ALI-ABA: Title VII AND PRODUCT DEFINITIONS August 24, 2012
Background 2
Background on Title VII Objectives of Title VII Reduce systemic risk posed by the swaps market to the U.S. financial system Increase transparency of the swaps market, particularly as to both pre and post execution pricing Enhance the integrity of the swaps market and improve the conduct of major market participants 3
Background on Title VII (cont d) Structure of Title VII Regulates products Swaps Security-based swaps Regulates entities Swap Dealers and security-based Swap Dealers Major Swap Participants and major Security-based Swap Participants Derivatives Clearing Organizations ( DCOs ) Swap Execution Facilities ( SEFs ) Swap Data Repositories ( SDRs ) Splits regulation between CFTC and SEC CFTC regulates swaps, swap dealers and major swap participants SEC regulates security-based swaps, security-based swap dealers and major security-based swap participants 4
Background on Title VII (cont d) Title VII applies to swaps and security-based swaps The impact of Title VII depends on the definitions of these terms as we will discuss The question of what is and is not a swap (or security-based swap) is of primary importance to market participants Definition is very broad and includes (among other things) Options of any kind that are for the purchase or sale, or based on the value, of one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind Any agreement, contract, or transaction that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence Swaps, including rate floors, caps, and collars Security-based swap agreements 5
Background on Title VII (cont d) However, swaps and security-based swaps do not include: Futures contracts (and options on futures contracts) and security futures products Retail foreign currency and commodity transactions Sales of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled (generally known as forward contracts ) Any option on any security, CD, or group or index of securities that is subject to the U.S. federal securities laws Listed foreign currency options Any purchase and sale agreement covering one or more securities that are subject to the U.S. federal securities laws (whether on a fixed or contingent basis) Any option on one or more securities that are subject to the U.S. federal securities laws Any note, bond, or evidence of indebtedness that is a security Identified banking products including CDs To simplify this discussion, we generally refer to swaps to mean swaps and security-based swaps. 6
Background on Title VII (cont d) FX swaps and FX forwards constitute swaps Unless the U.S. Secretary of the Treasury ( Treasury ) determines that either or both: Should not be regulated as swaps; and Are not structured to evade the Dodd-Frank Act ( DFA ) in violation of any rule The Treasury has issued a proposed rule indicating its intention to exempt FX swaps and FX forwards Note, however, that foreign exchange swap and foreign exchange forward are narrowly defined to cover only foreign exchange transactions with fixed (not variable) rates of exchange Even if the Treasury exempts FX swaps and FX forwards, the following Title VII requirements will continue to apply: All FX swaps and FX forwards must be reported to a SDR or, in the absence of one, to the CFTC or SEC, and All swap dealers and major swap participants ( MSP ) that are parties to FX swaps and FX forwards must comply with the business conduct standards required by the DFA 7
Status of Rulemaking 8
Status of Title VII Critical building blocks of the Title VII regulatory regime have recently been jointly adopted by the CFTC and SEC Entity Definitions (adopted in April and published in May 2012) covering definitions of swap dealer, security-based swap dealer, major swap participant, major security-based swap participant and eligible contract participant (referred to as the Entity Definitions) Product Definitions (adopted in July 2012, and published August 2012) covering definitions of swap and security-based swap However, still awaiting final action by the U.S. Treasury regarding the exemption of FX forwards and FX swaps for certain purposes Publication of Product Definitions triggered a host of compliance dates under the CFTC s Title VII regulations, but will not have a similar effect with respect to the SEC s Title VII regulations 9
Status of CFTC Title VII Implementation CFTC is moving ahead toward commencing implementation of significant components of its Title VII regime during the fall of 2012 CFTC has been more active than SEC in adopting final rules under Title VII, since April 2012, the CFTC has finalized rules for: End-User Exception Phase in Schedule for Mandatory Clearing Core Principles for Designated Contract Markets Customer Clearing Documentation and Timing Requirements Internal Business Conduct Standards for Swap Dealers and MSPs CFTC recently provisionally registered ICE Trade Vault as a swap data repository and approved DTCC-SWIFT as an interim provider of Legal Entity Identifiers (LEIs) to permit compliance with swap data reporting requirements CFTC also recently proposed its first list of swaps (covering certain categories of interest rate and credit default swaps) to be designated for mandatory clearing Subject to a post-publication 30-day comment period, this list could become final as early as September 2012 10
Status of CFTC Title VII Implementation (cont d) With the recent publication of the Product Definitions, registration for swap dealers and major swap participants will become mandatory on October 12, 2012 Once this registration requirement occurs, many other Title VII rules adopted by the CFTC will begin to take effect at that time or shortly thereafter, including: Real-time Reporting for Credit and Interest Rate Swaps General Recordkeeping and Reporting for Credit and Interest Rate Swaps Various Internal Business Conduct Standards for swap dealers and MSPs External Business Conduct Standards Position Limits for physical commodity-based futures and swaps for spot months and, for legacy agricultural commodities, non-spot months (CFTC recently provided temporary no-action relief from certain aggregation requirements under its position limit rules) Also under CFTC s rules, FCMs will be required in November 2012 to implement the LSOC method for segregating customer initial margin posted for cleared swaps 11
Status of CFTC Title VII Implementation (cont d) CFTC is also working to finalize guidance and compliance relief relating to the cross-border application of Title VII and the CFTC s Title VII rules In late June, CFTC issued: Proposed Guidance regarding the application of its Title VII rules beyond the U.S. borders, and Proposed Exemptive Order to permit delayed compliance with certain Title VII requirements for foreign entities Comment period for Exemptive Order closed on August 13, 2012, and comment period for Proposed Guidance closes on August 27, 2012 Following the applicable comments periods, Proposed Guidance could be finalized as early as September 2012, although many issues will need to be resolved, and Proposed Exemptive Order could be finalized by mid September 2012, but no later than October 12, 2012 effective date 12
Status of CFTC Title VII Implementation (cont d) Proposed Guidance attempts to address cross-border matters by: distinguishing between Entity-level requirements and Transaction-level requirements of Title VII defining who is a U.S. Person for cross-border purposes considering how Title VII should apply to foreign branches, subsidiaries and affiliates of U.S. Persons, as well as how guaranties by U.S. Persons might impact these considerations contemplating, in the case of some Entity-level requirements, potential Substituted Compliance based on comparably robust home country regulation The Proposed Guidance is already attracting a significant adverse reaction from the international banking and financial regulatory community Proposed Exemptive Order supplements the Guidance by allowing delayed compliance for certain (but not all) Entity-level requirements Primarily for non-u.s. swap dealers/msps who by complying with the order may delay some compliance until July 2013 However, U.S. swap dealers/msps who comply can delay their compliance with some Entitylevel requirements until January 1, 2013. Additional relief is also afforded foreign branches of U.S. swap dealers and MSPs. 13
Status of CFTC Title VII Implementation (cont d) Despite focus on October 12 th date, actual swap dealer and MSP filings may occur somewhat later Swap dealer rule provides that registration is not required until two months after the swap dealer s activity exceeds de minimis threshold with counting starting on the effective date (without a lookback). See Rules 1.3(ggg)(4)(i) and (iii). Using these provisions could delay registration for many entities by two to four months MSP rule provides that a filing requirement arises two months after the end of the first fiscal quarter in which the registration criteria are met (subject to certain re-evaluation rights) Does this imply that a potential MSP that exceeds the criteria as of September 30, 2012 could wait until November 30 th to register? Adopting release does not clarify whether CFTC intended these twomonth periods to be available to all potential registrants, or only to those who are uncertain based on their level of activities whether registration will be required. 14
Status of CFTC Title VII Implementation (cont d) All indications are that that CFTC is intent on having compliance commence by this fall, which will mean that over the next two months: Cross Border Proposed Guidance and Proposed Exemptive Order will need to be finalized Initial list of swaps designated for mandatory clearing should be published To the extent possible, further important rulemaking by the CFTC should be completed or, alternatively, guidance should be provided as to how newly registered swap dealers and MSPs should conduct themselves if such rules are not finalized To the extent possible, CFTC and NFA should endeavor to address many questions and uncertainties that have arisen over the interplay of the NFA s registration process for swap dealers and MSPs and the CFTC s regulatory implementation schedule U.S. Treasury should finalize its proposed exemption for FX forwards and FX swaps Potential swap dealer and MSP registrants will need to finalize and implement many policies, procedures and system/infrastructure enhancements To position the industry to comply with External Business Conduct Standards, OTC documentation will need to be supplemented, most likely via the Protocol, Supplement and Questionnaire process currently under development by ISDA Address other requests for guidance or clarification from various industry groups or participants 15
Status of SEC Title VII Implementation (cont d) SEC is taking a different approach to Title VII rulemaking It appears that no registration requirements will be imposed until all substantive Title VII rulemaking by SEC is complete Two of the CFTC s Commissioners (Sommers and O Malia) indicated they had hoped that the CFTC would proceed in a similar fashion SEC s substantive rulemaking has lagged significantly behind the CFTC s In some cases, the SEC is yet to publish a proposed rule on matters that the CFTC has long since published proposed rules on or even proceeded to adopt final rules For example, as yet no SEC proposed rule on: margin requirements for OTC swaps or capital for non-bank registrants cross border application of SEC s Title VII regulation Even where SEC has published proposed rules, the timeline for finalizing these rules is unclear 16
Status of CFTC Title VII Implementation (cont d) Despite all this recent activity, CFTC has significant rulemaking that it has not yet completed, including Margin requirements for OTC swaps (CFTC recently reopened the comment period on the rule it had proposed covering OTC swap margining) Capital requirements for non-bank swap dealers and MSPs Swap execution facility (SEF) requirements, the most significant of which are SEF market structure (central limit order book versus request for quote) Block trade definitions Available to trade criteria Documentation requirements for OTC swaps as well as portfolio compression and netting Additional phase-in rules covering trading documentation and margining 17
Status of SEC Title VII Implementation (cont d) At present, there is no clear indication that the SEC will be moving aggressively or on an expedited basis to finish its Title VII rulemaking In addition to manpower issues, the SEC has many other aspects of the Dodd- Frank Act that are drawing on its resources For swap dealers/msps that also are potential security-based swap dealers or major security-based swap participants, the lack of synchronization between the CFTC and SEC Title VII programs is likely to present some difficult and confounding compliance challenges 18
Requirements under Title VII 19
Requirements under Title VII Under the structure created by Title VII, new requirements are imposed in relation to entities that are swap dealers and major swap participants (which, in turn, depends on the product definitions) In addition to the requirements imposed upon these regulated entities, Title VII imposes general requirements related to transacting in swaps (which, again, turn on the product definitions), including clearing and margin requirements As a result, understanding the product definitions is critically important to all market participants the product definitions are essential in making an entity/registrant determination, and, even for non-registrants, essential in determining the framework that will be applicable to any swap going forward 20
Requirements for Regulated Entities Swap dealers and MSPs are two of the most heavily regulated new entities established by Title VII. The statutory definitions for these entities provide: Swap Dealer: Any person who Holds itself out as a swap dealer; Makes a market in swaps; Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or Is commonly known in the trade as a dealer or market maker in swaps Major Swap Participant: Any person who is not a dealer and Maintains a substantial position in swaps, excluding positions held for hedging or mitigating commercial risk; Outstanding positions create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or Is a highly leveraged financial entity that maintains a substantial position in swaps and is not subject to a Federal banking agency s capital requirements 21
Requirements for Regulated Entities (cont d) CFTC and SEC have jointly adopted rules and provided guidance in an effort to clarify these statutory definitions: For swap dealers, the regulations and guidance include: A three-step process to be followed in determining swap dealer status Importance of the dealer-trader distinction in this analysis-this is a concept long used by the SEC in regulating securities broker-dealers Exclusion of some hedging activities from the dealer determination Further description of what types of activities will be considered market making Clarification of the exclusion for swaps executed in connection with loan originations, though this exclusion is only available to insured depository institutions Expansion and phasing in of the de minimis exemption 22
Requirements for Regulated Entities (cont d) For MSPs, the regulations and guidance include: Definitions of major swap participant and major security-based swap participant focus on the market impacts and risks associated with that person s swap and security-based swap positions. (Note that swap dealer and security-based swap dealer definitions focus on activities) Major participants generally must follow the same statutory requirements that apply to swap dealers and security-based swap dealers since their activities could pose a high degree of risk to the U.S. financial system generally. MSP: Any person who is not a dealer and Maintains a substantial position in swaps, Outstanding positions create substantial counterparty exposure that could have serious adverse effects on the financial stability of the US banking system or financial markets; or Is a highly leveraged financial entity that maintains a substantial position in swaps and is not subject to federal bank capital requirements 23
Requirements for Regulated Entities (cont d) Swap dealers and MSPs are subject to extensive additional external and internal business conduct standards External Business Conduct Standards CFTC has finalized rules and SEC has issued proposed rules on general business conduct standards for all counterparties General standards include: Verification of counterparty status KYC and institutional suitability requirements Disclosure obligations relating to material risks, characteristics and conflicts of interest Daily mark-to-market values Clearing 24
Requirements for Regulated Entities (cont d) Internal Business Conduct Standards The DFA authorizes agencies to adopt other regulations regarding business conduct and risk management as they deem necessary CFTC has been much more active on this front than the SEC CFTC final rule: Requires registrants to adopt risk management programs Requires that swap documentation with counterparties address certain matters, including payments netting, events of default and termination, transfers, governing law 25
Requirements for Regulated Entities (cont d) Recordkeeping and Reporting Title VII imposes substantial new recordkeeping and reporting requirements on Regulated Entities The requirements include: General recordkeeping and reporting requirements Real-time public reporting requirements Requirements to maintain daily trade records CFTC has adopted final rules on covering general recordkeeping and reporting requirements, real time public reporting and daily trade records SEC has proposed rules for some, but not all, of these area 26
Requirements for Regulated Entities (cont d) Under the CFTC s rules: General recordkeeping and reporting requirements mandate the reporting of creation data and continuation data relating to swaps Creation data consist of Primary economic terms data ( PET ) and Confirmation data (i.e., all of the terms of the swap as confirmed by the parties) Continuation data consist of information arising during the term of a swap, such as: Valuation data Changes to previously reported economic terms Real-time public reporting requirements mandate that certain economic data be reported to SDRs as soon as technologically practicable so that the SDR can then publicly disseminate that information Daily trade recording requirements mandate that a swap dealer maintain records that are sufficient to permit comprehensive and accurate trade reconstruction and identifiable and searchable by transaction and counterparty, including both preexecution and post-execution information 27
Requirements for Regulated Entities (cont d) Documentation Developments -- for Cleared Swaps: The ISDA Master Agreement may serve a lesser or different role for cleared OTC swaps Clearing firms currently are proposing the following three types of documents: Futures Account Agreement ( FAA ) Governs the relationship between the parties to the swap and their regulated clearing members Cleared OTC Derivatives Addendum to FAA Necessary because FAAs do not address swaps or close-out rights in relation to cleared swaps Execution Agreement New documentation must address consequences if a transaction that is expected to clear is not accepted for clearing 28
Requirements for Regulated Entities (cont d) Documentation Requirements -- for Non-cleared Swaps Section 731 of the DFA mandates that the CFTC promulgate documentation standards that apply to swap dealers and MSPs and that promote timely and accurate confirmation, processing, netting documentation and valuation of all swaps the rules have been proposed but have not been finalized. ISDA has been meeting with their constituency and is in the process of drafting protocols and bridge documents to make existing ISDA Master Agreements compliant with the proposed new rules. 29
Requirements for Regulated Entities (cont d) Collateral Segregation -- for Cleared Swaps The CFTC has adopted the LSOC Model which stands for legal segregation of collateral with operational commingling Under the LSOC Model, each clearing firm and DCO would enter (or segregate''), in its books and records, the Cleared Swaps of each individual customer and relevant collateral and would ensure that such entries are separate from entries indicating (i) clearing firm or DCO obligations, or (ii) the obligations of non-cleared swaps customers. Operationally, however, each clearing firm and DCO would be permitted to hold (or commingle'') the relevant collateral in one account. Each clearing firm and DCO would ensure that such account is separate from any account holding proprietary property or holding property belonging to non-cleared swaps customers 30
Requirements for Regulated Entities (cont d) Collateral Segregation -- for Non-Cleared Swaps The CFTC has proposed regulations that a swap dealer or MSP must notify each counterparty at the beginning of a swap transaction that the counterparty has the right to require segregation of the funds or other property that it supplies to margin, guarantee, or secure its obligations; and at the request of the counterparty, the swap dealer or MSP must segregate such funds or other property with an independent third party As with other regulations for non-cleared swaps, this regulations have not been finalized 31
Requirements for Regulated Entities (cont d) Capital Requirements: Swap dealers and MSPs will be subject to minimum capital requirements Banking regulators to adopt rules for bank swap dealers and bank MSPs CFTC or SEC to adopt rules for non-bank swap dealers and non-bank MSPs To date, the prudential regulators and the CFTC (but not the SEC) have issued proposed rules covering capital requirements relating to non-cleared swaps 32
Requirements for Regulated Entities (cont d) Position Limits and Large Trader Reporting: CFTC has adopted a final rule expanding its position limit regime as mandated by Title VII, resulting in: Position limits being extended to cover many physical commodities Position limits being extended to cover both futures and certain swaps Expansion of CFTC position limits has been a focus of the CFTC prior to enactment of Title VII During this time, it has been a controversial topic among industry participants, government officials, economists and market critics Final CFTC rule was opposed by 2 of 5 Commissioners A lawsuit jointly filed by ISDA and SIFMA has challenged the rule, alleging lack of adequate findings by the CFTC and an inadequate cost-benefit analysis 33
Requirements for Regulated Entities (cont d) By contrast, the SEC has taken no formal action on position limits Title VII s mandate to the SEC on position limits is modest as compared to the mandate imposed on the CFTC At this stage, there is little indication that the SEC will aggressively undertake position limit regulation of the SBS market Both the SEC and CFTC have adopted rules imposing additional reporting requirements on large traders For market intermediaries, such as SEFs, DCO and DCMs, Title VII requires that the regulators establish financial standards and core principles to be implemented by these entities 34
General Requirements: Clearing Mandatory Clearing A basic concept of Title VII is that a swap must be cleared if: The applicable regulator (CFTC or SEC) determines that clearing is required; AND A clearinghouse accepts the swap for clearing Note--If no clearinghouse accepts the swap for clearing, the applicable regulator, after investigation, is authorized to take any action it determines to be necessary and in the public interest, including imposing margin and capital requirements on the parties Determination process can be for any single swap, or any group, category, type, or class of swaps Determination process may be initiated by the CFTC/SEC or by a clearinghouse Regulations will provide for periods of public review and comment before a determination is made 35
General Requirements: Clearing (cont d) Mandatory clearing requirement does not apply if one of the parties: Is not a financial entity ; Is using swaps to hedge or mitigate commercial risk; AND Notifies the applicable regulator how it generally meets its financial obligations associated with entering into non-cleared swaps A party that satisfies these requirements is often referred to as a commercial enduser (though the DFA does not use this term) The commercial end-user exception is solely at the discretion of the commercial hedging entity Definition of financial entity Swap dealers, MSPs, commodity pools, certain private funds, pension plans Persons predominantly engaged in the business of banking or in activities that are financial in nature 36
General Requirements: Execution Mandatory Exchange Execution If a swap is subject to the clearing requirement, it must be executed on an exchange or swap execution facility ( SEF ), unless: No exchange or SEF makes the contract available for trading, or A commercial end-user is a party to the swap and elects not to execute it on an exchange or SEF What is a SEF? Trading system or platform for multiple participants to execute or trade swaps by accepting bids and offers of participants Successor to the alternative trading platforms that have been in existence 37
General Requirements: Margining Margin Requirements Prudential regulators, CFTC, and SEC are required to establish margin requirements for non-cleared swaps executed by swap dealers and MSPs Prudential regulators (such as Fed, OCC and FDIC) are responsible for swap dealers and MSPs they regulate CFTC and SEC have this role for non-bank swap dealers and MSPs Prudential regulators are supposed to act in consultation with CFTC and SEC To date, the prudential regulators and CFTC (but not SEC) have issued proposed rules covering margin requirements relating to uncleared swaps 38
Product Definitions 39
40
Summary PRODUCT CHARACTERIZATION PRODUCT CHARACTERIZATION Cash/spot trades NOT TITLE VII Option on a single stock NOT TITLE VII CDS on a broad security index SWAP Option subject to securities laws NOT TITLE VII CDS on a narrow security index SBS Option on a swap SWAP CDS on a single name SBS OTC option on a single non-security loan SBS Commercial agreement NOT TITLE VII Retail OTC FX NOT TITLE VII Commodity swap SWAP SBS also based on certain CFTC-regulated rates, MIXED SWAP Consumer agreement NOT TITLE VII indices, currencies, commodities, etc. Correlation swap on a broad security index SWAP Security forward NOT TITLE VII Correlation swap on a commodity-based SWAP Spot FX transactions NOT TITLE VII Dividend swap on a broad security index SWAP Swap on an exempt security (other than muni) SWAP Dividend swap on a narrow security index SBS Swap on municipal security SBS Dividend swap on a single security SBS TBA MBS NOT TITLE VII Foreign exchange forward SWAP* TRS on a broad security index SWAP Foreign exchange swap SWAP* TRS on a narrow security index SBS Forward delivery contract NOT TITLE VII TRS on a single security SBS Guarantee of a swap SWAP Variance swap on a broad security index SWAP Guarantee of a SBS NOT TITLE VII Variance swap on a narrow security index SBS Insurance products NOT TITLE VII Variance swap on a single security SBS Interest rate swap SWAP Weather, energy, or emissions swap SWAP LCDS on multiple loans SWAP LCDS on a single loan SBS Abbreviations: Listed futures contract NOT TITLE VII CDS credit default swap Listed FX option contract NOT TITLE VII FX foreign exchange LTRS on multiple loans SWAP LCDS credit default swap on loan(s) LTRS on a single loan SBS LTRS total return swap on loan(s) Non-deliverable forward (NDF) SWAP MBS mortgage backed security Option on a SBS SBS SBS securities based swap TBA to be announced TRS total return swap * Treated as swap until Treasury determines otherwise Not Title VII Instruments are outside the scope of Title VII of Dodd-Frank 41
Product definitions On July 6, 2012, the SEC approved the Product Definitions on a unanimous vote of the SEC Commissioners. On July 10, 2012, the CFTC held an open meeting at which it approved the final Product Definitions in a 4-1 vote of the Commissioners (with Commissioner Chilton voting against the final rules). Title VII generally bifurcates regulation of the OTC derivatives markets, with the CFTC having jurisdiction over swaps and the SEC having jurisdiction over security-based swaps ( SBS, and with swaps, Title VII Instruments ). The SEC and CFTC share jurisdiction over mixed swaps. The CFTC also has regulatory and enforcement authority over security-based swap agreements ( SBSAs ), but the SEC has antifraud and certain other authority over SBSAs. 42
Product definitions Title VII defines a swap broadly to include transactions involving a purchase, sale, payment or delivery that is dependent on the occurrence, nonoccurrence, or extent of occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence This broad scope raised concerns regarding the status of a number of different types of products and instruments, and the final definitions include guidance regarding quite a number of products that are excluded from the definitions provided certain conditions are met. In the next series of slides, we will outline the treatment of a number of these products. The final rules also establish a process by which parties may request a joint interpretation from the CFTC/SEC regarding whether a particular OTC derivative or type of derivative that is subject to Title VII of Dodd-Frank should be treated as a swap, SBS or mixed swap. 43
Consumer transactions Certain consumer and commercial transactions are not swaps or SBS Consumer Transactions: understood to include agreements, contracts or transactions entered into by consumers primarily for personal, family or household purposes are not considered swaps or security-based swaps This exemption applies to transactions in which a consumer: acquires or leases real or personal property, obtains a mortgage, provides personal services, or assigns or sells rights of the consumer, including intellectual property rights. It also includes agreements for interest rate caps or locks on consumer loans or mortgages, as well as variable interest rate consumer loans or mortgages. 44
Commercial transactions Commercial Transactions: understood to include commercial agreements, contracts, or transactions that involve customary business or commercial arrangements. These will not be construed as Title VII Instruments. Commercial transactions include the following: employment contracts and retirement benefit arrangements, sales, servicing, or distribution arrangements, agreements, contracts, or transactions for the purpose of effecting a business combination transaction, the purchase, sale, lease, or transfer of real property, intellectual property, equipment, or inventory, 45
Commercial transactions (cont d) warehouse lending arrangements in connection with building an inventory of assets in anticipation of a securitization of such assets (such as in a securitization of mortgages, student loans, or receivables), mortgage or mortgage purchase commitments, sales of installment loan agreements or contracts or receivables; fixed or variable interest rate commercial loans entered into by banks and nonbanks, and commercial agreements, contracts and transactions (including, but not limited to, leases, service contracts and employment agreements) containing escalation clauses linked to an underlying commodity such as an interest rate or consumer price index. The final rule also lists characteristics and factors that the SEC/CFTC will consider in determining whether consumer or commercial transactions that are not included in the non-exclusive lists set out above are Title VII Instruments. 46
Forward contract exclusion DFA excludes from the definition of swap and security-based swap: Forward contracts for the sale of non-financial commodities and Forward contracts for the sale of securities Joint Final Rule confirms these exclusions and provides interpretive guidance for each category of forward contract 47
Forward Contracts-Nonfinancial Commodities CFTC confirmed that the exclusion of forward contracts on nonfinancial commodities from the swap definition will be interpreted based on existing CFTC precedent CFTC has over many years addressed how to distinguish forward contracts from futures contracts These interpretations will generally apply in the swap context as well Forward contracts are commercial merchandising transactions rather than transactions that solely serve to transfer price risk (such as futures and swaps) Intent to make or take delivery remains a key element of CFTC s facts and circumstances analysis In addition to generally applying existing precedent, the CFTC provided interpretations regarding how various common terms and features of commercial forward contracts might affect whether a forward contract qualifies for exclusion from the swap definition 48
Forward Contracts-Nonfinancial Commodities (cont d) Book-outs executed in a manner consistent with CFTC s Brent Interpretation (from 1990) fall within the forward contract exclusion relating to futures and swaps Book-outs are separate, independently negotiated subsequent transactions that extinguish obligations No pre-agreement or obligation to execute book-out Executed by commercial market participants in connection with their business To illustrate commercial requirement, CFTC distinguishes between Investment vehicle taking delivery of gold as an investment (not a commercial activity within the Brent Interpretation) and Investment vehicle that owns a gold mine and sells production forward (which is a commercial activity within the Brent Interpretation) Must be, to some extent, engaged in a commercial activity to rely on Brent Interpretation CFTC expands Brent Interpretation to all nonfinancial commodities Withdraws the Energy Exemption but preserves permissibility of master netting arrangements and other bona fide termination rights 49
Forward Contracts-Nonfinancial Commodities (cont d) CFTC clarifies that the term nonfinancial commodity for purposes of forward contract exclusion includes: Agricultural commodities Other nonfinancial commodities (referred to as exempt commodities ), which are capable of being physically delivered Indices of agricultural or exempt commodities cannot be physically delivered and are not nonfinancial commodities for this purpose However, certain intangible exempt commodities can be physically delivered and therefore qualify as nonfinancial commodities, e.g., environmental commodities such as renewable energy credits and emissions allowances can be consumed, so qualify but temperature-based swaps, such as a weather derivatives, would not 50
Forward Contracts-Nonfinancial Commodities (cont d) Forward contract can include Physical exchange transactions Fuel delivery agreements However, CFTC declined to state that cleared forward contracts executed through an exchange platform satisfy forward contract exclusion Commenter had proposed safe harbor if, on a rolling basis, an average of 50% of these contracts go to delivery CFTC was not prepared at this stage to consider this safe harbor request 51
Forward Contracts-Nonfinancial Commodities (cont d) CFTC addressed how embedded options might affect status of a forward contract In general, commodity options are swaps, though CFTC has adopted a modified trade option exemption for certain options between commercial parties Many commenters asked for clarification as to whether embedding an option in a forward contract might cause such contract to be considered a swap rather than an forward contract exempt from Title VII CFTC provided extensive guidance on this point which, while not exempting all forward contacts with embedded options, does cover many important commercial concerns CFTC reaffirmed its historical interpretations and guidance regarding the distinction between forwards and futures and confirmed that these, with certain modifications, apply in the swap context as well CFTC has addressed embedded options in a 1985 interpretation and various adjudicatory orders 52
Forward Contracts-Nonfinancial Commodities (cont d) Based on the principles reflected in these prior actions, CFTC provided a final three prong interpretation stating that a forward contract with an embedded option will continue to be an excluded forward contract if the embedded option: although it may adjust the forward price, does not undermine the overall nature of the contract as a forward contract, does not target the delivery term, so that the predominant feature of the contract is actual delivery, and cannot be severed and separately marketed These factors will be need to be evaluated in light of the specific facts and circumstances of each forward contract with embedded optionality 53
Forward Contracts-Nonfinancial Commodities (cont d) CFTC also provided guidance regarding several specific types of embedded options: Volumetric options: this type of optionality will not disqualify a forward contract so long as, together with the general conditions for embedded options, certain additional conditions are satisfied relating to (1) seller and buyer s intent to make and take delivery, (2) the commercial nature of the parties and (3) the dependence of the option on physical factors or regulatory requirements that are outside the parties control and reflect commercial considerations Requirements and output contracts: although amount deliverable under this type of contract may vary, these contracts often do not exhibit the type of optionality that would disqualify them from the forward contract exclusion Capacity, transmission services and tolling agreements: these contracts are capable of satisfying the general interpretation covering volumetric options Evergreen and extension terms: generally not regarded as the types of options that would disqualify contract from forward exclusion Delivery point/delivery date options: generally not regarded as the types of options that would disqualify contract from forward exclusion so long as delivery intent remains Supply and consumption agreements: despite option-like features, these contracts are capable of satisfying the three prong test and qualifying as forward contracts 54
Forward Contracts-Nonfinancial Commodities (cont d) Although the market can rely on the embedded option interpretation, CFTC is soliciting further comment on this interpretation together with the further comment that it has solicited on the modified trade option exemption Important to remember that a facts and circumstances analysis is required in all cases. For example: an Energy Management Agreement may cover a mix of services and transactions (such as spots, forwards and swaps), thus precluding any easy categorization of these agreements as forward contracts a liquidated damages provision, though not per se inconsistent with forward contract status, could in some cases reflect a lack of intent to deliver and as such undermine forward contract status 55
Forward Contracts-Securities Title VII statutory swap and SBS definitions exclude the following forward contracts on securities: Any transaction for the purchase and sale of one or more securities on a fixed or contingent basis (but, in the case of a contingent transaction, only if it is not a disguised CDS) Any sale of a security for deferred shipment or delivery if intended to be physically settled (this exclusion parallels forward contract exclusion for non-financial commodities) SEC confirmed that the core elements of these exclusions are actual purchases and sales and the intent to deliver In addition, SEC provided a specific interpretation confirming that forward sales of MBS in the to-be-announced (TBA) market fall within these exclusions even though the MBS to be delivered is typically not in existence at inception of deal 56
Loan Participations CFTC/SEC interpretive guidance excludes many loan participations from being categorized as a swap or a SBS Two basic types of loan participations LSTA style, which transfers a beneficial interest in an underlying loan (sometimes known as a true sale participation) LMA style, which establishes a debtor-creditor relationship between seller and participant (sometimes known as a risk participation) CFTC/SEC note three bases for excluding loan participations: First, some loan participations are securities and would be excluded as a purchase and sale of a security, Second, some loan participations may be identified banking products which are excluded, and Third, based on this interpretive guidance, loan participations that reflect an ownership interest in an underlying loan or commitment are excluded 57
Loan Participations (cont d) Regarding the ownership interest -based exclusion, SEC/CFTC identified the following characteristics that favor granting the exclusion: Seller is lender, participant or sub-participant in the underlying loan Participation interest does not exceed amount of the loan/commitment or seller s available interest in the loan/commitment Entire purchase price is paid at inception, not financed Participant takes all economic benefits and risks of participated portion of loan To satisfy these conditions, it is not essential that participation be a true sale participation or a participation that purports to be a true sale participation This permits LMA style participations to qualify Also clarified that participation can cover commitments to fund loans or letters of credit 58
Total Return Swaps Treatment of Total Return Swaps (TRS) provides a sharp illustration of the regulatory divide between swaps and SBS TRS are swaps or SBS which can cover one loan, multiple loans or other underlyers (including securities, narrow or broad based securities or commodities indices and non-security reference assets) In general under a TRS, one party receives the appreciation and pays the depreciation on the underlyer and also pays a synthetic financing payment based on an interest rate and notional amount CFTC/SEC guidance confirms that the synthetic interest based payment is incidental to the structure and therefore would not convert a TRS that is a SBS into a mixed swap 59
Total Return Swaps (cont d) CFTC/SEC also confirmed the following allocation of TRS between the swap and SBS categories: A TRS on a single loan, a single security or a narrow-based security index is an SBS A TRS on two or more loans or a broad-based security index is a swap Allocation between single loan and multiple loan TRS is a result of a very strict reading of the statute which defines a SBS to include a swap based on a single security or loan... Creates odd result that, if for convenience, parties used a single confirmation to evidence a TRS on two loans rather than two separate confirmations with otherwise identical terms the TRS would be a swap rather than a security-based swap 60
FX Swaps and FX Forwards Treatment of FX Swap and FX Forwards remains one of the more puzzling aspects of the Product Definitions Title VII permits the U.S. Treasury to exempt FX Swap and FX Forwards (but not other types of FX transactions) from the swap definition for some, but not all, aspects of Title VII FX Swap and FX Forwards are narrowly defined by the statute As a result, many other types of FX transactions (such as non-deliverable forwards, cross-currency swaps and FX options) are within the swap definition In general, FX market participants have been operating under the assumption that the U.S. Treasury would finalize this exemption prior to the effective date of the Product Definitions U.S. Treasury issued a proposed exemption in May 2011 61
FX Swaps and FX Forwards (cont d) At present, the Final Product Definitions cover FX Forwards and FX Swaps If the Treasury does not finalize its exemption prior to the effective date of the Product Definitions, then market participants would be forced to treat FX Forwards and FX Swaps as swaps for all purposes of Title VII This would have a major impact on many middle bracket financial institutions that presumed they would be able to continue to provide basic FX Forward and FX Swap dealing services for institutional clients without having to worry about registering as a swap dealer or MSP (so long as they didn t engage in other FX transactions) Failure of Treasury to act in a timely manner could cause unintended market disorder and illiquidity Even if Treasury does act, FX Forwards and FX Swaps remain subject to Title VII reporting and business conduct standards 62
Insurance products Insurance Safe Harbor Agreement must either be: An Enumerated Product ; or Satisfy the Product Test ; and The provider of the agreement must satisfy the Provider Test 63
Insurance products (cont d) Enumerated Products include: Surety Bond Fidelity Bond Life Insurance Health Insurance Long Term Care Insurance Title Insurance Property and Casualty Insurance Annuity Disability Insurance Insurance against default on individual residential mortgages; and Reinsurance on any of the foregoing products So long as the product is provided by an entity that meets the Provider Test 64
Insurance products (cont d) Product Test - An agreement, contract or transaction that: (A)By its terms or by law, as a condition of performance on the agreement, contract, or transaction: (1)Requires the beneficiary of the agreement, contract or transaction to have an insurable interest that is the subject of the agreement, contract or transaction and thereby carry the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract or transaction; (2)Requires that loss to occur and be provided, and that any payment or indemnification therefore be limited to the value of the insurable interest; (3)Is not traded, separately from the insured interest, on an organized market or over-the-counter; and (4)With respect to financial guaranty insurance only, in the event of payment default or insolvency of the obligor, any acceleration of payments under the policy is at the sole discretion of the insurer; and (B)Is provided by a person that satisfies the Provider Test. 65
Insurance products (cont d) The Provider Test requires that : (1) (i) the provider of the agreement, contract or transaction be a person that is subject to supervision by the insurance commissioner (or similar official or agency) of any State or the U.S. or any agency or instrumentality thereof, and (ii) such agreement, contract or transaction is regulated as insurance under applicable State law or the laws of the U.S.; (2) (i) the provider is, directly or indirectly, the U.S., any State or any of their respective agencies or instrumentalities, or (ii) pursuant to a statutorily authorized program thereof; or (3) In the case of Reinsurance only, by a person to another person that satisfies the Provider Test, provided that: 66
Insurance products (cont d) (i) such person is not prohibited by applicable State law or the laws of the U.S. from offering such agreement, contract or transaction to such person that satisfies the Provider Test ; (ii) the agreement, contract or transaction to be reinsured satisfies the Product Test or is an Enumerated Product ; and (iii) except as otherwise permitted under applicable State law, the total amount reimbursable by all reinsurers for such agreement, contract or transaction may not exceed the claims or losses paid by the person writing the risk being ceded or transferred by such person; or (4) In the case of non-admitted insurance, by a person who: (i) is located outside of the U.S. and listed on the Quarterly Listing of Alien Insurers maintained by the International Insurers Department of the NAIC; or (ii) meets the eligibility criteria for non-admitted insurers under applicable State law. 67
Insurance products (cont d) The SEC/CFTC expressly acknowledged that: CAT Bonds are securities and thus exempt from the Swap However, the SEC/CFTC expressly declined to provide interpretation regarding Industry Loss Warranty (ILW) contracts because it is inappropriate to determine whether a complex and novel product is a swap or a security-based swap in a general definitional rulemaking. 68