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7.4 Scope of Jurisdiction over Major Swap Participants and Commercial End Users

<< Title VII Overview

The following links provide expanded analysis within this section:


            7.4        Scope of Jurisdiction over Major Swap Participants and Commercial End Users.

                        7.4.1.    What is a Major Swap Participant?  Under Title VII, market participants other than swap dealers active in the derivatives markets may be considered "major swap participants" and subject to registration and record-keeping requirements.  As noted above, a "major swap participant" is defined as a person: (i)  who maintains a "substantial position" in swap transactions, excluding positions held for hedging or mitigating the participant's commercial risk (commonly referred to as "commercial end users") and positions held by employee benefit plans; (ii) whose outstanding swaps create "substantial counterparty" exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets; or (iii) who is a financial entity that (A) is "highly leveraged relative to the amount of capital it holds, and that is not subject to capital requirements established by an appropriate federal banking agency" and (B) maintains a substantial position in outstanding swaps transactions.  [§721]

            Title VII includes a substantially similar definition for a "major security-based swap participant," or a person that has swap positions in securities-based swap transactions.

            Title VII excludes from the major swap participant definition any entity whose primary business is providing financing, and which uses 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.

                        7.4.2.    What is a "Substantial Position" in Swap Transactions?  The Commissions are required to define "substantial position" as the amount the Commissions determine prudent for the effective monitoring, management, and oversight of market participants that are systemically important or can significantly impact the financial system of the United States.  However, there is no indication as to whether the "substantial position" will be determined across affiliated entities, such as across multiple funds advised by a single manager, or whether it will be determined on a person-by-person basis (e.g., long positions against short positions within a single portfolio).  While earlier iterations of the legislation were silent on the whether margin is relevant to this analysis, Title VII states that the Commissions may take into account the value and quality of collateral held against counterparty exposure.[§721]

            The determination of what will constitute "substantial counterparty exposure" is also unclear.  While a hedge fund may have $100 million in outstanding swaps facing an individual dealer, a $100 million counterparty exposure to a dealer with a $1 trillion balance sheet – i.e., 1% of the dealer's assets – might not be considered "substantial."

 

The SEC and CFTC are required to issue regulations defining "substantial position" as the amount each Commission determines is prudent for the effective monitoring, management and oversight of market participants that are systemically important or can significantly impact the financial system of the United States.

 

                        7.4.3.    What Regulatory Capital and Margin Requirements will apply to Major Swap Participants?  Major swap participants will face largely similar regulatory capital requirements as swap dealers. A major swap participant for which there is a prudential regulator must meet new minimum capital standards and initial and variation margin requirements for uncleared swaps as required by such prudential regulator.  For any major swap participant for which there is no prudential regulator, such capital standards and margin requirements will be set by the applicable Commission.[§731]

            It is important to note that on June 30, 2010, Chairmen Dodd and Lincoln sent a letter to Chairman Frank and Peterson, stating that, "Congress clearly stated in this bill that the margin and capital requirements are not to be imposed on end-users, nor can the regulators require clearing for end-user trades. . . . In cases where a Swap Dealer enters into an uncleared swap with an end-user, margin on the dealer side of the transaction should reflect the counterparty risk of the transaction."  This letter also recognizes that the capital and margin requirements in the bills could have an impact on existing swap contracts, but clarifies that the provisions in the bill giving legal certainty to those contracts currently in existence provides that "no contract could be terminated, renegotiated, modified, amended or supplemented (unless otherwise specified in the contract) based on the implementation of any requirement in this Act, including requirements on Swap Dealers and Major Swap Participants."

 

The applicable prudential regulators, in consultation with the SEC and CFTC, shall jointly adopt rules for major swap participants, with respect to their activities as major swap participants, for which there is a prudential regulator imposing capital requirements and both initial and variation margin requirements on all swaps that are not cleared by a DCO.

 

 

The SEC and CFTC shall adopt rules for major swap participants, with respect to their activities as major swap participants, for which there is no prudential regulator imposing capital requirements and both initial and variation margin requirements on all swaps that are not cleared by a DCO.

 

                        7.4.4.    What Reporting and Record-keeping Obligations Will Apply to Major Swap Participants?   As with swap dealers, major swap participants will be required to provide reports to the Commissions regarding the transactions and positions and financial condition of the major swap participant.  Daily trading records will need to be maintained and all related records, recorded communications (such as email, instant messaging and recorded telephone calls) for such period of time as the Commissions may require.  Major swap participants, like swap dealers, will also be required to maintain books and records of all activities related to its business as a major swap participant, in such form and manner and for such period of time as the Commissions may require.  Major swap participants will further be required to maintain a complete audit trail for conducting comprehensive and accurate trade reconstructions.[§731]

                        7.4.5.    Do Major Swap Participants Face New Business Conduct Standards?    Yes, major swap participants, like swap dealers, will face additional business conduct standards in respect of their swap counterparties.  Major swap participants will also be required to assume heightened responsibilities when dealing with counterparties that are "Special Entities," which include governmental plans and entities, retirement plans and endowments.[§731]

                        7.4.6.   How does the Act Affect Commercial End Users?  Commercial end users are counterparties to swaps that are not financial entities which are using such swaps to hedge or mitigate commercial risk.  The legislation specifically provides that the Commissions shall consider whether to exempt small banks, savings associations, farm credit system institutions, and credit unions from the definition of a "financial entity".  This exclusion could include depository institutions with total assets of $10,000,000,000 or less. In addition, if a swap is required to be cleared (as discussed below) and one party to the swap is a commercial end user, that party may choose not to clear the swap.  As noted above, commercial end users will also be exempt from the definition of a major swap participant.[§723]

            The legislation does explicitly provide commercial end-users with the option to clear swap contracts, the option to choose their clearinghouse or clearing agency, and the option to segregate margin with an independent third-party custodian (see below).