Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping

Federal RegisterMay 23, 2011

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AD46

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 33-9204; 34-64372; File No. S7-16-11]

RIN 3235-AL14

Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping

AGENCIES:

Commodity Futures Trading Commission; Securities and Exchange Commission.

ACTION:

Joint proposed rules; proposed interpretations.

SUMMARY:

In accordance with section 712(a)(8), section 712(d)(1), sections 712(d)(2)(B) and (C), sections 721(b) and (c), and section 761(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) (collectively, “Commissions”), in consultation with the Board of Governors of the Federal Reserve System (“Board”), are jointly issuing proposed rules and proposed interpretive guidance under the Commodity Exchange Act (“CEA”) and the Securities Exchange Act of 1934 (“Exchange Act”) to further define the terms “swap,” “security-based swap,” and “security-based swap agreement” (collectively, “Product Definitions”), regarding “mixed swaps,” and governing books and records with respect to “security-based swap agreements.”

DATES:

Comments should be received on or before July 22, 2011.

ADDRESSES:

Comments may be submitted, identified by File No. S7-16-11, 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: http://www.regulations.gov.

Follow the instructions for submitting comments.

Please submit your comments using only one method. “

Product 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. Comments will be posted as received to

http://www.cftc.gov.

You should submit only information that you wish to make available publicly. If you wish the CFTC to consider information that you believe is exempt from disclosure under the Freedom of Information Act, a petition for confidential treatment of the exempt information may be submitted according to the procedures established in section 145.9 of the CFTC's regulations.

17 CFR 145.9.

The CFTC reserves the right, but shall have no obligation, to review, pre-screen, filter, redact, refuse or remove any or all of your submission from www.cftc.gov that it may deem to be inappropriate for publication, including obscene language. All submissions that have been redacted or removed that contain comments on the merits of the rulemaking will be retained in the public comment file and will be considered as required under the Administrative Procedure Act and other applicable laws, and may be accessible under the Freedom of Information Act.

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 S7-16-11 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 S7-16-11. 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 SEC will post all comments on the SEC's Internet Web site (

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

). Comments are also available for Web site viewing and printing in the SEC'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; the SEC does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT:

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

jhammar@cftc.gov,

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

mfajfar@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: Matthew A. Daigler, Senior Special Counsel, at 202-551-5578, Cristie L. March, Attorney-Adviser, at 202-551-5574, or Leah M. Drennan, Attorney-Adviser, at 202-551-5507, Division of Trading and Markets, or Michael J. Reedich, Special Counsel, or Tamara Brightwell, Senior Special Counsel to the Director, at 202-551-3500, Division of Corporation Finance, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

The Commissions jointly are proposing new rules and interpretive guidance under the CEA and the Exchange Act relating to the Product Definitions, mixed swaps, and security-based swap agreements.

Table of Contents

I. Background

II. Scope of Definitions of Swap and Security-Based Swap

A. Introduction

B. Proposed Rules and Interpretive Guidance Regarding Certain Transactions Outside the Scope of the Definitions of the Terms “Swap” and “Security-Based Swap”

1. Insurance Products

(a) Types of Insurance Products

(b) Providers of Insurance Products

2. The Forward Contract Exclusion

(a) Forward Contracts in Nonfinancial Commodities

(b) Commodity Options and Commodity Options Embedded in Forward Contracts

3. Consumer and Commercial Agreements, Contracts, and Transactions

4. Loan Participations

C. Proposed Rules and Interpretive Guidance Regarding Certain Transactions Within the Scope of the Definitions of the Terms “Swap” and “Security-Based Swap”

1. In General

2. Foreign Exchange Products

(a) Foreign Exchange Products Subject to the Secretary's Swap Determination: Foreign Exchange Forwards and Foreign Exchange Swaps

(b) Foreign Exchange Products Not Subject to the Secretary's Swap Determination

(i) Foreign Currency Options

(ii) Non-Deliverable Forward Contracts Involving Foreign Exchange

(iii) Currency Swaps and Cross-Currency Swaps

3. Forward Rate Agreements

4. Combinations and Permutations of, or Options on, Swaps and Security-Based Swaps

5. Contracts for Differences

D. Certain Interpretive Issues

1. Agreements, Contracts, or Transactions That May Be Called, or Documented Using Form Contracts Typically Used for, Swaps or Security-Based Swaps

2. Transactions in Regional Transmission Organizations and Independent System Operators

III. The Relationship Between the Swap Definition and the Security-Based Swap Definition

A. Introduction

B. Title VII Instruments Based on Interest Rates, Other Monetary Rates, and Yields

1. Title VII Instruments Based on Interest Rates or Other Monetary Rates That Are Swaps

2. Title VII Instruments Based on Yields

3. Title VII Instruments Based on Government Debt Obligations

C. Total Return Swaps

D. Security-Based Swaps Based on a Single Security or Loan and Single-Name Credit Default Swaps

E. Title VII Instruments Based on Futures Contracts

F. Use of Certain Terms and Conditions in Title VII Instruments

G. The Term “Narrow-Based Security Index” in the Security-Based Swap Definition

1. Introduction

2. Applicability of the Statutory Narrow-Based Security Index Definition and Past Guidance of the Commissions to Title VII Instruments

3. Narrow-Based Security Index Criteria for Index Credit Default Swaps

(a) In General

(b) Proposed Rules Regarding the Definitions of “Issuers of Securities in a Narrow-Based Security Index” and “Narrow-Based Security Index” for Index Credit Default Swaps

(i) Number and Concentration Percentages of Reference Entities or Securities

(ii) Public Information Availability Regarding Reference Entities and Securities

(iii) Treatment of Indexes Including Reference Entities That Are Issuers of Exempted Securities or Including Exempted Securities

4. Security Indexes

5. Evaluation of Title VII Instruments on Security Indexes That Move From Broad-Based to Narrow-Based or Narrow-Based to Broad-Based

(a) In General

(b) Title VII Instruments on Security Indexes Traded on Designated Contract Markets, Swap Execution Facilities, Foreign Boards of Trade, Security-Based Swap Execution Facilities, and National Securities Exchanges

H. Method of Settlement of Index CDS

I. Security-Based Swaps as Securities Under the Exchange Act and Securities Act

IV. Mixed Swaps

A. Scope of the Category of Mixed Swap

B. Regulation of Mixed Swaps

1. Introduction

2. Bilateral Uncleared Mixed Swaps Entered Into by Dually-Registered Dealers or Major Participants

3. Regulatory Treatment for Other Mixed Swaps

V. Security-Based Swap Agreements

A. Introduction

B. Swaps That Are Security-Based Swap Agreements

C. Books and Records Requirements for Security-Based Swap Agreements

VI. Process for Requesting Interpretations of the Characterization of a Title VII Instrument

VII. Anti-Evasion

A. CFTC Proposed Anti-Evasion Rules

B. SEC Request for Comment Regarding Anti-Evasion

VIII. Administrative Law Matters—CEA Revisions

IX. Administrative Law Matters—Exchange Act Revisions

X. Statutory Basis and Rule Text

I. Background

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

Title VII of the Dodd-Frank Act

(“Title VII”) 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: (i) Providing for the registration and comprehensive regulation of swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants; (ii) imposing clearing and trade execution requirements on swaps and security-based swaps, subject to certain exceptions; (iii) creating rigorous recordkeeping and real-time reporting regimes; and (iv) 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 is available 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.”

Section 712(d)(1) of the Dodd-Frank Act provides that the Commissions, in consultation with the Board, shall jointly further define the terms “swap,” “security-based swap,” and “security-based swap agreement” (“SBSA”).

Section 712(a)(8) of the Dodd-Frank Act provides further that the Commissions shall jointly prescribe such regulations regarding “mixed swaps” as may be necessary to carry out the purposes of Title VII. In addition, sections 721(b) and 761(b) of the Dodd-Frank Act provide that the Commissions may adopt rules to further define terms included in subtitles A and B, respectively, of Title VII, and sections 721(c) and 761(b) of the Dodd-Frank Act provide the Commissions with authority to define the terms “swap” and “security-based swap,” as well as the terms “swap dealer,” “major swap participant,” “security-based swap dealer,” and “major security-based swap participant,” to include transactions and entities that have been structured to evade the requirements of subtitles A and B, respectively, of Title VII.

In addition, section 719(d)(1)(A) of the Dodd-Frank Act requires the Commissions to conduct a joint study, within 15 months of enactment, to determine whether stable value contracts, as defined in section 719(d)(2) of the Dodd-Frank Act, are encompassed by the swap definition. If the Commissions determine that stable value contracts are encompassed by the swap definition, section 719(d)(1)(B) of the Dodd-Frank Act requires the Commissions jointly to determine whether an exemption for those contracts from the swap definition is appropriate and in the public interest. Section 719(d)(1)(B) also requires the Commissions to issue regulations implementing the determinations made under the required study. Until the effective date of such regulations, the requirements under Title VII do not apply to stable value contracts, and stable value contracts in effect prior to the effective date of such regulations are not considered swaps.

See

section 719(d) of the Dodd-Frank Act. The Commissions currently are conducting the required joint study and will consider whether to propose any implementing regulations (including, if appropriate, regulations determining that stable value contracts: (i) are not encompassed within the swap definition; or (ii) are encompassed within the definition but are exempt from the swap definition) at the conclusion of that study.

Section 712(d)(2)(B) of the Dodd-Frank Act requires the Commissions, in consultation with the Board, to jointly adopt rules governing books and records requirements for SBSAs by persons registered as swap data repositories (“SDRs”) under the CEA,

including uniform rules that specify the data elements that shall be collected and maintained by each SDR.

Similarly,

section 712(d)(2)(C) of the Dodd-Frank Act requires the Commissions, in consultation with the Board, to jointly adopt rules governing books and records for SBSAs, including daily trading records, for swap dealers, major swap participants, security-based swap dealers, and security-based swap participants.

7 U.S.C. 1

et seq.

The CFTC has issued proposed rules regarding SDRs and, separately, swap data recordkeeping and reporting.

See

Regulations Establishing and

Governing the Duties of Swap Dealers and Major Swap Participants, 75 FR 71397, Nov. 23, 2010; Swap Data Recordkeeping and Reporting Requirements, 75 FR 76573, Dec. 8, 2010. The SEC has also issued proposed rules regarding security-based swap data repositories (“SBSDRs”), including rules specifying data collection and maintenance standards for SBSDRs, as well as rules regarding security-based swap data recordkeeping and reporting.

See

Security-Based Swap Data Repository Registration, Duties, and Core Principles, 75 FR 77306, Dec. 10, 2010; Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information, 75 FR 75208, Dec. 2, 2010.

The CFTC has issued proposed rules regarding recordkeeping requirements for swap dealers and major swap participants.

See

Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants, 75 FR 76666, Dec. 9, 2010.

Under the comprehensive framework for regulating swaps and security-based swaps established in Title VII, the CFTC is given regulatory authority over swaps,

the SEC is given regulatory authority over security-based swaps,

and the Commissions shall jointly prescribe such regulations regarding mixed swaps as may be necessary to carry out the purposes of Title VII.

In addition, the SEC is given antifraud authority over, and access to information from, certain CFTC-regulated entities regarding SBSAs, which are a type of swap related to securities over which the CFTC is given regulatory authority.

Section 721(a) of the Dodd-Frank Act defines the term “swap” by adding section 1a(47) to the CEA, 7 U.S.C. 1a(47). This new swap definition also is cross-referenced in new section 3(a)(69) of the Exchange Act, 15 U.S.C. 78c(a)(69). Citations to provisions of the CEA and the Exchange Act, 15 U.S.C. 78a

et seq.,

in this release refer to the numbering of those provisions after the effective date of Title VII, except as indicated.

Section 761(a) of the Dodd-Frank Act defines the term “security-based swap” by adding new section 3(a)(68) to the Exchange Act, 15 U.S.C. 78c(a)(68). This new security-based swap definition also is cross-referenced in new CEA section 1a(42), 7 U.S.C. 1a(42). The Dodd-Frank Act also explicitly includes security-based swaps in the definition of security under the Exchange Act and the Securities Act of 1933 (“Securities Act”), 15 U.S.C. 77a

et seq.

Section 721(a) of the Dodd-Frank Act describes the category of “mixed swap” by adding new section 1a(47)(D) to the CEA, 7 U.S.C. 1a(47)(D). Section 761(a) of the Dodd-Frank Act also includes the category of “mixed swap” by adding new section 3(a)(68)(D) to the Exchange Act, 15 U.S.C. 78c(68)(D). A mixed swap is defined as a subset of security-based swaps that also are based on the value of 1 or more interest or other rates, currencies, commodities, instruments of indebtedness, indices, quantitative measures, other financial or economic interest or property of any kind (other than a single security or a narrow-based security index), or the occurrence, non-occurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence (other than the occurrence, non-occurrence, or extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer).

Section 761(a) of the Dodd-Frank Act defines the term “security-based swap agreement” by adding new section 3(a)(78) to the Exchange Act, 15 U.S.C. 78c(a)(78). The CEA includes the definition of “security-based swap agreement” in subparagraph (A)(v) of the swap definition in CEA section 1a(47), 7 U.S.C. 1a(47). The only difference between these definitions is that the definition of SBSA in the Exchange Act specifically excludes security-based swaps (

see

section 3(a)(78)(B) of the Exchange Act, 15 U.S.C. 78c(a)(78)(B)), whereas the definition of SBSA in the CEA does not contain a similar exclusion. Instead, under the CEA, the exclusion for security-based swaps is placed in the general exclusions from the swap definition (

see

CEA section 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x)). Although the statutes are slightly different structurally, the Commissions interpret them to have consistent meaning that the category of security-based swap agreements excludes security-based swaps.

To assist the Commissions in further defining the Product Definitions (as well as certain other definitions) and in prescribing regulations regarding mixed swaps as may be necessary to carry out the purposes of Title VII, the Commissions published an advance notice of proposed rulemaking (“ANPR”) in the

Federal Register

on August 20, 2010.

The comment period for the ANPR closed on September 20, 2010.

The Commissions received comments addressing the Product Definitions and/or mixed swaps in response to the ANPR, as well as comments in response to the Commissions' informal solicitations,

from a wide range of commenters.

See

Definitions Contained in Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act, 75 FR 51429, Aug. 20, 2010. The ANPR also solicited comment regarding the definitions of the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.” These definitions are the subject of a separate joint proposed rulemaking by the Commissions.

See

Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 75 FR 80174, Dec. 21, 2010 (“Entity Definitions”). The Commissions also provided the public with the ability to present their views more generally on implementation of the Dodd-Frank Act through their Web sites, dedicated electronic mailboxes, and meetings with interested parties.

See

Public Comments on SEC Regulatory Initiatives Under the Dodd-Frank Act/Meetings with SEC Officials located at

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

Public Submissions, located at

http://comments.cftc.gov/PublicComments/ReleasesWithComments.aspx;

External Meetings, located at

http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm.

Copies of all comments received by the SEC on the ANPR are available on the SEC's Internet Web site, located at

http://www.sec.gov/comments/s7-16-10/s71610.shtml.

Comments are also available for Web site viewing and printing in the SEC'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. Copies of all comments received by the CFTC on the ANPR are available on the CFTC's Internet Web site, located at

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

See supra

note 12.

The Commissions have reviewed the comments received, and the staffs of the Commissions have met with many market participants and other interested parties to discuss the definitions.

Moreover, the Commissions' staffs have consulted extensively with each other as required by sections 712(a)(1) and (2) of the Dodd-Frank Act and have consulted with staff of the Board as required by section 712(d) of the Dodd-Frank Act.

Information about meetings that CFTC staff have had with outside organizations regarding the implementation of the Dodd-Frank Act is available at

http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm.

Information about meetings that SEC staff have had with outside organizations regarding the product definitions is available at

http://www.sec.gov/comments/s7-16-10/s71610.shtml#meetings.

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

Based on this review and consultation, the Commissions are proposing interpretive guidance, and in some instances also proposing rules, regarding, among other things: (i) The regulatory treatment of insurance products; (ii) the exclusion of forward contracts from the swap and security-based swap definitions; (iii) the regulatory treatment of certain consumer and commercial contracts; (iv) the regulatory treatment of certain foreign-exchange related and other instruments; (v) swaps and security-based swaps involving interest rates (or other rates) and yields; (vi) total return swaps (“TRS”); (vii) the application of the definition of “narrow-based security index” in distinguishing between certain swaps and security-based swaps, including credit default swaps (“CDS”) and index CDS; and viii) the specification of certain swaps and security-based swaps that are, and are not, mixed swaps. In addition, the Commissions are proposing rules: (i) establishing books and records requirements applicable to SBSAs; (ii) providing a mechanism for requesting the Commissions to interpret whether a particular type of agreement, contract, or transaction (or class of agreements, contracts, or transactions) is a swap, security-based swap, or both (

i.e.,

a mixed swap); and (iii) providing a mechanism for evaluating the applicability of certain regulatory requirements to particular mixed swaps. Finally, the CFTC is proposing rules to

implement the anti-evasion authority provided in the Dodd-Frank Act.

The Commissions believe that the proposed rules and interpretive guidance will further the purposes of Title VII. While the Commissions believe that these proposals, if adopted, would appropriately effect the intent of the Dodd-Frank Act, the Commissions are very interested in commenters' views as to whether those purposes have been achieved, and, if not, how to improve these proposals.

II. Scope of Definitions of Swap and Security-Based Swap

A. Introduction

Title VII of the Dodd-Frank Act applies to a wide variety of agreements, contracts, and transactions classified as swaps or security-based swaps. The statute lists these agreements, contracts, and transactions in the definition of the term “swap.”

The statutory definition of the term “swap” also has various exclusions,

rules of construction, and other provisions for the interpretation of the definition.

One of the exclusions to the definition of the term “swap” is for security-based swaps.

The term “security-based swap,” in turn, is defined as an agreement, contract, or transaction that is a “swap” (without regard to the exclusion from that definition for security-based swaps) and that also has certain characteristics specified in the statute.

Thus, the statutory definition of the term “swap” also determines the scope of agreements, contracts, and transactions that could be security-based swaps.

See

CEA section 1a(47)(A), 7 U.S.C. 1a(47)(A). This swap definition is also cross-referenced in new section 3(a)(69) of the Exchange Act, 15 U.S.C. 78c(a)(69).

See

CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B), clauses (i)-(x).

See

CEA sections 1a(47)(C)-(F), 7 U.S.C. 1a(47)(C)-(F).

See

CEA section 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x).

See

section 3(a)(68) of the Exchange Act, 15 U.S.C. 78c(a)(68).

The statutory definitions of “swap” and “security-based swap” are detailed and comprehensive, and the Commissions believe that extensive “further definition” of the terms by rule is not necessary. Nevertheless, several commenters have stated,

and the Commissions agree, that the definitions could be read to include certain types of agreements, contracts, and transactions that previously have not been considered swaps or security-based swaps and that nothing in the legislative history of the Dodd-Frank Act appears to suggest that Congress intended such agreements, contracts, and transactions to be regulated as swaps or security-based swaps under Title VII. The Commissions thus believe that it is important to clarify the treatment under the definitions of certain types of agreements, contracts, and transactions, such as insurance products and certain consumer and commercial contracts.

See, e.g.,

Letter from Edward J. Rosen, Cleary Gottlieb Steen & Hamilton LLP, Sept. 21, 2010 (“Cleary Letter”); Letter from Robert Pickel, Executive Vice President, International Swaps and Derivatives Association, Inc., Sept. 20, 2010 (“ISDA Letter”).

In addition, commenters also raised questions regarding, and the Commissions believe that it is important to clarify: (i) The exclusion for forward contracts from the definitions of the terms “swap” and “security-based swap;” and (ii) the status of certain commodity-related products (including various foreign exchange products and forward rate agreements (“FRAs”)) under the definitions of the terms “swap” and “security-based swap.” Finally, the Commissions are providing guidance regarding certain interpretive issues related to the definitions.

Some commenters raised concerns regarding the treatment of inter-affiliate swaps and security-based swaps.

See, e.g.,

Cleary Letter; Letter from Coalition for Derivatives End Users, Sept. 20, 2010 (“CDEU Letter”); ISDA Letter; Letter from Richard A. Miller, Vice President and Corporate Counsel, Prudential Financial Inc., Sept. 17, 2010; Letter from Richard M. Whiting, The Financial Services Roundtable, Sept. 20, 2010. A few commenters suggested that the Commissions should further define the term “swap” or “security-based swap” to exclude inter-affiliate transactions.

See

Cleary Letter; CDEU Letter. The Commissions are considering whether inter-affiliate swaps or security-based swaps should be treated differently from other swaps or security-based swaps in the context of the Commissions' other Title VII rulemakings.

B. Proposed Rules and Interpretive Guidance Regarding Certain Transactions Outside the Scope of the Definitions of the Terms “Swap” and “Security-Based Swap”

1. Insurance Products

A number of commenters expressed concern that the definitions of the terms “swap” and “security-based swap” potentially could include certain types of insurance products

because the statutory definition of the term “swap” includes, in part, any agreement, contract, or transaction “that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.”

The Commissions do not interpret this clause to mean that products historically treated as insurance products should be included within the swap or security-based swap definition.

See, e.g.,

Letter from Ernest C. Goodrich, Jr., Managing Director—Legal Department, and Marcelo Riffaud, Managing Director—Legal Department, Deutsche Bank AG, Sept. 20, 2010 (“Deutsche Bank Letter”); Letter from Sean W. McCarthy, Chairman, Association of Financial Guaranty Insurers, Sept. 20, 2010 (“AFGI Letter”); Letter from Robert J. Duke, The Surety & Fidelity Association of America, Sept. 20, 2010 (“SFAA Letter”); Letter from J. Stephen Zielezienski, Senior Vice President & General Counsel, American Insurance Association, Sept. 20, 2010; Letter from Franklin W. Nutter, President, Reinsurance Association of America, Sept. 20, 2010 (“RAA Letter”); Letter from James M. Olsen, Senior Director Accounting and Investment Policy, Property Casualty Insurers Association of America, Sept. 17, 2010; Letter from Jane L. Cline, President, and Therese M. Vaughan, Chief Executive Officer, National Association of Insurance Commissioners, Sept. 20, 2010; Letter from Joseph W. Brown, Chief Executive Officer, MBIA Inc., Sept. 20, 2010 (“MBIA Letter”); Cleary Letter; Letter from White & Case LLP (“White & Case Letter”), Sept. 20, 2010; Letter from Carl B. Wilkerson, Vice President and Chief Counsel, Securities & Litigation, American Council of Life Insurers, Nov. 12, 2010 (“ACLI Letter”); Letter from Stephen E. Roth, James M. Cain, and W. Thomas Conner, Sutherland Asbill & Brennan LLP, for the Committee of Annuity Insurers, Dec. 3, 2010.

CEA section 1a(47)(A)(ii), 7 U.S.C. 1a(47)(A)(ii).

The Commissions also believe it was not the intent of Congress through the swap and security-based swap definitions to preclude the provision of insurance to individual homeowners and small businesses that purchase property and casualty insurance.

See

CEA section 2(e), 7 U.S.C. 2(e) and section 6(l) of the Exchange Act, 15 U.S.C. 78f(l) (prohibiting individuals and small businesses that do not meet specified financial thresholds or other conditions from entering into swaps or security-based swaps other than on or subject to the rules of regulated futures and securities exchanges).

The Commissions are aware of nothing in Title VII to suggest that Congress intended for insurance products to be regulated as swaps or security-based swaps. Moreover, that swaps and insurance products are subject to different regulatory regimes is reflected in section 722(b) of the Dodd-Frank Act which, in new section 12(h) of the CEA, provides that a swap “shall not be considered to be insurance” and “may not be regulated as an insurance contract under the law of any State.”

Accordingly, the Commissions believe that state or Federally regulated insurance products that are provided by state or Federally regulated insurance companies

that otherwise could fall within the definitions should not be considered swaps or security-based swaps so long as they satisfy the proposed rules or comport with the related proposed interpretive guidance.

At the same time, however, the Commissions are concerned that agreements, contracts, or transactions that are swaps or security-based swaps might be characterized as insurance products to evade the regulatory regime under Title VII of the Dodd-Frank Act. Accordingly, the Commissions are proposing rules and interpretive guidance that would clarify that agreements, contracts, or transactions meeting certain requirements would be considered insurance and not swaps or security-based swaps.

7 U.S.C. 16(h). Moreover, other provisions of the Dodd-Frank Act address the status of insurance more directly, and more extensively, than Title VII. For example, Title V of the Dodd-Frank Act requires the newly established Federal Insurance Office to conduct a study and submit a report to Congress, within 18 months of enactment of the Dodd-Frank Act, on the regulation of insurance, including the consideration of Federal insurance regulation. Notably, the Federal Insurance Office's authority under Title V extends primarily to monitoring and information gathering; its ability to promulgate Federal insurance regulation that preempts state insurance regulation is significantly restricted.

See

section 502 of the Dodd-Frank Act (codified in various sections of 31 U.S.C.). Title X of the Dodd-Frank Act also specifically excludes the business of insurance from regulation by the Bureau of Consumer Financial Protection.

See

section 1027(m) of the Dodd-Frank Act, 12 U.S.C. 5517(m) (“The [Bureau of Consumer Financial Protection]

may not define as a financial product or service, by regulation or otherwise, engaging in the business of insurance.”); section 1027(f) of the Dodd-Frank Act, 12 U.S.C. 5517(f) (excluding persons regulated by a state insurance regulator, except to the extent they are engaged in the offering or provision of consumer financial products or services or otherwise subject to certain consumer laws as set forth in Title X of the Dodd-Frank Act).

As discussed above, the establishment of the Federal Insurance Office under Title V of the Dodd-Frank Act suggests that Federal insurance law could be established in the future. The Commissions believe that the proposed rules should, therefore, include a specific reference to Federal insurance law.

To the extent an insurance product does not fall within the language of the swap definition by its terms, it would not need to satisfy the requirements under the proposed rules in order to avoid being considered a swap or security-based swap.

The proposed rules contain two subparts; the first subpart addresses the agreement, contract, or transaction and the second subpart addresses the entity providing that agreement, contract, or transaction. More specifically, with respect to the former, paragraph (i) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (a) of proposed rule 3a69-1 under the Exchange Act would clarify, as discussed in more detail below, that the terms “swap” and “security-based swap” would not include an agreement, contract, or transaction that, by its terms or by law, as a condition of performance:

• Requires the beneficiary of the agreement, contract, or transaction to have an insurable interest that is the subject of the agreement, contract, or transaction and thereby carry the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract, or transaction;

• Requires that loss to occur and to be proved, and that any payment or indemnification therefor be limited to the value of the insurable interest;

• Is not traded, separately from the insured interest, on an organized market or over-the-counter; and

• With respect to financial guaranty insurance only, in the event of payment default or insolvency of the obligor, any acceleration of payments under the policy is at the sole discretion of the insurer.

In addition, the second subpart of the proposed rules, in paragraph (ii) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (b) of proposed rule 3a69-1 under the Exchange Act, would require that, in order to be excluded from the swap and security-based swap definitions as an insurance product, the agreement, contract, or transaction must be provided:

• By a company that is organized as an insurance company whose primary and predominant business activity is the writing of insurance or the reinsuring of risks underwritten by insurance companies and that is subject to supervision by the insurance commissioner (or similar official or agency) of any state

or by the United States or an agency or instrumentality thereof, and such agreement, contract, or transaction is regulated as insurance under the laws of such state or the United States;

The term “State” is defined in section 3(a)(16) of the Exchange Act to mean “any State of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, or any other possession of the United States.” 15 U.S.C. 78c(a)(16). The CFTC is proposing to incorporate this definition into proposed rule 1.3(xxx)(4) for purposes of ensuring consistency between the CFTC and SEC rules further defining the term “swap.”

• By the United States or any of its agencies or instrumentalities, or pursuant to a statutorily authorized program thereof; or

• In the case of reinsurance only, by a person located outside the United States to an insurance company that is eligible under the proposed rules, provided that: (i) such person is not prohibited by any law of any state or of the United States from offering such agreement, contract, or transaction to such an insurance company; (ii) the product to be reinsured meets the requirements under the proposed rules to be an insurance product; and (iii) the total amount reimbursable by all reinsurers for such insurance product cannot exceed the claims or losses paid by the cedant.

The “cedant” is the insurer writing the risk being ceded or transferred to such person located outside the United States.

In order for an agreement, contract, or transaction to qualify as an insurance product that would not be a swap or security-based swap: (i) The agreement, contract, or transaction would have to meet the criteria in the first subpart of the proposed rules and (ii) the person or entity providing the agreement, contract, or transaction would have to meet the criteria in the second subpart of the proposed rules.

The fact that an agreement, contract, or transaction qualifies as an insurance product does not exclude it from the swap or security-based swap definitions if it is not provided by a qualifying person or entity, nor does the fact that a product is regulated by an insurance regulator exclude it from the swap or security-based swap definitions if the agreement, contract, or transaction does not satisfy the criteria for insurance set forth in the proposed rules.

The Commissions note that certain variable life insurance and annuity products are securities and would not be swaps or security-based swaps regardless of whether they met the requirements under the proposed rules.

See

CEA section 1a(47)(B)(v), 7 U.S.C. 1a(47)(B)(v) (excluding from the definition of “swap” any “agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a fixed basis that is subject to—(I) the [Securities Act]; and (II) the [Exchange Act]”).

See also

156 Cong. Rec. H5248-49 (June 30, 2010) (introducing into the record a letter authored by Senator Blanche Lincoln, Chairman of the U.S. Senate Committee on Agriculture, Nutrition and Forestry, and Christopher Dodd, Chairman U.S. Senate Committee on Banking, Housing, and Urban Affairs, stating that the CFTC is encouraged “to clarify through rulemaking that the exclusion from the definition of swap for `any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled' is intended to be consistent with the forward contract exclusion that is currently in the [CEA] and the CFTC's established policy and orders on this subject, including situations where commercial parties agree to `book-out' their physical delivery obligations under a forward contract.”).

As noted above, the Brent Interpretation applies to “commercial participants in connection with their business.”

Market participants that regularly make or take delivery of the referenced commodity (in the case of the Brent Interpretation, a tanker full of Brent oil) in the ordinary course of their business meet that standard. Such entities qualify for the forward exclusion from both the future delivery and swap definitions for their forward transactions under the Brent Interpretation even if they enter a subsequent transaction to “book out” the forward contract rather than make or take delivery. Intent to make or take delivery can be inferred from the binding delivery obligation for the referenced commodity in the contract and the fact that the parties to the contract do, in fact, regularly make or take delivery of the referenced commodity in the contract in the ordinary course of their business.

See

Brent Interpretation,

supra

note 58, at 39192.

Some commenters to the ANPR requested clarification with regard to the application of the CFTC's 1993 order exempting certain energy contracts from regulation under the CEA (the “Energy Exemption”)

after enactment of the Dodd-Frank Act.

The Energy Exemption extended the Brent Interpretation regarding the forward contract exclusion from the term “future delivery” to energy commodities other than oil. The CFTC believes that the book-out provisions of the Brent Interpretation similarly should apply to the forward contract exclusion from the swap definition for nonfinancial commodities besides oil. Further, the CFTC also is proposing interpretive guidance herein that the Brent Interpretation with respect to the application of the forward contract exclusion from the term “future delivery” in the context of book-out transactions applies not just to oil, but to all nonfinancial commodities. The CFTC, therefore, is proposing to withdraw the Energy Exemption, while retaining and extending through this interpretive guidance the Brent Interpretation regarding book-outs under the forward contract exclusion with respect to nonfinancial commodities.

Exemption for Certain Contracts Involving Energy Products, 58 FR 21286, Apr. 20, 1993. The Energy Exemption generally applies to certain energy contracts: (i) Entered into by persons reasonably believed to be within a specified class of commercial and governmental entities; (ii) that are bilateral contracts between two parties acting as principals; (iii) the material economic terms of which are subject to individual negotiation by the parties; and (iv) that impose binding obligations on the parties to make and receive delivery of the underlying commodity, with no right of either party to effect a cash settlement of their obligations without the consent of the other party (except pursuant to a bona fide termination right such as default). Like the Brent Interpretation, the Energy Exemption provides that the parties can enter into a subsequent book-out settlement of the obligation in a manner other than by physical delivery of the commodity specified in the contract.

Id.

at 21294.

See, e.g.,

WGCEF letter. The CFTC issued the Energy Exemption shortly after Congress had provided the CFTC with exemptive authority pursuant to CEA section 4(c), 7 U.S.C. 6(c), in section 502 of the Futures Trading Practices Act of 1992, Public Law 102-546, 106 Stat. 3590 (1993).

To avoid any uncertainty, the CFTC also notes that the Dodd-Frank Act supersedes the Swap Policy Statement. The CFTC is aware that some commenters have suggested that the Commissions should exercise their authority to further define the term “eligible contract participant” to encompass the “line of business” provision of the Swap Policy Statement.

See

Swap Policy Statement, supra note 63, at 30696-30697. The Commissions will address these comments in their joint final rulemaking with respect to the Entity Definitions.

See supra

note 12.

(b) Commodity Options and Commodity Options Embedded in Forward Contracts

Some commenters responding to the ANPR requested clarification regarding the status of commodity options under the swap definition.

Questions also were raised regarding options embedded in forward contracts,

i.e.,

whether a forward contract with respect to a nonfinancial commodity that contains an embedded option can still qualify for the forward contract exclusion from the swap definition.

See, e.g.,

World Fuel Letter (exclusion for commercial options set forth in CFTC Regulation 32.4 should also be an exclusion from the swap definition).

See, e.g.,

Letter from Patrick Kelly, Policy Advisor, API, Sept. 20, 2010 (“API Letter”), EEI Letter; Letter from Daniel S.M. Dolan, VP, Policy Research & Communications, Electric Power Supply Association, Sept. 20, 2010 (“EPSA Letter”) (physically settled options should be included in the forward exclusion from the swap definition); DFA Letter; ISDA Letter. One commenter suggested that the CFTC should apply to each contract with an enforceable delivery obligation a rebuttable presumption of intent to deliver, even if an option to cash settle is included in that contract.

See

WGCEF Letter.

The statutory swap definition explicitly provides that commodity

options are swaps.

Accordingly, the CFTC recently proposed revisions to its existing options rules in parts 32 and 33 of its regulations with respect to the treatment of commodity options under the Dodd-Frank Act, and requested public comment on those proposed revisions.

The question of the application of the forward exclusion from the swap definition with respect to nonfinancial commodities, where commodity options are embedded in forward contracts (including embedded options to cash settle such contracts), is similar to that arising under the CEA's existing forward contract exclusion from the definition of the term “future delivery.” The CFTC's Office of General Counsel addressed forward contracts that contained embedded options in a 1985 interpretive statement (“1985 Interpretation”),

which the CFTC recently adhered to in its adjudicatory Order in the

Wright

case.

While both were issued prior to the effective date of the Dodd-Frank Act, the CFTC believes that it would be appropriate to apply this guidance to the treatment of forward contracts in nonfinancial commodities that contain embedded options under the Dodd-Frank Act.

7 U.S.C. 1a(47)(A)(i). Options on securities and certain options on foreign currency are excluded from the swap definition by CEA sections 1a(47)(B)(iii) and (iv), respectively. 7 U.S.C. 1a(47)(B)(iii) and (iv). These options are not subject to the Commissions' proposed guidance in this section.

See

Commodity Options and Agricultural Swaps, 76 FR 6095, Feb. 3, 2011.

See

Characteristics Distinguishing Cash and Forward Contracts and “Trade” Options, 50 FR 39656, Sept. 30, 1985.

Wright, supra

note 63.

Wright,

the CFTC described the 1985 Interpretation and stated that the CFTC traditionally has engaged in a two-step analysis of “embedded options” in which the first step focuses on whether the option operates on the price or the delivery term of the forward contract and the second step focuses on secondary trading.

The CFTC believes that these same principles can be applied with respect to the forward contract exclusion from the swap definition for nonfinancial commodities in the Dodd-Frank Act, too. That is, a forward contract that contains an embedded commodity option or options

would be considered an excluded nonfinancial commodity forward contract (and not a swap) if the embedded option(s): (i) May be used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward contract; (ii) do not target the delivery term, so that the predominant feature of the contract is actual delivery; and (iii) cannot be severed and marketed separately from the overall forward contract in which they are embedded.

Conversely, where the embedded commodity option(s) render delivery optional, the predominant feature of the contract cannot be actual delivery and, therefore, the embedded option(s) to not deliver preclude treatment of the contract as a forward contract for a nonfinancial commodity. The CFTC would look to the specific facts and circumstances of the transaction as a whole to evaluate whether any embedded optionality operates on the price or delivery term of the contract, and whether an embedded commodity option is marketed or traded separately from the underlying contract, to determine whether that transaction qualifies for the forward contract exclusion from the swap definition for nonfinancial commodities.

The CFTC believes that such an approach would help prevent commodity options that should fall within the swap definition from qualifying for the forward contract exclusion for nonfinancial commodities instead.

Id.

at n.5. In

Wright,

the CFTC affirmed the Administrative Law Judge's holding that an option embedded in a hedge-to-arrive contract did not violate CFTC rules regarding the sale of agricultural trade options. The CFTC first concluded that the puts at issue operated to adjust the forward price and did not render the farmer's overall obligation to make delivery optional. Then, turning to the next step of the analysis, the CFTC explained that “the put and [hedge-to-arrive contract] operated as a single contract, and in most cases were issued simultaneously * * *. We do not find that any put was severed from its forward or that either of [the put or the hedge-to-arrive contract] was traded separately from the other. We hold that in these circumstances, no freestanding option came into being. * * *”

Id.

at *7.

The CFTC believes that “options” in the plural would include, for example, a situation in which the embedded optionality involves option combinations, such as costless collars, that operate on the price term of the agreement, contract, or transaction.

See Wright,

supra

note 63, at **6-7.

This facts and circumstances approach to determining whether a particular embedded option takes a transaction out of the forward contract exclusion for nonfinancial commodities is consistent with the CFTC's historical approach to determining whether a particular embedded option takes a transaction out of the forward contract exclusion from the CEA definition of the term “future delivery.”

See Wright,

supra

note 63, at *5 (“As we have held since

Stovall,

the nature of a contract involves a multi-factor analysis . * * *”).

The discussion above regarding the exclusion from the swap definition for forward contracts on nonfinancial commodities does not apply to the exclusion from the swap and security-based swap definitions for security forwards or to the distinction between security forwards and security futures products.

No commenters sought clarification of the exclusion from the swap and security-based swap definitions for the “sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled,” in the context of most sales of securities for deferred shipment or delivery; however, some commenters sought clarification of this exclusion in the context of mortgage securitizations.

The Commissions believe it is appropriate to address how the exclusions from the definitions of swap and security-based swap apply to security forwards and other purchases and sales of securities.

Specifically, commenters requested clarification that the swap and security-based swap definitions do not include buying and selling mortgages and forward trading of agency (

i.e.,

Federal Home Loan Mortgage Corporation (“Freddie Mac”), Federal National Mortgage Association (“Fannie Mae”), and Government National Mortgage Association (“Ginnie Mae”) mortgage-backed securities (“MBS”) in the “To-Be-Announced” (“TBA”) market in order to provide the certainty needed to avoid unnecessary disruption of the securitization market.

See

Letter from Stephen H. McElhennon, Vice President & Deputy General Counsel, Fannie Mae, Sept. 20, 2010 (“Fannie Mae Letter”); Letter from Lisa M. Ledbetter, Freddie Mac, Sept. 20, 2010.

The Dodd-Frank Act excludes purchases and sales of securities from the definitions of swap and security-based swap in a number of different clauses.

Under these exclusions, purchases and sales of securities on a fixed or contingent basis

and sales of securities for deferred shipment or delivery that are intended to be physically delivered

are explicitly excluded from the definitions of swap and security-based swap.

The exclusion from the definitions of swap and security-based swap of a sale of a security for deferred shipment or delivery involves an agreement to purchase securities, or groups or indexes of securities, at a future date at a certain price.

See

CEA sections 1a(47)(B)(ii), (v), and (vi), 7 U.S.C. 1a(47)(B)(ii), (v), and (vi).

See

CEA section 1a(47)(B)(v), 7 U.S.C. 1a(47)(B)(v) (excluding from the swap and security-based swap definitions “any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a fixed basis that is subject to [the Securities Act and Exchange Act]”); CEA section 1a(47)(B)(vi), 7 U.S.C. 1a(47)(B)(vi) (excluding from the swap and security-based swap definitions “any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a contingent basis that is subject to [the Securities Act and Exchange Act], unless the agreement, contract, or transaction predicates the purchase or sale on the occurrence of a bona fide contingency that might reasonably be expected to affect or be affected by the creditworthiness of a party other than a party to the agreement, contract, or transaction”).

See

CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii).

The Commissions note that calling an agreement, contract, or transaction a swap or security-based swap does not determine its status.

See

discussion

supra

part II.D.1.

As with other purchases and sales of securities, security forwards are excluded from the definitions of swap and security-based swap. The sale of the security in this case occurs at the time the forward contract is entered into with the performance of the contract deferred or delayed. If such agreement, contract, or transaction is intended to be physically settled, the Commissions believe it would be within the security forward exclusion and therefore outside the swap and security-based swap definitions.

Moreover, as a purchase or sale of a security, the Commissions believe it also would be within the exclusions for the purchase or sale of one or more securities on a fixed basis (or, depending on its terms, a contingent basis) and, therefore, outside the swap and security-based swap definitions.

See

CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii).

See

CEA sections 1a(47)(B)(v) and (vi), 7 U.S.C. 1a(47)(B)(v) and (vi).

As noted above, commenters requested specific guidance in the context of forward sales of MBS that are guaranteed or sold by Fannie Mae, Freddie Mac, and Ginnie Mae and the mortgages underlying such MBS.

MBS guaranteed or sold by Fannie Mae, Freddie Mac and Ginnie Mae are eligible to be sold in the TBA market, which is essentially a forward or delayed delivery market.

The TBA market has been described as one that “allows mortgage lenders essentially to sell the loans they intend to fund even before the loans are closed.”

In the TBA market, the lender enters into a forward contract to sell MBS and agrees to deliver MBS on the settlement date in the future. The specific MBS that will be delivered in the future may not yet be created at the time the forward contract is entered into.

The Commissions believe that such forward sales of MBS in the TBA market would fall within the exclusion for sales of securities on a deferred settlement or delivery basis even though the precise MBS are not in existence at the time the forward MBS sale is entered into.

Moreover, as the purchase or sale of a security, the Commissions believe such forward sales of MBS in the TBA market would fall within the exclusions for the purchase or sale of one or more securities on a fixed basis (or, depending on its terms, a contingent basis) and therefore outside the swap and security-based swap definitions.

Task Force on Mortgage-Backed Securities Disclosure, “Staff Report: Enhancing Disclosure in the Mortgage-Backed Securities Markets,” part II.E.2 (Jan. 2003).

Id.

See

CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii).

See

CEA sections 1a(47)(B)(v) and (vi), 7 U.S.C. 1a(47)(B)(v) and (vi).

Request for Comment

22. The Commissions request comment on all aspects of the proposed interpretive guidance set forth in this section regarding the forward contract exclusion from the swap and security-based swap definitions with respect to nonfinancial commodities and securities.

23. Is the proposed interpretive guidance set forth in this section sufficient with respect to the application of the forward contract exclusion from the swap definition with respect to nonfinancial commodities? If not, what changes should be made? Commenters also are invited to comment on whether the application of the Brent Interpretation generally, and its conclusions regarding book-outs in particular, is appropriate to the forward exclusion from the swap definition with respect to nonfinancial commodities. Would it permit transactions that should be subject to the swap regulatory regime to fall outside of the Dodd-Frank Act?

24. Is it appropriate, in light of the Dodd-Frank Act, for the CFTC to withdraw the Energy Exemption while concurrently retaining the Brent Interpretation, and extending it to the forward contract exclusion from the definition of “future delivery” and the swap definition, for book-out transactions in all nonfinancial commodities? Why or why not? Is the conclusion that the Dodd-Frank Act supersedes the Swap Policy Statement appropriate? Why or why not?

25. Are there any provisions of the Energy Exemption or Swap Policy Statement that the Commissions should consider incorporating into the definitions rulemakings (other than the request already submitted by some commenters in response to the proposed Entity Definitions that the “line of business” provision of the Swap Policy Statement be incorporated into the definition of the term “eligible contract participant” (“ECP”))? If so, please explain in detail how such provisions are consistent with the requirements of the Dodd-Frank Act and would not permit transactions that should be subject to the swap regulatory regime to fall outside of the Dodd-Frank Act.

26. How frequently do book-out transactions of the type described in the Brent Interpretation occur with respect to nonfinancial commodities? Please provide descriptions of any such transactions, and data with respect to their frequency. Are there any nonfinancial commodities or transactions to which the Brent Interpretation should not apply, either with respect to the forward contract exclusion from the definition of “future delivery” or the forward contract exclusion from the swap definition, or both? Why or why not?

27. Should a minimum contract size for a transaction in a nonfinancial commodity (

e.g.,

a tanker full of Brent oil) be required in order for the transaction to qualify as a forward contract under the Brent Interpretation with respect to the future delivery and swap definitions? Why or why not? If so, what standards should apply to determine such a minimum contract size? Should the Brent Interpretation for nonfinancial commodities with respect to the future delivery and swap definitions be limited to market participants that meet certain requirements? Why or why not? If so, does the “eligible commercial entity” definition in CEA section 1a(17)

provide an appropriate requirement? Why or why not? What other requirements, if any, should be imposed?

7 U.S.C. 1a(17).

28. How often, and to what extent, do entities that do not regularly make or take delivery of the commodity in the ordinary course of their business engage in transactions that should qualify as forward contracts? Should such contracts qualify for the safe harbor provided by the Brent Interpretation? Why or why not? If so, how can it be demonstrated that the primary purpose of such transaction is to acquire or sell the physical commodity? Would including these transactions in the scope of the Brent Interpretation permit transactions that should be subject to the swap regulatory regime to fall outside of the Dodd-Frank Act? If so, could this concern be addressed by imposing conditions in order to qualify for the forward exclusion? What conditions, if any, would be appropriate?

29. Are “ring” or “daisy chain” markets for forward contracts, such as the 15-day Brent market, primarily used for commercial merchandising, or do they serve other purposes such as price discovery or risk management? Please explain in detail.

30. Should contracts in nonfinancial commodities that may qualify as forward contracts be permitted to trade on registered trading platforms such as DCMs or swap execution facilities (“SEFs”)? If so, are additional guidance

or rules necessary to determine whether contracts traded on such platforms are excluded from the CEA definition of “future delivery” and/or the swap definition? If so, please describe in detail such markets and explain what further guidance or rules would be appropriate? Should conditions be imposed with respect to the nature of the market participants or the percentage of transactions that must result in delivery over a specified measurement period, or both? If so, what conditions would be appropriate?

31. Should the Commissions provide guidance regarding the scope of the term “nonfinancial commodity” in the forward contract exclusion from the swap definition? If so, how and where should the Commissions draw the line between financial and nonfinancial commodities?

32. Should the forward contract exclusion from the swap definition apply to environmental commodities such as emissions allowances, carbon offsets/credits, or renewable energy certificates? If so, please describe these commodities, and explain how transactions can be physically settled where the commodity lacks a physical existence (or lacks a physical existence other than on paper)? Would application of the forward contract exclusion to such environmental commodities permit transactions that should be subject to the swap regulatory regime to fall outside the Dodd-Frank Act?

33. Are there other factors that should be considered in determining how to characterize forward contracts with embedded options with respect to nonfinancial commodities? If so, what factors should be considered? Do provisions in forward contracts with respect to nonfinancial commodities other than delivery and price contain embedded optionality? How do such provisions operate? Please provide a detailed analysis regarding how such provisions should be analyzed under the Dodd-Frank Act.

34. Is the analysis of forward contracts with embedded options in the 1985 Interpretation and the CFTC's

Wright

decision appropriately applied to transactions entered into after the effective date of the Dodd-Frank Act? Why or why not? If not, how should the analysis be modified?

35. How would the proposed interpretive guidance set forth in this section affect full requirements contracts, capacity contracts, reserve sharing agreements, tolling agreements, energy management agreements, and ancillary services? Do these agreements, contracts, or transactions have optionality as to delivery? If so, should they—or any other agreement, contract, or transaction in a nonfinancial commodity that has optionality as to delivery—be excluded from the swap definition? If so, please provide a detailed analysis of such agreements, contracts, or transactions and how they can be distinguished from options that are to be regulated as swaps pursuant to the Dodd-Frank Act. To what extent are any such agreements, contracts, or transactions in the electric industry regulated by the Federal Energy Regulatory Commission (“FERC”), State regulatory authorities, regional transmission organizations (“RTOs”), independent system operators (“ISOs”) or market monitoring units associated with RTOs or ISOs?

36. Is there any issue with respect to the treatment of commodity options that the Commissions have not addressed and that should be addressed as a definitional matter in this rulemaking?

37. Should the Commissions provide more detailed guidance regarding what constitutes a security forward? For instance, should the Commissions provide more guidance on what it means for a security forward to be “intended to be physically settled”? If so, what further guidance would be appropriate?

38. Should the Commissions provide more guidance regarding when forward sales of MBS in the TBA market would fall within the exclusion for sales of securities on a deferred settlement or delivery basis? Is there any more guidance the Commissions should provide regarding types of transactions that occur in the TBA market?

3. Consumer and Commercial Agreements, Contracts, and Transactions

Commenters on the ANPR pointed out a number of areas in which a broad reading of the swap and security-based swap definitions could cover certain consumer and commercial arrangements that historically have not been considered swaps or security-based swaps. Examples of such instruments cited by commenters include evidences of indebtedness with a variable rate of interest;

commercial contracts containing acceleration, escalation, or indexation clauses;

100

agreements to acquire personal property or real property, or to obtain mortgages;

101

employment, lease, and service agreements, including those that contain contingent payment arrangements;

102

and consumer mortgage and utility rate caps.

103

See

Cleary Letter; Letter from Kenneth E. Auer, President and CEO, The Farm Credit Council, Sept. 20, 2010 (“Farm Credit Council Letter”).

100

See

Cleary Letter; White & Case Letter.

101

See

White & Case Letter; Fannie Mae Letter.

102

See

BlackRock Letter.

103

See

White & Case Letter; Deutsche Bank Letter.

Consumers enter into various types of agreements, contracts, and transactions as part of their household and personal lives that may have attributes that could be viewed as falling within the swap or security-based swap definition. Similarly, businesses and other entities, whether or not for profit, also enter into agreements, contracts, and transactions as part of their operations relating to, among other things, acquisitions or sales of property (tangible and intangible), provisions of services, employment of individuals, and other matters that could be viewed as falling within the definitions.

The Commissions do not believe that Congress intended to include these types of customary consumer and commercial agreements, contracts, or transactions in the swap or security-based swap definition, to limit the types of persons that can enter into or engage in them, or to otherwise to subject these agreements, contracts, or transactions to the regulatory scheme for swaps and security-based swaps. The Commissions, therefore, are proposing the following interpretive guidance to assist consumers and businesses in understanding whether certain agreements, contracts, or transactions that they enter into would be regulated as swaps or security-based swaps.

With respect to consumers, the Commissions believe that the types of agreements, contracts, or transactions that should not be considered swaps or security-based swaps when entered into by consumers (natural persons or their agents) as principals primarily for personal, family, or household purposes, include:

• Agreements, contracts, or transactions to acquire or lease real or personal property, to obtain a mortgage, to provide personal services, or to sell or assign rights owned by such consumer (such as intellectual property rights);

• Agreements, contracts, or transactions to purchase products or services at a fixed price or a capped or collared price, at a future date or over a certain time period (such as agreements to purchase home heating fuel);

104

These agreements, contracts, or transactions involve physical delivery which is deferred for convenience or necessity and thus can be viewed as being akin to forward purchase agreements (sometimes with embedded options, in the case of those with price caps), which were discussed above

in the context of the exclusion from the swap definition for forward contracts in nonfinancial commodities. While the CFTC traditionally has viewed forward contracts in nonfinancial commodities as limited to commercial merchandising transactions, the Commissions view consumer agreements, contracts, and transactions involving periodic or future purchases of consumer products and services, such as agreements to purchase energy commodities to heat or cool consumers' homes, as transactions that are not swaps.

• Agreements, contracts, or transactions that provide for an interest rate cap or lock on a consumer loan or mortgage, where the benefit of the rate cap or lock is realized only if the loan or mortgage is made to the consumer; and

• Consumer loans or mortgages with variable rates of interest or embedded interest rate options, including such loans with provisions for the rates to change upon certain events related to the consumer, such as a higher rate of interest following a default.

The types of commercial agreements, contracts, or transactions that involve customary business arrangements (whether or not involving a for-profit entity) and would not be considered swaps or security-based swaps under this proposed interpretive guidance include:

• Employment contracts and retirement benefit arrangements;

• Sales, servicing, or distribution arrangements;

• Agreements, contracts, or transactions for the purpose of effecting a business combination transaction;

105

These business combination transactions include, for example, a reclassification, merger, consolidation, or transfer of assets as defined under the Federal securities laws or any tender offer subject to section 13(e) and/or section 14(d) or (e) of the Exchange Act, 15 U.S.C. 78m(e) and/or 78n(d) or (e). These business combination agreements, contracts, or transactions can be contingent on the continued validity of representations and warranties and can contain earn-out provisions and contingent value rights.

• The purchase, sale, lease, or transfer of real property, intellectual property, equipment, or inventory;

• Warehouse lending arrangements in connection with building an inventory of assets in anticipation of a securitization of such assets (such as in a securitization of mortgages, student loans, or receivables);

106

The Commissions believe that such lending arrangements included in this category are traditional borrower/lender arrangements documented using, for example, a loan agreement or indenture, as opposed to a synthetic lending arrangement documented in the form of, for example, a TRS. The Commissions also note that securitization transaction agreements also may contain contingent obligations if the representations and warranties about the underlying assets are not satisfied.

• Mortgage or mortgage purchase commitments, or sales of installment loan agreements or contracts or receivables;

• Fixed or variable interest rate commercial loans entered into by non-banks

107

; and

107

See infra

note 115 regarding identified banking products.

• Commercial agreements, contracts, and transactions (including, but not limited to, leases, service contracts, and employment agreements) containing escalation clauses linked to an underlying commodity such as an interest rate or consumer price index.

The Commissions intend this proposed interpretive guidance to allow consumers to engage in customary transactions relating to their households and personal or family activities without concern that such arrangements would be considered swaps or security-based swaps. Similarly, applying this guidance to customary commercial arrangements should allow commercial and non-profit entities to continue to operate their businesses and operations without significant disruption and ensure that the swap and security-based swap definitions are not read to include commercial and non-profit operations that historically have not been considered to involve swaps or security-based swaps.

The types of agreements, contracts, and transactions discussed above are not intended to be exhaustive of the customary consumer or commercial arrangements that should not be considered to be swaps or security-based swaps. There may be other, similar types of agreements, contracts, and transactions that also should not be considered to be swaps or security-based swaps. In determining whether similar types of agreements, contracts, and transactions entered into by consumers or commercial entities are swaps or security-based swaps, the Commissions intend to consider the characteristics and factors that are common to the consumer and commercial transactions listed above:

• They do not contain payment obligations, whether or not contingent, that are severable from the agreement, contract, or transaction;

• They are not traded on an organized market or over-the-counter; and

• In the case of consumer arrangements, they:

—Involve an asset of which the consumer is the owner or beneficiary, or that the consumer is purchasing, or they involve a service provided, or to be provided, by or to the consumer, or

• In the case of commercial arrangements, they are entered into:

—By commercial or non-profit entities as principals (or by their agents) to serve an independent commercial, business, or non-profit purpose, and

—Other than for speculative, hedging, or investment purposes.

Two of the key components reflected in these characteristics that distinguish these agreements, contracts, and transactions from swaps and security-based swaps are that: (i) The payment provisions of the arrangements are not severable; and (ii) the agreement, contract, or transaction is not traded on an organized market or over-the-counter—so that such arrangements would not involve risk-shifting arrangements with financial entities, as would be the case for swaps and security-based swaps.

108

There also are alternative regulatory regimes that have been enacted as part of the Dodd-Frank Act specifically to provide enhanced protections to consumers relating to various consumer transactions.

See, e.g.,

the Consumer Financial Protection Act of 2010, Public Law 111-203, title X, 124 Stat. 1376 (July 21, 2010) (establishing the Bureau of Consumer Financial Protection to regulate a broad category of consumer products and amending certain laws under the jurisdiction of the Federal Trade Commission); the Mortgage Reform and Anti-Predatory Lending Act, Public Law 111-203, title XIV, 124 Stat. 1376 (July 21, 2010) (amending existing laws, and adding new provisions, related to certain mortgages). Some of these agreements, contracts, or transactions are subject to regulation by the Federal Trade Commission and other Federal financial regulators and state regulators.

This proposed interpretive guidance is not intended to be the exclusive means for consumers and commercial or non-profit entities to determine whether their agreements, contracts, or transactions fall within the swap or security-based swap definition. If there is a type of agreement, contract, or transaction that is not enumerated above, or does not have all the characteristics and factors that are listed above (including new types of arrangements that may be developed in the future), but that a party to the agreement, contract, or transaction believes is not a swap or security-based swap, the Commissions invite such party to seek an interpretation from the Commissions as to whether the agreement, contract, or transaction is a swap or security-based swap.

Request for Comment

39. Is interpretive guidance of the type proposed in this section necessary with respect to the application of the swap and security-based swap definitions to certain consumer and commercial agreements, contracts, or transactions?

40. Is the interpretive guidance proposed in this section useful,

appropriate, and sufficient for persons to consider when evaluating whether agreements, contracts, or transactions of the types described in this section fall within the swap or security-based swap definition?

41. In particular, are the listed characteristics and factors for consumer transactions and for commercial transactions appropriate for purposes of evaluating whether agreements, contracts, or transactions fall within the swap or security-based swap definition? If not, what characteristics or factors should be included or excluded, and why? Are any of the characteristics or factors too narrow or too broad? If so, how should the listed characteristics and factors be modified, and why?

42. Is a joint interpretation as provided for in section 712(d)(4) of the Dodd-Frank Act, pursuant to the proposed process discussed in part VI below, an appropriate means of addressing any further interpretive questions?

43. Does the interpretive guidance proposed in this section sufficiently enumerate the types of consumer and commercial agreements, contracts, or transactions that should not be considered swaps or security-based swaps? If not, please provide details of other types of such agreements, contracts, or transactions and an explanation of the reasons why the definitions should not apply to them.

44. Is the treatment of consumer or commercial contracts containing payment arrangements sufficiently clear? For example, should the interpretive guidance expressly address any other specific types of contracts, such as installment sales contracts, financings used in normal business operations (such as receivables financings), pensions and other post-retirement benefits, contracts relating to the performance of a service, standby liquidity agreements, indemnification agreements, reimbursement agreements, or affiliate guarantees? Why or why not?

45. Is the treatment of purchases, sales, leases, or transfers of equipment and inventory sufficiently flexible to not interfere with ordinary business operations? As an alternative, should the guidance expressly cover the purchase, sale, lease, or transfer of assets (excluding financial assets) that are anticipated to be owned, leased, licensed, produced, manufactured, processed, or merchandized by one of the parties or an affiliate? Why or why not?

4. Loan Participations

Two commenters inquired whether loan participations fall within the scope of the swap and security-based swap definitions.

109

According to these commenters, loan participations arise when a lender transfers the economic risks and benefits of all or a portion of a loan it has entered into with a borrower to another party as an alternative or precursor to assigning to such person the loan or an interest in the loan.

110

Two types of loan participations are offered in the market today according to these commenters: LSTA-style participations and LMA-style participations.

111

An LSTA-style participation “specifically provides that the participation is intended by the parties to be treated as a sale by the grantor and a purchase by the participant” and “is intended to effect a `true sale' of the loan from the grantor to the participant and put the participant's beneficial ownership interest in the loan beyond the reach of the grantor's bankruptcy estate.”

112

By contrast, an LMA-style participation, while not effecting a sale, “creates a current debtor-creditor relationship between the grantor and the participant under which a future ownership interest is conveyed.”

113

Neither type of loan participation is a “synthetic” transaction according to the March LSTA letter because “they are merely transfers of cash loan positions” and “[t]he ratio of underlying loan to participation is always one-to-one.”

109

See

Letter from R. Bram Smith, Executive Director, The Loan Syndications and Trading Association, Jan. 25, 2011 (“January LSTA Letter”) and letter from Elliot Ganz, General Counsel, The Loan Syndications and Trading Association, Mar. 1, 2011 (“March LSTA Letter, and collectively with the January LSTA Letter, “LSTA Letters”); Letter from Clare Dawson, Managing Director, Loan Market Association, Feb. 23, 2011.

110

See

Loan Market Association, “Guide to Syndicated Loans,” section 6.2.5 (“Risk participation may be provided by a new lender as an interim measure before it takes full transfer of a loan.”), available at

http://www.lma.eu.com/uploads/files/Introductory_Guides/Guide_to_Par_Syndicated_Loans.pdf

111

The LSTA is The Loan Syndications and Trading Association. The LMA is the Loan Market Association.

112

See

January LSTA Letter (citation omitted).

113

See

LSTA Letters.

But see

Jon Kibbe, Julia Lu and Carl Winkworth, Richards Kibbe & Orbe, LLP, “Dodd-Frank Crosses the Pond: Unintended Consequences for LMA-Style Loan Participations?,” 3 (Nov. 12, 2010) (“The grantor of an LMA-style participation does not grant an ownership interest in the loan to the participant.”) (“LMA-Style LP Memo”), available at

http://www.rkollp.com/assets/attachments/Dodd-Frank%20Crosses%20the%20Pond%20-%20Unintended%20Consequences%20for%20LMA-Style%20Loan%20Participations.pdf

Depending on the facts and circumstances, a loan participation may be a security under the Federal securities laws and, as such, the loan participation would be excluded from the definition of swap as the purchase and sale of a security on a fixed or contingent basis.

114

In addition, depending on the facts and circumstances, a loan participation may be an identified banking product and, as such, would be excluded from CFTC jurisdiction and from the “security-based swap” and “security-based swap agreement” definitions.

115

114

See

CEA sections 1a(47)(B)(v) and (vi), 7 U.S.C. 1a(47)(b)(v) and (vi), as amended by section 721(a)(21) of the Dodd-Frank Act (excluding purchases and sales of a security on a fixed or contingent basis, respectively from the swap definition).

115

See

section 403(a) of the Legal Certainty for Bank Products Act of 2000, 7 U.S.C. 27a(a), as amended by section 725(g)(2) of the Dodd-Frank Act (providing that, under certain circumstances, the CEA shall not apply to, and the CFTC shall not exercise regulatory authority over, identified banking products, and the definitions of the terms “security-based swap” and “security-based swap agreement” shall not include identified banking products).

The Commissions do not interpret the swap and security-based swap definitions to include loan participations in which the purchaser is acquiring a current or future direct or indirect ownership interest in the related loan and the loan participations are “true participations” (the participant acquires a beneficial ownership interest in the underlying loans).

116

See generally

Richard M. Gray and Suhrud Mehta, Milbank Tweed Hadley & McCloy LLP, “US and UK compared Fundamental differences remain between the markets. But is it worth considering using a New York participation agreement in an English deal?,” International Financial Law Review (Oct. 1, 2009) (discussing differences between New York and English participation markets and features distinguishing true participations from financings), available at

http://www.milbank.com/NR/rdonlyres/B95C06AD-C3CA-44C9-8433-B6021C4455C9/0/102009_IFLR_USandUKcompared_RGray_SMehta.pdf;

Cleary, Gottlieb, Steen & Hamilton,

Memorandum for the Financial Accounting Standards Board,

Re: Participations (June 14, 2004) (discussing, among other things, what a “good” or “true” participation is under the Uniform Commercial Code, the Bankruptcy Code, case law, and other authority), available at

http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175817895286&blobheader=application%2Fpdf

Request for Comment

46. Should any of the enumerated agreements, contracts, or transactions be considered swaps or security-based swaps whether in general or in certain narrow circumstances? If so, which ones and why? In particular, how are loan participations similar to and different from loan TRS? Does the proposed guidance adequately distinguish between loan participations similar to and different from loan TRS?

47. Does the Commissions' proposed interpretive guidance regarding loan participations exclude from the swap or security-based swap definitions agreements, contracts, or transactions

that are swaps or security-based swaps? If so, please describe such agreements, contracts, or transactions and suggested adjustments to the proposed guidance to capture such agreements, contracts, or transactions as swaps or security-based swaps.

48. Is the Commissions' proposed interpretive guidance regarding loan participations as not falling within the swap and security-based swap definitions appropriate? Why or why not? Should the Commissions provide further guidance on what constitutes an “ownership interest” in the loan underlying a loan participation? If so, what should such guidance provide?

49. Do all loan participations convey a current or future direct or indirect ownership interest from the grantor to the participant or sub-participant? If so, what indicia of ownership are conveyed and when, particularly in LMA-style loan participations? Do loan participations use leverage? If so, how?

50. Are any swaps or security-based swaps partly or fully defeased?

51. Should the Commissions provide further guidance regarding the scope of “true participation?” If so, how should the Commissions delineate the scope thereof?

C. Proposed Rules and Interpretive Guidance Regarding Certain Transactions Within the Scope of the Definitions of the Terms “Swap” and “Security-Based Swap”

1. In General

In light of provisions in the Dodd-Frank Act that specifically address certain foreign exchange products, the Commissions are proposing rules to clarify the status of products such as foreign exchange forwards, foreign exchange swaps, foreign exchange options, non-deliverable forwards involving foreign exchange (“NDFs”), and cross-currency swaps. The Commissions also are proposing a rule to clarify the status of FRAs and providing interpretive guidance regarding: (i) Combinations and permutations of, or options on, swaps or security-based swaps; and (ii) contracts for differences (“CFDs”).

Proposed rule 1.3(xxx)(2) under the CEA and proposed rule 3a69-2 under the Exchange Act would explicitly define the term “swap” to include certain foreign exchange-related products and FRAs unless such products would be excluded by the list of exclusions in subparagraph (B) of the swap definition.

117

In proposing these rules, the Commissions do not mean to suggest that any other agreement, contract, or transaction not mentioned in the proposed rules or specifically enumerated in the statutory definition would not be covered by the swap or security-based swap definitions in the Dodd-Frank Act.

117

See

CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B).

2. Foreign Exchange Products

(a) Foreign Exchange Products Subject to the Secretary's Swap Determination: Foreign Exchange Forwards and Foreign Exchange Swaps

The Dodd-Frank Act provides that “foreign exchange forwards” and “foreign exchange swaps” shall be considered swaps under the swap definition unless the Secretary of the Treasury (“Secretary”) issues a written determination that either foreign exchange swaps, foreign exchange forwards, or both: (i) Should not be regulated as swaps; and (ii) are not structured to evade the Dodd-Frank Act in violation of any rule promulgated by the CFTC pursuant to section 721(c) of the Dodd-Frank Act.

118

A foreign exchange forward is defined as “a transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange.”

119

A foreign exchange swap, in turn, is defined as “a transaction that solely involves—(A) An exchange of 2 different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange; and (B) a reverse exchange of the 2 currencies described in subparagraph (A) at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange.”

120

118

See

CEA section 1a(47)(E)(i), 7 U.S.C. 1a(47)(E)(i). The Secretary has issued a request for comment about whether an exclusion from the swap definition for foreign exchange swaps, foreign exchange forwards, or both, is warranted, and on the application of the statutory factors that the Secretary must consider in making a determination regarding whether to exclude these products.

See

Determinations of Foreign Exchange Swaps and Forwards, 75 FR 66829, Oct. 29, 2010.

119

See

CEA section 1a(24), 7 U.S.C. 1a(24).

120

See

CEA section 1a(25), 7 U.S.C. 1a(25).

Under the Dodd-Frank Act, if foreign exchange forwards or foreign exchange swaps are no longer considered swaps due to a determination by the Secretary, nevertheless, certain provisions of the CEA added by the Dodd-Frank Act would continue to apply to such transactions. Specifically, those transactions still would be subject to certain requirements for reporting swaps, and swap dealers and major swap participants engaging in such transactions still would be subject to certain business conduct standards.

121

See, e.g.,

CEA sections 1a(47)(E)(iii) and (iv), 7 U.S.C. 1a(47)(E)(iii) and (iv) (reporting and business conduct standards, respectively).

The Commissions are proposing to provide greater clarity by explicitly defining by rule the term “swap” to include foreign exchange forwards and foreign exchange swaps (as those terms are defined in the CEA).

122

The proposed rules would incorporate the provision of the Dodd-Frank Act that, if the Secretary issues the written determination described above, foreign exchange forwards and foreign exchange swaps would no longer be considered swaps. The proposed rules also would reflect the continuing applicability of certain reporting requirements and business conduct standards in the event that the Secretary makes such a determination.

123

122

As noted above, the proposed rules provide that foreign exchange forwards and forward exchange swaps would not be swaps if they fall within one of the exclusions set forth in subparagraph (B) of the swap definition.

123

The exclusion of foreign exchange forwards and foreign exchange swaps would become effective upon the Secretary's submission of the determination to the appropriate Congressional Committees.

See

CEA section 1a(47)(E)(ii), 7 U.S.C. 1a(46)(E)(ii).

(b) Foreign Exchange Products Not Subject to the Secretary's Swap Determination

The Commissions also are proposing rules to provide clarity that a determination by the Secretary that foreign exchange forwards or foreign exchange swaps, or both, should not be regulated as swaps would not affect other products involving foreign currency, such as foreign currency options, NDFs, and cross-currency swaps. The Commissions are proposing rules to explicitly define the term “swap” to include such products, irrespective of whether the Secretary makes a determination to exempt foreign exchange forwards or foreign exchange swaps.

124

As discussed above, however, the proposed rules provide that none of the products discussed in this section (b) would be swaps if they fall within one of the exclusions set forth in subparagraph (B) of the swap definition.

(i) Foreign Currency Options

125

This discussion is not intended to address, and has no bearing on, the CFTC's jurisdiction over foreign currency options in other contexts.

See, e.g.,

CEA sections 2(c)(2)(A)(iii) and 2(c)(2)(B)-(C), 7 U.S.C. 2(c)(2)(A)(iii) and 2(c)(2)(B)-(C) (off-exchange options in foreign currency offered or entered into with retail customers).

As discussed above, the statutory swap definition includes options, and it expressly enumerates foreign currency options. It encompasses any agreement, contract, or transaction: ” (i) that is a

put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest

or other rates, currencies,

commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind.”

126

See

CEA section 1a(47)(A)(i), 7 U.S.C. 1a(47)(A)(i) (emphasis added).

Foreign exchange options traded on a national securities exchange (“NSE”), however, are securities under the Federal securities laws and not swaps or security-based swaps.

127

See

CEA section 1a(47)(B)(iv), 7 U.S.C. 1a(47)(B)(iv).

Any determination by the Secretary, discussed above, that foreign exchange forwards or foreign exchange swaps should not be regulated as swaps would not impact foreign currency options because a foreign currency option is neither a foreign exchange swap nor a foreign exchange forward, as those terms are defined in the CEA. Consequently, the Commissions are proposing rules to provide clarity by explicitly defining the term “swap” to include foreign currency options (other than foreign currency options traded on an NSE).

128

The proposed rules also would clarify that foreign currency options are not foreign exchange forwards or foreign exchange swaps under the CEA.

128

The proposed rules would treat the terms foreign currency options, currency options, foreign exchange options, and foreign exchange rate options as synonymous. Moreover, for purposes of the proposed rules, foreign currency options include options to enter into or terminate, or that otherwise operate on, a foreign exchange swap or foreign exchange forward or on the terms thereof. As discussed above, foreign exchange options traded on an NSE are securities and therefore not addressed in the proposed rules.

(ii) Non-Deliverable Forward Contracts Involving Foreign Exchange

An NDF generally is similar to a forward foreign exchange contract,

129

except that at maturity, the NDF does not require physical delivery of currencies and is typically settled in U.S. dollars. The other currency, usually an emerging market currency subject to capital controls, is therefore said to be “nondeliverable.”

130

If the spot market exchange rate on the settlement date is greater (in foreign currency per dollar terms) than the previously agreed forward exchange rate, the party to the contract that is long the emerging market currency must pay its counterparty the difference between the contracted forward price and the spot market rate, multiplied by the notional amount.

131

129

A deliverable forward foreign exchange contract is an obligation to buy or sell a specific currency on a future settlement date at a fixed price set on the trade date.

See

Laura Lipscomb, “Federal Reserve Bank of New York, An Overview of Non-Deliverable Foreign Exchange Forward Markets,” 1 (May 2005) (citation omitted) (“Fed NDF Overview”).

130

See id.

at 1-2 (citation omitted).

131

See id.

at 2. Being long the emerging market currency means that the holder of the NDF contract is the “buyer” of the emerging market currency and the “seller” of dollars. Conversely, if the emerging market currency appreciates relative to the previously agreed forward rate, the holder of the contract that is short the emerging market currency must pay its counterparty the difference between the spot market rate and the contracted forward price, multiplied by the notional amount.

See id.

at 2, n.4.

NDFs are not expressly enumerated in the swap definition, but they satisfy clause (A)(iii) of the definition because they provide for a future (executory) payment based on an exchange rate, which is an “interest or other rate[]” within the meaning of clause (A)(iii) of the swap definition.

132

Each party to an NDF transfers to its counterparty the risk of the exchange rate moving against the counterparty, thus satisfying the requirement that there be a transfer of financial risk associated with a future change in rate. This financial risk transfer in the context of an NDF is not accompanied by a transfer of an ownership interest in any asset or liability. Thus, an NDF is a swap under clause (A)(iii) of the swap definition.

133

132

See

CEA section 1a(47)(A)(iii), 7 U.S.C. 1a(47)(A)(iii) (providing that a swap is an agreement, contract, or transaction “that provides on an executory basis for the exchange, on a fixed or contingent basis, of 1 or more payments based on the value or level of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred * * *.”).

133

It appears that at least some market participants view NDFs as swaps today.

See, e.g.,

Credit Suisse, “Non-Deliverable Forwards,” at 1 (characterizing NDFs as “a derivative instrument for hedging * * * exchange-rate risk” in the absence of a forwards market), available at

https://www.credit-suisse.com/ch/unternehmen/kmugrossunternehmen/doc/nondeliverable_forward_en.pdf;

Association of Corporate Treasurers, “Glossary of Terms” (defining an NDF as “[a] foreign currency financial derivative contract”), available at

http://www.treasurers.org/glossary/N#Non-deliverableforward.

Thus, NDFs also may fall within clause (A)(iv) of the swap definition as “an agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap.”

See

CEA section 1a(47)(A)(iv), 7 U.S.C. 1a(47)(A)(iv).

Cf.

CFTC rule 35.1(b)(1)(i), 17 CFR 35.1(b)(1)(i) (providing that the definition of “swap agreement” includes a “forward foreign exchange agreement,” without reference to convertibility or delivery).

As discussed above, the Secretary may determine that foreign exchange swaps or foreign exchange forwards should not be regulated as swaps. The outcome of the Secretary's determination would not impact NDFs, however, because NDFs (like foreign currency options) do not meet the definitions of the terms foreign exchange forward or foreign exchange swap set forth in the CEA. NDFs do not involve an “exchange” of two different currencies (an element of the definition of both a foreign exchange forward and a foreign exchange swap); instead, they are settled by payment in one currency (usually U.S. dollars).

Notwithstanding their “forward” label, NDFs do not fall within the forward contract exclusion of the swap definition. Currency is outside the scope of the forward contract exclusion for nonfinancial commodities. Nor have NDFs traditionally been considered commercial merchandising transactions. Rather, the NDF markets appear to be driven in large part by speculation

134

and hedging,

135

which features are more characteristic of swap markets than forward markets.

134

See

“Fed NDF Overview,”

supra

note 129, at 5 (“[E]stimates vary but many major market participants estimate as much as 60 to 80 percent of NDF volume is generated by speculative interest, noting growing participation from international hedge funds.”) and 4 (“[D]ealers note that much of the volume in Chinese

yuan

NDFs is generated by speculative positioning based on expectations for an alteration in China's current, basically fixed exchange rate.”) (italics in original).

135

See id.

at 4 (noting that “[much of the] Korean

won

NDF volume[,] * * * estimated to be the largest of any currency, * * * is estimated to originate with international investment portfolio managers hedging the currency risk associated with their onshore investments”).

Based on the foregoing considerations, the Commissions are proposing to provide greater clarity by explicitly defining the term “swap” to include NDFs. The proposed rules also would clarify that NDFs are not foreign exchange forwards or foreign exchange swaps as those terms are defined in the CEA.

(iii) Currency Swaps and Cross-Currency Swaps

A currency swap

136

and a cross-currency swap

137

each generally can be

described as a swap in which the fixed legs or floating legs based on various interest rates are exchanged in different currencies. Such swaps can be used to reduce borrowing costs, to hedge currency exposure, and to create synthetic assets

138

and are viewed as an important tool, given that they can be used to hedge currency and interest rate risk in a single transaction.

136

A swap that exchanges a fixed rate against a fixed rate is known as a currency swap.

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