Federal regulators unveiled proposed rules Wednesday spelling out which companies will be captured by sweeping new derivatives regulations.
The Commodity Futures Trading Commission seeks to clarify the scope of new derivatives rules. The definitions explain exactly what firms would qualify as swap dealers and major traders of swaps known as "major swap participants."
The financial industry and corporations across the United States have all been anxiously awaiting the rules by the commission, which is working to implement provisions in the Dodd-Frank Act.
That law targets primarily swap dealers, like banks, and major swap traders by requiring them to execute standard swaps on trading platforms and route them through clearinghouses, which guarantee trades. Swaps are financial instruments often used to hedge against risks like price movements.
But the law leaves it up to regulators at the CFTC and the Securities and Exchange Commission to flesh out the definitions for dealers and major traders. Those definitions will have major implications for businesses across the United States.
The law states that a swap dealer is a firm that holds itself out as a dealer, makes a market in swaps or regularly trades them as part of its business.
The CFTC laid out several other qualifying characteristics to help define swap dealers. A firm that proposes its own terms of a standard swap contract or arranges customized terms for a swap upon request, for instance, would qualify as a dealer and be subject to most of the regulations. The law provides a way that firms can be exempt from the definition as long as they engage only in a "de minimis" amount of trading.
In its proposed rules, the CFTC said it would determine the exemption using a four-part test.
To be exempt, a company would:
• Need to have the aggregate notional amount of its swap book in the prior year not exceed $100 million.
• Need to keep the notional amount of its swaps executed with "special entities" such as governmental entities over the past 12 months under $25 million.
• Not enter into swaps as a dealer with more than 15 counterparties, other than security-based swap dealers, over the past year.
• Not enter into more than 20 swaps as a dealer in the past year.
As for the term "major swap participant," the law defines that term as a firm that maintains a substantial position in swaps excluding those used to mitigate commercial risks or those used by employee benefit plans. A firm also can qualify if it has enough swaps to create a "substantial counterparty exposure" that could put the broader market at risk. A financial company that is highly leveraged, not subject to bank capital rules and maintains a large swap book would also be counted as a major swap participant.
Among the key things the CFTC proposed to define is how it would calculate if a firm holds a "substantial position." Anyone who maintains a "substantial" position in swaps will be captured by the regulations.
To come up with appropriate amounts, the agency proposed two different tests that use mathematical formulas to calculate a firm's positions. One test would take into account swaps that aren't backed by collateral and the other test would look at both uncollateralized swaps as well as any potential future exposure. If a firm's total swaps meet either test, it would constitute a "substantial position."
The CFTC said the tests would apply to a firm's swaps in four major categories: rate swaps, credit swaps, equity swaps and other commodity swaps, such as a crude oil swap. Positions used for hedging risk wouldn't be counted toward the total.
In the first test, a firm would qualify as a major swap participant if its daily average of current uncollateralized exposure exceeds $3 billion in rate swaps, or $1 billion on other swap categories.
Using the second test, a firm would qualify if its uncollateralized exposure and future possible exposures exceed a $2 billion daily average, or a $6 billion daily average in rate swaps.