Congress directed the SEC to regulate security-based swap dealers, and the CFTC to regulate swap dealers, through the Dodd-Frank Act. Persons that meet either of those definitions are subject to statutory requirements related to, among other things, registration, margin, capital, and business conduct.
On April 27, 2012, the Commissions adopted final rules and interpretations to further define “swap dealer” and “security-based swap dealer.” These terms were defined in the context of the following: (i) analysis identifying dealing activity involving swaps and security-based swaps; (ii) exclusion from the “swap dealer” definition in connection with the origination of loans by insured depository institutions; (iii) application of the dealer activity analysis to inter-affiliate swaps and security-based swaps; (iv) the application of the deminimis exception from the dealer definitions; and (v) the limited designation of swap dealers and security-based swap dealers.
The rule provided exceptions that certain swaps are not considered in the determination of swap dealers. Specifically, swaps entered into by an insured depository institution with a customer in connection with originating a loan with that customer; swaps between majority-owned affiliates; swaps entered into by a cooperative with its members; swaps entered into for hedging physical positions as defined in the rule; and certain swaps entered into by registered floor traders are excluded from the swap dealer determination.
The definition of swap dealers begins with the statutory definition: (i) holding out to be a swap dealer (ii) making a market in swaps or security-based swaps, (iii) regularly entering into swaps with counterparties as an ordinary course of business for one’s own account, (iv) engaging in any activity causing oneself to be commonly known in the trade as a dealer or market maker in swaps.
Next, the dealers determine if they are engaged in more than a de minimis quantity of swap dealing. If yes, then they must register with the CFTC as swap dealers. When registering the dealers may apply to limit its designation as a swap dealer to specified categories of swaps or specified activities of the person in connection with swaps, holding oneself out as a dealer in swaps.
There were several relevant comments regarding dealer-trader distinctions. The Commissions modified the proposal with the following activities as indicative of dealing activity in the application of a person acting as a swap dealer: (i) providing liquidity by accommodating demand for or facilitating interest in the instrument (swaps, in this case), holding oneself out as willing to enter into swaps (independent of whether another party has already expressed interest), or being known in the industry as being available to accommodate demand for swaps; (ii) advising a counterparty as to how to use swaps to meet the counterparty’s hedging goals, or structuring swaps on behalf of a counterparty; (iii) having a regular clientele and actively advertising or soliciting clients in connection with swaps; (iv) acting in a market maker capacity on an organized exchange or trading system for swaps; and (v) helping to set the prices offered in the market (such as by acting as a market maker) rather than taking those prices, although the fact that a person regularly takes the market price for its swaps does not foreclose the possibility that the person may be a swap dealer.
The Commissions added that the following elements of their interpretive approach to the swap dealer definition are also generally consistent with the dealer-trader distinction as it will be applied to determine if a person is a security-based swap dealer: (i) a willingness to enter into swaps on either side of the market is not a prerequisite to swap dealer status; (ii) the swap dealer analysis does not turn on whether a person’s swap dealing activity constitutes that person’s sole or predominant business; (iii) a customer relationship is not a prerequisite to swap dealer status; and (iv) in general, entering into a swap for the purpose of hedging, absent other activity, is unlikely to be indicative of dealing. (v) under the interpretive approach to the definition of both the terms “swap dealer” and “security-based swap dealer,” whether a person is acting as a dealer will turn upon the relevant facts and circumstances, as informed by the interpretive guidance set forth in the adopting release.
For the security-based swap dealers, the four statutory qualifications also apply. Further, the following differences between a dealer and security-based swap dealer were listed:
Level of activity – Security-based swap markets are marked by less activity than markets involving certain other types of securities (while recognizing that some debt and equity securities are not actively traded). This suggests that in the security-based swap context concepts of “regularity” should account for the level of activity in the market.
No separate issuer – Each counterparty to a security-based swap in essence is the “issuer” of that instrument; in contrast, dealers in cash market securities generally transact in securities issued by another party. This distinction suggests that the concept of turnover of “inventory” of securities, which has been identified as a factor in connection with the dealer-trader distinction, is inapposite in the context of security-based swaps. Moreover, this distinction along with the fact that the “security-based swap dealer” definition lacks the conjunctive “buying and selling” language of the “dealer” definition – suggests that concepts of two-sided markets at times would be less relevant for identifying “security-based swap dealers” than they would be for identifying “dealers.”
Predominance of over-the-counter and non-standardized instruments – Security-based swaps thus far are not significantly traded on exchanges or other trading systems, in contrast to some cash market securities (while recognizing that many cash market securities also are not significantly traded on those systems). These attributes – along with the lack of “buying and selling” language in the security-based swap dealer definition, as noted above – suggest that concepts of what it means to make a market need to be construed flexibly in the context of the security-based swap market.
Mutuality of obligations and significance to “customer” relationship – In contrast to a secondary market transaction involving equity or debt securities, in which the completion of a purchase or sale transaction can be expected to terminate the mutual obligations of the parties to the transaction, the parties to a security-based swap often will have an ongoing obligation to exchange cash flows over the life of the agreement. In light of this attribute, some market participants have expressed the view that they have “counterparties” rather than “customers” in the context of their swap activities.
The new rules and interpretative guidance are effective 60 days after its publication in the federal register.