Hedge Fund Industry Urges SEC-CFTC Rulemaking to Limit Breadth of Dodd-Frank Swap Dealer Definition

Concerned about the possible breadth of the definitions of swap dealer and security-based swap dealer in the Dodd-Frank Act, the hedge fund industry urges the SEC and CFTC to use the traditional definition of dealer when defining these terms in the derivatives regulations adopted under the Act. Sections 721(a)(21) and 761(a)(6) define swap dealer and security-based swap dealer as persons who hold themselves out as swap dealers, make a market in swaps, regularly enter into swaps in the ordinary course of their business, or engage in any activity causing them to be commonly known in the trade in the as a dealer or market maker in swaps. In a letter to the SEC and CFTC, the Managed Funds Association is concerned that because of the breadth of this definition may inadvertently capture non-bank customers entering into swaps for their own accounts that do not act as dealers and that Congress did not intend to regulate as dealers. 

In addition, the part of the definition capturing persons regularly entering swaps could improperly be read to capture parties that would traditionally be thought of as investors or hedgers as opposed to true dealers or market makers. The MFA urged that the SEC and CFTC follow the SEC's traditional definition of dealer when adopting regulatory definitions of swap dealer and security-based swap dealer under Sections 721(a)(21) and 761(a)(6). The SEC's traditional definition of dealer excludes institutional traders like private investment funds and their advisers who are not entering into swaps as part of their regular business. The MFA also believes that the concept of a dealer should be consistent under both the securities and commodities as commanded by Section 712(d)(2)(D) of Dodd-Frank, which mandates that jointly adopted SEC-CFTC regulations under Title VII must be comparable to the maximum extent possible. 

Dodd-Frank defines major swap and security-based swap participants as non-swap dealers who maintain a substantial position in swaps, whose outstanding swaps create a substantial counterparty exposure that could have serious adverse effects on the financial stability of the US financial system, or is a highly leveraged financial firm and maintains a substantial position in outstanding swaps. In the MFA's view, the intent of Congress in creating a major swap participant designation was to shine a regulatory spotlight on systemically important non-dealer market participants whose swap positions may pose systemic risk. 

The MFA urged the SEC and CFTC, when adopting regulations for major swap participants, to apply a different construct to different categories of derivatives market participants. The first category should apply only to non-financial firms with swaps positions creating systemic risk. The secon d category should apply to financialand non-financial firms main taining swaps positions capable of creating serious adverse effects to the US financial system. The third category should apply to highly leveraged non-bank financial firms miantaining swap positions resulting in  systemic risk.

The term highly leveraged is a significant component of the definition of major swap participant. Yet, Dodd-Frank neither defines the term nor offers the SEC and CFTC guidance on what the term means or on what factors they should use in creating a definition. The MFA said that in determining who is highly leveraged, the Commissions should apply a debt to equity leverage ratio based on GAAP balance sheet leverage.