CFTC Approves Long-Awaited Rule Further Defining Swap Dealer; Adopts Interim Final Rule Excluding Bona-Fide Hedgers from Swap Dealer Definition

April 24, 2012 Authors: Jeffrey Allen Sherman, Peggy A. Heeg, Michael Loesch

On April 18, 2012, the Commodity Futures Trading Commission ("CFTC" or "Commission") held its 26th open meeting to consider rules proposed to implement Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). The highlight of the meeting was the repeatedly delayed entity definition rules being considered by the CFTC jointly with the Securities Exchange Commission ("SEC"), which further define swap dealers and major swap participants. The CFTC voted to approve the final rules in a 4-1 vote, with Commissioner Scott O'Malia dissenting. A key portion of the final rules, relating to an exclusion from the swap dealer definition for activities that qualify as "hedging" as defined in the final rules, has been designated as an "interim final rule," which provides for an additional 60-day comment period. Comments on the interim final rule are due 60 days after the rule is published in the Federal Register.

According to discussions during the public meeting and summary materials available on the CFTC's web site1 the final rules closely follow the Dodd-Frank statutory definition of a "swap dealer" as any person who:

  1. holds itself out as a dealer in swaps,
  2. makes a market in swaps,
  3. regularly enters into swaps with counterparties as an ordinary course of business for its own account, or
  4. engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.

While the CFTC generally felt constrained by these statutory prongs in adopting its final rules, it nevertheless provided critical clarifications and exclusions to what ultimately will constitute dealing activity requiring a firm to register, and be regulated, as a swap dealer. At the same time, many questions still remain, as Commissioner O'Malia pointed out in detail in his lengthy dissent.2

Factors Indicating Swap Dealer Status

As with the proposed rules, the determination of whether a company is a swap dealer is a functional, activity-based test considering all relevant facts and circumstances. In particular, with respect to the market maker prong, the Commission observed that making a market in swaps is appropriately described as routinely standing ready to enter into swaps at the request or demand of a counterparty. The Commission noted that a person can be a market maker even if it makes a one-way market, and even if it trades on electronic exchanges. The regular business prong includes entering into swaps to satisfy the business or risk management needs of the counterparty, maintaining a separate profit and loss statement for swap activity, or allocating staff and resources to dealer-type activities. As part of its swap dealer determination, a company could apply elements of the SEC's dealer-trader distinction, discussed below.

Furthermore, certain swaps may be excluded from a swap dealer determination: (i) swaps entered into between an insured depository institution and a customer in connection with originating a loan, (ii) swaps between majority-owned affiliates, (iii) swaps between a cooperative and its members, and (iv) swaps entered into for hedging physical positions.

Hedging Carve-Out

As rumored for several months, and as promised in Chairman Gensler's recent public statements,3 the final rules will exclude certain hedging activities from the determination of swap dealer status. Congress previously has made it clear that swaps end users such as hedgers were never intended to be considered as swap dealers.4 However, Dodd-Frank itself does not expressly carve out hedgers or other commercial end users from the swap dealer definition. The final rules thus include an explicit hedging exclusion to swap dealing in a new rule 1.3(ppp)(6)(iii). Although the text of the rule is not yet available, the CFTC took the position that "hedging a physical position is not swap dealing."5 Thus, the rule provides that swaps positions that hedge price risks related to physical commodity positions will not trigger swap dealer status. The CFTC indicated that the hedge exclusion does include portfolio hedging and anticipatory hedging. It does not, however, create a per se exclusion of all swaps used for hedging. Rather, commercial end users with anticipatory or financial hedging needs may satisfy the exclusion if their swaps are entered into for the purpose of offsetting or mitigating their price risks and if:

  1. the price risks arise from the potential change in the value of assets that the person owns, produces, manufactures, processes, or merchandises, liabilities that the person owns or anticipates incurring, or services that the person provides or purchases;
  2. the swap represents a substitute for transactions or positions in a physical marketing channel;
  3. the swap is economically appropriate to the reduction of the person's risks in the conduct and management of a commercial enterprise; and
  4. the swap is entered into in accordance with sound commercial practices and is not structured to evade designation as a swap dealer.

The swap dealer hedge exclusion borrows some, but not all, of the bona fide hedge concepts embedded in the final position limit rules finalized by the Commission on November 18, 2011,6 which in turn derive from the Commission's 1977 definition of bona fide hedging originally enacted in the context of futures contracts position limits. Notably, the swap dealer hedge exclusion does not mirror the definition of hedging or mitigating commercial risk for purposes of the end user exception to mandatory clearing.7 As Commissioner O'Malia pointed out quite correctly in his dissent, there are now five different definitions of "hedging" in the Commission's post-Dodd-Frank rulemakings.8 Unfortunately, the added confusion of numerous different hedging definitions throughout the CFTC's rules will make the application of the various hedge exemptions more confusing. 

Furthermore, although a step in the right direction for commodity producing, processing, marketing and merchandising companies who use swaps to hedge physical commodity positions, the swap dealer hedge exclusion is less useful for firms that use swaps to hedge purely financial risks such as currency or interest rate exposure.9 The Commission offered only that "[i]f a swap is not entered into for the specific hedging purposes identified in the rule, then all relevant facts and circumstances about the swap would be considered in determining if the person is a swap dealer."10 Indeed, Commissioner O'Malia was confused "why the Commission does not wish to allow commercial end-users to hedge financial risks (e.g., through interest rate swaps) without fearing that they could be deemed 'swap dealers.'"11 Until the final rules are released, it is unclear how the exclusion will apply to various swaps market participants. But because the Commission designated the swap dealer hedging carve-out as an "interim final rule," market participants will have an additional comment period to voice their concerns or suggest alternative approaches, including making the definition conform to the end user exception to mandatory clearing and extending the exclusion to other hedging activities such as financial hedging.

Recognition of Dealer-Trader Distinction and the Floor Trader Exception

In a departure from the proposed rules, the final rules explicitly incorporate elements of the SEC's dealer-trader distinction in assessing swap dealer status: "although the CFTC is not formally adopting the SEC's dealer-trader precedents, those precedents may be applied to determine if a person is a swap dealer."12  This acknowledgement reflects the Commission's belief "that the dealer-trader distinction — which already forms a basis for identifying which persons fall within the longstanding [Securities] Exchange Act definition of 'dealer' — in general provides an appropriate framework for interpreting the statutory definition of the term 'swap dealer.'"13 However, the Commission also noted that the dealer-trader precedent may be inapplicable to swaps in certain circumstances or may be applied differently in the context of dealing activities involving commodity, interest rate, or other types of swaps.14 Applying the dealer-trader distinction to a company's swaps trading activities must therefore take into consideration the particular facts and circumstances relevant to each company.

In another departure from the proposed rules, the Commission also adopted an alternative process by which certain traders may register and be regulated as "floor traders" (as defined in section 1a(23) of the Commodity Exchange Act) instead of as swap dealers. According to Commissioner Sommers:

proprietary traders who meet specific criteria [may] register as floor traders pursuant to CFTC Regulation 3.11 instead of registering as swap dealers. Allowing for registration as a floor trader recognizes the reality that certain proprietary traders with no customers, who do not negotiate swaps with counterparties, and who only interact with counterparties on a designated contract market or swap execution facility are traders, not dealers.15

The floor trader exclusion, however, is limited in scope. For example, an entity cannot rely on this exclusion if it participates in a market-making program offered by a designated contract market or swap execution facility.16

De-Minimis Threshold

In a welcome change from the proposed rules, the final rules substantially raise the de minimis threshold from $100 million to an aggregate gross notional amount of $3 billion, subject to a phase-in level of $8 billion. The Commission will study 2.5 years of swaps data (once it is reported), and will issue a report within nine months thereafter regarding an appropriate de minimis level.  If the CFTC takes no action, the phase-in period will end five years after swaps data starts being reported. The de minimis threshold with regard to swaps with a "special entity" (which includes municipalities, other political subdivisions and employee benefit plans) is $25 million. Importantly, swaps that are not connected to swap dealing activity, as defined in the rules and interpretive guidance, do not count against the de minimis threshold.

Exclusion of Swaps Between Affiliates and Members of Agricultural Cooperatives and Cooperative Financial Institutions

The determination of whether a person is a swap dealer excludes swaps between majority-owned affiliates, which will assist companies engaging in intra-company risk allocation or those with affiliates that perform a centralized swaps function. Furthermore, as Chairman Gensler promised in his recent public testimony, the final rule will treat members of agricultural cooperatives essentially as affiliates and thereby exclude swaps between cooperatives and their members from any swap dealer determination.17

Swaps Between an Insured Depository Institution and a Customer in Connection with Originating a Loan

Dodd-Frank provides for an explicit swap-dealing exclusion to insured depository institutions that enter into a swap with a customer in connection with originating a loan with that customer. The final rules provide more guidance with respect to this exclusion. All of the following must be satisfied:

  • the swap is connected to the financial terms of the loan or is required by loan underwriting criteria to be in place as a condition of the loan in order to hedge the borrower's commodity price risks;
  • the swap is entered into within 90 days before or 180 days after the date of the loan agreement, or any draw of principal under the loan;
  • the loan is within the common law meaning of "loan;" and
  • the insured depository institution is the sole lender or, if it is a participant in a lending syndicate, it is responsible for at least 10% of the loan (otherwise, the notional amount of the swap may not exceed the amount of the insured depository institution's participation).

This article was prepared by Jeffrey A. Sherman (jsherman@fulbright.com or 202 662 4573), Peggy A. Heeg (pheeg@fulbright.com or 713 651 8443) and Michael Loesch (mloesch@fulbright.com or 202 662 4552) from Fulbright's Energy Practice Group. 


[1] This summary is based on the discussion at the public meeting and related materials published by the CFTC. The text of the final rules is not yet available. Summary materials and Commissioner statements are available here.
[2] Statement of Dissent of Commissioner Scott O'Malia, April 18, 2002 ("O'Malia Dissent").
[3] See our March 2, 2012 Alert, "CFTC Chairman Gary Gensler Testifies Before House Committee That Most Swaps End-Users Will Not Be Swap Dealers and That Rural Electric Co-Ops, Munis, and RTOs May Be Exempted From Dodd-Frank."
[4] See id.; see also O'Malia Dissent at n.21 and accompanying text.
[6] Position Limits for Futures and Swaps, 76 Fed. Reg. 71,626 (Nov. 18, 2011).  A bona fide hedge for purposes of "Referenced Contracts" is defined in 17 C.F.R. § 151.5(a)
[7] End-User Exception to Mandatory Clearing of Swaps, 76 Fed. Reg. 80,747, 80,752 (Dec. 23, 2010) (defining "hedging or mitigating commercial risk" to include accounting hedges, bona fide hedges, and hedges that are "economically appropriate" to reduce certain risks arising from a commercial enterprise).
[8] The definition of  "substantial positions" in swaps for purposes of defining "major swap participant" includes a "hedging or mitigating commercial risk" definition similar to the end user exception to mandatory clearing.  For position limit purposes, there are actually two definitions of "bona-fide hedge": 17 C.F.R. § 1.3(z) (limited to "excluded" commodities, which are financial commodities such as currency swaps); and §151.5(a) (applicable to "Referenced Contracts").  In our detailed summary of the position limits rule, we explained that the key difference between the §151.5(a) and §1.3(z) definitions is the omission, in the new definition, of the word "normally" before the "represents a substitute" language. See "CFTC Publishes Final Rules on Position Limits: Limited Comment Period Closes on January 17, 2012," Fulbright Briefing, December 8, 2011, at 13. 
[9] Entities that engage in swaps to hedge purely financial risks would be considered swap dealers only if they satisfy one of the four statutory prongs. Under the interim final rule, the fact that they are hedging presumably would be considered along with all of the other facts and circumstances of their situation.
[11] O'Malia Dissent at n.40 and accompanying text.
[12] Q & A – Final Rulemaking Regarding Further Defining "Swap Dealer," "Major Swap Participant" and "Eligible Contract Participant", at 1. The SEC 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)." Further Definition of "Swap Dealer," "Security-Based Swap Dealer," "Major Swap Participant," "Major Security-Based Swap Participant" and "Eligible Contract Participant"; Proposed Rule, 75 Fed. Reg. 80174, 80,177 (Dec. 21, 2010). The proposed rules had rejected this concept for CFTC-regulated swap dealers.
[13] O'Malia Dissent at n.26 and accompanying text. 
[14] Id. at n.32 and accompanying text.
[15] Sommers Dissent.
[16] O'Malia Dissent at n.29.