(e) Identification of Non-Cleared Swaps or Swaps Not Made Available to Trade.
Under the CFTC Proposed SEF Rules, an SEF may allow the execution and trading of swaps
that are not subject to the mandatory clearing requirement or swaps that have not been
made available for trading. If the SEF chooses to offer to facilitate bilateral trading of such
swaps, it must clearly identify to market participants that the particular swap is to be
executed bilaterally between the parties pursuant to one of the applicable exemptions from
execution and clearing.
(f) Core Principles. For purposes of convenience, the core principles set
forth in the CFTC Proposed SEF Rules are summarized below and, unless indicated otherwise,
the SEC’s proposed rules regarding core principles for SBS SEFs are substantially similar.
To maintain registration with the CFTC, an SEF must comply with all core principles
summarized below and all other regulatory requirements:
(i) Compliance with Rules. Each SEF must (i) establish and enforce
compliance with any rule of the SEF, (ii) establish and enforce trading, trade processing, and
participation rules that will deter abuses and have the capacity to detect, investigate and
enforce those rules, (iii) establish rules governing the operation of the facility, including rules
specifying trading procedures to be followed by members and market participants when
entering and executing orders traded or posed on the SEF (including block trades), (iv)
establish procedures to capture and retain information that may be used in establishing
whether rule violations have occurred, and (v) provide any eligible contract participant (ECP)
and any independent software vendor with impartial access to its market(s) and market
services (including any indicative quote screens or any similar pricing data displays).
(ii) SEF May Permit Trading Only in Swaps That Are Not Susceptible
to Manipulation. In order to demonstrate compliance with this requirement, an SEF must
submit new swap contracts in advance to the CFTC either by requesting prior approval or selfcertification
for the new product submission.
(iii) Monitoring of Trading and Trade Processing. Each SEF must (i)
establish and enforce rules or terms and conditions defining or specifications detailing
trading procedures and procedures for trade processing of swaps, (ii) monitor trading in
swaps to prevent manipulation, price distortion, and disruptions of the delivery or cash
settlement process through surveillance, compliance and disciplinary practices and
procedures and (iii) establish and maintain risk control mechanisms to reduce the potential
risk of market disruptions.
(iv) Ability to Obtain Information. Each SEF must establish and
enforce rules that will allow it to obtain any necessary information to perform any of its
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equisite functions, and must provide such information upon request by the CFTC to the CFTC
or for international information-sharing.
(v) Position Limits or Accountability. Each SEF that is a trading
facility must adopt for each of its contracts, as is necessary or appropriate, speculative
position limitations or position accountability standards for speculation.
(vi) Financial Integrity of Transactions - each SEF must establish and
enforce rules and procedures for ensuring the financial integrity of swaps entered on or
through the facilities of the SEF, including the clearance and settlement of the swap, by (i)
establishing and monitoring compliance with minimum financial standards for its members
(which, at a minimum, require members to qualify as ECPs), (ii) for cleared transactions,
ensuring the SEF has the capacity to route transactions to the DCO in a manner acceptable to
the DCO for purposes of ongoing risk management, and (iii) for uncleared transactions,
requiring members to demonstrate that they have entered into credit arrangement
documentation for the transaction, have ability to exchange collateral and meet any credit
filters that may be adopted by the SEF.
(vii) Emergency Authority. Each SEF must adopt rules to provide for
the exercise of emergency authority, in consultation and cooperation with the CFTC, as
necessary and appropriate, including the authority to liquidate or transfer open positions in
any swap or to suspend or curtail trading in a swap.
(viii) Timely Publication of Trading Information. Each SEF must make
public timely information on price, trading volume, and other trading data on swaps to the
extent prescribed by the CFTC.
(ix) Recordkeeping and Reporting - each SEF is required to maintain
records of all activities relating to the business of the facility for a period of 5 years and to
report such information to the CFTC; the CFTC will adopt further data collection and reporting
requirements for SEFs, which will be comparable to those imposed on DCOs and SDRs.
(x) Antitrust Considerations. Unless necessary and appropriate to
achieve the purposes of the CEA, SEFs are prohibited from adopting any rules or taking any
actions that result in any unreasonable restraint on trade or impose any material
anticompetitive burden on trading or clearing;
(xi) Conflicts of Interest. Each SEF must establish and enforce rules
to minimize conflicts of interest in its decision-making process and establish a process for
resolving conflicts of interest.
(xii) Financial Resources. Each SEF is required to have adequate
financial, operational and managerial resources to discharge its responsibilities; the financial
resources of an SEF will be considered adequate if (i) their value exceeds the total amount
that would enable the SEF to cover its operating costs for a 1 year period, as calculated on a
rolling basis and (ii) the financial resources include unencumbered, liquid financial assets (i.e.,
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cash and highly liquid securities) equal to at least 6 months’ operating costs; SEFs will be
required to provide quarterly reports to the CFTC regarding their financial resources.
(xiii) System Safeguards. Each SEF is required to establish and
maintain (i) a program of risk analysis and oversight to identify and minimize sources of
operational risk through the development of appropriate controls and procedures and the
development of automated systems that are reliable, secure and have adequate scalable
capacity, and (ii) emergency procedures, backup facilities and a plan for disaster recovery that
allow for the timely recovery and resumption of operations and the fulfillment of the SEF’s
responsibilities and obligations; the SEF must conduct periodic tests to verify that backup
resources are sufficient.
(xiv) Designation of chief compliance officer - each SEF must
designate a chief compliance officer who will review compliance with the core principles and
will report directly to the board or senior officer of the facility.
SEFs will be permitted to contract with a registered futures association or another
registered entity for the provision of services to assist it in complying with the core principles,
however the SEF will at all times remain responsible for its compliance. The SEF must ensure
that its service provider has the capacity and resources necessary to provide timely and
effective regulatory services and will have a duty to supervise the service provider.
5. Proposed Rules Regarding Core Principles for DCMs
The Dodd-Frank Act amended the CEA to revise the existing core principles applicable
to DCMs and to add five additional core principles for DCMs (making a total of 23 core
principles). The CFTC has issued final rules regarding core principles for DCMs.
Each board of trade seeking designation as a DCM must apply with the CFTC. Each
applicant must either submit for approval to the CFTC all of its operational rules and the
terms and conditions of futures, swaps and option products listed for trading on the facility,
or otherwise submit to the CFTC a certification that all of its rules comply with the CEA and
CFTC regulations.
(a) Information Relating to Contract Market Compliance. Upon request by
the CFTC, a DCM must file with the CFTC (i) information related to its business as a DCM,
including information relating to data entry and trade details and (ii) a written demonstration,
containing supporting data, information and documents, that the DCM is in compliance with
the core principles. Each DCM must report to the CFTC the transfer of 10% or more of the
equity in such DCM.
(b) Prohibited Use of Data Collected. A DCM is prohibited from using for
business or marketing purposes any proprietary data or personal information it collects or
receives, from or on behalf of any person, for the purpose of fulfilling its regulatory
obligations; provided however, that a DCM may use such data and information for business or
marketing purposes if the person from whom it collects or receives such data or information
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clearly consents to such use. A DCM may not condition access to its trading facility on a
market participant’s consent to the use of proprietary data or personal information for
business or marketing purposes. In addition, a DCM may, where necessary for regulatory
purposes, share such data or information with other DCMs or SEFs registered with the CFTC.
(c) Listing of Swaps on a DCM. When a DCM lists for the first time a swap
contract for trading, it must either prior to or at the time of such listing, detail in writing to the
CFTC written how the DCM is addressing its self-regulatory obligations and is fulfilling its
statutory and regulatory obligations with respect to the swap transaction.
(d) Core Principles. The core principles applicable to DCMs are substantially
similar to the core principles proposed for SEFs, as summarized above.
(e) Compliance Date. DCMs must comply with the CFTC’s core principles
rules by October 17, 2012 (other than the core principle requiring open access, which has a
different compliance date).
VII.
CROSS-BORDER APPLICATION OF SWAPS RULES
1. Cross-Border Framework
The CFTC has proposed interpretative guidance and a policy statement regarding the
extraterritorial reach of the swaps provisions of the Dodd-Frank Act and swaps regulations
promulgated by the CFTC (the "Proposed Cross-Border Guidance"), while the SEC has not yet
done so. The Dodd-Frank Act stated that its provisions will not apply to activities outside the
U.S. unless (i) those activities have a direct and significant connection with activities in, or
effect on, commerce in the U.S. or (ii) contravene such rules or regulations as the CFTC may
prescribe or promulgate as are necessary or appropriate to prevent the evasion of any
provision of Dodd-Frank. Under the Proposed Cross-Border Guidance, transactions covered
by U.S. regulations would include those involving U.S. persons, as well as other that may have
U.S. connections.
A "U.S. person" is defined broadly by the Proposed Cross-Border Guidance, and would
include:
(a)
any natural person who is a U.S. resident;
(b) any corporation, partnership or other entity either (i) that is organized
or incorporated under the laws of the U.S. or a state thereof or having its principal place of
business in the U.S. or (ii) in which the direct or indirect owners are responsible for the
liabilities of such entity and one or more of such owners is a U.S. person;
(c)
is a U.S. person;
any individual account (discretionary or not) where the beneficial owner
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(d) (i) any commodity pool or collective investment vehicle (regardless of
where it is organized) of which a majority ownership is held, directly or indirectly, by a U.S.
person or persons and (ii) any commodity pool the operator of which would be required to
register as a commodity pool operator under the CEA;
(e) any pension plan for employees, officers or principles of a legal entity
with its principal place of business in the U.S.; and
(f)
regardless of source.
an estate or trust, the income of which is subject to U.S. income tax
2. Registration and Regulation of Non-U.S. SDs and MSPs
In order to determine whether a non-U.S. entity must register as an SD because it
exceeds the de minimis threshold of swap dealing transactions, (i) it would only need to
count swap dealing activity with U.S. persons and swaps guaranteed by U.S. persons and (ii)
would only be required to aggregate transactions of its non-U.S. affiliates with U.S. persons.
In order to determine whether a non-U.S. entity must register as an MSP, only swaps with U.S.
persons would count toward the relevant thresholds (not swaps guaranteed by U.S. persons).
Non-U.S. persons which fall into these categories and that exceed the de minimis thresholds
for SDs or the position thresholds for MSPs would be required to register with the CFTC and
would be subject to the CEA and CFTC regulations, though the Proposed Cross-Border
Guidance would provide limited relief from some of the requirements under those
regulations.
"Transaction-level requirements", including mandatory clearing and swap processing,
margin for uncleared swaps, trade execution requirements, trading relationship
documentation portfolio reconciliation and compression, real-time public reporting, trade
confirmation, daily trading records and business conduct rules, would apply to all
transactions between registered non-U.S. SDs or MSPs and U.S. persons. All transaction-level
requirements, other than business conduct rules, would also apply to transactions with
certain non-U.S. persons (e.g., those that are guaranteed by a U.S. person or if the non-U.S.
person acting as a conduit for a U.S. person); however, for a non-U.S. person is acting as a
conduit for a U.S. person, substituted compliance with comparable home country rules may
be permitted so long as such home country rules are comparable with relevant U.S.
regulations. This means that the transaction-level requirements would not apply to
transactions between a registered non-U.S. SD or MSP and other non-U.S. persons without a
U.S. connection.
"Entity-level requirements", including capital requirements, appointment of a chief
compliance officer, risk management, and swap data recordkeeping and reporting, would
apply to all registered non-U.S. SDs and MSPs; however such entities may be able to rely on
substituted compliance with home country requirements so long as such requirements are
comparable with relevant U.S. regulations.
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3. Regulation of Other Non-U.S. Market Participants
Various regulatory requirements apply to non-SD/MSP market participants, including
clearing, trade-execution, and public and SDR reporting and record-keeping requirements.
Under the Proposed Cross-Border Guidance, such requirements would apply to any swap
where at least one of the parties is a U.S. person, regardless of the location or subject of the
transaction or the activities of the parties in connection with the transaction. In certain
circumstances, non-U.S. persons would be permitted to rely on substituted compliance with
home country requirements so long as such requirements are comparable with relevant U.S.
regulations.
4. Compliance Phase-In
The Proposed Cross-Border Guidance includes a delayed timetable for compliance
with regulatory requirements for non-U.S. SDs, MSPs and other market participants.
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VIII.
SUMMARY OF COMPLIANCE DATES
Below is a summary of CFTC and SEC swaps rules that have been enacted thus far.
September 29, 2011
October 31, 2011
CFTC rules regarding the process for review of swaps for
mandatory clearing became effective. The SEC rules
regarding the process for review of security-based swaps for
mandatory clearing will become effective 30 days after the
publication of such rules in the Federal Register; however, the
compliance date for SBS CA submissions is 60 days after the
SEC issues its first written determination on whether a
security-based swap (or group, category, type or class of
security-based swap) is subject to mandatory clearing.
CFTC rules regarding registration and regulation of SDRs (the
CFTC noted, however, that while SDRs can register, they will
not otherwise be fully operational on such effective date but
instead will require a compliance period based on the R&R
rules and the real-time reporting rules)
October 12, 2012 CFTC regulations regarding reporting and
recordkeeping of swap data by SDs and MSPs for
credit swaps and interest rate swaps (including
historical swaps)
SDs and MSPs must comply with the CFTC’s business
conduct rules by the later of (i) October 14, 2012 and
(ii) the date on which the SDs or MSPs are required to
apply for registration with the CFTC
October 17, 2012
May 6, 2012
June 1, 2012
August 30, 2012
DCMs must comply with the CFTC’s core principles rules
(other than the core principle requiring open access, which
has a different compliance date).
Core principles for DCOs (with a few exceptions, the
compliance date for which will be November 8, 2012).
SDs and MSPs that are currently regulated by a U.S.
prudential regulator or are registered with the SEC, must
comply with the CFTC’s recordkeeping rules by the later of (i)
June 1, 2012 and (ii) the date on which the SDs or MSPs are
required to apply for registration with the CFTC
SDs and MSPs that are not currently regulated by a U.S.
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prudential regulator or are registered with the SEC, must
comply with the CFTC’s recordkeeping rules by the later of (i)
August 30, 2012 and (ii) the date on which the SDs or MSPs
are required to apply for registration with the CFTC
December 11, 2012
December 31, 2012
January 13, 2012
February 28, 2013
April 10, 2013
CFTC position limits rules.
SDs will be required to register with the CFTC on the earlier of
(i) December 31, 2012 or (ii) within 2 months following the
end of the month in which it exceeds the applicable de
minimis threshold of aggregate notional amount of swaps
executed.
CFTC regulations regarding reporting and recordkeeping of
swap data by SDs and MSPs for equity swaps, foreign
exchange swaps and other commodity swaps (including
historical swaps)
MSPs will be required to register with the CFTC.
CFTC regulations regarding reporting and recordkeeping of
swap data for non-SDs/MSPs (including historical swaps)
139

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NEW YORK
2 Park Avenue
New York, NY 10016
t 212.592.1400
f 212.592.1500
NEWARK
One Gateway Center
Newark, NJ 07102
t 973.274.2000
f 973.247.2500
PRINCETON
210 Carnegie Center
Princeton, NJ 08540
t 609.452.3800
f 609.520.9095
>> WWW.HERRICK.COM

NEW YORK
2 Park Avenue
New York, NY 10016
t 212.592.1400
f 212.592.1500
NEWARK
One Gateway Center
Newark, NJ 07102
t 973.274.2000
f 973.247.2500
PRINCETON
210 Carnegie Center
Princeton, NJ 08540
t 609.452.3800
f 609.520.9095
>> WWW.HERRICK.COM