Friday, December 03, 2010

SEC Proposed Definition of Security-Based Swap Participant Exempts Commercial End Users in Spirit of Dodd-Frank Legislative History

True to the spirit of the legislative history of Title VII of the Dodd-Frank Act, the SEC proposes a test for the definition of major security-based swap participant that excludes positions held for hedging or mitigating commercial risk. The proposed definition of “hedging or mitigating commercial risk” would encompass any security-based swap position that is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from a potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises, liabilities that a person incurs, or services that a person provides or purchases. However, the proposed definition of hedging or mitigating commercial risk would not encompass any security-based swap position that is held for a purpose that is in the nature of speculation or trading.

As part of the legislative history, Senator Chris Dodd and Senator Blanche Lincoln, the author of the derivatives title, instructed the SEC and CFTC not to make hedging so costly that it becomes prohibitively expensive for end users to manage their risks. In a letter to the Chairs of the House Financial Services and Agriculture Committees, the senators emphasized that Congress does not intend to regulate end users as major swap participants or swap dealers just because they use swaps to hedge or manage the commercial risks associated with their business. Just as Congress has heard the end user community, they said, regulators must carefully consider the impact of regulation and capital and margin on end users.

Echoing these comments, House Agriculture Committee Chair Colin Peterson said that Congress focused on creating a regulatory approach that permits end users to continue using derivatives to hedge risks associated with their underlying businesses, whether it is energy exploration, manufacturing, or commercial activities. The section in question governs the regulation of major swap participants and swap dealers, and its provisions apply only to major swap participants and swap dealers. Regulators are not authorized to impose capital and margin requirements on end users. Cong. Record, June 30, 2010, p. H5425.

The SEC proposed a three-part definition of “major security-based swap participant” under the Dodd-Frank Act. A person who satisfies any one of them is a major security-based swap participant. The first part is a person who maintains a substantial position in any of the major security-based 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. The second part is a person whose outstanding security-based swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the banking system or financial markets. The third part of the definition is 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 security-based swap categories.

The Commission proposes to define “substantial position” using objective numerical criteria which promote the predictable application and enforcement of the requirements governing major participants. The Commission proposes tests that would account for both current uncollateralized exposure and potential future exposure. A position that satisfies either test would be a substantial position. The first substantial position test noted above would exclude positions hedging commercial risk and employee benefit plan positions from the substantial position analysis. The proposed tests would apply to a person’s security-based swap positions in each of two major security-based swap categories: security-based credit derivatives (any security-based swap based on instruments of indebtedness, including loans, or on credit events relating to one or more issuers or securities), and other security-based swaps.

The first substantial position test in the proposed rules would measure a person’s current uncollateralized exposure by marking the security-based swap positions to market using industry standard practices, allow the deduction of the value of collateral that is posted with respect to the security-based swap positions, and calculate exposure on a net basis, according to the terms of any master netting agreement that applies. The proposed thresholds for the first test would be a daily average current uncollateralized exposure of $1 billion in the applicable major category of security-based swaps.

The second test proposed by the Commission would account for both current uncollateralized exposure and the potential future exposure associated with a person’s security-based swap positions. The second substantial position test would determine potential future exposure by multiplying the total notional principal amount of the person’s security-based swap positions by specified risk factor percentages (ranging from 6% to 15%) based on the type of swap and the duration of the position and discounting the amount of positions subject to master netting agreements by a factor ranging between zero and 60%, depending on the effects of the agreement.

If the security-based swaps are cleared or subject to daily mark-to-market margining, there would be further discounting the amount of the positions by 80%.The proposed thresholds for the second test would be $2 billion in daily average current uncollateralized exposure plus potential future exposure in the applicable major security-based swap category.

The Commission proposes to define substantial counterparty exposure using a calculation method that is the same as the method used to calculate substantial position. However, the definition of substantial counterparty exposure is not limited to the major categories of security-based swaps, and it does not exclude hedging or employee benefit plan positions. Rather it encompasses all of a person’s security-based swap positions.

The proposed thresholds for substantial counterparty exposure are a current uncollateralized exposure of $2 billion, or a sum of current uncollateralized exposure and potential future exposure of $4 billion, across the entirety of a person’s security-based swap positions.

The third aspect of the statutory definition of major security-based swap participant addresses any “financial entity,” other than one subject to capital requirements established by an appropriate Federal banking agency, that is “highly leveraged” relative to the amount of capital it holds, and that maintains a substantial position in a major category of security-based swaps. For this part of the definition, the Commission proposes to use the same definition of substantial position described above, without excluding hedging or employee benefit plan positions.

For this aspect of the definition, the Commission proposes to use the definition of “financial entity” that is based on the definition of that term in the Dodd-Frank Act provision for an end-user exception from mandatory clearing in Exchange Act Section 3C(g)(3). For the definition of “highly leveraged,” the Commission proposes two possible definitions: either a ratio of total liabilities to equity, as determined in accordance with U.S. GAAP, of 8 to 1, or a ratio of 15 to 1 measured in the same way.

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