What Is a “Swap”?

Dodd-Frank Essentials for End Users of OTC Derivatives - Update 1

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Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), signed into law on July 21, 2010, mandates comprehensive changes to the U.S. over-the-counter (“OTC”) derivatives market. We are commencing a series of updates, “Dodd-Frank Essentials for End Users of OTC Derivatives,” aimed at our end-user or buy-side clients to discuss the implications of this law in their day-to-day activities. This update, the first in the series, provides an overview of the types of products that are covered by Title VII, including swaps, security-based swaps, mixed swaps and foreign exchange swaps.1

Products Covered by Title VII

The products that are covered by Title VII of Dodd-Frank are divided into two main categories: swaps and security-based swaps. A third category, “mixed swaps”, covers products that have both swap and security-based swap characteristics. At this writing it is difficult to tell whether the distinction between whether a party trades in swaps or security-based swaps (or mixed swaps) will result in materially different compliance requirements. Swaps will be subject to the jurisdiction of the Commodity Futures Trading Commission (“CFTC”), and security-based swaps will be subject to the jurisdiction of the Securities and Exchange Commission (“SEC”). The CFTC and the SEC, in consultation with the Federal Reserve, will have joint rule-making authority over mixed swaps. Title VII of Dodd-Frank sets out a short list of exclusions to the definition of “swap” and “security-based swap.” The list is not a long one and includes many products that are already subject to the jurisdiction of the SEC or CFTC.

Dodd-Frank requires that in promulgating rules for regulation of swaps and security-based swaps, the CFTC and SEC are to regulate similarly (but not necessarily identically) products that are functionally and economically similar. Ideally, this will mean that an end user that must implement a CFTC compliance regime for its swaps activity will be able to easily implement its SEC compliance regime for security-based swaps. Whether this will be true or not in practice remains to be seen.

Title VII’s Definition of a “Swap”

Title VII of Dodd-Frank includes in its definition of “swap”, subject to CFTC regulation, the following products:

  • credit default swaps referencing a broad-based security index;2
  • credit default swaps referencing more than one loan3 or any loan index;
  • total return swaps referencing a broad-based security index (whether comprising debt securities or equity securities);
  • total return swaps referencing more than one loan;
  • equity variance and dividend swaps referencing a broad-based security index;
  • correlation swaps referencing a broad-based security index and any commodity or commodity index (including FX, rates and rate indices/indexes);
  • interest rate swaps;
  • FX swaps and forwards (subject to potential exemptions that may be recommended by the Treasury Department);
  • OTC options on or referencing any asset other than an option on a security or a certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof;
  • commodity swaps;
  • weather, energy and emissions swaps;
  • other swaps referencing broad-based (as opposed to narrow-based) securities indices, government securities and most other reference assets; and
  • swaptions on any of the above.

Title VII’s Definition of a “Security-Based Swap”

Title VII of Dodd-Frank includes in its definition of “security-based swap”, subject to SEC regulation, the following products:

  • total return swaps referencing a single security or loan;
  • total return swaps referencing a narrow-based index of securities;
  • OTC options for the purchase or sale of a single loan, including any interest therein or based on the value thereof;
  • equity variance or dividend swaps referencing a single security or narrow-based index of securities;
  • single-name CDS; and
  • CDS referencing a narrow-based index of securities.

End users trading CDS and equity swaps will note that jurisdiction over CDS and equity swaps referencing indices is split between the SEC and CFTC based upon the broad-based/narrow-based distinction. As for swaps referencing loans, only a swap referencing a single loan (and that is not a loan CDS) falls explicitly under the definition of “security-based swap”. A CDS referencing a single loan appears to be characterized under Title VII as a “mixed swap,” as described below, while other swaps referencing more than one loan are “swaps” subject to CFTC jurisdiction.

Note also that OTC options on securities and security indices are not “security-based swaps” and appear to remain subject to the jurisdiction of the SEC.4 While this means that OTC options on securities and security indices are outside the scope of Title VII, and so not subject to its mandatory clearing or exchange trading requirements, it remains to be seen how the SEC will choose to regulate these products going forward.

Mixed Swaps

As noted above, a “mixed swap” under Title VII of Dodd-Frank is a swap with both “swap” and “security-based swap” characteristics, for example:

  • a total return swap on a single security that also incorporates an FX hedge;
  • a correlation or basket swap that includes a narrow-based index of securities and an index or basket of commodities; and
  • a CDS referencing a single loan.

Foreign Exchange

There was considerable debate about the status of FX swaps and forwards during the legislative process. In the end, the compromise was to include these in the definition of “swap”, but to leave to the Treasury Department to determine whether these contracts should be regulated as swaps. Should the Treasury Department notify Congress that FX swaps and forwards be exempt from regulation, Title VII would still impose certain business conduct standards and reporting requirements on OTC FX market participants that are “swap dealers” or “major swap participants”. In addition, FX swaps and forwards that are cleared via a central counterparty or traded on an exchange (or swap execution facility) will be subject to the prohibitions of Title VII against fraud and manipulation.

Next Steps

With respect to the products covered by Title VII, we will soon learn which of these will be subject to mandatory clearing requirements. Those swaps and security-based swaps that were “listed for clearing” by a derivatives clearing organization or clearing agency as of the date of enactment of Dodd-Frank are already deemed to be submitted for clearing, and the CFTC and SEC are required to make a determination within 90 days of such enactment as to whether these products will be required to be cleared.

Key dates relevant to this process are the following:

July 21, 2010 – Dodd-Frank signed into law

October 19, 2010 – CFTC and SEC required to issue rules with respect to reporting requirements for swaps and security-based swaps in existence as of Dodd-Frank’s date of enactment

October 19, 2010 – CFTC and SEC required to determine which swaps and security-based swaps “listed for clearing” as of enactment will be required to be centrally cleared

The SEC and CFTC are required to promulgate rules within 360 days of enactment of Title VII to regulate major participants in these products. Compliance will entail reporting and registration requirements, minimum capital and variation margin requirements, business conduct standards, and recordkeeping. These issues, including what constitutes a “major swap participant” or “major security-based swap participant,” will be the subject of future installments in this series.

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1 This is a general overview: specific products and instruments may require additional analysis before reaching a conclusion as to whether and how the applicable definitions would apply to that particular product. The base definition of a “swap” is very broad and may include products that would not ordinarily be thought of as swaps. In addition, the anti-evasion provisions of Title VII could be interpreted to bring in products that are of a type that would ordinarily be excluded from the definition if they are determined to have been structured to evade the application of Title VII. For example, certain “identified banking products” are excluded from the definitions of “swap” and “security-based swap.” However, the relevant banking regulator (in consultation with the CFTC and the SEC) may except an identified banking product from this exclusion if it otherwise meets these definitions and is “known to the trade as a swap or security-based swap, or otherwise has been structured as an identified banking product for the purpose of evading [Title VII]”.

2 A broad-based security index is one that has ten or more component securities, or that otherwise does not meet the criteria for a narrow-based security index. A narrow-based security index must have nine or fewer component securities and meet certain weighting and other requirements.

3 In referring to any asset as a “loan” in this update, we mean to refer to any loan that would not otherwise be captured by the definition of “security” under the Securities Act of 1933, as amended. This is consistent with the implicit distinction drawn between “securities” and “loans” in Title VII of Dodd-Frank.

4 This is because an option on a security, or a certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof, is a “security” as defined in the Securities Act of 1933 and the Securities Exchange Act of 1934, and is neither a swap nor a security-based swap as defined in Title VII.

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