SEC Approves Rules and Interpretations on Key Terms for Regulating Derivatives
The US Securities and Exchange Commission late Friday took another step toward regulating the over-the-counter derivatives market by unanimously approving rules and interpretations for key definitions of certain derivative products.
The SEC rules and interpretations further define the terms “swap” and “security-based swap” and whether a particular instrument is a “swap” regulated by the Commodity Futures Trading Commission (CFTC) or a “security-based swap” regulated by the SEC. The SEC action also addresses “mixed swaps,” which are regulated by both agencies, and “security-based swap agreements,” which are regulated by the CFTC but over which the SEC has antifraud and other authority.
The rules and interpretations written jointly with the CFTC implement provisions of the 2010 Dodd-Frank Act that establish a comprehensive framework for regulating over-the-counter derivatives.
“Approving the product rules and interpretations is another foundational step in the establishment of a new regulatory regime for derivatives,” said SEC Chairman Mary L. Schapiro. “I look forward to action on the rules and interpretations by my colleagues at the CFTC.”
Once both agencies adopt the final rules, they will become effective 60 days after the date of publication in the Federal Register. The compliance date of such rules for purposes of certain interim exemptions under the federal securities laws will be 180 days after the date of publication in the Federal Register. The final rule text and a fact sheet will be available after both agencies adopt the final rules.
The Dodd-Frank Act established a comprehensive framework for regulating the over-the-counter swaps markets. In particular, the Act provides that the SEC will regulate “security-based swaps,” the CFTC will regulate “swaps,” and the CFTC and the SEC will jointly regulate “mixed swaps.”
Title VII of the Dodd-Frank Act requires that both the SEC and CFTC, in consultation with the Board of Governors of the Federal Reserve System, shall jointly further define the terms “swap,” “security-based swap,” and “security-based swap agreement.” Title VII further provides that the SEC and CFTC shall jointly establish such regulations regarding “mixed swaps” as may be necessary to carry out the purposes of swap and security-based swap regulation under Title VII.
In addition, Title VII requires the SEC and CFTC to jointly adopt rules governing the way in which books and records must be kept for security-based swap agreements.
The SEC action (joint with the CFTC) will add rules under the Securities Exchange Act of 1934 and provide interpretations regarding which products would – and would not – be considered a “swap” or a “security-based swap.”
The SEC rules also will provide which Title VII products are swaps subject to CFTC regulation, security-based swaps subject to SEC regulation, or mixed swaps subject to regulation by the CFTC and the SEC.
Products that Are Not “Swaps” or “Security-Based Swaps”
Insurance : Under the final rules insurance products will not be considered swaps or security-based swaps if they meet any of the following three provisions:
- Grandfather provision: The product will not be considered a swap or security-based swap if it is an existing insurance agreement, contract or transaction entered into before the effective date of the final rules and was provided by a person or entity that satisfied the “provider test.”
A person or entity satisfies the “provider test” if they are:
- A person subject to supervision by the insurance commissioner of any state or by the federal government and the agreement, contract, or transaction is regulated as insurance under applicable state or federal law;
- The United States, any state, or any of their respective agencies or instrumentalities, as well as statutorily authorized programs of each;
- In the case of reinsurance, a person providing the agreement, contract or transaction to another person eligible under the provider test, provided that:
- Such person is not prohibited by applicable state or federal law from offering such agreement, contract, or transaction to such other person; and
- The agreement, contract, or transaction to be reinsured satisfies the product test or is an enumerated product (as describe below); and
- The total amount reimbursable by all reinsurers under such agreement, contract, or transaction does not exceed the losses or claims paid by the cedant, unless otherwise permitted by applicable state law; or
- In the case of non-admitted insurance, a person that is:
- Located outside of the United States and listed on the National Association of Insurance Commissioners’ Quarterly Listing of Alien Insurers; or
- Meets the eligibility criteria for non-admitted insurers under applicable state law.
- Product Safe Harbor : The product will not be considered a swap or security-based swap if the agreement, contract, or transaction is provided in accordance with the provider test and satisfies the following conditions:
- The beneficiary of the insurance product must have an insurable interest and thereby bear the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract, or transaction.
- The loss must occur and be proved.
- Any payment or indemnification for loss must be limited to the value of the insurable interest.
- The agreement, contract or transaction must not be traded, separately from the insured interest, on an organized market or over-the-counter.
- With respect to financial guaranty insurance only, in the event of a payment default or insolvency of the obligor, any acceleration of payments under the policy must be at the sole discretion of the insurer.
- Enumerated Product Safe Harbor: The product will not be considered a swap or security-based swap if the product is provided in accordance with the provider test and falls within the following categories:
surety bond; fidelity bond; life insurance; health insurance; long term care insurance; title insurance; property and casualty insurance; annuity; disability insurance; insurance against default on individual residential mortgages; and reinsurance (including retrocession) of any of the foregoing products.
In the proposing release the list of enumerated products was contained in an interpretation.
Security forwards : Under newly adopted interpretations, security forwards fall outside the definitions of swap and security-based swap. This includes the treatment of mortgage-backed securities that are eligible to be sold in the “to-be-announced” or “TBA” market.
Consumer and Commercial Transactions : The newly adopted interpretations describe the way in which certain consumer and commercial transactions fall outside the definitions of swap and security-based swap.
Consumer Transactions: Under the interpretations, certain agreements, contracts, or transactions entered into by consumers primarily for personal, family, or household purposes are not considered swaps or security-based swaps.
They include agreements, contracts or transactions:
- To acquire or lease real or personal property, to obtain a mortgage, to provide personal services, or to sell or assign rights owned by such consumer (such as intellectual property rights).
- That provide for an interest rate cap or lock on a consumer loan or mortgage, where the benefit of the rate cap or lock is realized by the consumer only if the loan or mortgage is made thereto.
They also include consumer loans or mortgages with variable rates of interest, including such loans with provisions for the rates to change upon certain events related to the consumer, such as a higher rate of interest following a default.
Commercial Transactions: Under the interpretation, commercial agreements, contracts, or transactions that involve customary business or commercial arrangements (whether or not involving a for-profit entity) are not considered swaps or security-based swaps.
- Employment contracts and retirement benefit arrangements.
- Sales, servicing, or distribution arrangements.
- Agreements, contracts, or transactions for the purpose of effecting a business combination transaction.
- The purchase, sale, lease, or transfer of real property, intellectual property, equipment, or inventory.
- Warehouse lending arrangements in connection with building an inventory of assets in anticipation of a securitization of such assets (such as in a securitization of mortgages, student loans, or receivables).
- Mortgage or mortgage purchase commitments, or sales of installment loan agreements or contracts or receivables.
- Fixed or variable interest rate commercial loans entered into by banks and non-banks.
- Commercial agreements, contracts, and transactions (including, but not limited to, leases, service contracts, and employment agreements) containing escalation clauses linked to an underlying commodity such as an interest rate or consumer price index.
The consumer and commercial transactions listed in the interpretation are not an exhaustive list of transactions that should not be considered swaps or security-based swaps. The interpretation provides for certain characteristics and factors the Commissions will consider in determining whether consumer and commercial transactions that are not listed are swaps or security-based swaps.
The Commission also provided an interpretation that loan participations that reflect an ownership interest in the underlying loan or commitment will not be considered swaps or security-based swaps.
Transactions that are “Swaps” or Security-Based Swaps”
Under the newly adopted rule and interpretations, the following transactions will fall within the definition of swap or security-based swap: foreign exchange forwards, foreign exchange swaps, foreign currency options (other than foreign currency options traded on a national securities exchange), non-deliverable forward contracts involving foreign exchange, currency and cross-currency swaps, forward rate agreements, contracts for differences, and certain combinations and permutations of (or options on) swaps and security-based swaps.
In its interpretation, the SEC clarifies whether particular agreements, contracts or transactions are swaps, security-based swaps, or mixed swaps. Among other things, the interpretation provides that such a determination is to be made at the inception of the Title VII instrument and that such a characterization would remain throughout the life of the instrument unless the instrument is amended or modified.
Interest Rates, Other Monetary Rates and Yields : Under the interpretation, Title VII instruments on interest rates and other monetary rates will be swaps. And, Title VII instruments on “yields” – where “yield” is a proxy for the price or value of a debt security, loan, or narrow-based security index – would be security-based swaps, except in the case of certain exempted securities.
Meanwhile, Title VII instruments on rates or yields of U.S. Treasuries and certain other exempted securities (other than municipal securities) will be swaps and not security-based swaps.
Total Return Swaps : Under the interpretation, a Total Return Swap, or TRS, on a single security, loan, or narrow-based security index generally will be a security-based swap. Where counterparties embed interest-rate optionality or a non-securities component into the TRS (e.g., the price of oil, a currency hedge), it will be a mixed swap.
Title VII Instruments Based on Futures : Under the interpretations, Title VII instruments on futures (other than futures on foreign government debt securities) would generally be swaps and Title VII instruments on security futures would generally be security-based swaps. For Title VII instruments based on futures contracts on certain foreign government debt securities, the Commission adopted rules providing for the circumstance under which such instruments will be swaps or security-based swaps.
Swaps and Security-Based Swaps Based on Security Indexes : The newly adopted rules and interpretations define “narrow-based security index” and “issuers of securities in a narrow-based security index” for purposes of determining the status of index credit default swaps (index CDS) as either swaps or security-based swaps.
The SEC also adopted rules and interpretations regarding the definition of a security index and the evaluation of Title VII instruments based on security indexes that migrate from broad-based to narrow-based and vice versa.
The rules and interpretations regarding the term “narrow-based security index” in the security-based swap definition cover:
- The existing criteria for determining whether a security index is a narrow-based security index and the applicability of past guidance of the SEC and CFTC regarding those criteria to Title VII instruments.
- New criteria for determining whether an index CDS where the underlying reference is a group or index of entities or obligations of entities is based on an index that is a narrow-based security index.
- The meaning of the term “index.”
- A rule governing the tolerance period for Title VII instruments on security indexes traded on designated contract markets (DCMs), swap execution facilities (SEFs), foreign boards of trade (FBOTs), security-based SEFs, or national securities exchanges (NSEs), where the security index temporarily moves from broad-based to narrow-based or from narrow-based to broad-based.
- A rule governing the grace period for Title VII instruments on security indexes traded on DCMs, SEFs, FBOTs, security-based SEFs, or NSEs, where the security index moves from broad-based to narrow-based or from narrow-based to broad-based and the move is not temporary.
If a broad-based index CDS requires mandatory physical settlement, it will be a mixed swap.
If a broad-based index CDS requires cash settlement or auction settlement, it will be a swap, and will not be considered a security-based swap or a mixed swap solely because the determination of the cash price to be paid is established through a security or loan auction.
The SEC adopted interpretations regarding the scope of the mixed swap category, which both the SEC and CFTC believe to be narrow.
The SEC also adopted rules and interpretations that mixed swaps would remain subject to the entirety of the SEC and CFTC regulatory regimes, but that for bilateral uncleared mixed swaps entered into by at least one dually-regulated swap and security-based swap dealer or major swap and security-based swap participant, certain regulatory requirements would apply.
In addition, the SEC adopted a rule establishing a process, for all other mixed swaps, by which persons may request modified regulatory treatment by joint order of the SEC and CFTC.
Security-Based Swap Agreements
The SEC adopted interpretations regarding certain products that are security-based swap agreements (SBSA). It also adopted a rule requiring market participants to maintain the same books and records for security-based swap agreements as they would under the CFTC’s books and records requirements for swaps.
Interpretation of the Characterization of a Product
The SEC adopted a rule establishing a process that will allow market participants or either the SEC or CFTC to request a determination from the SEC and CFTC of whether a product is a swap, security-based swap, or both (i.e., a mixed swap).
In its adopting release, the SEC stated its belief that a guarantee of an obligation under a security-based swap is not a separate security-based swap. In addition, the SEC is not adopting an interpretation that a guarantee of a security-based swap is part of the security-based swap.
The adopting release noted that the SEC will consider requiring, as part of its rulemaking relating to the reporting of security-based swaps, the reporting of information about any guarantees and the guarantors of obligations under security-based swaps in connection with the reporting of the security-based swap transaction itself. The adopting release also noted that the SEC will consider issues involving cross-border guarantees of security-based swaps in a separate release that addresses the cross-border application of Title VII.