Under the Commodity Exchange Act (“CEA”), a person who qualifies as a “swap dealer” or “major swap participant” is required to register with the Commodity Futures Trading Commission (“CFTC”) and comply with the Dodd-Frank Wall Street Reform and Consumer Protection Act’s regulatory regime governing swaps, which generally requires, among other things:
- Mandatory clearing of certain designated derivatives through a “derivatives clearing organization” (“DCO”)
- Mandatory execution of certain designated derivatives by a “designated contract market” (“DCM”) or a “swap execution facility (“SEF”)
- Recordkeeping requirements and documentation of swaps
- Reporting of swap data
- Certain capital and margin requirements
- Certain internal and external business conduct requirements
Swap market participants that are neither swap dealers nor major swap participants are generally referred to as “end users,” and are still subject to the CFTC’s swap regulations, however such end users are subject to fewer regulatory burdens than swap dealers and major swap participants.
The following is a broad overview of the classifications of swap market participants regulated by the CFTC, as well as an overview of what constitutes a “swap” for purposes of the CEA.
Classification of Swap Market Participants
Classification | Definition | Miscellaneous |
Swap Dealer | Any person who: (i) Holds itself out as a dealer in swaps, (ii) Makes a market in swaps, (iii) Regularly enters into swaps with counterparties as an ordinary course of business for its own account, or (iv) Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps. | De minimis exemption if: (i) Aggregate gross notional amount of swaps entered into over the past 12 months in connection with dealing activities does not exceed $3 billion; (ii) Aggregate gross notional amount of such swaps with “special entities” (primarily governmental entities and certain employee benefit plans) over the past 12 months does not exceed $25 million |
Major Swap Participant | Defined as: (i) A person that maintains a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan. (ii) A person whose outstanding swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets.” (iii) Any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency” and that maintains a “substantial position” in any of the major swap categories. | A substantial position” is defined as: (i) For rate or currency swaps, a $3 billion negative mark-to-market exposure or $6 billion in negative mark-to-market plus potential future exposure; (ii) For credit, equity, or commodity swaps, $1 billion in negative mark-to-market exposure or $2 billion in negative mark-to-market plus potential future exposure.
“Substantial counterparty exposure” is defined as: $5 billion in negative mark-to-market exposure across all swaps or $8 billion in negative mark-to-market plus potential future exposure across all swaps. |
End Users | Swap market participants that are neither swap dealers nor major swap participants. There are two categories of end users: Financial Entities: any person that is: 1. A swap dealer or security based swap dealer; 2. A major swap participant or a major security-based swap participant; 3. A commodity pool; 4. A private fund; 5. An ERISA plan; or 6. A person predominantly engaged in the business of banking, or in activities that are financial in nature.
Commercial End Users: End users that do not fall under the definition of financial entities. | End users are not subject to the same regulatory burdens under the CEA as swap dealers and major swap participants however, status as an end user still entails many of the CEA’s regulatory requirements.
Furthermore, commercial end users are treated differently from financial entities – the former being subject to less regulation than the latter (for example, swap documentation requirements and external business conduct standards are more limited for non-financial end users). |
Definition of “Swap”
Regulated commodity interests that come within the definition of “swap” include, among other financial instruments, interest rate swaps, foreign exchange derivatives, and commodity swaps, including swaps on physical commodities. Non-deliverable foreign exchange forwards, currency and cross-currency swaps, foreign exchange options, i.e. “rolling spot” transactions and contingent foreign exchange forwards are not exempt from the definition of swap, and thus are subject to all swap requirements.
There are several exemptions to the definition of “swap”:
1. Spot transactions, including cash market transactions in foreign exchange, commodities and securities
2. Futures and options on futures
3. Options on a single security or group or index of securities
4. Physically settled forward transactions, including transactions in physical commodities and securities for deferred delivery
The CFTC has provided further guidance on exemptions for options on physical commodities that meet specified conditions:
(a) Embedded Commodity Options are exempt from the definition of “swap” if (1) the option may be used to adjust the forward price, but does not undermine the overall nature of the contract as a forward; (2) the option does not target the delivery term, so that the predominant feature of the contract is actual delivery; and (3) the option cannot be severed and marketed separately from the overall forward in which it is embedded.
(b) Embedded Volumetric Commodity Options are exempt from the definition of “swap” if (1) the embedded optionality does not undermine the overall nature of the contract as a forward; (2) the predominant feature of the contract is delivery; (3) the embedded optionality cannot be severed and marketed separately; (4) the seller intends to deliver the commodity if the option is exercised; (5) the buyer intends to take delivery if the option is exercised; (6) both parties are commercial parties; and (7) the exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors or regulatory requirements that are outside the control of the parties.
(c) Trade options are exempt from the definition of “swap” if (1) the option is offered by either an “eligible contract participant” (generally, a financially sophisticated entity) or a commercial participant (a producer, processor, commercial user of, or merchant handling, the underlying physical commodity); (2) the option is offered to a commercial participant; and (3) the option is intended to be physically settled so that, if exercised, the option would result in the sale of an exempt or agricultural commodity for immediate or deferred shipment or delivery.
5. Spot foreign exchange transactions
6. Foreign exchange forwards and deliverable foreign exchange swaps are exempt from most, but not all swap regulation.
Conclusion
Fund managers should (1) determine whether they are engaging in the dealing or trading of swaps, and (2) determine whether they qualify as a swap dealer, major swap participant, or end user. Based on these determinations, fund managers should then consider their obligations under the Commodity Exchange Act.
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