The SEC further defined the terms “swap” and “security-based swap” to clarify whether particular agreements, contracts, transactions are swaps or security-based swaps based on characteristics, including the specific terms and conditions of the instrument and the nature of the prices, rates, securities, indexes, or commodities upon which the instrument is based. They stated that the determination of whether a derivative instrument is either a swap or a security-based swap should be made based on the facts and circumstances relating to the instrument prior to execution, but no later than when the parties offer to enter into the instrument. If the instrument itself is not amended, modified, or otherwise adjusted during its term by the parties, its characterization as a swap or security-based swap will not change during its duration because of any changes that may occur to the factors affecting its character as a swap or security-based swap.
The new rule provided an interpretation in the Proposing Release to clarify the classification of swaps and security-based swaps in certain areas and to provide an interpretation regarding the use of certain terms and conditions in the instruments. The new rule listed the interpretations set out in the Proposing Release with certain modifications to the interpretation regarding total return swaps (see table below).
This is part 2 of a four-part blog on the new technical rule issued by the SEC on July 18, 2012.
| Swap Value Derived from:
Interest, yield, or other defined monetary rates, that are not based on one or more securities.Price or yield of the defined exempted security-based swaps securities only, e.g. U.S. Treasury. Total return swaps that create additional interest rate or currency exposures that would shift or limit the financing of the swap is both a swap and security-based swap, a “mixed swap.” A total return swap is based on non-security-based components (such as the price of oil, or a currency), is a mixed swap. Loan total return swaps based on two or more non-security loans. Swap derived from a futures contract when the underlying reference is not a security future. Swap derived from a qualifying foreign futures contract on the debt securities of one or more of the 21 enumerated foreign governments (See rule 3a12-8(a)(1) under the Exchange Act), provided that the following conditions are satisfied: (i) the futures contract on which the swap is based or that is referenced is a qualifying foreign futures contract (as defined in rule 3a12-8)707 on the debt securities of any one or more of the 21 enumerated foreign governments that satisfies the conditions of rule 3a12-8; (ii) the swap is traded on or through a board of trade (as defined in section 1a(6) of the CEA); (iii) the debt securities on which the qualifying foreign futures contract is based or referenced and any security used to determine the cash settlement amount pursuant to the fourth condition below are not covered by an effective registration statement under the Securities Act or the subject of any American depositary receipt covered by an effective registration statement under the Securities Act; (iv) the swap may only be cash settled; and (v) the swap is not entered into by the issuer of the securities upon which the qualifying foreign futures contract is based or referenced (including any security used to determine the cash payment due on settlement of such swap, an affiliate (as defined in the Securities Act and the rules and regulations thereunder) of the issuer, or an underwriter with respect to such securities. |
Security-Based Swaps Derived from:
Yield or value of single security, with certain exempted securities, loan, or narrow based security index.Price, value or yield of foreign government securities, or a narrow-based security index composed of foreign government securities. Total Return Swap derived from a single security or loan, or a narrow-based security index. Total return swaps that create additional interest rate or currency exposures that would shift or limit the financing of the swap are both a swap and security-based swap, a “mixed swap.” A total return swap is based on non-security-based components (such as the price of oil, or a currency) is a mixed swap. A quanto equity swap, is not a mixed swap, where (i) the purpose of the swap is to transfer exposure to the return of a security or security index without transferring exposure to any currency or exchange rate risk; and (ii) any exchange rate or currency risk exposure incurred by the dealer due to a difference in the currency denomination of the quanto equity swap and of the underlying security or security index is incidental to the quanto equity swap and arises from the instrument(s) the dealer chooses to use to hedge the quanto equity swap and is not a direct result of any expected payment obligations by either party under the quanto equity swap. Single-name credit default swap derived from a single referenced obligation. Swap that is based on the occurrence of an event relating to a single security issuer, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer. This provision applies generally to event-triggered swap contracts. With respect to a credit default swap, such events could include, for example, the bankruptcy of an issuer, a default on one of an issuer’s debt securities, or the default on a non-security loan of an issuer. Swap derived from a futures contract when the underlying reference is a security future. |
The new rule restated the definition of narrow-based security index as defined in the CEA and Exchange Ac as an index that meeting any one the following four criteria: (i) it has nine or fewer component securities; (ii) a component security comprises more than 30 percent of the index’s weighting; (iii) the five highest weighted component securities in the aggregate comprise more than 60 percent of the index’s weighting; or (iv) the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000 (or in the case of an index with more than 15 component securities, $30,000,000), except that if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting, such securities shall be ranked from lowest to highest dollar value of average daily trading volume and shall be included in the calculation based on their ranking starting with the lowest ranked security. The rule also clarified the definition of narrow-based security index for Index Credit Default Swaps.
