CFTC and SEC Adopt New Rules Further Defining “Major
Swap Participant” and “Major Security-Based Swap
Participant”
May 3, 2012
Pursuant to Section 712 of the Dodd-Frank Wall Street Reform and Consumer Protection Act(the “Dodd-Frank Act”), the Commodity Futures Trading Commission and the Securities andExchange Commission (collectively, the “Commissions”), in consultation with the Board ofGovernors of the Federal Reserve System, have issued critical, final rules defining the terms“major swap participant” and “major security-based swap participant” (collectively, “major
participants”).1 These new regulations establish a comprehensive testing methodology thatswap and security-based swap counterparties must employ both to determine whether they will
be subject to heightened regulation as a major participant and to establish whether they will beshielded from such requirements by a safe harbor. To the extent that an entity satisfies any of
the three alternative major participant tests, it will generally become subject to additional
statutory and regulatory requirements, encompassing margin, capital, business conduct,
recordkeeping, and reporting. Because the CFTC rule and the SEC rule (collectively, the “final
rules”) are substantially similar in both substance and approach, this memo discusses the tworules concurrently, highlighting areas in which they differ.

I.

STATUTORY DEFINITION

Under the Dodd-Frank Act, the definition of major swap participant and major security-based
swap participant captures persons who are not swap dealers or security-based swap dealers2
and who fall into any one of the following three statutory categories:
1. A person who maintains a “substantial position” in swaps, or security-based swaps, in
any of the major categories, excluding both positions held for “hedging or mitigating
commercial risk”, and positions maintained by qualifying employee benefit plans andgovernmental plans for the primary purpose of hedging or mitigating any risk directly
associated with the operation of the plan;

See CFTC and SEC, Release No. 34–66868, Further Definition of “Swap Dealer,” “Security-Based Swap
Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract
Participant” (2012). (the “Adopting Release”). The CFTC rules will be codified at 17 C.F.R. § 1.3(hhh)and the SEC rules at 17 C.F.R. 240.3a67.
2 Although the final rules defining the terms “swap dealer” and “security-based swap dealer” areaddressed in the same final rule, they are discussed in a separate memorandum, available at:
http://www.stblaw.com/siteContent.cfm?contentID=4&itemID=80&focusID=1413.
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Memorandum – May 3, 2012

2. A person whose outstanding swaps or security-based swaps create “substantial
counterparty exposure” that could have serious adverse effects on the financial stabilityof the United States banking system or financial markets; or
3. A person who is a “financial entity” that is “highly leveraged” relative to the amount of
capital it holds and is not subject to capital requirements established by an appropriate
Federal banking agency; and who maintains a “substantial position” in outstanding
swaps or security-based swaps in any major swap or security-based swap category. 3
The final rules further define the terms “substantial position”, “hedging or mitigating
commercial risk”, “substantial counterparty exposure”, “financial entity”, and “highly
leveraged”, each of which are discussed in detail below.

II.

KEY RISK MEASUREMENT CONCEPTS:
UNCOLLATERALIZEDOUTWARD EXPOSURE AND POTENTIAL OUTWARD EXPOSURE

The final rules establish two key risk metrics which form the basis for each risk calculation
under the three major participant tests. In contrast to the activities-based analysis that theCommissions established for swap dealers and security-based swap dealers, the major
participant definitions focus on the potential market impacts and systemic risks associated withan entity’s outstanding swap and security-based swap positions. Among other considerations,the final rules seek to identity those entities whose exposure to swaps and security-based swaps
pose market risks that, in the view of the Commissions, warrant enhanced regulatory oversightand control. To identify these entities, the final rules adopt two quantitative measurements ofthe current and the potential default-related credit risk associated with swap and security-based
swap positions —“uncollateralized outward exposure” and “potential outward exposure”.
A. Daily Calculations
Each of the major participant tests calls for the daily average aggregate uncollateralized
outward exposure and/or the daily average aggregate potential outward exposure. This daily
average is calculated by taking the arithmetic mean of the relevant exposure at the close of eachbusiness day, beginning on the first business day of each calendar quarter and continuing
through the last business day of that quarter.4
B. Uncollateralized Outward Exposure
Uncollateralized outward exposure measures the current amount of potential risk that an entity
would pose to its counterparties if it were to default today. In general terms, the test requires
an entity, on a counterparty-by-counterparty basis, to mark-to-market each of its swap andsecurity-based swap positions with a negative value and to then offset those negative positions
with the value of any posted collateral.5 The aggregate uncollateralized outward exposure for a

Sections 721(a)(16) and 761(a)(6) of the Dodd-Frank Act.
See CFTC Regulation § 1.3(jjj)(4) and Exchange Act Rule 240.3a67–3(c)(3)(d).
5 See CFTC Regulation § 1.3(jjj)(2) and Exchange Act Rule 240.3a67–3.
3
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Memorandum – May 3, 2012

given category of swaps6 or security-based swaps7 is the sum of the negative uncollateralized
amounts within that category. In-the-money positions, fully collateralized positions, andperfectly netted positions are effectively disregarded under this analysis.
1. Master Netting Agreements
For counterparties with master netting agreements in place, such as an ISDA Master
Agreement, aggregate uncollateralized outward exposure is calculated on a net basis subject tothe terms of the master netting agreement.8 Pursuant to the final rules, permitted offsets
include any position governed by a master netting agreement that is also subject to netting
offsets under applicable bankruptcy law. In applying the netting provisions, the final rules
require a pro rata allocation of the offset among the out-of-the-money positions subject to themaster netting agreement in each swap and security-based swap category. Importantly, thenetting may only occur on a counterparty-by-counterparty basis—netting across multiple
counterparties is prohibited.
C. Potential Outward Exposure
The potential outward exposure metric is intended to be a measure of the potential risk that anentity’s positions might pose in the future. Under the rules, this measure is calculated as afunction of the notional value of an entity’s outstanding swaps or security-based swaps
multiplied by a risk factor, which is based on the classification and tenor of the position. If such
positions are subject to a master netting agreement, they will be further reduced by a factor totake into account the netting offsets. Similarly, for those swaps or security-based swaps that areeither cleared by a registered or exempt clearing agency, or subject to daily mark-to-market
margining the potential outward exposure of such swaps or security based swaps is further
reduced by an additional risk multiplier to reflect the reduced risk associated withcleared/mark-to-market margined positions.9 The total aggregate potential outward exposure
for an entity equals the sum of the potential outward exposure of the entity’s swap, or securitybased swap, positions pursuant to the calculations below.

The CFTC rule separates swaps into four major categories: rate swaps, which encompass any swap thatis primarily based on one or more reference rates; credit swaps, which encompass any swap that is
primarily based on instruments of indebtedness; equity swaps, which encompass any swap that is
primarily based on equity securities, e.g., broad-based indices of equity securities; and other commodity
swaps, which encompass any swap that is not a rate swap, credit swap, or equity swap. See CFTC
Regulation § 1.3(jjj)(1).
7 The SEC rule separates security-based swaps into two major categories: debt security-based swaps,
which encompass any security-based swap that is based, in whole or in part, on one or more instruments
of indebtedness, or on a credit event relating to one or more issuers or securities; and other security-based
swaps, which encompass any security-based swap that is not a debt security-based swap. See Exchange
Act Regulation 240.3a67–2.
6

8
9

See CFTC Regulation § 1.3(jjj)(2)(iii), (iv) and Exchange Act Rule 240.3a67–3(b)(3), (4).
See CFTC Regulation § 1.3(jjj)(3) and Exchange Act Rule 240.3a67–3(c).
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Memorandum – May 3, 2012

1. Swaps and Security-Based Swaps Not Subject to Clearing or Mark-to-Market
Margining
As indicated above, for positions in swaps or security-based swaps that are neither cleared by aregistered or exempt clearing agency, nor subject to daily mark-to-market margining, theaggregate potential outward exposure is calculated by aggregating the product of: (i) thenotional principal amount of the outstanding positions10 multiplied by (ii) a risk factor based on
the classification and the tenor of the position, on a position-by-position basis.11
Risk Factor Multiplier for Swaps

Interest rate
Foreign exchange andgoldPrecious metals(except for gold)
Other commodities
CreditEquityMaturity in 1 year or
less

Maturity in 1 to 5
years

Maturity in morethan 5 years

0.00
0.01

0.005
0.05

0.015
0.075

0.07

0.07

0.08

0.10
0.10
0.06

0.12
0.10
0.08

0.15
0.10
0.10

Risk Factor Multiplier for Security-Based Swaps

Debt
Equity and other

Maturity in 1 year or
less

Maturity in 1 to 5
years

Maturity in morethan 5 years

0.10
0.06

0.10
0.08

0.10
0.10

For swaps or security-based swaps governed by a master netting agreement, the potential
outward exposure is reduced on a counterparty-by-counterparty basis by multiplying thepotential outward exposure by a factor ranging from 0.4 to 1.0 depending on the ratio of current
net exposure over current gross exposure (absent netting) in the relevant major swap or major
security-based swap category.

The total notional amount excludes positions such as options and other positions for which a party has
prepaid or has otherwise satisfied in-full all of its payment obligations. Further, for those positions where
the only future obligation is to pay fixed premium amounts—e.g., buying credit protection or an optionthat has remaining premium payments—the potential outward exposure is capped at the net present
value of the unpaid premiums. Finally, if the stated notional amount is leveraged or enhanced by the
structure of the transaction, then the notional amount included in the calculation must be the effective
notional amount rather than the stated notional amount.
11 See CFTC Regulation § 1.3(jjj)(3)(ii) and Exchange Act Rule 240.3a67–3(c)(2).
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Memorandum – May 3, 2012

2. Swaps and Security-Based Swaps Subject to Clearing or Mark-to-Market
Margining
For swap, or security-based swap, positions that are either cleared by a registered or exempt
clearing agency, or subject to daily mark-to-market margining,12 the calculation of potential
outward exposure involves two steps.13 The first step is to calculate the potential outward
exposure as if the positions were not subject to clearing or mark-to-market margining, including
risk-based adjustments (see above). The second step is to take such potential outward exposureand multiply it by one of the following additional risk multipliers: (i) 0.1 in the case of positions
cleared by a registered or exempt clearing agency, and (ii) 0.2 in the case of positions subject todaily mark-to-market margining.

III.

TEST 1:

MAINTAINS A SUBSTANTIAL POSITION IN SWAPS OR
SECURITY-BASED SWAPS, FOR ANY OF THE MAJOR SWAP
OR SECURITY-BASED SWAP CATEGORIES

Under both the CFTC and the SEC rules, the determination of whether an entity’s swaps or
security-based swaps meet the standard for a “substantial position” rests on the satisfaction of
one of two alternative tests.14 The first metric is the daily average aggregate uncollateralized
outward exposure (see calculation methods above). The second metric is the daily average
aggregate uncollateralized outward exposure plus the daily average aggregate potential
outward exposure (see calculation methods above). The thresholds for each of the categories ofswaps, and security-based swaps, are laid out in the table below. It is important to note that forthis test, and this test only, a substantial position excludes both positions held for hedging or
mitigating commercial risk, as well as positions maintained by qualifying employee benefit
plans and governmental plans for the primary purpose of hedging or mitigating any risk
directly associated with the operation of the plan. Each of these exclusions is discussed infurther detail below.

A swap or security-based swap is subject to daily mark-to-market margining if the counterparties
follow the daily practice of exchanging collateral to reflect changes in exposure. Importantly, the use of athreshold below which the entity is not required to post collateral will not disqualify the position fromthe daily mark-to-market margining risk adjustment. In such a case, the total amount of the threshold(less any initial margin posted) will be included in the calculation of the party’s aggregate
uncollateralized outward exposure, regardless of the actual exposure at any time. Similarly, if a swap, or
security-based swap, position is subject to a minimum transfer amount which is greater than $1 million,
the position may still be considered subject to daily mark-to-market margining, but the entirety of theminimum transfer amount will be added to the party’s aggregate uncollateralized outward exposure,regardless of actual exposure at any time. Instead of adding the threshold and minimum transfer
amounts, an entity may choose instead to forego applying the risk reduction multipliers.
13 See CFTC Regulation § 1.3(jjj)(3)(iii) and Exchange Act Rule 240.3a67–3(c)(3).
14 See CFTC Regulation § 1.3(jjj) and Exchange Act Rule 240.3a67–3.
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Memorandum – May 3, 2012

Substantial Position in Swaps and Security-Based Swaps
Swap/Security-Based SwapClassification

Swaps
Rate Swaps
Credit Swaps
Equity Swaps
Other Swaps
Security-Based Swaps
Debt Security-Based Swaps
Other Security-Based Swaps

Daily Average Aggregate
Uncollateralized Outward
Exposure

Daily Average Aggregate
Uncollateralized Outward
Exposure plus Daily Average
Aggregate Potential Outward
Exposure$3 billion$1 billion$1 billion$1 billion$6 billion$2 billion$2 billion$2 billion$1 billion$1 billion$2 billion$2 billion

A. Hedging or Mitigating Commercial Risk
The first test of the major participant definitions—and only the first—excludes swap andsecurity-based swap positions held for hedging or mitigating commercial risk. Because
counterparties use swaps and security-based swaps to mitigate risks in different ways, the
CFTC and the SEC rules are not identical. Notwithstanding these differences, the Commissions
take a similar approach with respect to the general availability of the exclusion. The
Commissions agree that the exclusion is not dependent on organizational status and is available
to financial entities and non-financial entities alike. In addition, the exclusion extends to bothswaps and security-based swaps that hedge against financial or balance sheet risks. Moreover,under both rules, the scope of the exclusion is not limited to the mitigation of an entity’s own
risks. Instead, it extends to hedges against the risks of majority-owned affiliates, as long as theaffiliate could have taken advantage of the exclusion itself. The differences between theCommissions with respect to the hedging exclusion are discussed below.
1. Hedging Exclusion for Swaps
To qualify for the hedging exclusion under the CFTC’s final rule,15 a swap counterparty must
demonstrate that the relevant position:
1. Is “economically appropriate” to the reduction of risks in the conduct and managementof a commercial enterprise;
2. Qualifies as bona fide hedging for purposes of an exemption from position limits under
the Commodity Exchange Act;16 or
3. Qualifies for hedging treatment under:

15
16

See CFTC Regulation § 1.3(kkk).
See Position Limits for Futures and Swaps, 76 F.R. 71626 (Nov. 18, 2011).
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Memorandum – May 3, 2012i)

Financial Accounting Standards Board Accounting Statements Codification Topic
815, Derivatives and Hedging; orii) Government Accounting Standards Board Statement 53, Accounting and Financial
Reporting for Derivative Instruments.
In reviewing whether a swap is “economically appropriate” to the reduction of risks in the
conduct and management of a commercial enterprise, the CFTC will examine the facts andcircumstances as they existed when the entity claiming the exemption established the position.
The final rule enumerates a list of specific risk mitigation practices that qualify for the
exclusion.17 This list is exhaustive, and a risk mitigation strategy that does not fall within one of
the enumerated categories will not satisfy the economically appropriate analysis.
In addition to the three threshold tests above, an entity claiming the hedging exclusion mustalso establish that the swap position is:
1. Not held for a purpose that is in the nature of speculation, investing, or trading;18 and
2. Not held to hedge or mitigate the risk of another swap or security-based swap position,
unless that other position itself is held for the purpose of hedging or mitigating
commercial risk.
2. Hedging Exclusion for Security-Based Swaps
For security-based swaps, the SEC has defined a position that is for hedging or mitigating
commercial risk19 as one which is:
1. Economically appropriate to the reduction of risks that are associated with the present
conduct and management of a commercial enterprise (or of a majority-owned affiliate of

These include scenarios where the risks arise from: (i) the potential change in the value of assets that aperson owns, produces, manufacturers, processes or merchandises or reasonably anticipates owning,producing, manufacturing, processing or merchandising in the ordinary course of business of theenterprise; (ii) the potential change in the value of liabilities that a person has incurred or reasonably
anticipates incurring in the ordinary course of business of the enterprise; (iii) the potential change invalue of services that a person provides, purchases, or reasonably anticipates providing or purchasing in
the ordinary course of business of the enterprise; (iv) the potential change in the value of assets, services,
inputs, products, or commodities that a person owns, produces, manufacturers, processes, merchandises,
leases, or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising,leasing, or selling in the ordinary course of business of the enterprise; (v) any potential change in value
related to any of the foregoing arising from interest, currency, or foreign exchange rate movements
associated with such assets, liabilities, services, inputs, products, or commodities; or (vi) any fluctuation
in interest, currency, or foreign exchange rate exposure arising from a person’s current or anticipatedassets or liabilities. CFTC Regulation § 1.3(kkk)(1)(i).
18 Swaps that hedge against other positions held for speculation, investment, or trading fail to qualify forthe hedging exemption. See Adopting Release at 310–11.
19 See Exchange Act Rule 240.3a67–4.
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Memorandum – May 3, 2012

the enterprise), or are reasonably expected to arise in the future conduct andmanagement of the commercial enterprise; and2. Such position is:a. not held for speculative or trading purposes, andb. not held to hedge or mitigate risk of another security-based swap position or
swap position, unless that other position itself is held for the purpose of hedging
or mitigating commercial risk.
The SEC defines a position as economically appropriate to the reduction of risk associated withthe conduct of a commercial enterprise where the risks arise from the potential change in thevalue of: (i) assets a person owns, produces, manufactures, processes, or merchandises in theordinary course of business; (ii) liabilities that a person has incurred in the ordinary course ofbusiness; or (iii) services that person provides or purchases in the ordinary course of business.
In each case, this analysis also applies to hedging risks associated with affiliates under common
control with the enterprise.
The SEC’s final rule provides a non-exclusive list of positions that may be considered for
purposes of hedging or mitigating commercial risk, dependent on a facts and circumstances
analysis of each such position.20
B. Exclusion for Positions Held by Qualifying ERISA Plans
In addition to the hedging exclusion, the first major participant test also excludes swap andsecurity-based swap positions maintained by certain employee benefit plans and governmental
plans,21 for the primary purpose of hedging or mitigating any risk directly associated with theoperation of the plan.22 According to the Commissions, this exemption is broader than the
exclusion for hedging discussed above, because it is not limited to commercial risks or to
20

This list includes: (i) positions established to manage the risk posed by customer’s, supplier’s orcounterparty’s potential default in connection with financing provided to a customer in connection withthe sale of real property or a good, product or service; a customer’s lease of real property or a good,
product or service; a customer’s agreement to purchase real property or a good, product or service infuture, or a supplier’s commitment to provide the same; (ii) positions established to manage the default
risk posed by a financial counterparty in connection with a separate transaction (including credit
derivative, equity swap, other security-based swap, interest rate swap, commodity swap, FX swap orother swap, option, or future that is itself hedging for commercial risk); (iii) positions established to
manage equity or market risk associated with certain employee compensation plans; (iv) positions
established to manage equity market price risks in connection with certain business combinations, suchas a merger or consolidation in which securities of a person are exchanged for securities of any otherperson, or a transfer of assets in exchange for securities; (v) positions established by a bank to manage
counterparty risks in connection with loans; and (vi) positions established to close out or reduce any ofthe positions described above.
For qualifying entities, see Paragraphs (3) and (32) of section 3 of the Employee Retirement Income
Security Act of 1974.
22 See Adopting Release at 328–321.
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Memorandum – May 3, 2012

positions that have a sole hedging purpose. Instead, the qualifying plan exclusion extends toany risk directly associated with the operation of the plan, and encompasses swap and securitybased swap positions that have a secondary, non-hedging purpose.
A swap or security-based swap has a “primary purpose” of hedging or mitigating risk directly
associated with the operation of a qualifying plan if the position was established to reduce
disruptions or costs in connection with: (i) the anticipated inflows or outflows of plan assets, (ii)risks related to interest rates, and (iii) changes in portfolio management or strategies.
C. Procedural Conditions
Although the final rules do not require entities to demonstrate the effectiveness of hedges, toretain specific documentation, or to employ periodic retesting to qualify for the hedging
exemption,23 the SEC provided interpretive guidance in the Adopting Release that it may be
prudent for entities relying on the exemption to retain documents and records consistent withsuch procedures.24 According to the SEC, in the event that an exemption is disputed, theexistence of such records may help to establish the basis for the exclusion.

IV.

TEST 2:OUTSTANDING SWAPS OR SECURITY-BASED SWAPS CREATE
SUBSTANTIAL COUNTERPARTY EXPOSURE THAT COULD HAVESERIOUS ADVERSE EFFECTS ON THE FINANCIAL STATBILITY
OF THE UNITED STATES BANKING SYSTEM OR FINANCIAL
MARKETS

The second major participant test targets entities whose outstanding swaps or security-based
swaps create substantial counterparty exposure that could have serious adverse effects on thefinancial stability of the United States banking system or financial markets.25 Unlike thesubstantial position analysis, the substantial counterparty exposure calculation is not limited topositions in a single swap or security-based swap category. Instead, the substantial
counterparty exposure test aggregates all the swap and security-based swap positions of anentity.26 Importantly, positions held for hedging or mitigating commercial risks as well as those
held by qualifying employee benefit and governmental plans are not excluded from thesubstantial counterparty exposure analysis.27 Consequently, the triggering thresholds arehigher for this test than for those under the substantial position test.
Pursuant to the substantial counterparty exposure analysis, an entity will qualify as a major
participant if it exceeds any of the following thresholds:

See id. at 310, 325.
See id. at 324–25.
25 See CFTC Regulation § 1.3(lll) and Exchange Act Rule 240.3a67–5.
26 See CFTC Regulation § 1.3(lll)(2) and Exchange Act Rule 240.3a67–5(b).
27 See Adopting Release at 335.
23
24

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Swaps or Security-Based Swaps Create Substantial Counterparty Exposure
Major Swap Participant

Major Security-Based Swap
Participant

Daily Average Aggregate
Uncollateralized Outward
Exposure$5 billion, calculated byreference to all swap positions$2 billion, calculated byreference to all security-based
swap positions

Daily Average Aggregate
Uncollateralized Outward
Exposure plus Daily Average
Aggregate Potential Outward
Exposure$8 billion, calculated byreference to all swap positions$4 billion, calculated byreference to all security-based
swap positions

V.

TEST 3:

HIGHLY LEVERAGED FINANCIAL ENTITIES WITH
SUBSTANTIAL POSITIONS IN ANY MAJOR CATEGORY OF
SWAPS OR SECUIRTY-BASED SWAPSThe third major participant test encompasses any person that is: (i) a “financial entity” that is“highly leveraged” relative to the amount of capital it holds (and is not subject to capitalrequirements established by an appropriate Federal banking agency) and (ii) maintains a“substantial position” in outstanding swaps in any major swap or security-based swap
category.
A. Financial Entity
To define the term “financial entity,” the Commissions relied on the corresponding statutory
language employed in the clearing exception in Title VII of the Dodd-Frank Act. Thus, withcertain modifications to avoid circularity, a “financial entity” includes: 28
1. Swap dealers and security-based swap dealers;
2. Major swap participants and major security-based swap participants;
3. Commodity pools;
4. Private funds;29
5. Employee benefit plans and governmental plans;30 and
6. Persons predominately engaged in activities that are in the business of banking.31

See CFTC Regulation 1.3(mmm)(1) and Exchange Act Rule 240.3a67–6.
See section 202(a) of the Investments Advisors Act of 1940.
30 See paragraphs (3) and (32) of Section 3 of Employee Retirement Income Security Act of 1974.
28
29

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In addition, the SEC’s final rule also includes a specific carveout for centralized hedging andtreasury entities that would otherwise qualify as financial entities solely because they facilitate
hedging activities by majority-owned affiliates that themselves are not financial entities. Whilethe interpretive guidance provided by the Commissions in the Adopting Release discussed thisexemption for both swaps and security-based swaps,32 the carveout is not included in the
CFTC’s final rule.
B. Highly-Leveraged
Under the third major participant test, an entity is highly-leveraged relative to the amount of
capital it holds if its ratio of liabilities to equity exceeds 12 to 1.33 According to the final rules,
the liability and equity calculations must be made at the close of business on the last day of theapplicable fiscal quarter and, generally, must be determined in accordance with GAAP. For
qualifying employee benefit plans, the calculation may: (i) exclude obligations to pay benefits
to plan participants from liabilities and (ii) substitute the total value of plan assets for equity.
C. Substantial Position
If a financial entity is highly leveraged, it will be deemed a major participant if it maintains a“substantial position” in any major swap or security-based swap category. It is important tonote that, though the triggering thresholds are the same as those established under the first
substantial position test, the analysis for highly leveraged financial entities does not exclude
positions held for hedging or those held by qualifying employee benefit plans andgovernmental plans.34 As a result, a highly leveraged financial entity will be deemed to be amajor participant if it exceeds any of the following thresholds:
Substantial Position in Swaps and Security-Based Swaps
Swap/Security-Based SwapClassification

Swaps
Rate Swaps
Credit Swaps
Equity Swaps
Other Swaps
Security-Based Swaps
Debt Security-Based Swaps
Other Security-Based Swaps

Daily Average Aggregate
Uncollateralized Outward
Exposure

Daily Average Aggregate
Uncollateralized Outward
Exposure plus Daily Average
Aggregate Potential Outward
Exposure$3 billion$1 billion$1 billion$1 billion$6 billion$2 billion$2 billion$2 billion$1 billion$1 billion$2 billion$2 billion

See section 4(k) of the Bank Holding Company Act of 1956.
See Adopting Release at 344.
33 See CFTC Regulation § 1.3(mmm)(2) and Exchange Act Rule
34 See Adopting Release at 337.
31
32

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Memorandum – May 3, 2012

VI.

AFFILIATE TRANSACTIONS & MANAGED ACCOUNTS
A. Affiliate Transactions
1. Inter-Affiliate Transaction Exclusion

In an expansion from the wholly-owned affiliate exclusion contemplated by the proposed rules,
the final rules exclude swaps and security-based swaps entered into between majority-owned
affiliates from the major participant analysis.35 According to the Commissions, positions
between majority-owned affiliates typically apportion risk within a corporate group and thus
fail to pose the potential for widespread market impact as those positions between unaffiliatedentities. Under the final rules, counterparties will qualify as majority-owned affiliates if one ofthem directly or indirectly owns a majority interest in the other or a third party directly or
indirectly owns a majority interest in both. A majority interest is defined as: (i) the right to voteor direct the vote of a majority of a class of voting securities of an entity, (ii) the power to sell or
direct the sale of a majority of a class of voting securities of an entity, or (iii) the right to receive
upon dissolution or the contribution of a majority of the capital of a partnership.
2. Attribution of Affiliate Positions
In addition to the inter-affiliate exclusion, the interpretive guidance in the Adopting Releasealso clarifies that the Commissions will not, as a general matter, attribute the swap and securitybased swaps of subsidiaries at the parent-level for purposes of the major participant analysis.36
Instead, an entity’s swaps and security-based swaps will only be attributable to a parent, otheraffiliate, or guarantor to the extent that the counterparty to the transaction has recourse to theparent, other affiliate, or guarantor. Even in situations where recourse is available, however,
the Commissions will not attribute the positions if the parent or guarantor is already subject tocapital regulation by the CFTC or the SEC,37 or is a U.S. entity regulated as a bank in the UnitedStates.
In the event that an entity is deemed to be a major participant due to the attribution of affiliate
positions as discussed in the preceding paragraph, the Commissions have provided interpretive
guidance in the Adopting Release with respect to operational compliance.38 For thoserequirements that are transaction-focused, such as certain business conduct standards andrequirements related to trading records, documentation, and confirmations, the parent may
delegate its compliance duties to the entities that are direct parties to the relevant transactions.
By contrast, for entity-focused regulations, such as requirements related to registration, capital,
risk management, supervision, and chief compliance officers, the parent cannot delegate its
compliance duties. Importantly, under either scenario, the parent remains liable for any failureof the subsidiary to comply with the applicable CFTC and SEC rules.

See CFTC Regulation § 1.3(jjj)(5) and Exchange Act Rule 240.3a67–3(d).
See Adopting Release at 357–59.
37 For example, the parent is already registered as a: swap dealer, security-based swap dealer, major
swap participant, major security-based swap participant, futures commission merchant, or broker-dealer.
38 See Adopting Release at 358–59.
35
36

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Memorandum – May 3, 2012

B. Managed Accounts
The interpretive guidance in the Adopting Release exempts swap and security-based swap
positions in client accounts from the major participant analysis for asset managers andinvestment advisers.39 Similarly, swap and security-based swap positions will not be attributed
to a beneficial owner in the absence of recourse against the beneficial owner.40

VII.

SAFE HARBORS

Regardless of a whether an entity would otherwise be a major swap participant or major
security-based swap participant based on the analysis above, both the SEC and the CFTC rules
provide safe harbors from major participant status if an entity meets one of the three tests
below, each of which are based on measures of outward exposure.41 For purposes of the safe
harbor calculations, an entity’s aggregate uncollateralized outward exposure for positions heldwith swap dealers, or security-based swap dealers, is equal to the exposure of such positions
reported on the most recent reports of such dealer. Positions that are not reflected in any suchdealer report are calculated according to the aggregate uncollateralized outward exposure
analysis (see above). Further, for purposes of the safe harbor, total notional principal amounts
are calculated without using risk reduction multipliers for clearing, mark-to-marking
margining, or netting.
A. Safe Harbor 1: Cap on uncollateralized exposure and notional positions.
To satisfy the first safe harbor: (i) the express term’s of such entity’s agreements relating toswaps, or security-based swaps, must at no time permit the entity to maintain a total
uncollateralized exposure of more than $100 million to all swap, or security-based swap,
counterparties, respectively, including any exposure resulting from threshold or minimumtransfer amounts; and (ii) the entity must not maintain positions with an effective notionalamount of more than (a) $2 billion in any major category of swaps, or security-based swaps, or(b) $4 billion in the aggregate across all categories of swaps, or all categories of security-based
swaps, respectively.42
B. Safe Harbor 2: Cap on uncollateralized exposure plus monthly calculation
To meet the second test: (i) the express term’s of such entity’s agreements relating to swaps, or
security-based swaps must at no time permit the entity to maintain a total uncollateralized
exposure of more than $200 million to all parties (with respect to swaps, or security-based
swaps, respectively, as well as any other instruments by which the entity may have exposure),
including any exposure resulting from threshold or minimum transfer amounts; and (ii) its
aggregate uncollateralized outward exposure plus its aggregate potential outward exposure (ineach case disregarding daily averaging) calculated at the end of each month produce thresholds
of no more than: (1) $1 billion in aggregate uncollateralized outward exposure (excluding
See id. at 362.
See id. at 632–63.
41 See CFTC Regulation § 1.3(hhh)(6) and Exchange Act Rule 240.3a67–9.
42 See CFTC Regulation § 1.3(hhh)(6)(i) and Exchange Act Rule 240.3a67–9(a)(1).
39
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Memorandum – May 3, 2012

hedging activities for all entities other than highly leveraged financial entities not subject tocapital requirements established by an appropriate Federal banking agency), plus aggregate
potential outward exposure in any major category of swaps, or security-based swaps,
respectively; and (2) $2 billion in aggregate uncollateralized outward exposure plus aggregate
potential outward exposure (without excluding any positions) with regard to all of the entity’sswap positions, or security-based swap positions, respectively. 43
C. Safe Harbor 3: Calculations based on certain information
The third test requires an entity to make calculations at the end of each month that meet either
one of two prongs.44 For the SEC rule, the first prong is that: (i) the entity’s aggregate
uncollateralized outward exposure with respect to its security-based swap positions is less than$500 million with respect to each of the major categories of security-based swaps, and (ii) thesum of (a) the entity’s aggregate uncollateralized outward exposure with respect to its securitybased swap positions in each major category, plus (b) the total notional principal amount ofsuch positions in each category (adjusted by the risk multipliers on a position-by-positionbasis), is less than $1 billion with respect to each of the major security-based swap categories.45
The first prong of the CFTC rule for swaps is similar except that the thresholds in (i) and (ii)above are instead: (i) $1.5 billion for rate swaps and $500 million for each other major swap
category; and (ii) $3 billion for rate swaps and $1 billion for all other major swap categories.46
The thresholds for the second prong are (i) the entity’s aggregate uncollateralized outward
exposure with respect to its swap, or security-based swap, positions across all major categories
of swaps, or security-based swaps, respectively, is less than $500 million; and (ii) the sum of (a)the entity’s aggregate uncollateralized outward exposure with respect to its swap, or securitybased swap, positions across all major categories of swaps, and security based swaps,
respectively; plus (b) the product of the total effective notional principal amount of the entity’sswap, or security-based swap, positions across all major categories multiplied by 0.15 withrespect to swaps, or 0.10 with respect to security-based swaps, is less than $1 billion.47

VIII. CAPTIVE FINANCE COMPANY EXCLUSION
In addition to the safe harbors described above, Title VII of the Dodd-Frank Act incorporates a
specific exception from the major swap participant definition—and the major swap participant
definition only—for entities whose primary business is providing financing and use derivatives
for the purpose of hedging underlying commercial risks related to interest rate and foreign
currency exposure, 90 percent or more of which arise from financing that facilitates thepurchase or lease of products, 90 percent or more are manufactured by the parent company oranother subsidiary of the parent company.48 To qualify for this so-called “captive financecompany exclusion,” the CFTC’s interpretive guidance in the Adopting Release requires an
See CFTC Regulation § 1.3(hhh)(6)(ii) and Exchange Act Rule 240.3a67–9(a)(2).
See CFTC Regulation § 1.3(hhh)(6)(iii) and Exchange Act Rule 240.3a67–9(a)(3).
45 See Exchange Act Rule 240.3a67–9(a)(3)(i)(A).
46 See CFTC Regulation § 1.3(hhh)(6)(iii)(A).
47 See CFTC Regulation § 1.3(hhh)(6)(iii)(B) and Exchange Act Rule 240.3a67–9(a)(iii)(B).
48 Section 721(a)(33)(D) of the Dodd-Frank Act.
43
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entity to provide financing for purchases from its parent company as a primary business—
providing financing as a secondary or complementary activity is not sufficient.49 The
Commission has also clarified that qualifying financing activity includes the financing ofservice, labor, component parts, and attachments related to products produced by the parent.

IX.

IMPLEMENTATION STANDARD,SCOPE OF DESIGNATION

RE-EVALUATIONPERIOD,AND

A. Implementation Standard and Re-evaluation Period
In the event that an entity satisfies any of the three major participant tests, it will not be deemed
to be a major participant until the earlier of: (i) the date that it submits an application forregistration as a major participant or (ii) two months after the end of the fiscal quarter in which
it qualifies as a major participant.50 Importantly, these provisions do not apply if the entity did
not exceed the major participant thresholds by more than 20 percent.51 In those situations, thetiming provisions will not apply unless the entity exceeds any of the applicable thresholds inthe next fiscal quarter. Once an entity attains major participant status, it will be a major
participant until its swap and security-based swap positions do not exceed any of the applicable
thresholds for four consecutive fiscal quarters.52
B. Scope of Designation
If an entity qualifies as a major swap participant or major security-based swap participant, theCommissions will deem it to be a major participant with respect to all categories of swaps or
security-based swaps, respectively, notwithstanding the category of swaps or security-based
swaps that triggered its major participant status.53 A major participant may, however, submit
an application to the CFTC or the SEC, as appropriate, to limit its designation to a specified
category of swaps or security-based swaps.54 Importantly, the Commissions will not approve
an application for limited designation unless the entity can demonstrate its ability comply, as alimited designee, with the statutory and the regulatory requirements applicable to major
participants at both the transaction- and the entity-level.

X.

EFFECTIVE DATE AND REQUIRED REGISTRATION

The major participant definitions become effective 60 days after publication in the Federal
Register. Although the SEC has not yet issued final rules implementing the registration
requirements and substantive regulations for major security-based swap participants, the CFTC
has issued final rules imposing registration requirements and operational constraints on major
swap participants. As a result, major security-based swap participants will not need to register
See Adopting Release at 373–74.
See CFTC Regulation § 1.3(hhh)(3) and Exchange Act Rule 240.3a67–8(a).
51 See CFTC Regulation § 1.3(hhh)(4) and Exchange Act Rule 240.3a67–8(b).
52 See CFTC Regulation § 1.3(hhh)(5) and Exchange Act Rule 240.3a67–8(c).
53 See CFTC Regulation § 1.3(hhh)(2) and Exchange Act Rule 240.3a67–1(b).
54 See CFTC Regulation § 1.3(hhh)(2). The SEC plans to address the procedures to apply for a limited
designation in a separate rulemaking. See Adopting Release at 385.
49
50

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Memorandum – May 3, 2012

until the date provided by the SEC in the final registration rule. For major swap participants,
existing CFTC rules require these entities to apply for registration with the Commission, via the
National Futures Association, no later than the latest effective date of the final rule defining theterm “swap”.55 Depending on when the CFTC adopts a final rule defining the term “swap,” it ispossible that once registered, major swap participants will immediately become subject to the
panoply of final rules and regulations governing internal business conduct standards,56 externalbusiness conduct standards,57 and swap data recordkeeping and reporting.58

XI.

CONCLUSION

Under the final rules, all counterparties to swaps and security-based swaps are responsible fordetermining whether they satisfy the major participant tests. Given the scope of this substantial
undertaking as well as the existence of substantive rules governing the conduct and business
operations of major participants, it would be advisable to prepare for this exercise to ensurecompliance once the final rules become effective.
***

For more information about any of the foregoing, please contact a member of the Firm’s
Derivatives Group.
This memorandum is for general information purposes and should not be regarded as legal advice. Pleasecontact your relationship partner if we can be of assistance regarding these important developments. The
names and office locations of all of our partners, as well as our recent memoranda, can be obtained fromour website, www.simpsonthacher.com.

The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

See Registration of Swap Dealers and Major Swap Participants, 77 F.R. 2613 (Jan. 19, 2012);
Performance of Registration Functions by National Futures Association With Respect to Swap Dealersand Major Swap Participants, 77 F.R. 2708 (Jan. 19, 2012).
56 Swap Dealer and Major Swap Participant Recordkeeping and Reporting, Duties and Conflicts ofInterest Policies and Procedures, 77 F.R. 20128 (Apr. 3, 2012).
57 Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties, 77
F.R. 9734 (Feb. 17, 2012).
58 Real-Time Public Reporting of Swap Transaction Data, 77 F.R. 1182 (Jan. 9, 2012); Swap Date
Recordkeeping and Reporting Requirements, 77 F.R. 2136 (Jan. 13, 2012).
55

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