Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant”

Federal RegisterDec 21, 2010

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AD06

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-63452; File No. S7-39-10]

RIN 3235-AK65

Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant”

AGENCY:

Commodity Futures Trading Commission; Securities and Exchange Commission.

ACTION:

Joint proposed rule; proposed interpretations.

SUMMARY:

In accordance with Section 712(d)(1) of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) (collectively, the “Commissions”), in consultation with the Board of Governors of the Federal Reserve System, are proposing rules and interpretative guidance under the Commodity Exchange Act (“CEA”), 7 U.S.C. 1

et seq.,

and the Securities Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. 78a

et seq.,

to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.”

DATES:

Submit comments on or before February 22, 2011.

ADDRESSES:

Comments may be submitted by any of the following methods:

CFTC:

•

Agency Web site,

via its Comments Online process:

http://comments.cftc.gov.

Follow the instructions for submitting comments through the Web site.

•

Mail:

David A. Stawick, Secretary, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.

•

Hand Delivery/Courier:

Same as mail above.

•

Federal eRulemaking Portal:

Comments also may be submitted at

http://www.regulations.gov.

Follow the instructions for submitting comments. “Definitions” must be in the subject field of responses submitted via e-mail, and clearly indicated on written submissions. All comments must be submitted in English, or if not, accompanied by an English translation. All comments provided in any electronic form or on paper will be published on the CFTC Web site, without review and without removal of personally identifying information. All comments are subject to the CFTC Privacy Policy.

SEC

Electronic Comments

• Use the Commission's Internet comment form (

http://www.sec.gov/rules/proposed.shtml

);

• Send an e-mail to

rule-comments@sec.gov.

Please include File Number S7-39-10 on the subject line; or

• Use the Federal eRulemaking Portal (

http://www.regulations.gov

). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-39-10. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (

http://www.sec.gov/rules/proposed.shtml

). Comments are also available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT:

CFTC: Mark Fajfar, Assistant General Counsel, at 202-418-6636,

mfajfar@cftc.gov,

Julian E. Hammar, Assistant General Counsel, at 202-418-5118,

jhammar@cftc.gov,

or David E. Aron, Counsel, at 202-418-6621,

daron@cftc.gov,

Office of General Counsel, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581; SEC: Joshua Kans, Senior Special Counsel, Jeffrey Dinwoodie, Attorney Advisor, or Richard Grant, Attorney Advisor, at 202-551-5550, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

I. Background

On July 21, 2010, President Obama signed the Dodd-Frank Act into law.

Title VII of the Dodd-Frank Act

established a comprehensive new regulatory framework for swaps and security-based swaps. The legislation was enacted, among other reasons, to reduce risk, increase transparency, and promote market integrity within the financial system, including by: (1) Providing for the registration and comprehensive regulation of swap dealers, security-based swap dealers, major swap participants and major security-based swap participants; (2) imposing clearing and trade execution requirements on swaps and security-based swaps, subject to certain exceptions; (3) creating rigorous recordkeeping and real-time reporting regimes; and (4) enhancing the rulemaking and enforcement authorities of the Commissions with respect to, among others, all registered entities and intermediaries subject to the Commissions' oversight.

See

Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the Dodd-Frank Act may be accessed at

http://www.cftc.gov./LawRegulation/OTCDERIVATIVES/index.htm.

Pursuant to Section 701 of the Dodd-Frank Act, Title VII may be cited as the “Wall Street Transparency and Accountability Act of 2010.”

More specifically, the Dodd-Frank Act provides that the CFTC will regulate “swaps,” and the SEC will regulate “security-based swaps.” The Dodd-Frank Act also adds to the CEA and Exchange Act definitions of the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.” These terms are defined in Sections 721 and 761 of the Dodd-Frank Act and, with respect to the term “eligible contract participant,” in Section 1a(18) of the CEA,

as re-designated and amended by Section 721 of the Dodd-Frank Act.

See

7 U.S.C. 1a(18).

Section 712(d)(1) of the Dodd-Frank Act provides that the CFTC and the SEC, in consultation with the Board of Governors of the Federal Reserve System, shall jointly further define the terms “swap,” “security-based swap,” “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” “eligible contract participant,” and “security-based swap agreement.”

Further, Section 721(c) of the Dodd-Frank Act requires the CFTC to adopt a rule to further define the terms “swap,” “swap dealer,” “major swap participant,” and “eligible contract participant,” and Section 761(b) of the Dodd-Frank Act permits the SEC to adopt a rule to further define the terms “security-based swap,” “security-based swap dealer,” “major security-based swap participant,” and “eligible contract participant,” with regard to security-based swaps, for the purpose of including transactions and entities that have been structured to evade Title VII of the Dodd-Frank Act.

The definitions of the terms “swap,” “security-based swap,” and “security-based swap agreement,” and regulations regarding mixed swaps are the subject of a separate rulemaking by the Commissions.

In light of the requirements in the Dodd-Frank Act noted above, the CFTC and the SEC issued a joint Advance Notice of Proposed Rulemaking (“ANPRM”) on August 13, 2010, requesting public comment regarding the definitions of “swap,” “security-based swap,” “security-based swap agreement,” “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant” in Title VII of the Dodd-Frank Act.

The Commissions reviewed more than 80 comments in response to the ANPRM. The Commissions also informally solicited comments on the definitions on their respective Web sites.

In addition, the staffs of the CFTC and the SEC have met with many market participants and other interested parties to discuss the definitions.

See

Definitions Contained in Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act, Exchange Act Rel. No. 34-62717, 75 FR 51429 (Aug. 20, 2010). The comment period for the ANPRM closed on September 20, 2010.

Comments were solicited by the CFTC at

http://www.cftc.gov/LawRegulation/DoddFrankAct/OTC_2_Definitions.html

and the SEC at

http://www.sec.gov/spotlight/regreformcomments.shtml/.

The views expressed in the comments in response to the ANPRM, in response to the Commissions' informal solicitation, and at such meetings are collectively referred to as the views of “commenters.”

In this release, the Commissions propose to further define “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant,” and propose related rules, and also discuss certain factors that are relevant to market participants when determining their status with respect to the defined terms. In developing these proposals, the Commissions have been mindful that the markets for swaps and security-based swaps are evolving, and that the rules that we adopt will, as intended by the Dodd-Frank Act, significantly affect those markets. The rules not only will help determine which entities will be subject to comprehensive regulation of their swap and security-based swap activities, but may also cause certain entities to modify their activities to avoid being subject to the regulations. As a result, we are aware of the importance of crafting these rules carefully to maximize the benefits of the regulation imposed by the Dodd-Frank Act, and to do so in a way that is flexible enough to respond to market developments. While we preliminarily believe that these proposals, if adopted, would appropriately effect the intent of the Dodd-Frank Act, we are very interested in commenters' views as to whether we have achieved this purpose, and, if not, how to improve these proposals.

In addition, we recognize that the appropriateness of these proposals also should be considered in light of the substantive requirements that will be applicable to dealers and major participants, including capital, margin and business conduct requirements, which are the subject of separate rulemakings. For example, whether the definition of a major participant is too broad or too narrow may well depend in part on the substantive requirements applicable to such entities, and whether those substantive requirements are themselves appropriate may in turn depend in part on the scope of the major participant definition. We therefore encourage comments that take into account the interplay between the proposed definitions and these substantive requirements.

II. Definitions of “Swap Dealer” and “Security-Based Swap Dealer”

The Dodd-Frank Act defines the terms “swap dealer” and “security-based swap dealer” in terms of whether a person engages in certain types of activities involving swaps or security-based swaps.

Persons that meet either of those definitions are subject to statutory requirements related to, among other things, registration, margin, capital and business conduct.

See

Section 721 of the Dodd-Frank Act (defining “swap dealer” in new Section 1a(49) of the CEA, 7 U.S.C. 1a(49)) and Section 761 of the Dodd-Frank Act (defining “security-based swap dealer” in new Section 3(a)(71) of the Exchange Act, 15 U.S.C. 78c(a)(71)).

The Dodd-Frank Act excludes from the Exchange Act definition of “dealer” persons who engage in security-based swap transactions with eligible contract participants.

See

Section 3(a)(5) of the Exchange Act, 15 U.S.C. 78c(a)(5), as amended by Section 761(a)(1) of the Dodd-Frank Act.

The Dodd-Frank Act does not include comparable amendments for persons who act as brokers in swaps and security-based swaps. Because security-based swaps are a type of security, persons who act as brokers in connection with security-based swaps must, absent an exemption, register with the SEC as a broker pursuant to Exchange Act section 15(a), and comply with the Exchange Act's requirements applicable to brokers.

The two definitions in general encompass persons that engage in any of the following types of activity:

(i) Holding oneself out as a dealer in swaps or security-based swaps,

(ii) Making a market in swaps or security-based swaps,

(iii) Regularly entering into swaps or security-based swaps with counterparties as an ordinary course of business for one's own account, or

(iv) Engaging in activity causing oneself to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.

See

CEA section 1a(49)(A); Exchange Act section 3(a)(71)(A).

The definitions are disjunctive, in that a person that engages in any of the enumerated dealing activities is a swap dealer or security-based swap dealer even if the person does not engage in any of the other enumerated activities.

The definitions, in contrast, do not include a person that enters into swaps or security-based 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 instructs the Commissions to exempt from designation as a dealer an entity that “engages in a

de minimis

quantity of [swap or security-based swap] dealing in connection with transactions with or on behalf of its customers.”

Moreover, the definition of “swap dealer” (but not the definition of “security-based swap dealer”) provides that an insured depository institution is not 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.”

See

CEA section 1a(49)(C); Exchange Act section 3(a)(71)(C).

See

CEA section 1a(49)(D); Exchange Act section 3(a)(71)(D).

CEA section 1a(49)(A).

The definitions also provide that a person may be designated as a dealer for one or more types, classes or categories of swaps, security-based swaps, or activities without being designated a dealer for other types, classes or categories or activities.

See

CEA section 1a(49)(B); Exchange Act section 3(a)(71)(B).

The Commissions are proposing rules to further define certain aspects of the meaning of “swap dealer” and “security-based swap dealer,” and are providing guidance on how the Commissions propose to interpret these terms. This release specifically addresses: (A) The types of activities that would cause a person to be a swap dealer or security-based swap dealer, including differences in how those two definitions should be applied; (B) the statutory provisions requiring the Commissions to exempt persons from the dealer

definitions in connection with

de minimis

activity; (C) the exception from the “swap dealer” definition in connection with loans by insured depository institutions; (D) the possibility that a person may be considered a dealer for some types, classes or categories of swaps, security-based swaps, or activities but not others; and (E) certain interpretative issues that arise in particular situations. The Commissions request comment on all aspects of the proposals, including the particular points noted in the discussion below.

A. Swap and Security-Based Swap Dealing Activity

1. Comments Regarding Dealing Activities

Commenters provided numerous examples of conduct they viewed as dealing activities—as well as conduct they did not view as dealing activities. For example, many of the commenters stated that dealers provide “bid/ask” or “two-way” prices for swaps on a regular basis, or regularly participate in both sides of the swap market. Some commenters indicated that dealers perform an intermediary function. Other commenters stated that a person holds itself out as a dealer if it consistently and systematically markets itself as a swap dealer to third parties. Some commenters described market makers in the swap markets as persons that stand ready to buy or sell swaps at all times, are open to doing swaps business on both sides of a market, or make bids to buy and offers to sell swaps or a type of swap at all times. Commenters stated that a person should be included in the definition of dealer if its sole or dominant line of business is swaps activity. One commenter urged the Commissions to adopt a swap association's definition of a primary member as the definition of dealer.

Some commenters stated that the definition of dealer should be read narrowly. For example, some commenters suggested that the market maker concept should not encompass persons that provide occasional quotes or that do not make bids or offers consistently or at all times. Another commenter stated that a willingness to buy or sell a swap or security-based swap at a particular time does not constitute market making absent the creating of a two-way market. One commenter suggested that solely acting as a market maker should not cause a person to be a dealer, since firms may have commercial purposes for offering two-way trades. Another commenter stated that an entity that “holds itself out” as a dealer should qualify as a swap dealer only if it “consistently and systematically markets itself as a dealer to third-parties.”

See

letter from Eric Dennison, Sr. Vice President and General Counsel, Stephanie Miller, Assistant General Counsel—Commodities, and Bill Hellinghausen, Director of Regulatory Affairs, EDF Trading, dated September 20, 2010 (distinguishing transactions that the commenter enters into as part of energy management services).

Many commenters called for the exclusion of particular types of persons from the definition of swap dealer or security-based swap dealer. Several commenters maintained that commercial end-users of swaps or security-based swaps that enter into swaps or security-based swaps to hedge or mitigate commercial risk should be excluded from the definitions. Another commenter stated the definitions should exclude persons who use swaps or security-based swaps for bona fide hedging. Other commenters indicated that cooperatives that enter into swaps in connection with the business of their members should be excluded. Commenters also stated that if all of a person's swaps are cleared on an exchange or derivatives clearing organization, the person should not be deemed to be a dealer. One commenter stated competitive power suppliers should be excluded, and another stated that the dealer definition should not apply to futures commission merchants that act economically like brokers.

Commenters, particularly those in the securities industry, urged the Commissions to interpret the definitions of swap dealer and security-based swap dealer consistently with precedent that distinguishes between dealers in securities and traders in securities. However, one commenter also noted that some concepts from the securities and commodities laws may not easily be applied to these markets.

2. Application of the Core Tests to “Swap Dealers” and “Security-Based Swap Dealers”

The Dodd-Frank Act defines the terms “swap dealer” and “security-based swap dealer” in a functional manner, encompassing how a person holds itself out in the market, the nature of the conduct engaged in by the person, and how the market perceives the person's activities. This suggests that the definitions should not be interpreted in a constrained or overly technical manner. Rigid standards would not provide the necessary flexibility to respond to evolution in the ways that dealers enter into swaps and security-based swaps. The different types of swap and security-based swap markets are diverse, and there does not appear to be a single set of criteria that can be determinative in all markets.

At the same time, we note that there may be certain distinguishing characteristics of swap dealers and security-based swap dealers, including that:

• Dealers tend to accommodate demand for swaps and security-based swaps from other parties;

• Dealers are generally available to enter into swaps or security-based swaps to facilitate other parties' interest in entering into those instruments;

• Dealers tend not to request that other parties propose the terms of swaps or security-based swaps; rather, dealers tend to enter into those instruments on their own standard terms or on terms they arrange in response to other parties' interest; and

• Dealers tend to be able to arrange customized terms for swaps or security-based swaps upon request, or to create new types of swaps or security-based swaps at the dealer's own initiative.

We also recognize that the principles relevant to identifying dealing activity involving swaps can differ from comparable principles associated with security-based swaps. These differences are due, in part, to differences in how those instruments are used. For example, because security-based swaps may be used to hedge or gain economic exposure to underlying securities (while recognizing distinctions between securities-based swaps and other types of securities, as discussed below), there is a basis to build upon the same principles that are presently used to identify dealers for other types of securities. Accordingly, we separately address how the core tests would apply to swap dealers and to security-based swap dealers.

a. Application to Swap Dealers

The definition of swap dealer should be informed by the differences between swaps, on the one hand, and securities and commodities, on the other. Transactions in cash market securities and commodities generally involve purchases and sales of tangible or intangible property. Swaps, in contrast, are notional contracts requiring the performance of agreed terms by each party.

Thus, many of the concepts cited by commenters, such as whether a person buys and sells swaps or makes a two-sided market in swaps or trades within a bid/offer spread, cannot

necessarily be applied to all types of swaps to determine if the person is a swap dealer. We understand that market participants do use this terminology colloquially to describe the process of entering into a swap. For example, a person seeking a fixed/floating interest rate swap may inquire as to the fixed rates, spread above the floating rate and other payments that another person would require in order to enter into a swap. But, while these persons may discuss bids, offers, prices and so forth, the parties are negotiating the terms of a contract, they are not negotiating the price at which they will transfer ownership of tangible or intangible property. Accordingly, these concepts are not determinative of whether a person is a “swap dealer.”

As discussed below, however (

see

note 42,

infra

), the Dodd-Frank Act amended the Exchange Act definitions of “buy,” “purchase,” “sale” and “sell” to apply to particular actions involving security-based swaps.

Instead, persons who are swap dealers may be identified by the functional role they fulfill in the swap markets. As noted above, swap dealers tend to accommodate demand and to be available to enter into swaps to facilitate other parties' interest in swaps (although swap dealers may also advance their own investment and liquidity objectives by entering into such swaps). In addition, swap dealers can often be identified by their relationships with counterparties. Swap dealers tend to enter into swaps with more counterparties than do non-dealers, and in some markets, non-dealers tend to constitute a large portion of swap dealers' counterparties. In contrast, non-dealers tend to enter into swaps with swap dealers more often than with other non-dealers.

The Commissions can most efficiently achieve the purposes underlying Title VII of the Dodd-Frank Act—to reduce risk and to enhance operational standards and fair dealing in the swap markets—by focusing their attention on those persons whose function is to serve as the points of connection in those markets. The definition of swap dealer, construed functionally in the manner set forth above, will help to identify those persons.

Some of the commenters appeared to suggest that significant parts of the swap markets operate without the involvement of swap dealers. We believe that this analysis is likely incorrect, and that the parties that fulfill the function of dealers should be identified and are likely to be swap dealers.

Clause (A)(iii) of the statutory definition of swap dealer, which includes any person that “regularly enters into swaps with counterparties as an ordinary course of business for its own account,”

has been the subject of significant uncertainty among commenters. The commenters point out that its literal terms could encompass many parties who regularly enter into swaps without engaging in any form of swap dealing activity. In this regard, clause (A)(iii) of the definition should be read in combination with the express exception in subparagraph (C) of the swap dealer definition, which excludes “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.” Thus, the difference between the inclusion in clause (A)(iii) and the exclusion in subparagraph (C) is whether or not the person enters into swaps as a part of, or as an ordinary course of, a “regular business.”

We believe that persons who enter into swaps as a part of a “regular business” are those persons whose function is to accommodate demand for swaps from other parties and enter into swaps in response to interest expressed by other parties. Conversely, persons who do not fulfill this function should not be deemed to enter into swaps as part of a “regular business” and are not likely to be swap dealers.

We interpret this reference to a person entering into swaps “with counterparties * * * for its own account” to refer to a person entering into a swap as a principal, and not as an agent. A person who entered into swaps as an agent for customers (

i.e.,

for the customers' accounts) would be required to register as either a Futures Commission Merchant, Introducing Broker, Commodity Pool Operator or Commodity Trading Advisor, depending on the nature of the person's activity.

The definition of “security-based swap dealer” is structured similarly, and should be interpreted similarly.

In sum, to determine if a person is a swap dealer, we would consider that person's activities in relation to the other parties with which it interacts in the swap markets. If the person is available to accommodate demand for swaps from other parties, tends to propose terms, or tends to engage in the other activities discussed above, then the person is likely to be a swap dealer. Persons that rarely engage in such activities are less likely to be deemed swap dealers.

We request comment on this interpretive approach for identifying whether a person is a swap dealer.

b. Application to Security-Based Swap Dealers

The definition of “security-based swap dealer” has parallels to the definition of “dealer” under the Exchange Act.

In addition, security-based swaps may be used to hedge risks associated with the ownership of certain other types of securities,

and security-based swaps may be used to gain economic exposure akin to ownership of certain other types of securities.

As a result, the SEC would consider the same factors that are relevant to determining whether a person is a “dealer” under the Exchange Act as also generally relevant to the analysis of whether a person is a security-based swap dealer.

The Exchange Act in relevant part defines “dealer” to mean “any person engaged in the business of buying and selling securities (not including security-based swaps, other than security-based swaps with or for persons that are not eligible contract participants) for such person's own account through a broker or otherwise,” but with an exception for “a person that buys or sells securities (not including security-based swaps, other than security-based swaps with or for persons that are not eligible contract participants) for such person's own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” Exchange Act sections 3(a)(5)(A) and (B), 15 U.S.C. 78c(a)(5)(A) and (B), as amended by Section 761(a)(1) of the Dodd-Frank Act.

For example, an entity that owns a particular security may use a security-based swap to hedge the risks of that security. Conversely, an entity may seek to offset exposure involving a security-based swap by using another security as a hedge.

For example, an entity may enter into a security-based swap to gain economic exposure akin to a long or short position in a stock or bond, without having to engage in a cash market transaction for that instrument.

The Exchange Act has been interpreted to distinguish between “dealers” and “traders.” In this context, the SEC previously has 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).

Securities Exchange Act Release No. 47364 (Feb. 13, 2003) (footnotes omitted).

Other non-exclusive factors that are relevant for distinguishing between dealers and non-dealers can include the receipt of customer property and the furnishing of incidental advice in connection with transactions.

The markets involving security-based swaps are distinguishable in certain respects from markets involving cash market securities—particularly with regard to the concepts of “inventory” (which generally appears inapplicable in this context)

and “regular place of business.” For example, the suggestion that dealers are more likely to operate at a “regular place of business” than traders should not be construed in a way that ignores the reality of how the security-based swap markets operate (or that

ignores evolution in dealing practices involving other types of securities). Dealers may use a variety of methods to communicate their availability to enter into security-based swaps with other market participants. The dealer-trader distinction should not be applied to the security-based swap markets without taking those distinctions into account.

Even in light of those differences, however, we believe that the dealer-trader distinction provides an important analytical tool to assist in determining whether a person is a “security-based swap dealer.”

In particular, an analysis that considers dealers to differ from traders in part because dealers have regular turnover in “inventory” appears not to apply in the context of security-based swaps, given that those instruments are created by contract between two market counterparties, rather than reflecting financial rights issued by third-parties.

The definition of “security-based swap dealer,” unlike the Exchange Act's definition of “dealer,” does not specifically refer to “buying” and “selling.” We do not believe that this language difference is significant, however, as the Dodd-Frank Act amended the Exchange Act definitions of “buy” and “purchase,” and the Exchange Act definitions of “sale” and “sell,” to encompass the execution, termination (prior to its scheduled maturity date), assignment, exchange or similar transfer or conveyance of, or extinguishing of rights or obligations under, a security-based swap.

See

Dodd-Frank Act sections 761(a)(3), (4) (amending Exchange Act sections 3(a)(13), (14)).

Commenters have raised concerns that the ambit of the security-based swap dealer definition could encompass end-users that use security-based swaps for hedging their business risks. Deeming those entities to be security-based swap dealers due to their hedging activities could discourage their use of hedging transactions or subject them to a regulatory framework that was not intended to address their businesses and could subject them to unnecessary costs. Under the dealer-trader distinction, however, we would expect entities that use security-based swaps to hedge their business risks, absent other activity, likely would not be dealers.

Also, as discussed below, both the “security-based swap dealer” definition and the dealer-trader distinction in part turn on whether a person holds itself out as a dealer.

Of course, if a person's other activities satisfy the definition of security-based swap dealer, it must comply with the applicable requirements with regard to all of its security-based swap activities, absent an order to the contrary, as discussed below. Also, as discussed below, we would expect end-users to use security-based swaps for hedging purposes less commonly than they use swaps for hedging purposes.

We request comment on the application of the dealer-trader distinction as part of the analysis of whether a person is a security-based swap dealer.

c. Issues Common to Both Definitions

i. Holding Oneself Out as, and Being Commonly Known in the Trade as, a Swap Dealer or Security-Based Swap Dealer

As noted above, the application of these definitions to persons that “hold themselves out” as dealers or that are “commonly known in the trade” as dealers highlights the need for a functional interpretation of the dealer definitions. We believe that factors that may reasonably indicate that a person is holding itself out as a dealer or is commonly known in the trade as a dealer may include (but are not limited to) the following:

• Contacting potential counterparties to solicit interest in swaps or security-based swaps,

• Developing new types of swaps or security-based swaps (which may include financial products that contain swaps or security-based swaps) and informing potential counterparties of the availability of such swaps or security-based swaps and a willingness to enter into such swaps or security-based swaps with the potential counterparties,

• Membership in a swap association in a category reserved for dealers,

• Providing marketing materials (such as a Web site) that describe the types of swaps or security-based swaps that one is willing to enter into with other parties, or

• Generally expressing a willingness to offer or provide a range of financial products that would include swaps or security-based swaps.

Notably, holding oneself out as a security-based swap dealer would likely encompass a situation in which a person that is a “dealer” in another type of security enters into a security-based swap with a customer.

Another example of holding oneself out as a security-based swap dealer would likely be an entity expressing its availability to provide liquidity to counterparties that seek to enter into security-based swaps, regardless of the “direction” of the transaction or across a broad spectrum of risks (

e.g.,

credit default swaps related to a variety of issuers).

For example, if a person that is a dealer in securities that are not security-based swaps enters into a security-based swap transaction with one of its cash market customers, the person would appear to be engaged in security-based swap dealing activity with that customer. In that circumstance, the customer reasonably would be expected to view the person as a dealer for purposes of the security-based swap, making the applicable business conduct requirements particularly important.

The determination of who is commonly known in the trade as a swap dealer or security-based swap dealer may appropriately reflect, among other factors, the perspective of persons with substantial experience with and knowledge of the swap and security-based swap markets, regardless of whether an entity is known as a dealer by persons without that experience and knowledge.

ii. Making a Market in Swaps or Security-Based Swaps

A number of commenters suggested that the market making component of the definitions should apply only to persons that quote a two-sided market consistently or at all times. Some commenters also suggested that a person's willingness to buy or to sell a swap or security-based swap at any particular time should not be deemed to be market making activity. While continuous two-sided quotations and a willingness to stand ready to buy and sell a security are important indicators of market making in the equities markets,

these indicia may not be appropriate in the context of the swap or security-based swap markets, given that parties do not enter into many types of swaps or security-based swaps on a continuous basis, and that parties may use a variety of methods for communicating their willingness to enter into swaps or security-based swaps. Any analysis that would impute to the definitions a “continuous” activity requirement may cause certain persons that engage in non-continuous dealing activities not to be regulated as swap dealers or security-based swap dealers. We have not identified anything in the statutory text or legislative history of the Dodd-Frank Act to suggest that Congress intended such a result.

See

Exchange Act Release No. 58875 (Oct. 14, 2008), 73 FR 61690 (Oct. 17, 2008) (“Although determining whether or not a market maker is engaged in bona-fide market making would depend on the facts and circumstances of the particular activity, factors that indicate a market maker is engaged in bona-fide market making activities may include, for example, whether the market maker incurs any economic or market risk with respect to the securities (

e.g.,

by putting their own capital at risk to provide continuous two-sided quotes in markets).”).

iii. No Predominance Test

Although some commenters suggested that a person should be a swap dealer or security-based swap dealer only if such activity is the person's sole or predominant business, the statutory definition does not contain a predominance test or otherwise depend upon the level of the person's dealing activity, other than the

de minimis

exception discussed below. A predominance standard would not

provide a workable test of dealer status because many of the parties that are commonly acknowledged as swap or security-based swap dealers also engage in other businesses that often outweigh their swap or security-based swap dealing business in terms of transaction volume or other measures. Based on the plain meaning of the statutory definition, so long as a person engages in dealing activity that is not

de minimis,

as discussed below, the person is a swap dealer or security-based swap dealer.

As one example, a non-financial company that engages in both swap dealing and other commercial activities would fall within the definition of swap dealer because of its swap dealing activities, notwithstanding that it also engages in other commercial activities.

iv. Application of the Definition to New Types of Swaps and New Activities

The Commissions intend to apply the definitions of swap dealer and security-based swap dealer flexibly when the development of innovative business models is accompanied by new types of dealer activity. As discussed above, the Commissions generally intend to follow a “facts-and-circumstances” approach with respect to identifying dealing activities. The dealer definitions must be flexible enough to cover appropriate persons as the swap markets evolve.

v. Request for Comment

The Commissions request comment on these interpretations of holding oneself out as a dealer and being commonly known in the trade as a dealer, as well as the lack of a predominance test, and the application of the definitions to new types of swaps and new activities. Commenters particularly are requested to address the relevance, to the dealer analysis, of activities such as an entity's membership in a swap execution facility (“SEF”) or a security-based SEF, or use of facilities that may not be SEFs or security-based SEFs. Are there factors that would lead entities to become members of SEFs that would not make membership relevant to the dealer analysis? Commenters also are requested to generally address how the dealer analysis should appropriately apply the requirements applicable to dealers (

e.g.,

capital, margin and business conduct requirements) to the entities that should be subject to those requirements. In addition, commenters are requested to address how the dealer definitions should be applied to entities such as, for example, Federal home loan banks subject to restrictions limiting their dealing activities to particular types of counterparties. Finally, commenters are requested to address whether additional guidance is advisable to help identify dealer activity and to promote effective enforcement of the requirements applicable to swap dealers and security-based swap dealers.

3. Designation of a Person as a Swap Dealer

The Dodd-Frank Act has amended the CEA and the Exchange Act to require a person that meets either of the definitions to register as a swap dealer and/or security-based swap dealer,

and the Commissions are proposing separate rules regarding this registration requirement. In connection with the registration requirement, market participants are in a position to assess their activities to determine whether they function in the manner described in the definitions. In addition, the Commissions have the authority to take enforcement actions in response to a dealer's failure to register. In determining whether a person meets the applicable definitions, the Commissions may use information from other regulators, swap data repositories, registered clearing agencies, derivatives clearing organizations and other sources.

See

CEA section 4s(a)-(b); Exchange Act section 15F(a)-(b).

4. Application of the Swap Dealer Definition to Agricultural Commodities

Section 723(c)(3)(B) of the Dodd-Frank Act provides that swaps in agricultural commodities shall be subject to such terms and conditions as the CFTC may prescribe. In a separate rulemaking, the CFTC has proposed a definition of the term “agricultural commodity.”

Acting under the authority in Section 723(c)(3)(B), the CFTC may develop particular terms and conditions for the interpretation of the swap dealer definition when it is applied to dealing in swaps in agricultural commodities. Any such terms and conditions would not be applicable to the definition of security-based swap dealer. The CFTC requests comment on the application of the swap dealer definition to dealers, including potentially agricultural cooperatives, that limit their dealing activity primarily to swaps in agricultural commodities. The CFTC may consider any comments on this topic for both the definition of swap dealer and also for any rulemaking regarding swaps in agricultural commodities.

See

75 FR 65586 (Oct. 26, 2010).

B. De Minimis Exemption to the Definitions

The Dodd-Frank Act requires that the Commissions exempt, from designation as a “swap dealer” or “security-based swap dealer,” a person who “engages in a

de minimis

quantity of [swap or security-based swap] dealing in connection with transactions with or on behalf of its customers.”

The statutory definitions do not require that the Commissions fix a specific level of swap activity that will be considered

de minimis,

but instead require that the Commissions “promulgate regulations to establish factors with respect to the making of this determination to exempt.”

See

CEA section 1a(49)(D); Exchange Act section 3(a)(71)(D).

1. Comments Regarding the

De Minimis

Exemption

Some commenters asserted that the

de minimis

exemption should be linked to systemic risk concerns, stating that persons engaged in dealing activities that do not pose systemic risk should be able to take advantage of the exemption. Other commenters suggested that a person's dealing activities should be considered

de minimis

if they do not pose undue risks to the person. Commenters also expressed the view that the application of the exemption should be based on quantitative criteria.

2. Proposed Rule Regarding the

De Minimis

Exemption

The Commissions preliminarily believe that the “

de minimis”

exemption should be interpreted to address amounts of dealing activity that are sufficiently small that they do not warrant registration to address concerns implicated by the regulations governing swap dealers and security-based swap dealers.

In other words, the exemption should apply only when an entity's dealing activity is so minimal that applying dealer regulations to the entity would not be warranted.

The Title VII requirements applicable to swap and security-based swap dealers include, for example: requirements that dealers conform to regulatory standards relating to the confirmation, processing, netting, documentation and valuation of swaps and security-based swaps (CEA section 4s(i), Exchange Act section 15F(i)); requirements that dealers disclose, to regulators, information concerning terms and conditions of swaps or security-based swaps, as well as information concerning trading practices, financial integrity protections and other trading information (CEA section 4s(j)(3), Exchange Act section 15F(j)(3)); conflicts of interest provisions (CEA section 4s(j)(5), Exchange Act section 15F(j)(5)); and chief compliance officer requirements (CEA section 4s(k), Exchange Act section 15F(k)).

We thus preliminarily do not agree with those commenters that argued that

de minimis

quantity of dealing should be measured in relation to the level of the person's other activities (or other swap or security-based swap activities). Aside from the fact that the statute does not explicitly call for a relative test, such an approach would lead to the result that larger and more active companies, which presumably would be more able to influence the swap markets, would be more likely to qualify for the exemption than smaller and less active companies. Also, a relative test not only would require a means of measuring the person's dealing activities, but also would require a means of measuring the larger scope of activities to which its swap dealing or security-based swap dealing activities are to be compared, thus introducing unnecessary complexity to the exemption's application.

Our proposed factors for the

de minimis

exemption seek to focus the availability of the exemption toward entities for which registration would not be warranted from a regulatory point of view in light of the limited nature of their dealing activities. At the same time, we recognize that this focus does not appear to readily translate into objective criteria. Thus, while the proposed factors discussed below reflect our attempt to delimit the

de minimis

exemption appropriately, we recognize that a range of alternative approaches may be reasonable, and we are particularly interested in commenters' suggestions as to the appropriate factors.

The first proposed factor is that the aggregate effective notional amount, measured on a gross basis, of swaps or security-based swaps that an entity enters into over the prior 12 months in connection with its dealing activities

could not exceed $100 million.

We understand that in general the notional size of a small swap or security-based swap is $5 million or less, and this proposed threshold would reflect 20 instruments of that size. Given the customer protection issues raised by swaps and security-based swaps—including the risks that counterparties may not fully appreciate when entering into swaps or security-based swaps—we believe that this notional amount reflects a reasonable limit for identifying those entities that engage in a

de minimis

level of dealing activity.

This standard would measure an entity's quantity of dealing on a gross basis (without consideration of the market risk offsets associated with combining long and short positions) to reflect the entity's overall amount of dealing activity. Similarly, the proposed notional threshold would not account for the amount of collateral held by or provided by the entity, nor other risk mitigating factors, in determining whether it engages in a

de minimis

quantity of dealing, given that dealer status focuses on an entity's absolute level of activity, and is not directly based on the risks that an entity poses or faces.

The

de minimis

exemption specifically places limits on a person's dealing activity involving swaps or security-based swaps. Thus, these limits would not apply to swap or security-based swap activity that does not itself constitute dealing activity, such as activity in which a person hedges or mitigates a commercial risk of its business that is unrelated to a dealing business (

i.e.,

as discussed above, when the person did not accommodate demand from the other party, respond to the other party's interest in swaps or security-based swaps, solicit the other party, propose economic terms, intermediate between parties, provide liquidity, or engage in other dealing activities).

See

part II.A.2,

supra.

See

proposed CEA rule 1.3(ppp)(4)(ii); proposed Exchange Act rule 3a71-2(a). To the extent that the stated notional amount of a swap or security-based swap is leveraged or enhanced by its structure, the calculation shall be based on the effective notional amount of the swap or security-based swap rather than on its stated notional amount.

We preliminarily believe that activity above this amount would be sufficient to warrant dealer registration to bring about the benefits of such registration.

Also, allowing offsets for collateral would result in a

de minimis

standard that could encompass positions of virtually unlimited size.

In addition, the aggregate effective notional amount of such swaps or security-based swaps, in which the person's counterparty is a “special entity” (as that term is defined in CEA Section 4s(h)(2)(C) and Exchange Act Section 15F(h)(2)(C)),

that an entity enters into over the prior 12 months could not exceed $25 million.

The Dodd-Frank Act provided special protections to special entities in connection with swaps and security-based swaps, and we preliminarily believe that this lower proposed threshold reasonably reflects the special protections afforded to those entities.

The term “special entity” encompasses: Federal agencies; States, State agencies and political subdivisions (including cities, counties and municipalities); “employee benefit plans” as defined under the Employee Retirement Income Security Act of 1974 (“ERISA”); “governmental plans” as defined under ERISA; and endowments.

See

proposed CEA rule 1.3(ppp)(4)(ii); proposed Exchange Act rule 3a71-2(b).

In addition, to take advantage of the

de minimis

exemption, the proposed rule would provide that the entity could not have entered into swaps or security-based swaps (as applicable) as a dealer with more than 15 counterparties, other than security-based swap dealers, over the prior 12 months.

The Commissions preliminarily believe that an entity that enters into swaps or security-based swaps, in a dealer capacity, with a larger number of counterparties should be registered to help achieve Title VII's orderly market goals, and thus cannot be said to engage in a

de minimis

quantity of dealing (even if the aggregate effective notional amount of the swaps or security-based swaps is less than the thresholds noted above).

For purposes of determining the number of counterparties, we preliminarily believe that counterparties who are members of an affiliated group would generally count as one counterparty, given that the purpose of the limit is to measure the scope of dealer's interaction with separate counterparties.

See

proposed CEA rule 1.3(ppp)(4)(iii); proposed Exchange Act rule 3a71-2(c). That these tests measure the entity's activities over the prior 12 months provides certainty. As of the end of each month, the entity will know whether it may qualify for the exemption during the following month.

Similarly, because all the

de minimis

factors must be satisfied, a person who enters into only a single swap or security-based swap, as a swap dealer, with a single counterparty could not qualify for the

de minimis

exemption if that swap or security-based swap exceeds the effective notional amount threshold.

For this purpose, an affiliated group would be defined as any group of entities that is under common control and that reports information or prepares its financial statements on a consolidated basis.

Finally, the proposed rule would provide that, to take advantage of the

de minimis

exemption, the entity could not have entered into more than 20 swaps or security-based swaps (as applicable) as a dealer during the prior 12 months.

As is the case for the limitation on the number of counterparties, the Commissions preliminarily believe that an entity that enters into a larger number of swaps or security-based swaps, in a dealer capacity, would, if registered, help achieve Title VII's orderly market goals, and thus cannot be said to engage in a

de minimis

quantity of dealing. For these purposes, we would expect that each separate transaction the entity enters into under a swap or security-based swap master agreement in general would count as entering into a swap or security-based swap, but that an amendment of an existing swap or security-based swap in which the counterparty remained the same and the underlying item remained substantially the same would not count as a new swap or security based swap.

See

proposed CEA rule 1.3(ppp)(4)(iv); proposed Exchange Act rule 3a71-2(d).

For these purposes only, an amendment to an existing swap or security-based swap would not need to be counted as a new swap or security-based swap if the underlying item is substantially the same as the original item. This may occur, for example, to reflect the effect of a corporate action such as a merger. An amendment would be counted as a new swap or security-based swap, however, to

the extent that the change in the underlying item modifies the economic risk reflected by the swap or security-based swap.

The proposed rule would not distinguish between different types of swaps or security-based swaps into which entities may enter (

e.g.,

rate swaps versus other commodity swaps, or credit default swaps versus equity swaps). The Commissions preliminarily do not believe that the ceiling for distinguishing

de minimis

dealing activities from other dealing activities appropriately turns upon the particular type of swap or security-based swap.

The Exchange Act's definition of “dealer” does not include a

de minimis

exemption. Thus, an entity that engages in dealing activity involving securities (other than security-based swaps with eligible contract participants) would be required to register as a “dealer” under the Exchange Act, and comply with the Exchange Act's requirements applicable to dealers, absent some other exception or exemption from registration.

The Commissions request comment on the proposed rule regarding the

de minimis

exemption. Commenters particularly are requested to address whether certain of the proposed factors should be modified or eliminated; for example, should the proposed $100 million limit on annual notional swaps or security-based swaps entered into in a dealer capacity be raised or lowered to better implement the intended scope of the

de minimis

exemption—

i.e.,

to exclude entities for which dealer regulation would not be warranted? Should we adopt different thresholds that would appropriately limit the exemption so it encompasses only those entities whose dealing activities are such that dealer regulation is not warranted? To what extent would certain entities be expected to reduce or otherwise adjust their dealing activity to fall within the scope of the

de minimis

exemption? Would there be any adverse implications for market participants if this happens? To what extent could the proposed factors potentially reduce dealing activity, and in doing so reduce the liquidity available in the swap or security-based swap market?

Commenters also are requested to address whether the rule should seek to identify only certain types of counterparties with which a person could engage in dealing activities under the exemption. We also particularly request comment on the proposed $25 million notional threshold for dealer transactions with “special entities,” including whether that proposed threshold should be raised or lowered, and whether an entity that enters into dealing transactions with “special entities” should be able to take advantage of the exemption at all. In addition, we request comment on whether the proposed threshold for transactions with “special entities” would provide a disincentive to dealers entering into transactions with such entities.

Commenters further are requested to address whether the factors may appropriately account for the size of the swap or security-based swap activities compared to the size of the entity; how an entity's swaps or security-based swaps with affiliated counterparties should be treated for purposes of the test; and whether the exemption's factors should vary depending on the type of swap or security-based swap at issue.

In addition, commenters are requested to address the significance of the fact that the statutory

de minimis

exemption specifically references transactions with or on behalf of a customer. Does that mean the exemption was intended to specifically address dealing activity as an accommodation to an entity's customers? If so, should the exemption be conditioned on the presence of an existing relationship between the entity and the counterparty that does not entail swap or security-based swap dealing activity, and if so, which types of relationships should be treated as creating a “customer” relationship?

Commenters also are requested to address whether the

de minimis

exemption should excuse an entity from having to comply with certain regulatory requirements imposed on swap dealers or security-based swap dealers, while also mandating compliance with other dealer requirements. In addition, commenters are requested to address whether, in lieu of the self-executing approach proposed here, the Commissions instead should require that entities which seek relief under this

de minimis

exemption must submit exemptive requests to the relevant agency for the agency's consideration and action. Commenters further are requested to address whether the proposed notional threshold for the

de minimis

exception should be subject to a formula that permits automatic periodic adjustments to the threshold, such as to reflect changes in market size or in the size of typical contracts.

C. Statutory Exclusion for Swaps in Connection With Originating a Loan

The “swap dealer” definition excludes an insured depository institution (“IDI”) “to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.”

This exclusion does not appear in the definition of “security-based swap dealer.”

See

CEA section 1a(49)(A).

1. Comments Regarding the Exclusion for Swaps in Connection With Loans

Three IDIs commented on this aspect of the definition, stating that the exclusion should encompass any swap entered into contemporaneously with a loan that is related to any of the borrower's activities that affect the ability to repay the loan and can be hedged. Thus, in their view, the exclusion should cover exchange rate and physical commodity swaps in addition to interest rate swaps. The IDIs also said the exclusion should apply to amendments, restructurings and workouts of loans, and to lenders that act through a syndicate.

Another commenter expressed similar views, and also asked for clarification whether the exclusion applies to all aspects of the definition, or if it applies only to whether a person is commonly known in the trade as a swap dealer. The CFTC preliminarily believes the exclusion applies to all aspects of the swap dealer definition.

2. Proposed Rule Regarding the Exclusion for Swaps in Connection With Loans

The CFTC preliminarily interprets the word “offer” in this exclusion to include scenarios where the IDI requires the customer to enter into a swap, or the customer asks the IDI to enter into a swap, specifically in connection with a loan made by that IDI. Also, the proposed rule provides that, in order to prevent evasion, the statutory exclusion does not apply where (i) The purpose of the swap is not linked to the financial terms of the loan; (ii) the IDI enters into a “sham” loan; or (iii) the purported “loan” is actually a synthetic loan such as a loan credit default swap or loan total return swap.

The proposed rule would apply the statutory exclusion only to swaps that are connected to the financial terms of the loan, such as, for example, its duration, interest rate, currency or principal amount. Although commenters urged that this exclusion be extended to other aspects of the lending relationship, we preliminarily believe that it would not be appropriate that this exclusion from the swap dealer definition encompass swaps that are connected to the borrower's other business activities, even if the loan agreement requires that the borrower enter into such swaps or otherwise refers to them. We preliminarily believe that a broader reading of the exclusion could encompass all swap activity

between an IDI and its borrowers, which we do not think is intended.

The origination of commercial loans is a complex process, and the CFTC preliminarily believes that this exclusion should be available to all IDIs that are a source of funds to a borrower. For example, all IDIs that are part of a loan syndicate providing a loan to a borrower could claim this exclusion with respect to swaps entered into with the borrower that are connected to the financial terms of the loan. Similarly, the proposed exclusion could be claimed with respect to such swaps entered into by any IDI that participates in or obtains a participation in such loan by means of a transfer or otherwise.

Also, an IDI that is a source of funds for the refinancing of a loan (whether directly or through a syndicate, participation or otherwise) could claim the exclusion if it enters into a swap with the refinancing borrower.

The CFTC preliminarily believes that the proposed exclusion could be claimed by any IDI that participates in a loan through any means that involves a payment to a lender to take the place of that lender, including an “English style” participation.

We emphasize that this proposed exclusion, by its statutory terms, is available only to IDIs. If an IDI were to transfer its participation in a loan to a non-IDI, then the non-IDI would not be able to claim this exclusion, regardless of the terms of the loan or the manner of the transfer. Similarly, a non-IDI that is part of a loan syndicate with IDIs would not be able to claim the exclusion.

In sum, the proposed exclusion may be claimed by a person that meets the following three conditions: (i) The person is an IDI; (ii) the person is the source of funds to a borrower in connection with a loan (either directly or through syndication, participation, refinancing or otherwise); and (iii) the person enters into a swap with the borrower that is connected to the financial terms of the loan (so long as the loan is not a sham or a synthetic loan).

The CFTC requests comment on the proposed rule relating to the statutory exclusion for swaps in connection with originating a loan, and in particular on whether this statutory exclusion should be extended beyond swaps that are connected to the financial terms of the loan, and if so, why. The CFTC also requests comment on whether this exclusion should apply only to swaps that are entered into contemporaneously with the IDI's origination of the loan (and if so, how “contemporaneously” should be defined for this purpose), or whether this exclusion should also apply to swaps entered into during part or all of the duration of the loan.

D. Designation as a Dealer for Certain Types, Classes, or Categories of Swaps, Security-Based Swaps, or Activities

The statutory definitions include a provision stating that a person may be designated as a dealer for one or more types, classes or categories of swaps, security-based swaps, or activities without being considered a swap dealer or security-based swap dealer for other types, classes or categories of swaps, security-based swaps, or activities. This provision is permissive and does not require the Commissions to designate persons as dealers for only a limited set of types, classes or categories of swaps, security-based swaps, or activities.

1. Comments Regarding Limited Designation as a Swap Dealer or Security-Based Swap Dealer

One commenter stated that the Commissions should allow a person to register as a swap dealer or security-based swap dealer for only a limited set of types, classes or categories of swaps or security-based swaps. Another commenter expressed the view that a person designated as a swap dealer or security-based swap dealer should be designated as such for all types of swaps or security-based swaps, respectively.

2. Proposed Rule Regarding Limited Designation as a Swap Dealer or Security-Based Swap Dealer

In general, the Commissions propose that a person that satisfies the definition of swap dealer or security-based swap dealer would be a dealer for all types, classes or categories of swaps or security-based swaps, or activities involving swaps or security-based swaps, in which the person engages.

Thus, the person would be subject to all regulatory requirements applicable to dealers for all swaps or security-based swaps into which it enters. We propose this approach because it may be difficult for swap dealers and security-based swap dealers to separate their dealing activities from their other activities involving swaps or security-based swaps.

See

proposed CEA rule 1.3(ppp)(3); proposed Exchange Act rule 3a71-1(c).

For example, in order to efficiently impose the dealer requirements on only the person's dealing activities, it may be necessary for the person to have separate books and records and a separate compliance regime for its dealing activities.

The proposed rule also states, however, that the Commissions may provide for a person to be designated as a swap dealer or security-based swap dealer for only specified categories of swaps, security-based swaps, or activities, without being classified as a dealer for all categories.

This proposed rule would afford persons an opportunity to seek, on an appropriate showing, a limited designation based on facts and circumstances applicable to their particular activities. The Commissions anticipate that a swap dealer could seek a limited designation at the same time as, or at a later time subsequent to, the person's initial registration as a swap dealer.

CEA section 1a(49)(B); Exchange Act section 3(a)(71)(B). As discussed below, the Commissions preliminarily believe that there are four major categories of swaps and two major categories of security-based swaps.

See

part IV.A,

infra.

The designation as a swap dealer or security-based swap dealer may, for example, be limited in terms of these categories or in terms of particular activities of the person.

The CFTC understands that there may potentially be non-financial entities, such as physical commodity firms, that conduct swap dealing activity through a division of the entity, and not a separately-incorporated subsidiary. In these instances, the entity's swap dealing activity would not be a core component of the entity's overall business. If this type of entity registered as a swap dealer, the CFTC anticipates that certain swap dealer requirements would apply to the swap dealing activities of the division, but not necessarily to the swap activities of other parts of the entity.

The Commissions request comment on the proposed rules regarding limited designation as a swap dealer or security-based swap dealer. Commenters particularly are requested to address the circumstances in which such limited purpose designations would be appropriate, the factors that the Commissions should consider when addressing such requests, and the type of information requestors should provide in support of their request. For example, would it be appropriate to grant such limited purpose designations only to entities that do not otherwise fall within the definition of a financial entity, and whose dealing activity is below a defined threshold of the entity's overall activity? At what level should the Commissions set such a threshold? Which of the requirements applicable to dealers should or should not apply to such entity's non-dealing activities in swaps and security-based swaps?

In addition, commenters are requested to address whether the Commissions should provide for limited purpose designations of swap dealers or security-based swap dealers through some other mechanism as an alternative to, or in

addition to, case-by-case evaluations of individual applications. If so, what criteria and procedures would be appropriate for making limited purpose designations through this type of approach? Also, should the limited purpose designation apply on a provisional basis starting at the time that the entity makes an application for a limited purpose designation?

Finally, commenters also are asked to address whether such limited purpose designations should be conditioned in any way, such as by the provision of information of the type that would be required with respect to an entity's swaps or security-based swaps involving the particular category or activity for which they are not designated as a dealer.

E. Certain Interpretative Issues

1. Affiliate Issues

We preliminarily believe that the word “person” in the swap dealer and security-based swap dealer definitions should be interpreted to mean that the designation applies with respect to a particular legal person. That is, for example, we would not view a trading desk or other discrete business unit that is not a separately organized legal person as a swap dealer; rather, the legal person of which it is a part would be the swap dealer. Also, an affiliated group of legal persons under common control could include more than one dealer. Within such a group, any legal person that engages in swap or security-based swap dealing activities would be a swap dealer or security-based swap dealer, as applicable.

In determining whether a particular legal person is a swap dealer or security-based swap dealer, we preliminarily believe it would be appropriate for the person to consider the economic reality of any swaps and security-based swaps it enters into with affiliates (

i.e.,

legal persons under common control with the person at issue), including whether those swaps and security-based swaps simply represent an allocation of risk within a corporate group.

Swaps and security-based swaps between persons under common control may not involve the interaction with unaffiliated persons that we believe is a hallmark of the elements of the definitions that refer to holding oneself out as a dealer or being commonly known as a dealer. To the extent, however, that an entity seeks to use transactions between persons under common control to avoid one of the dealer definitions, the Commissions have the authority to prohibit practices designed to evade the requirements applicable to swap dealers and security-based swap dealers.

Such swaps and security-based swaps should be considered in this way only for purposes of determining whether a particular person is a swap dealer or security-based swap dealer and does not necessarily apply in the context of the Exchange Act's general definition of “dealer.” The swaps and security-based swaps, moreover, would continue to be subject to all laws and requirements applicable to such swaps and security-based swaps.

See

Dodd-Frank Act sections 721(b)(2), 761(b)(3). For example, it would not be permissible for an entity that provides liquidity on one side of the market to use affiliated entities to provide liquidity on the other side in an attempt to avoid having to register as a swap or security-based swap dealer.

The Commissions invite comment as to how the swap dealer and security-based swap dealer definitions should be applied to members of an affiliated group. Commenters particularly are invited to address how the Commissions should interpret common control for these purposes, and whether this interpretation should be limited to wholly-owned affiliates.

2. Application to Particular Swap Markets

The swap markets are diverse and encompass a variety of situations in which parties enter into swaps with each other. We believe it is helpful to the understanding of the rule to discuss some of these situations, particularly those that have been raised by commenters, here. The situations discussed below include persons who enter into swaps as aggregators, as part of their participation in physical markets, or in connection with the generation and transmission of electricity. We invite comment as to what aspects of the parties' conduct in these situations should, or should not, be considered swap dealing activities, and whether the parties involved in these situations are swap dealers.

a. Aggregators

Commenters explained that some persons enter into swaps with other parties in order to aggregate the swap positions of the other parties into a size that would be more amenable to entering into swaps in the larger swap market, or otherwise to make entering into such swaps more efficient. For example, certain cooperatives enter into swaps with smaller cooperatives, smaller businesses or their members in order to establish a position in a commodity that is large enough to be traded on a swap or futures market. Similarly, one smaller financial institution explained that it enters into swaps with counterparties whose swap positions would not be large enough to be of interest to larger financial institutions. This institution stated that it enters into offsetting swaps with larger financial institutions so that it is in a neutral position between the counterparties and the larger financial institutions.

The result of these arrangements is that such persons engage in activities that are similar in many respects to those of a swap dealer as set out in the definition—the person enters into swaps to accommodate demand from other parties, it enters into swaps with a relatively large number of non-dealers, and it holds itself out as willing to enter into swaps. It may be that the swap dealing activities of these aggregators would not exceed the

de minimis

threshold, and therefore they would not be swap dealers. The CFTC, in particular, requests comment as to how the

de minimis

threshold would apply to such persons. If their activity would exceed the

de minimis

threshold set forth in the proposed rule, the Commissions request comment on the application of the swap dealer definition to their activity.

b. Physical Market Participants

The markets in physical commodities such as oil, natural gas, chemicals and metals are complex and varied. They involve a large number of market participants that, over time, have developed highly customized transactions and market practices that facilitate efficiencies in their market in unique ways. Some of these transactions would be encompassed by the statutory definition of “swap,” and some participants in these markets engage in swap dealing activities that are above the proposed

de minimis

threshold. The Commissions invite comment as to any different or additional factors that should be considered in applying the swap dealer definition to participants in these markets.

c. Electricity Generation and Transmission

The use of swaps in the generation and transmission of electricity is highly complex because electricity cannot be stored and therefore is generated, transmitted and used on a continuous, real-time basis. Also, the number and variety of participants in the electricity market is very large and some electricity services are provided as a public good rather than for profit. Nevertheless, some participants engage in swap dealing activities as described above that are above the

de minimis

threshold set forth in the proposed rule. The Commissions invite comment as to any different or additional factors that should be considered in applying the

swap dealer definition to participants in the generation and transmission of electricity. Specifically, the Commissions invite comment on whether there are special considerations, including without limitation special considerations arising from section 201(f) of the Federal Power Act, related to non-profit, public power systems such as rural electric cooperatives and entities operating as political subdivisions of a State, and the applicability of the exemptive authority in section 722(f) of the Dodd-Frank Act to address those considerations.

III. Amendments to Definition of Eligible Contract Participant

A. Overview

The Commodity Futures Modernization Act of 2000 (“CFMA”)

generally excluded or exempted transactions between eligible contract participants (“ECPs”) from most provisions of the CEA.

Section 723(a)(1)(A) of the Dodd-Frank Act repeals those exclusions and exemptions. ECP status remains important, however, because Section 723(a)(2) of the Dodd-Frank Act renders it unlawful for a non-ECP to enter into a swap other than on, or subject to the rules of, a designated contract market (“DCM”).

Section 763(e) of the Dodd-Frank Act also renders it unlawful for a non-ECP to enter into a security-based swap unless such transaction is effected on a national securities exchange registered pursuant to Section 6(b) of the Exchange Act.

In addition, Section 768(b) of the Dodd-Frank Act makes it unlawful for a non-ECP to enter into a security-based swap unless a registration statement is in effect. While this means that non-ECPs cannot enter into swaps on SEFs or on a bilateral, off-exchange basis, it also opens swaps to non-ECPs, so long as the swaps are entered into on, or subject to the rules of, a DCM. Similarly, while non-ECPs cannot enter into security-based swaps unless the transaction is effected on a national securities exchange and the security-based swap has an effective registration statement, it also opens security-based swaps to non-ECPs.

Public Law 106-554, 114 Stat. 2763 (Dec. 21, 2000).

See

CEA sections 2(d) (Excluded Derivative Transactions), 2(e) (Excluded Electronic Trading Facilities), 2(g) (Excluded Swap Transactions) and 2(h) (Legal Certainty for Certain Transactions in Exempt Commodities) (7 U.S.C. 2(d), (e), (g), (h)). The CFMA also excluded swap agreements from the definitions of “security” in Section 3(a)(10) of the Exchange Act and Section 2(a)(1) of the Securities Act.

See

Section 3A of the Exchange Act, 15 U.S.C. 78c-1, and Section 2A of the Securities Act, 15 U.S.C. 77b-1 (both of which have been modified by the Dodd-Frank Act). The CFMA, however, provided that the SEC had antifraud authority over security-based swap agreements.

Section 723(a)(2) of the Dodd-Frank Act adds new subsection (e) to CEA section 2 (7 U.S.C. 2(e)). New CEA section 2(e) provides that “[i]t shall be unlawful for any person, other than an eligible contract participant, to enter into a swap unless the swap is entered into on, or subject to the rules of, a board of trade designated as a contract market under section 5.”

Section 763(e) of the Dodd-Frank Act adds paragraph (l) to Exchange Act section 6. New Exchange section 6(l) provides that “[i]t shall be unlawful for any person to effect a transaction in a security-based swap with or for a person that is not an eligible contract participant, unless such transaction is effected on a national securities exchange registered pursuant to subsection (b).”

Congress also amended

the ECP definition in Section 721(a)(9) of the Dodd-Frank Act by: (1) Raising a threshold that governmental entities may use to qualify as ECPs, in certain situations, from $25 million in discretionary investments to $50 million in such investments; and (2) replacing the “total asset” standard for individuals to qualify as ECPs with a discretionary investment standard.

The changes to the ECP definition made by the Dodd-Frank Act originated in the Administration's “White Paper” on financial regulatory reform.

See

Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation, available at

http://www.financialstability.gov/docs/regs/FinalReprot_web.pdf,

at 48-49 (June 17, 2009) (“Current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. But the limits are not sufficiently stringent.”).

The monetary component of ECP status for individuals remains the same under the amended ECP definition: More than $10 million (but now in discretionary investments, not in total assets), or $5 million if the transactions for which ECP status is necessary are for risk management of an asset or liability the individual owns or incurs, or is reasonably likely to own or incur.

B. Commenters' Views

The ECP definition elicited comment from nine commenters. The comments ranged from requests not to increase the monetary thresholds for governmental employee benefit plans in certain instances to suggestions to dramatically raise them across the board, and from requests not to change the definition in a way that would limit the commenter's access to swaps to specific proposals to address such otherwise limited access.

In the Dodd-Frank Act, Congress addressed aspects of the ECP definition that it found to be of particular concern regarding governmental entities and individuals. Otherwise, though, persons who qualified for exclusions or exemptions to enter into bilateral, off-exchange swaps prior to the Dodd-Frank Act will still qualify to do so with respect to non-standardized swaps under the Dodd-Frank Act, with the exceptions discussed below. We have not identified any legislative history suggesting that Congress intended the Commissions to undertake a wholesale revision of the ECP definition. Accordingly, the Commissions are limiting the further definition of the term ECP to the discrete issues discussed below.

C. New ECP categories

The CEA definition of ECP generally is comprised of regulated persons;

entities defined as ECPs based on a total asset test (

e.g.,

a corporation, partnership, proprietorship, organization, trust, or other entity with total assets exceeding $10 million)

or an alternative monetary test coupled with a non-monetary component (

e.g.,

an entity with a net worth in excess of $1 million and engaging in business-related hedging;

or certain employee benefit plans, the investment decisions of which are made by one of four enumerated types of regulated entities

); and certain governmental entities and individuals that meet defined thresholds.

CEA section 1a(18)(A)(i), (ii), (iii), (iv), (viii), (ix), (x) (7 U.S.C. 1a(18)(A)(i), (ii), (iii), (iv), (viii), (ix), (x)), as redesignated by Section 721(a)(9) of the Dodd-Frank Act.

CEA section 1a(18)(A)(v)(I) (7 U.S.C. 1a(18)(A)(v)(I)), as redesignated by Section 721(a)(9) of the Dodd-Frank Act.

CEA section 1a(18)(A)(v)(III) (7 U.S.C. 1a(18)(A)(v)(III)), as redesignated by Section 721(a)(9) of the Dodd-Frank Act.

CEA section 1a(18)(A)(vi) (7 U.S.C. 1a(18)(A)(vi)), as redesignated by Section 721(a)(9) of the Dodd-Frank Act.

CEA sections 1a(18)(A)(vii) and (xi) (7 U.S.C. 1a(18)(A)(vii) and (xi), as redesignated by Section 721(a)(9) of the Dodd-Frank Act.

Persons in the new major swap participant, major security-based swap participant, swap dealer and security-based swap dealer categories are likely to be among the most active and largest users of swaps and security-based swaps. Accordingly, the Commissions propose to further define the term ECP to include these new categories, which will permit such persons to enter into swaps and security-based swaps on SEFs and on a bilateral basis (where otherwise permitted under the Dodd-Frank Act and regulations thereunder).

We seek comment on this proposed expansion of the ECP definition.

D. Relationship Between Retail Foreign Currency and ECP Status in the Context of a Commodity Pool

Prior to the Dodd-Frank Act, clause (A)(iv) of the ECP definition provided that a commodity pool was an ECP if the pool and its operator met certain requirements (

i.e.,

the commodity pool has $5 million in total assets and is operated by a commodity pool operator regulated under the CEA or subject to

foreign regulation), regardless of whether each pool participant was itself an ECP.

Section 741(b)(10) of the Dodd-Frank Act amended clause (A)(iv) of the ECP definition to provide that a commodity pool engaging in retail foreign currency transactions of the type described in CEA sections 2(c)(2)(B) or 2(c)(2)(C) ;

(“retail forex” and such pools, “Retail Forex Pools”) no longer qualifies as an ECP for those purposes if any participant in the pool is not independently an ECP. The Commissions believe that in some cases commodity pools unable to satisfy the conditions of clause (A)(iv) of the ECP definition may rely on clause (A)(v) to qualify as ECPs instead for purposes of retail forex. Clause (A)(v) of the ECP definition applies to business entities irrespective of their form of organization (

i.e.,

corporations, partnerships, proprietorships, organizations, trusts and other entities), and contains a $1 million net worth test where such an entity “enters into an agreement, contract, or transaction in connection with the conduct of the entity's business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of the entity's business.”

CEA section 1a(12)(A)(iv) (7 U.S.C. 1a(12)(A)(iv)).

7 U.S.C. 2(c)(2)(B) and (C).

See generally

“Regulation of Off-Exchange Retail Foreign Exchange Transactions and Intermediaries,” 75 FR 55410 (Final Rule; Sept. 10, 2010) (discussing the new CFTC retail forex regulatory regime); “Regulation of Off-Exchange Retail Foreign Exchange Transactions and Intermediaries,” 75 FR 3282 (Proposed Rule; Jan. 20, 2010) (providing historical background on the regulation of retail forex transactions).

CEA section 1a(18)(A)(v) (7 U.S.C. 1a(18)(A)(v), as redesignated by Section 721(a)(9) of the Dodd-Frank Act.

The Commissions believe that permitting Retail Forex Pools with one or more non-ECP participants to achieve ECP status by relying on clause (A)(v) of the ECP definition would frustrate the intent of Congress in denying ECP status to Retail Forex Pools under clause (A)(iv). Consequently, the Commissions propose to further define the term ECP to preclude a Retail Forex Pool with one or more non-ECP participants from qualifying as an ECP by relying on clause (A)(v) of the ECP definition if such Retail Forex Pool is not an ECP due to the language added to clause (A)(iv) of the ECP definition by section 741(b)(10) of the Dodd-Frank Act (

i.e.,

because the pool contains one or more non-ECP participants). Because commodity pools can be structured in various ways and can have one or more feeder funds and/or pools, many with their own participants, the Commissions propose to preclude a Retail Forex Pool from being an ECP pursuant to clause (A)(iv) of the ECP definition if there is a non-ECP participant at any investment level (

e.g.,

a participant in the pool itself (a direct participant), an investor or participant in a fund or pool that invests in the pool in question (an indirect participant), an investor or participant in a fund or pool that invests in that investor fund or pool (also an indirect participant),

etc.

Similarly, the Commissions believe that some commodity pools unable to satisfy the total asset or regulated status components of clause (A)(iv) of the ECP definition may rely on clause (A)(v) to qualify as ECPs instead. The Commissions are of the view that a commodity pool that cannot satisfy the monetary and regulatory status conditions prescribed in clause (A)(iv) should not qualify as an ECP in reliance on clause (A)(v) of the ECP definition. Therefore, the Commissions propose to further define the term ECP to prevent such an entity from qualifying as an ECP pursuant to clause (A)(v) of the ECP definition.

E. Request for comment

The Commissions request comment on all aspects of the proposed amendments to the definition of “eligible contract participant.” Are the proposed interpretations with respect to Retail Forex Pools and other commodity pools appropriate? Do entities described in the various enumerated ECP categories (other than commodity pools) rely on clause (A)(v) to qualify as ECPs? If so, should an entity that would be described in one of the clauses of paragraph (A) of the ECP definition, but cannot satisfy the conditions prescribed in that clause, be prohibited from relying on clause (A)(v) of the ECP definition?

In addition, should the Commissions further narrow any or all of the ECP categories? Why or why not? If so, what additional conditions would be appropriate? Should the Commissions define the term “discretionary basis,” as requested by one commenter, either solely for purposes of clause (A)(vii) or clause (A)(xi), or for both clauses? Alternatively, should the Commissions add any additional categories of ECPs, such as the following categories suggested by commenters: Commercial real estate developers; energy or agricultural cooperatives or their members; or firms using swaps as hedges pursuant to the terms of the CFTC's Swap Policy Statement? If so, which ones and why?

IV. Definitions of “Major Swap Participant” and “Major Security-Based Swap Participant”

The definitions of “major swap participant” and “major security-based swap participant” (also jointly referred to as the “major participant” definitions) respectively focus on the market impacts and risks associated with an entity's swap and security-based swap positions. In this respect, the major participant definitions differ from the definitions of “swap dealer” and “security-based swap dealer,” which focus on an entity's activities and account for the amount or significance of those activities only in the context of the

de minimis

exception.

Despite those differences in focus, persons that meet the major participant definitions in large part must follow the same statutory requirements that apply to swap dealers and security-based swap dealers.

In this way, the statute applies comprehensive regulation to entities whose swap or security-based swap activities do not cause them to be dealers, but nonetheless could pose a high degree of risk to the U.S. financial system generally.

In particular, under CEA section 4s and Exchange Act section 15F, dealers and major participants in swaps or security-based swaps generally are subject to the same types of margin, capital, business conduct and certain other requirements, unless an exclusion applies.

See

CEA section 4s(h)(4), (5); Exchange Act section 15F(h)(4), (5).

As discussed below, the tests of the major participant definitions use terms—particularly “systemically important,” “significantly impact the financial system” or “create substantial counterparty exposure”—that denote a focus on entities that pose a high degree of risk through their swap and security-based swap activities. In addition, the link between the major participant definition and risk was highlighted during the Congressional debate on the statute.

See

156 Cong. Rec. S5907 (daily ed. July 15, 2010) (dialogue between Senators Hagen and Lincoln, discussing how the goal of the major participant definition was to “focus on risk factors that contributed to the recent financial crisis, such as excessive leverage, under-collateralization of swap positions, and a lack of information about the aggregate size of positions”).

The major participant definitions are similar in their key provisions, although one exception, as discussed below, is available only in connection with the “major swap participant” definition. Both major participant definitions encompass persons that satisfy any of three alternative tests:

Also, neither major participant definition encompasses an entity that meets the respective swap dealer or security-based swap dealer definition.

See

CEA section 1a(33)(A); Exchange Act section 3(a)(67)(A)(i).

• The first test encompasses persons that maintain a “substantial position” in any of the “major” categories of swaps or security-based swaps, as those categories are determined by the CFTC

or SEC as applicable. This test excludes both “positions held for hedging or mitigating commercial risk,” and positions maintained by or contracts held by any employee benefit plan (as defined in paragraphs (3) and (32) of section 3 of ERISA (29 U.S.C. 1002)) for the primary purpose of hedging or mitigating risks directly associated with the operation of the plan.

See

CEA section 1a(33)(A)(i); Exchange Act section 3(a)(67)(A)(ii)(I).

• The second test encompasses persons whose outstanding swaps or security-based swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.”

See

CEA section 1a(33)(A)(ii); Exchange Act section 3(a)(67)(A)(ii)(II).

• The third test encompasses any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency” and that maintains a “substantial position” in swaps or security-based swaps for any of the “major” categories of swaps or security-based swaps.

See

CEA section 1a(33)(A)(iii); Exchange Act section 3(a)(67)(A)(ii)(III).

The statute directs the CFTC or the SEC to define “substantial position” for the respective definition at the threshold that it determines to be “prudent for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the United States.” The definitions further provide that when defining “substantial position,” the CFTC or SEC “shall consider the person's relative position in uncleared as opposed to cleared [swaps or security-based swaps] and may take into consideration the value and quality of collateral held against counterparty exposures.”

See

CEA Section 1a(33)(B); Exchange Act section 3(a)(67)(B).

Both major participant definitions provide that a person may be designated as a major participant for one or more categories of swaps or security-based swaps without being classified as a major participant for all classes of swaps or security-based swaps.

See

CEA section 1a(33)(C); Exchange Act section 3(a)(67)(C).

Finally, the definition of “major swap participant”—but not the definition of “major security-based swap participant”—includes an exception for any “entity whose primary business is providing financing, and uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing that facilitates the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company.”

See

CEA section 1a(33)(D).

Although the two major participant definitions are similar, they address instruments that reflect different types of risks and that can be used by end-users and other market participants for different purposes. Interpretation of the definitions must appropriately account for those differences.

The Commissions are proposing rules to further define the “major swap participant” and “major security-based swap participant” definitions, by specifically addressing: (a) The “major” categories of swaps or securities-based swaps; (b) the meaning of “substantial position”; (c) the meaning of “hedging or mitigating commercial risk”; (d) the meaning of “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”; and (e) the meanings of “financial entity” and “highly leveraged.” We also are proposing rules to specify the use of a daily average methodology for identifying whether a person meets one of the major participant definitions, provide for a reevaluation period for certain entities that exceed the relevant daily average by a small amount, and provide for a minimum length of time before a person may no longer be deemed a major participant.

We further propose that the CFTC or SEC may limit an entity's designation as a major participant to only certain types, classes or categories of swaps or security-based swaps. We also address certain additional interpretive issues that commenters have raised. Finally, while the Commissions also are not proposing any exclusions from the major participant definitions, we are soliciting comment as to whether certain types of entities should be excluded from the definitions' application.

In light of the significant and novel issues raised by the major participant definitions, the Commissions recognize the importance of monitoring the swap and security-based swap markets following adoption of major participant rules. This will help us evaluate whether the rules appropriately reflect how market participants use these instruments, and will help us consider the impact of market evolution and the ways in which market participants may change their practices in response to the rules, so we may identify potential improvements to the rules or other actions to enhance enforcement of major participant regulation.

A. “Major” Categories of Swaps and Securities-Based Swaps

The first and third tests of the statutory major participant definitions encompass entities that have a substantial position in a “major” category of swaps or security-based swaps. The Commissions are responsible for designating these “major” categories.

See

CEA section 1a(33)(A)(i), (iii); Exchange Act section 3(a)(67)(a)(2)(i), (iii). One commenter suggested that we determine these categories by reference to the types of instruments specifically listed in the statutory definition of “swap.”

See

Northwestern Mutual letter (suggesting that, for regulatory consistency, each type of swap listed in the definition and options on each of those swaps should be considered to be an individual major category). The statutory definition of “swap” lists 22 different types of swaps.

The Commissions propose to designate “major” categories of swaps and security-based swaps in a manner that reflects the risk profiles of these various instruments and the different purposes for which end-users make use of the various instruments. We preliminarily believe that it is important not to parse these “major” categories so finely as to base the “substantial position” thresholds on unduly narrow risks that would reduce those thresholds' effectiveness as risk measures. The “major” categories will apply only for purposes of the major participant definitions and are not necessarily determinative with respect to any other provision of the Dodd-Frank Act or the regulations adopted thereunder.

1. Major Categories of Swaps

We propose to designate four “major” categories of swaps for purposes of the “major swap participant” definition. The four categories are rate swaps, credit swaps, equity swaps and other commodity swaps.

The first category would encompass any swap which is primarily based on one or more reference rates, such as swaps of payments determined by fixed and floating interest rates, currency exchange rates, inflation rates or other monetary rates. The second category would encompass any swap that is primarily based on instruments of indebtedness, including but not limited to any swap primarily based on one or more indices related to debt instruments, or any swap that is an index credit default swap or total return

swap on one or more indices of debt instruments. The third category would encompass any swap that is primarily based on equity securities, such as any swap primarily based on one or more indices of equity securities, or any total return swap on one or more equity indices. The fourth category would encompass any swap not included in any of the first three categories. This fourth category would generally include, for example and not by way of limitation, any swap for which the primary underlying item is a physical commodity or the price or any other aspect of a physical commodity.

See

proposed CEA rule 1.3(rrr). For the avoidance of doubt, the term “swap” as it is used in the definitions of the major swap categories in rule 1.3(rrr) has the meaning set forth in section 1a(47) of the CEA and the rules promulgated thereunder.

The term “commodity” as defined in Section 1a(9) of the CEA, 7 U.S.C. 1a(9), and CFTC Rule § 1.3(e), 17 CFR 1.3(e) includes interest rates, foreign exchange rates, and equity and debt indices as well as physical commodities. Thus, the fourth category of swaps is entitled “other commodity swaps” because it includes any swap not included in the other three categories.

The four major categories of swaps are intended to cover all swaps. Each swap would be in the category that most closely describes the primary item underlying the swap. If a swap is based on more than one underlying item of different types, the swap would be in the category that describes the underlying item that is likely to have the most significant effect on the economic return of the swap. The proposed categories are consistent with market statistics that distinguish between these general types of swaps, as well as market infrastructures that have been established for these types of swaps.

We request comment on this proposed method of allocating swaps among “major” categories. Commenters particularly are asked to address whether there are any types of swaps that would have unclear status under this proposal, as well as whether all swaps instead should be placed into a single “major” category for purposes of the “major swap participant” definition, or whether there should be additional “major” categories of swaps. Commenters are also asked to address whether the rate swap category should be divided into two separate categories—one for swaps based on rates of exchange between different currencies, and another for swaps based on interest rates, inflation rates and other monetary rates—and if so, in which category cross-currency rate swaps should be included. Also, should the major swap category for other commodity swaps be divided into two separate categories—one for swaps based on agricultural commodities, and another for swaps based on all other commodities not included in the other categories?

2. Major Categories of Security-Based Swaps

We propose to designate two “major” categories of security-based swaps for purposes of the “major security-based swap definition.” The first category would encompass any security-based swap that is based, in whole or in part, on one or more instruments of indebtedness (including loans), or a credit event relating to one or more issuers or securities, including but not limited to any security-based swap that is a credit default swap, total return swap on one or more debt instruments, debt swap, debt index swap, or credit spread.

The second category would encompass any other security-based swaps not included in the first category; this category would include, for example, equity swaps.

This category does not encompass a security-based swap that is based on an instrument of indebtedness solely in connection with the swap's financing leg.

See

proposed Exchange Act rule 3a67-2.

The proposed categories reflect the fact that entities that transact in security-based swaps for non-speculative purposes would be expected to use the respective instruments for different purposes. For example, swaps based on instruments of indebtedness, such as credit derivatives, can be used to hedge the risks associated with the default of a counterparty or debt obligation. Equity swaps can be used, among other ways, to hedge the risks associated with equity ownership or gain synthetic exposure to equities.

The proposed categories also are consistent with market statistics that currently distinguish between those general types of security-based swaps, as well as market infrastructures, including separate trade warehouses, that have been established for credit default swaps and equity swaps.

At the same time, we note that the distinctions between these proposed “major” categories of “security-based swaps” arguably are less significant than the distinctions among the proposed major categories of “swaps” (such as, for example, the distinction between other commodity swaps and rate swaps).

We request comment on this proposed method of allocating security-based swaps between two “major” categories. In particular, we request comment on whether there are any types of security-based swaps that would have unclear status under this proposal, as well as whether all security-based swaps instead should be placed into a single “major” category for purposes of the “major security-based swap participant” definition, or whether there should be additional “major” categories of security-based swaps.

B. “Substantial Position”

As noted above, the Commissions are required to define the term “substantial position” as a threshold that is “prudent for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the United States.”

This raises two fundamental issues: (i) What types of measures should be used to identify the risks posed by an entity's swap or security-based swap positions; and (ii) for each of those measures, how much risk should be required to evidence a “substantial position”?

See

CEA section 1a(33)(B); Exchange Act section 3(a)(67)(B).

1. Commenters' Views

Commenters have expressed diverse views as to what should constitute a substantial position. A number of commenters suggested the use of a test based on the current uncollateralized mark-to-market exposure posed by an entity's swap or security-based swap positions, after taking bilateral netting agreements into account. Two commenters suggested specific dollar amounts of uncollateralized exposure to use as the substantial position threshold.

Several commenters expressed the view that positions subject to central clearing should be entirely excluded from the analysis, or at least should be discounted for purposes of the analysis.

See

letter from Timothy W. Cameron, Esq., Managing Director, SIFMA Asset Management Group, dated September 20, 2010 (“SIFMA AMG letter”) (suggesting a standard of $2.5 billion average exposure in any calendar quarter based on the entity's entire portfolio of swaps and security-based swaps, other than foreign exchange swaps and forwards); letter from Gus Sauter, Chief Investment Officer, Vanguard, dated September 20, 2010 (“Vanguard letter”) (suggesting that the applicable threshold be $500 million in uncollateralized exposure for any single major swap category or $1 billion aggregate exposure across all major categories).

See

letter from Jennifer J. Kalb, Associate General Counsel, Metropolitan Life Insurance Company, dated September 20, 2010 (“MetLife letter”) (suggesting that cleared trades be subject to a lesser “charge” for purposes of the substantial position calculation, or be excluded entirely).

Some commenters opposed using the notional amount of swap or security-based swap positions to set the threshold, stating that the notional amount is not indicative of the risks associated with a position. Some commenters similarly opposed using measures of swap or security-based swap volume to set the threshold,

contending that the number of trades does not reflect risk.

But see

letter from Christopher A. Klem, Ropes & Gray, dated September 2, 2010 (test should account for frequency of trading and frequency of trading with non-dealers).

A few commenters addressed the possibility that the threshold could take into account the potential future risks associated with a position, in addition to the risks associated with uncollateralized current exposure.

Some commenters suggested that the threshold take into account the potential riskiness of the particular type of instrument at issue. Some commenters maintained that the threshold should take into account the number of counterparties an entity has, the size of an entity's positions compared to the size of the market, the size of an entity's swap or security-based swap positions compared to the entity's ability to absorb losses of that magnitude, or the financial strength of an entity's counterparties. Several commenters stated that the threshold should be based on an average measure over time, so that short-term spikes in measures such as exposure would not by themselves cause an entity to meet the major participant definitions. Some commenters suggested that the substantial position threshold should reflect an amount of “systemic risk.”

See

letter from Andrew Baker, Chief Executive Officer, Alternative Investment Management Association, dated September 24, 2010 (“AIMA letter”) (discussing possible methods of estimating the maximum risk of loss related to positions); letter from Warren Davis, Of Counsel, Sutherland Asbill & Brennan LLP on behalf of the Federal Home Loan Banks, dated September 20, 2010 (in addressing “substantial counterparty exposure” test, noting the possibility of accounting for the potential exposure of a portfolio).

See

letter from Edward J. Rosen, Cleary Gottlieb Steen & Hamilton LLP, dated September 21, 2010 (“Cleary letter”) (suggesting that the threshold should be akin to the amount that is required for a non-financial entity to be designated as systemically important under Title I of the Dodd-Frank Act).

Section 113 of the Dodd-Frank Act provides that the Financial Stability Oversight Council (“FSOC”) may determine that a non-bank financial company shall be supervised by the Federal Reserve Board, subject to prudential standards, if the FSOC “determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.” In making that determination, the FSOC is to consider: Leverage; off-balance sheet exposures; transactions and relationships with other significant non-bank financial companies and bank holding companies; importance as a source of credit and liquidity; extent to which assets are managed rather than owned; the nature, scope, size, scale, concentration, interconnectedness and mix of activities; presence of a primary financial regulator; assets and liabilities; and any other appropriate risk-related factors.

2. Proposed Substantial Position Thresholds

The Commissions recognize that it is important for the substantial position thresholds to be set using objective numerical criteria. Objective criteria should permit regulators, market participants and entities that may be subject to the regulations to readily evaluate whether swap or security-based swap positions meet the thresholds, and should promote the predictable application and enforcement of the requirements governing major participants.

In determining the substantial position thresholds—in light of what is “prudent for the effective monitoring, management, and oversight” of entities that are systemically important or can significantly impact the U.S. financial system—the Commissions are mindful that tests based on

current uncollateralized

exposure and tests based on

potential future

exposure both have respective advantages and disadvantages. We thus are proposing tests that would account for both types of exposure.

A test that focuses solely on the current uncollateralized exposure associated with an entity's swap and security-based swap positions should provide a reasonable measure of the theoretical amount of potential risk that an entity would pose to its counterparties if the entity currently were to default.

Such a test also should be relatively clear-cut for market entities to implement, and would be based on calculations that we expect that market entities would perform as a matter of course.

In practice, however, this measure may underestimate the amount of risk that an entity poses to its counterparties, given that it may take multiple days to liquidate a defaulting entity's swap or security-based swap positions, during which time prices may move against the defaulting entity.

At the same time, a focus solely on current uncollateralized exposure could be overly narrow by failing to identify risky entities until some time after they begin to pose the level of risk that should subject them to regulation as major participants. Because exposure can change significantly over short periods of time, and a swap or security-based swap position that may pose large potential exposures nonetheless would often have a mark-to-market exposure of zero at inception, an entity's positions may already pose significant risk to counterparties and to the market even before its uncollateralized mark-to-market exposure increases up to the applicable threshold. A test that focuses solely on current uncollateralized exposure thus would not appear to be sufficient to satisfy the systemic importance standard required by the statute.

Tests based on measures of potential future exposure—which would address an estimate of how much the value of a swap or security-based swap might change against an entity over the remaining life of the contract—could address the gap left by a current uncollateralized exposure test. Potential future exposure tests, however, would reflect only an estimate of that type of risk, and would only be as effective as the factors used by the test.

While we have considered several other types of tests that could be used to determine the substantial position threshold, we preliminarily do not believe that the advantages of those tests justify their disadvantages. For example, while a threshold based on the number of an entity's counterparties could help identify highly interconnected entities (a factor that some have argued is important for identifying an entity's systemic risk), it also has been argued that a large number of counterparties could mean that the losses associated with that entity's default would be divided and absorbed by many counterparties without broader market effects.

While a threshold that is based on an entity's financial strength would help account for the possibility of an entity's default as well as the effects of such a default, it would not address swap-related risks to the market that are not directly linked to the entity's default. In other words, an entity that has large out-of-the-money swap or security-based swap positions and faces a margin call may cause significant price movements in the swaps or security-based swaps and in the related reference entities or assets if the entity chooses to unwind its positions, even if the entity itself does not appear to present a large threat of default. These movements may be exacerbated if other entities have similar positions.

See

AIMA letter (“An entity that has only a small number of counterparties may only affect a small number of entities directly, should it fail, but the impact could be significant if the position is large and the counterparty is a systemically important entity. A diversified exposure to multiple entities could affect more entities but is likely to be smaller and thus shares the losses in the industry and having less systemic impact.”).

Moreover, although substantial position thresholds based on the financial strength of an entity's counterparties would help measure the potential that an entity's default would have a broader impact, such thresholds could result in disparate results between two entities with identical positions,

and also could encourage concentration of exposure or potential future exposure within a few counterparties. While tests that are based on the volume of an entity's swaps or security-based swaps may be helpful in identifying significant swap or security-based swap activity, such tests would not directly be germane to the current or potential future exposure posed by an entity's swap and security-based swap positions. Finally, while we have considered the feasibility of tests that take specific contract features into account (

e.g.,

triggers that require the payment of mark-to-market margin if an entity's credit rating is lowered), we preliminarily believe that simpler tests of exposure can more efficiently identify the risks associated with particular swap or security-based swap positions.

After considering these alternatives, the Commissions are proposing two tests to define “substantial position.” One test would focus exclusively on an entity's current uncollateralized exposure; the other would supplement a current uncollateralized exposure measure with an additional measure that estimates potential future exposure. A position that satisfies either test would be a “substantial position.”

The Commissions, however, request comment on whether it would be appropriate to use other types of approaches for determining whether an entity has a substantial position—as an alternative to, or in addition to, the two proposed tests.

a. Proposed Current Exposure Test

The proposed first substantial position test, which would focus solely on current uncollateralized exposure, in general would set the substantial position threshold by reference to the sum of the uncollateralized current exposure, obtained by marking-to-market using industry standard practices, arising from each of the person's positions with negative value in each of the applicable “major” category of swaps or security-based swaps (other than positions excluded from consideration, such as positions for the purpose of “hedging or mitigating commercial risk”).

See

proposed CEA rule 1.3(sss)(2); proposed Exchange Act rule 3a67-3(b)(1). In other words, the test would measure the portion of the exposure that is not offset by the posting of collateral. If a position was collateralized only partially, the value of the collateral posted would be offset against the total exposure, and the test would measure the residual part of the exposure. We recognize that there may be operational delays between changes in exposure and the resulting exchanges of collateral, and in general we would not expect that operational delays associated with the daily exchange of collateral would be considered to lead to uncollateralized exposure for these purposes.

As noted above, the statutory definitions require us to consider the presence of central clearing in setting the substantial position threshold. This test would account for the risk-mitigating effects of central clearing in that centrally cleared swaps and security-based swaps are subject to mark-to-market margining that would largely eliminate the uncollateralized exposure associated with a position, effectively resulting in cleared positions being excluded from the analysis.

A person would apply this proposed substantial position test on a major category-by-major category basis, examining its positions with each counterparty with which the person has swaps or security-based swaps in the particular category. For each counterparty, the person would determine the dollar value of the aggregate current exposure arising from each of its swap or security-based swap positions with negative value (subject to the netting provisions described below) in that major category by marking-to-market using industry standard practices, and deduct from that amount the aggregate value of the collateral the person has posted with respect to the swap or security-based swap positions. The aggregate uncollateralized outward exposure would be the sum of those uncollateralized amounts over all counterparties with which the person has entered into swaps or security-based swaps in the applicable major category.

See

proposed CEA rule 1.3(sss)(2); proposed Exchange Act rule 3a67-3(b)(2).

The proposed test would not prescribe any particular methodology for measuring current exposure or the value of collateral posted,

and instead would provide that the method should be consistent with counterparty practices and industry practices generally.

Depending on the particular circumstances of the swap or security-based swap, such collateral may be posted to a third-party custodian, directly to the counterparty, or in accordance with the rules of a derivatives clearing organization or clearing agency.

Consistent with industry practices, we would expect that entities may value exposure based on measures that take into account the amounts that would be payable if the transaction were terminated. Also, to the extent the valuation of collateral posted in connection with swaps or security-based swaps is subject to other rules or regulations, we would expect that the valuation of collateral for purposes of the major participant calculations would be consistent with those applicable rules.

At the same time, we recognize that there can be disputes or uncertainty as to an entity's exposure in connection with swap and security-based swap positions, and as to the valuation of the collateral it has posted in connection with those positions. In some circumstances this could lead to uncertainty as to whether the entity is a major participant. As addressed below, we are requesting comment as to the potential significance of these issues, and as to whether we should set forth additional guidance or mandate the use of specific standards with respect to these valuations.

Also, it is important to recognize that while we expect that other regulatory requirements applicable to the valuation of swap or security-based swap positions and collateral would be relevant to certain calculations relating to major participant status, our proposed rules would not be relevant for other purposes, such as in the context of capital and margin requirements.

This proposed test would account for the risk mitigating effects of netting agreements

by permitting an entity to calculate its exposure on a net basis, by applying the terms of master netting agreements entered into between the entity and a single counterparty.

When calculating the net exposure the entity may take into account offsetting positions with that particular counterparty involving swaps, security-based swaps and securities financing transactions (consisting of securities lending and borrowing, securities margin lending and repurchase and reverse repurchase agreements) to the extent that is consistent with the offsets provided by the master netting agreement.

Section 362(b)(17) of the United States Bankruptcy Code generally provides derivatives contracts with a safe harbor from the Bankruptcy Code's automatic stay, thus allowing parties to these contracts to enforce their contractual rights, including those associated with netting and offsets, even after a counterparty has filed for bankruptcy.

In addition, Section 210(c)(8)(A) of the Dodd-Frank Act reaffirms the enforceability of netting and offset provisions in certain derivatives contracts with insolvent counterparties that have been placed under the receivership of the Federal Deposit Insurance Corporation (“FDIC”). However, the Dodd-Frank Act also places certain limitations on the timing by which netting rights may be exercised when the FDIC has been appointed as the receiver of an insolvent counterparty.

See

Dodd-Frank Act section 210(c)(10)(B).

To the extent that the two counterparties maintain multiple netting agreements (

e.g.,

separate agreements for dollar-denominated and euro-denominated instruments), the calculation would account only for the netting permitted under the netting agreement that is relevant to the swap or security-based swap at issue.

See

proposed CEA rule 1.3(sss)(2)(iii)(A); proposed Exchange Act rule 3a67-3(b)(3)(A). As is the case for the proposed rules on valuation, the proposed rules regarding possible offsets of various positions are for purposes of determining major participant status only. Other rules proposed by the Commissions may address the extent to which, if any, persons such as dealers and major participants may offset positions for other purposes.

The Commissions preliminarily believe that this approach is appropriate because it avoids identifying a position's exposure as being “uncollateralized” when there is no current counterparty risk associated with it due to offsets under a netting agreement with the counterparty.

calculating current uncollateralized exposure, however, the entity may not take into account the market risk offsets associated with holding positions with multiple counterparties.

100

Also, the entity may not “double count” any offset or collateral—once any item of collateral or any position with positive value has been applied against current exposure, the same item cannot be applied for purposes of this test against any other exposure.

If, for example, an entity was $X out of the money in connection with a security-based swap, but was $X in the money with the same counterparty in connection with a swap, there would be no economic need for the entities to exchange collateral in connection with those offsetting positions. A test that fails to account for

this netting of exposure could lead the entities to engage in needless offsetting exchanges of collateral.

100

See

proposed CEA rule 1.3(sss)(2)(iii)(C); proposed Exchange Act rule 3a67-3(b)(2)(iii). While recognizing that offsetting positions of that type would reduce the market risk facing the entity, the offsets would not be expected to directly mitigate the risks that the entity's counterparties would face if the entity were to default.

The proposal to permit this type of netting, however, raises questions as to how an entity's net out-of-the-money exposure with a counterparty, and the collateral posted with respect to its positions with the counterparty, should be allocated among swap positions, security-based swap positions and other positions specified in the rule.

101

In particular, when an entity has not fully collateralized its net current exposure to a particular counterparty with which it has a netting agreement, there may be questions regarding how to attribute the net out-of-the-money positions and associated collateral to its swap or security-based swap positions. We preliminarily believe that an entity that has net uncollateralized exposure to a counterparty should, for purposes of the test, allocate that net uncollateralized exposure

pro rata

in a manner that reflects the exposure associated with each of its out-of-the-money swap positions, security-based swap positions and non-swap positions.

102

This allocation would be intended to cause the measure of uncollateralized exposure connected with swaps or security-based swaps for purposes of the test to reasonably reflect the relative contribution of those instruments to an entity's total overall uncollateralized exposure.

101

This issue does not arise to the extent that an entity's net positions with a counterparty are fully collateralized.

102

In other words, if an entity's out-of-the-money rate swap positions have $W exposure, its out-of-the-money other commodity swap positions have $X exposure, its out-of-the-money security-based swap positions have $Y exposure, and its other out-of-the money positions covered by that netting agreement have $Z exposure, fractions of the collateral equal to W/(W+X+Y+Z) should be allocated to the rate swap positions, X/(W+X+Y+Z) to the other commodity swap positions and Y/(W+X+Y+Z) to the security-based swap positions. A similar process should be used for allocating net out-of-the-money exposure across the categories of swaps and security-based swaps that have out-of-the-money exposure when one or more categories are in-the-money.

For purposes of the definition of “major swap participant,” the Commissions are proposing to set the current uncollateralized exposure threshold at a daily average of $1 billion in the applicable major category of swaps, except that the threshold for the rate swap category would be a daily average of $3 billion. For purposes of the definition of “major security-based swap participant,” this threshold would be based on a daily average of $1 billion in the applicable major category of security-based swaps.

103

We preliminarily believe that these proposed thresholds are appropriate for identifying entities that, through their swap and security-based swap activities, have a significant potential to pose the systemic importance or risks to the U.S. financial system that the major participant definition and associated statutory requirements were intended to address, but we also recognize that it is possible that the appropriate threshold should be higher or lower. In proposing these specific thresholds, we have sought to take into account several factors: (i) The ability of the financial system to absorb losses of a particular size;

104

(ii) the appropriateness of setting “prudent” thresholds that are materially below the level that could cause significant losses to the financial system as it would not be appropriate for the substantial position test to encompass entities only after they pose significant risks to the market through their swap or security-based swap activity;

105

and (iii) the need to account for the possibility that multiple market participants may fail close in time, rather than focusing narrowly on the potential impact of a single participant's default.

106

Based on these factors, we preliminarily believe that the proposed substantial position thresholds would reasonably be expected to apply to entities that have the potential of satisfying the statutory criteria of systemic importance or significant impact to the U.S. financial system. As discussed below, however, we welcome comments on the appropriateness of the proposed threshold.

103

See

proposed CEA rule 1.3(sss)(1); proposed Exchange Act rule 3a67-3(a)(1).

104

In this regard, the Commissions preliminarily believe that the “Tier 1” capital of major dealer banks provides relevant information about the ability of the financial system to absorb losses of a particular size. We note that, among U.S. banks that are dealers in credit derivatives, the six largest banks account for the vast majority of dealing activities. We understand that the most liquid “Tier 1” regulatory capital for those six banks ranges from $14 billion to $113 billion.

105

In other words, the proposed thresholds are intended to be low enough to provide for the appropriately early regulation of an entity whose swap or security-based swap positions have a reasonable potential of posing significant counterparty risks and risks to the market that stress the financial system, while being high enough that it would not unduly burden entities that are materially less likely to pose these types of risks.

106

For example, the proposed $1 billion threshold for swaps and security-based swaps would reflect a potential loss of $3 billion if three large swap or security-based swap entities were to fail close in time. That $3 billion could represent a significant impairment of the ability of some major dealers to absorb losses, as reflected by their Tier 1 capital.

We also are mindful of the views expressed by the two commenters that suggested particular dollar values for the threshold.

See

note 85,

supra.

These proposed thresholds would be evaluated by reference to a calculation of the mean of an entity's uncollateralized exposure measured at the close of each business day, beginning on the first business day of each calendar quarter and continuing through the last business day of that quarter.

107

In this regard, the Commissions have taken into account commenters' concerns that an entity's exposure should not be evaluated based on a single point in time, as short-term market fluctuations may not fairly reflect the risks of the entity's positions. The use of a daily average approach should help address commenters' concerns about the impact of short-term price fluctuations, and also help preclude the possibility that an entity may seek to use short-term transactions to distort the measure of exposure.

107

See

proposed CEA rule 1.3(sss)(4); proposed Exchange Act rule 3a67-3(d).

The Commissions request comment on the proposed current uncollateralized exposure test. Commenters particularly are requested to address whether the proposed threshold amounts of current uncollateralized exposure are appropriate, and, if not, what alternative higher or lower threshold amounts would appropriately identify entities that pose the types of risks that the definition was intended to address. In this regard, commenters specifically are requested to address whether bank Tier 1 capital provides a good indicative reference of the ability of major dealers to absorb losses of a particular size, or whether alternative reference points for the analysis (

e.g.,

the size of the swap market or security-based swap market) would also be applied. Commenters are requested to address whether uncollateralized mark-to-market exposure is the appropriate way to measure current exposure, and if not, what alternative approach is more appropriate, and why. Commenters also are requested to address whether the

proposed thresholds reasonably address the need to set the threshold at a prudent level so as to avoid the possibility that the substantial position test would encompass entities only after they pose significant risks to the market, whether the proposed thresholds reasonably address the possibility that multiple market entities could fail close in time, and whether the proposed thresholds reasonably address the fact that swap or security-based swap activities would comprise only part of the risks to the market posed by an entity. To what extent would this proposed definition of “substantial position” have an effect on the activities of entities that potentially may be deemed to be major participants? What impact could these types of effects have on liquidity, on risk-taking or risk-reducing activities, or on other aspects of the relevant markets?

Also, more fundamentally, we request comment on whether the substantial position analysis also should encompass a test that does not account for the collateral posted in connection with an entity's exposure, given that tests that account for the posting of collateral would not encompass entities that have very large swap or security-based swap positions that are fully collateralized (either by the posting of bilateral collateral or by virtue of central clearing). In that light, should the analysis seek to capture entities that have very large positions in light of potential market disruptions such entities could cause, regardless of whether the positions are collateralized?

Commenters further are requested to address whether such thresholds should also account for entities that have large in-the-money positions that may indicate their potential significance to the market. In this regard, commenters also are asked to address whether the thresholds should specifically address entities with large in-the-money positions that lead them to receive large amounts of collateral posted by their counterparties, particularly to the extent that such collateralized in-the-money positions could later turn and lead the entity to incur losses.

In addition, commenters are requested to address whether and how it would be appropriate to adjust the threshold amounts over time, including whether these proposed current uncollateralized exposure thresholds should periodically be adjusted by formula to reflect changes in the ability of the market to absorb losses over time, or changes in other criteria over time. Commenters further are requested to address whether the test will be practical for potential major participants to use. Moreover, commenters are requested to address whether the proposed current exposure test should be modified to account for the risks associated with the expected time lag between an entity's default and the liquidation of its swap or security-based swap positions.

Commenters also are requested to address whether we should set forth additional guidance or mandate the use of specific standards with respect to the measure of exposure or valuing collateral posted, or should specify particular procedures in the event of valuation disputes. What particular industry standard documentation and other methodologies could be used to measure exposure and value collateral? Also, how could regulatory requirements applicable to the valuation of collateral be relevant to the valuation of collateral for purposes of the major participant definitions?

Commenters are invited to address whether the rule should provide that, in measuring their current uncollateralized exposure, entities must value collateral in a way that is at least as conservative as such collateral would be valued according to applicable haircuts or other adjustments dictated by applicable regulations. Commenters further are requested to address whether the test should exclude certain types of collateral that cannot readily be valued. Also, commenters are requested to address whether the proposed method of evaluation—the mean of an entity's uncollateralized exposure measures at the close of each business day, beginning on the first business day of each calendar quarter and continuing through the last business day of that quarter—would be unduly burdensome or potentially subject to gaming or evasion.

Should the proposed approach for measuring uncollateralized current exposure be amended or supplemented, such as by establishing requirements for how exposure should be measured or collateral should be valued in certain circumstances (

e.g.,

requiring the valuation of certain types of collateral to be conservative during times of rapid price changes in the relevant asset class)? Should current exposure and collateral be required to be valued in accordance with US generally accepted accounting principles? Would measurement according to such principles differ in any respects from measurement under the proposal, and, if so, how?

In addition, commenters are requested to address the proposed netting provisions of this test, including: whether the proposed test would reasonably permit the measure of uncollateralized exposure to account for bilateral netting agreements; whether additional types of positions should be included within the netting provisions; whether the proposal appropriately takes into account the netting of exposures and collateral involving positions in financial instruments other than swaps, security-based swaps and securities financing transactions and if so, whether any limitations to such offsetting would be necessary or appropriate; whether the netting provisions should accommodate offsetting positions involving the net equity balance in an entity's securities account (

e.g.,

free credit balances, other credit balances, and fully paid securities), and if so, whether any limitations to such offsetting would be necessary or appropriate; whether the netting provisions should accommodate offsets for exposures, or collateral connected with the positions that an entity has with the affiliate of a counterparty; and whether the proposed method of allocating the uncollateralized portion of exposures among the different types of financial instruments that are all subject to a single netting agreement is appropriate.

Commenters also are requested to address whether the proposed current uncollateralized exposure test would pose significant monitoring burdens upon entities that have swap or security-based swap positions that are significant enough to potentially meet the current uncollateralized exposure threshold. Should we provide guidance as to policies and procedures that such an entity should be able to follow to demonstrate that it does not meet the applicable thresholds?

b. Proposed Current Exposure Plus Potential Future Exposure test

The second proposed test would account both for current uncollateralized exposure (as discussed above) and for the potential future exposure associated with swap or security-based swap positions in the applicable “major” category of swaps or security-based swaps. This additional test would allow the major participant analysis to take into account estimates of how the value of an entity's swap or security-based swap positions may move against the entity over time.

The potential future exposure portion of this proposed test would be based on an entity's “aggregate potential outward exposure,” which would reflect the potential exposure of the entity's swap or security-based swap positions in the applicable “major” category of swap or security-based swaps, subject to certain adjustments. Bank capital standards also

make use of this type of test,

108

and this proposal builds upon those standards but modifies them to focus on the risk that an entity poses to its counterparties (rather than on the risk that counterparties pose to an entity). In doing so, this proposal seeks to use a test that can be implemented by a range of market participants, and that can be expected to lead to reproducible results across market participants with identical swap or security-based swap portfolios, rather than relying on alternative tests (

e.g.,

value at risk measures or stress testing methodologies) that may be costly for market participants to implement and that would not be expected to lead to reproducible results across participants.

108

See

12 CFR part 3, app. C, section 32 (Office of the Comptroller of the Currency bank capital standards).

The exposure measures in general would be based on the total notional principal amount of those positions, adjusted by certain risk factors that reflect the type of swap or security-based swap at issue and the duration of the position.

109

For positions in which the stated notional amount is leveraged or enhanced by the particular structure, this calculation would be based on the position's effective notional amount.

110

109

For example, consistent with the bank standards, the multiplier for equity swaps would range from 0.06 for equity swaps of one year or less to 0.10 for equity swaps with a maturity of more than five years.

See

proposed Exchange Act rule 3a67-3(c)(2)(i)(A). For security-based swaps based on the credit of a reference entity, the multiplier would be 0.1.

The current bank capital standards contain a distinction based on whether the credit derivative is on “investment grade” or “non-investment grade” reference entities, providing a 0.1 multiplier for the former and a lower 0.05 multiplier for the latter. We preliminarily do not believe that a test that distinguishes among reference entities by reference to their credit ratings would be appropriate for purposes of these definitions, particularly in light of the fact that the Dodd-Frank Act mandates the substitution of credit ratings with other standards of creditworthiness in U.S. regulations.

See

Dodd-Frank Act section 939A.

The multipliers in part will be a function of the remaining maturity of the swap or security-based swap. If the swap or security-based swap, however, is structured such that on specified dates the outstanding exposure is settled and the terms are reset so the market value is zero, the remaining maturity would equal the time until the next reset date.

Although we recognize that these risk multipliers may suggest a lower than expected volatility of credit or equity derivatives of that duration, this may be offset by the fact that the proposed calculations of potential future exposure do not directly account for portfolio netting or collateral updates that could mitigate future exposure. We preliminarily believe that the use of these thresholds (and proposed related calculations) for purposes of identifying major participants are consistent with similar bank capital standards and are therefore suitable for use as an estimate of potential future exposure. We are also cognizant that requiring a more complete calculation of potential future exposure may be costly and burdensome for participants, especially those who would otherwise not meet the thresholds for major swap or security-based swap participant and would not have systems in place to perform a more complete calculation.

110

See

proposed CEA rule 1.3(sss)(3)(ii); proposed Exchange Act rule 3a67-3(c)(2)(i)(B). For purposes of this rule, in the case of positions that represent the sale of an option on a swap or security-based swap (other than the sale of an option permitting the person exercising the option to purchase a credit default swap), we would view the effective notional amount of the option as being equal to the effective notional amount of the underlying swap or security-based swap, and we would view the duration used for purposes of the formula as being equal to the sum of the duration of the option and the duration of the underlying swap or security-based swap.

At the same time, the proposed measures would contain adjustments for certain types of positions that pose relatively lower potential risks.

111

In addition, the general risk-adjusted notional measures of potential future exposure would be reduced to reflect the risk mitigation effects of master netting agreements, in a manner consistent with bank capital standards.

112

111

The analysis would exclude swap or security-based swap positions that constitute the purchase of an option, such that the person has no additional payment obligations under the position, as well as other positions on which the person has prepaid or otherwise satisfied all of its payment obligations.

See

proposed Exchange Act rule 3a67-3(c)(2)(i)(C).

For similar reasons, the potential outward exposure associated with a position by which a person buys credit protection using a credit default swap would be capped at the net present value of the unpaid premiums.

See

proposed CEA rule 1.3(sss)(3)(ii)(A)(4); proposed Exchange Act rule 3a67-3(c)(2)(i)(D).

112

In particular, for swaps or security-based swaps subject to master netting agreements the potential exposure associated with the person's swap or security-based swaps with each counterparty would equal a weighted average of the potential exposure in the applicable “major” category of swaps or security-based swaps with a particular counterparty as calculated without reference to netting, and that amount reduced by the ratio of net current replacement cost to gross current replacement cost of all swap and security-based swap positions with that counterparty, consistent with the following equation: P

Net

= 0.4 x P

Gross

+ 0.6 x NGR x P

Gross

Under this formula, P

Net

is the potential exposure in the applicable “major” category of swaps or security-based swaps adjusted for bilateral netting; P

Gross

is the potential exposure in that category without adjustment for bilateral netting; and

NGR

is the ratio of net current replacement cost to gross current replacement cost.

See

proposed CEA rule 1.3(sss)(3)(ii)(B); proposed Exchange Act rule 3a67-3(c)(2)(ii).

The “NGR” ratio is intended to serve as a type of proxy for the impact of netting on potential future exposure, but does not serve as a precise indicator of future changes in net exposure relative to gross exposure, as the ratio and potential exposure can be influenced by many idiosyncratic properties of individual portfolios.

See

Basle Committee on Banking Supervision, “The Treatment of the Credit Risk Associated with Certain Off-Balance-Sheet Items” (July 1994).

The proposed measures of potential future exposure would contain further downward adjustments to account for the risk mitigation effects of central clearing and mark-to-market margining. In particular, if the swap or security-based swap positions are cleared by a registered clearing agency or subject to daily mark-to-market margining,

113

the measures of potential future exposure would further be adjusted to equal twenty percent of the potential future exposure calculated using the methodology described above.

114

The Commissions preliminarily believe that a significant downward adjustment would be appropriate because clearing and daily mark-to-market margining would be expected to reduce the potential future risks posed by an entity's swap or security-based swap positions. Also, it is appropriate to incentivize the use of central clearing and daily mark-to-market margining as practices for helping to control risks. We are not proposing to entirely eliminate such cleared and margined positions from the analysis of potential future exposure, however, because clearing may not entirely eliminate the risks posed by an entity's potential default,

115

and daily mark-to-market margining would not eliminate the risks associated with large intra-day price movements. While the proposed amount of the adjustment seeks to balance these

competing factors, we recognize that alternative higher or lower downward adjustments may also be appropriate.

113

For these purposes, a swap or security-based swap would be considered to be subject to daily mark-to-market margining if, and for as long as, the counterparties follow the daily practice of exchanging collateral to reflect changes in exposure (after taking into account any other positions addressed by a netting agreement between the parties). If a person is permitted to maintain an uncollateralized “threshold” amount under the agreement, that amount (regardless of actual exposure) would be considered current uncollateralized exposure for purposes of the test. Also, if the agreement provides for a minimum transfer amount in excess of $1 million, the entirety of that amount would be considered current uncollateralized exposure.

See

proposed CEA rule 1.3(sss)(3)(iii)(B); proposed Exchange Act rule 3a67-3(c)(3)(ii).

In this way, the measure of potential future exposure would reflect for the risk mitigating benefits of daily margining, while specifically accounting for industry practices that limit those benefits. Of course, to take advantage of this adjustment it is not enough to the agreement to provide for daily mark-to-market margining—the parties must actually follow that practice.

114

See

proposed CEA rule 1.3(sss)(3)(iii)(A); proposed Exchange Act rule 3a67-3(c)(3).

115

For example, the central counterparties that clear credit default swaps do not necessarily become the counterparties of their members' customers (although even absent direct privity those central counterparties benefit customers by providing for protection of collateral they post as margin, and by providing procedures for the portability of the customer's positions in the event of a dealer's default). As a result, central clearing may not eliminate the counterparty risk that the customer poses to the dealer. Even then, however, required mark-to-market margining should help control that risk, and central clearing thus would be expected to reduce the likelihood that an entity's default would lead to broader market impacts.

For purposes of the “major swap participant” definition, the substantial position threshold would be $2 billion in daily average current uncollateralized exposure plus aggregate potential outward exposure in the applicable major swap category, except that the threshold for the rate swap category would be a daily average of $6 billion. For purposes of the “major security-based swap participant” definition, the substantial position threshold would be $2 billion in daily average current uncollateralized exposure plus aggregate potential outward exposure in any major security-based swap category.

116

These proposed amounts reflect the same factors discussed above in the context of the current uncollateralized exposure test,

117

but are raised to reflect the fact that potential future exposure is a measure of potential risk over time, and hence is less likely to pose a direct, immediate impact on the markets than current measures of uncollateralized exposure. We recognize that alternative risk thresholds may also be appropriate, and we welcome comment on potential alternatives.

116

See

proposed Exchange Act rule 3a67-3(a)(2).

117

See

notes 103 to 106,

supra,

and accompanying text.

In light of the amount of this threshold and the underlying risk adjustments, we preliminarily do not believe that an entity would need to calculate its potential future exposure for purposes of the test unless the entity has large notional positions. For example, in light of the proposed risk adjustment of 0.10 for credit derivatives, an entity that does not have any uncollateralized current exposure would have to have notional positions of at least $20 billion to potentially meet the $2 billion threshold, even before accounting for the discounts associated with netting agreements. If those swaps or security-based swaps are cleared or subject to mark-to-market margining, the additional 20 percent risk adjustment would mean that the entity without current uncollateralized exposure would have to have cleared notional positions of at least $100 billion to possibly meet that threshold.

118

Based on these thresholds, we preliminarily believe that only relatively few entities would regularly have to perform these potential future exposure calculations with regard to their security-based swaps.

See

notes 181 and 182,

infra,

and accompanying text.

The Commissions request comment on this proposed use of a current exposure plus potential future exposure test to determine the substantial position threshold. Commenters particularly are requested to address the appropriateness of using potential exposure risk adjustments derived from bank capital rules; and the appropriateness of using bank capital methodologies for addressing positions subject to netting agreements. Also, should this test be supplemented by a test that accounts for the notional amount of an entity's swap or security-based swap positions without risk-adjustments, to focus on entities that have very large swap or security-based swap positions?

Commenters are requested to address whether the proposed threshold amounts for the proposed current exposure plus potential future exposure test are appropriate, and if not, what alternative threshold amounts would be more appropriate, and why. In addition, commenters are requested to address the proposed method of discounting the potential future exposure associated with cleared positions or positions subject to daily mark-to-market margining to equal 20 percent of what the measure of potential future exposure would be otherwise. Would a larger or smaller discount be appropriate? Is there data available that may assist with reaching the appropriate discount factor? Also, in that regard, should both sets of discounts be equal, or should cleared positions be subject to more of a discount than uncleared positions subject to daily mark-to-market margining? Commenters also are invited to address whether the proposed discounts for cleared positions or positions that are marked-to-market would make it unnecessary or duplicative for this test separately to account for netting agreements. Also, if an entity currently has posted excess collateral in connection with a position, should the amount of that current overcollateralization be deducted from its measure of potential future exposure?

Commen

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