On April 18 the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) approved a final rule defining the terms “swap dealers,” “major swap participants,” and “eligible contract participants.” Many market participants were pleased that the regulators appeared to have listened to their concerns and defined the terms “swap dealers” and “major swap participants” in such a way that will not capture the vast majority of derivatives end users. The final rule provided less comfort to small end users, however, who may find that they will no longer be able to enter into over-the-counter derivative transactions because they do not qualify as “eligible contract participants.”
– Major Swap Participants (“MSPs”): The final rule appears to be consistent with Congressional intent to focus the MSP definition on entities whose derivatives use is so material that the failure of any one could undermine financial stability. According to the rule, an entity’s swaps exposure (i.e., current and/or potential future exposure) must exceed thresholds ranging from $1 billion to $8 billion in order for it to be deemed an MSP. The exact thresholds that apply depend on factors such as asset class (e.g., interest rates vs. commodities) and transaction purpose (i.e., hedge vs. non-hedge). Importantly, posted collateral and transaction netting are taken into account when assessing whether a party is an MSP. As a result, many end users will not be deemed MSPs, and those who are at risk of being one could put in place credit support annexes or lower the thresholds above which they must post collateral in order to avoid becoming MSPs.
– Swap Dealer (“SDs”): Dodd-Frank’s SD definition was broadly worded and there was concern that it could include end-user hedging activity. The final rule addressed this concern by focusing the SD definition on those who offer swaps to satisfy customer demand. It also excluded those whose swap dealing activity falls below thresholds that range from $3 billion to $8 billion. Additionally, the CFTC opted to exclude a company’s inter-affiliate swaps when considering whether that company is a swap dealer. These and other changes make it likely that the vast majority of end users will not be deemed SDs .
– Eligible Contract Participant (“ECPs”): Dodd-Frank prohibits non-ECPs (which for companies mean having less than $10 million in total assets or $1 million in net worth) from entering into OTC derivatives transactions that are regulated as “swaps.” End users, some of whom may not qualify as ECPs but in the past were able to enter into OTC derivatives transactions through an exemption known as the “line of business” exemption, were interested to see whether the regulators would amend the definition of ECP in a way that would allow at least some of them to continue using OTC derivative products. The final rule on entity definitions relaxes the restriction slightly by allowing a non-ECP to continue entering into OTC derivatives so long as it is hedging or mitigating commercial risk, all of its owners are ECPs, and has a net worth – which may include the net worth of any of its owners – of at least $1 million. This amendment will help some non-ECPs, but certain end users will be left out.
Although this rule represents an important step for increasing certainty for end users, many questions remain. Chief among them is the cost of hedging, the answer to which will largely be a product of capital and margin rules. Capital costs will be driven by prudential regulators’ rules to implement Basel III, anticipated sometime this year. Margin rules will also be finally determined by prudential regulators, as early as late summer. In the meantime, most end users will likely be pleased to see that regulatory agencies listened to their concerns as they finalized the entity definitions rule.