[Federal Register Volume 65, Number 121 (Thursday, June 22, 2000)]
[Proposed Rules]
[Pages 39033-39039]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-14917]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 35

RIN 3038-AB58


Exemption for Bilateral Transactions

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed Rulemaking.

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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC) 
is proposing to clarify the operation of the current swaps exemption, 
17 CFR Part 35. In addition, in a companion notice of proposed 
rulemaking on clearing, the Commission is proposing rules clarifying 
that transactions under its Part 35 swaps exemption can be cleared. The 
Commission, in companion releases published in this edition of the 
Federal Register, also is proposing a new regulatory framework to apply 
to multilateral transaction execution facilities, to market 
intermediaries and to clearing organizations. This new framework 
establishes a number of new market categories, including a category of 
exempt multilateral transaction execution facility. Nothing in these 
releases, however, would affect the continued vitality of the 
Commission's exemption for swaps transactions under Part 35 of its 
rules, or any of its other existing exemptions, policy statements or 
interpretations.

DATES: Comments must be received by August 7, 2000.

ADDRESSES: Comments should be sent to the Commodity Futures Trading 
Commission, Three Lafayette Centre, 1125 21st Street, NW., Washington, 
DC 20581, attention: Office of the Secretariat. Comments may be sent by 
facsimile transmission to (202) 418-5521 or, by e-mail to 
<a href="/cdn-cgi/l/email-protection#f784929485928396858eb794918394d9909881"><span class="__cf_email__" data-cfemail="3340565041564752414a73505547501d545c45">[email protected]</span></a>. Reference should be made to ``Exemption for 
Bilateral Transactions.''

FOR FURTHER INFORMATION CONTACT: Paul M. Architzel, Chief Counsel, 
Division of Economic Analysis, Commodity Futures Trading Commission, 
Three Lafayette Centre, 1125 21st Street, NW, Washington, DC 20581. 
Telephone: (202) 418-5260. E-mail: [<a href="/cdn-cgi/l/email-protection#d68697a4b5bebfa2acb3ba96b5b0a2b5f8b1b9a0"><span class="__cf_email__" data-cfemail="2e7e6f5c4d46475a544b426e4d485a4d00494158">[email protected]</span></a>].

SUPPLEMENTARY INFORMATION:   

[[Page 39034]]

I. Background

    The Commission is proposing to amend its Part 35 exemption to 
expand and to clarify its operation, including the availability of 
clearing for these transactions. These proposed amendments would 
provide greater legal certainty to the OTC markets and reduce systemic 
risk. The Commission was encouraged in this undertaking by the other 
Federal financial regulators that comprise the President's Working 
Group on Financial Markets \1\ and by the chairmen of the Commission's 
Congressional oversight committees.
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    \1\ Recognizing the importance of the OTC derivatives markets, 
the Chairmen of the Senate and House Agriculture Committees 
requested that the President's Working Group on Financial Markets 
(PWG) conduct a study of OTC derivatives markets. After studying the 
existing regulatory framework for OTC derivatives, recent 
innovations, and the potential for future developments, the PWG on 
November 9, 1999, reported to Congress its recommendations. See 
Over-the-Counter Derivative Markets and the Commodity exchange Act, 
Report of the President's Working Group. The PWG report focused on 
promoting innovation, competition, efficiency, and transparency in 
OTC derivatives markets and in reducing systemic risk.
    Although specific recommendations about the regulatory structure 
applicable to exchange-traded futures were beyond the scope of its 
report, the PWG suggested that the Commission review existing 
regulatory structures (particularly those applicable to markets for 
financial futures) to determine whether they were appropriately 
tailored to serve valid regulatory goals.
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    The proposed amendments to part 35 respond to changes that have 
occurred in the over-the-counter (OTC) markets since the Commission 
adopted its Swaps Policy Statement in 1989, and its subsequent part 35 
swaps exemption in 1993. In the intervening years, the OTC derivatives 
markets have experienced dramatic and sustained growth. During this 
period, OTC financial derivatives have developed into global markets 
having outstanding contracts with a total notional value of over $80 
trillion. OTC derivatives have transformed finance, increasing the 
range of financial products available for managing risk.

II. Legal Certainty for Bilateral OTC Transactions

    The Commission is proposing to amend its part 35 swaps exemption in 
a number of ways. First, it is proposing to delete specific reference 
to ``swaps'' within the exemption itself. Instead, the rule would refer 
to a ``contract, agreement or transaction'' that meets the requisite 
exemptive conditions. This is being proposed to clarify that an 
instrument's denomination as a ``swap'' was not, and is not, an 
independent condition of the exemption. Moreover, as suggested by the 
PWG Report, the Commission has also proposed to delete the requirement 
that exempt transactions not be fungible or standardized and has made 
clear that insofar that such exempt transactions may be cleared, 
creditworthiness of the counterparty is not a condition of the 
exemption. PWG Report at 17-18. In addition, the Commission is 
proposing, through an exemption from the private right of action 
provision of section 22 of the Act, that transactions entered into in 
reliance on the part 35 swaps exemption would not be subject to a claim 
for rescission solely due to a violation of the exemption's 
requirements. See Id. at 18.
    The Commission has proposed these changes to its part 35 swaps 
exemption in order to enhance the legal certainty for such instruments. 
These changes would in no way call into question any transaction 
undertaken under the part 35 rules as currently drafted. Moreover, in 
recognition of its continuing vitality and to assist the public in 
locating it, the Commission is proposing to incorporate by reference 
its 1989 Swaps Policy Statement as Appendix A to part 35.\2\ Moreover, 
the Commission is not proposing any changes to its energy 
interpretation (55 FR 39188) and energy exemption (58 FR 21286) and 
affirms their continued applicability.
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    \2\ The Swaps Policy Statement is found at 54 FR 30694 (July 21, 
1989).
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    A condition of the part 35 exemption is that such transactions not 
be entered into and traded on or through a ``multilateral transaction 
execution facility'' (MTEF). The Commission is proposing to define MTEF 
in amendments to part 36 of its rules included in a companion release 
published in this edition of the Federal Register. The Commission is 
proposing to define MTEF as ``an electronic or non-electronic market or 
similar facility through which persons, for their own accounts or for 
the accounts of others, enter into, agree to enter into or execute 
binding transactions by accepting bids or offers made by one person 
that are open to multiple persons conducting business through such 
market or similar facility.'' This definition highlights the essential 
nature of an MTEF as a place or facility through, or on, which traders 
have the ability to execute agreements or contracts. It does not, 
however, require that every trader have access to every transaction 
offered through the facility. The definition as proposed does not, and 
is not intended to, ``preclude participants from engaging in privately 
negotiated bilateral transactions, even where these participants use 
computer or other electronic facilities, such as `broker screens,' to 
communicate simultaneously with other participants so long as they do 
not use such systems to enter orders to execute transactions.'' See, 58 
FR 5587, 5591 (Jan. 22, 1993). Accordingly, the proposed definition 
makes clear that it does not include facilities merely used as a means 
of communicating bids or offers nor does it include markets in which a 
single party offers to enter into bilateral transactions with multiple 
counterparties who may not transact with each other.
    As proposed, the Commission would not make any determination that 
the exempted transactions are or are not subject to its jurisdiction. 
When it adopted Section 4(c) in 1992, the Conferees of the Congress 
stated:

    The Conferees do not intend that the exercise of exemptive 
authority by the Commission (under section 4(c)) would require any 
determination beforehand that the agreement, instrument, or 
transaction for which an exemption is sought is subject to the Act. 
Rather, this provision provides flexibility for the Commission to 
provide legal certainty to novel instruments where the determination 
as to jurisdiction is not straightforward.\3\
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    \3\ H.R. Rep. No. 978, 102d Cong., 2d Sess. 82-83 (1992).
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III. Section 4(c) Findings

    These proposed rule amendments are being proposed under section 
4(c) of the Act, which grants the Commission broad exemptive authority. 
Section 4(c) of the Act provides that, in order to promote responsible 
economic or financial innovation and fair competition, the Commission 
may by rule, regulation or order exempt any class of agreements, 
contracts or transactions, either unconditionally or on stated terms or 
conditions. To grant such an exemption, the Commission must find that 
the exemption would be consistent with the public interest, that the 
agreement, contract, or transaction to be exempted would be entered 
into solely between appropriate persons and that the exemption would 
not have a material adverse effect on the ability of the Commission or 
any contract market to discharge its regulatory or self-regulatory 
duties under the Act.\4\
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    \4\ See 7 U.S.C. 6(c).
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    As explained above, the proposed exemption for bilateral 
transactions is available only to appropriate persons. Moreover, these 
amendments to part 35 will promote financial innovation and reduce 
systemic risk. The Commission further finds that these proposed 
amendments would have no adverse effect on any of the regulatory or 
self-regulatory responsibilities imposed by the Act. The Commission 
specifically

[[Page 39035]]

requests the public to comment on these findings.

IV. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA), 5 U.S.C. 601 et seq., 
requires that agencies, in promulgating rules, consider the impact of 
these rules on small entities. Information of the type that would be 
required under the proposed rule does not involve any small 
organizations.

B. Paperwork Reduction Act

    The Paperwork Reduction Act (PRA) of 1995 (44 U.S.C. 3507(d)), 
which imposes certain requirements on federal agencies (including the 
Commission) in connection with their conducting or sponsoring any 
collection of information as defined by the PRA does not apply to this 
rule. The Commission believes the proposed amendments to this rule do 
not contain information collection requirements which require the 
approval of the Office of Management and Budget. The purpose of these 
proposed rule amendments is to provide greater legal certainty for the 
specified OTC transactions.

List of Subjects in 17 CFR Part 35

    Commodity futures, Commodity Futures Trading Commission.

    In consideration of the foregoing, and pursuant to the authority 
contained in the Commodity Exchange Act and, in particular, sections 2, 
4, 4(c), and 8a thereof, 7 U.S.C. 2, 6, 6c, and 12a, the Commission 
hereby proposes to amend Chapter I, Part 35 of Title 17 of the Code of 
Federal Regulations as follows:

PART 35--EXEMPTION OF BILATERAL AGREEMENTS

    1. The authority citation for Part 35 continues to read as follows:

    Authority: 7 U.S.C. Secs. 2, 6, 6c, and 12a.

    2. The heading of part 35 is proposed to be revised as set forth 
above.
    3. Section 35.1 is proposed to be amended by revising paragraph (b) 
to read as follows:


Sec. 35.1  Scope and definitions.

* * * * *
    (b) Definition. As used in this part, ``eligible participant'' 
means, and shall be limited to, the following persons or classes of 
persons:
    (1) A bank or trust company (acting on its own behalf or on behalf 
of another eligible participant);
    (2) A savings association or credit union;
    (3) An insurance company;
    (4) An investment company subject to regulation under the 
Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) or a foreign 
person performing a similar role or function subject as such to foreign 
regulation, provided that such investment company or foreign person is 
not formed solely for the specific purpose of constituting an eligible 
participant;
    (5) A commodity pool formed and operated by a person subject to 
regulation under the Act or a foreign person performing a similar role 
or function subject as such to foreign regulation, provided that such 
commodity pool or foreign person is not formed solely for the specific 
purpose of constituting an eligible participant and has total assets 
exceeding $5,000,000;
    (6) A corporation, partnership, proprietorship, organization, 
trust, or other entity not formed solely for the specific purpose of 
constituting an eligible participant:
    (i) Which has total assets exceeding $10,000,000, or
    (ii) The obligations of which under the agreement are guaranteed or 
otherwise supported by a letter of credit or keepwell, support, or 
other agreement by any such entity referenced in this paragraph 
(b)(6)(i) of this section or by an entity referred to in paragraph 
(b)(1), (2), (3), (4), (5), (6) or (8) of this section; or
    (iii) Which has a net worth of $1,000,000 and enters into the 
agreement in connection with the conduct of its business; or which has 
a net worth of $1,000,000 and enters into the agreement to manage the 
risk of an asset or liability owned or incurred in the conduct of its 
business or reasonably likely to be owned or incurred in the conduct of 
its business;
    (7) An employee benefit plan subject to the Employee Retirement 
Income Security Act of 1974 or a foreign person performing a similar 
role or function subject as such to foreign regulation with total 
assets exceeding $5,000,000, or whose investment decisions are made by 
a bank, trust company, insurance company, investment adviser subject to 
regulation under the Investment Advisers Act of 1940 (15 U.S.C. 80a-1 
et seq.), or a commodity trading advisor subject to regulation under 
the Act;
    (8) Any governmental entity (including the United States, any 
state, or any foreign government) or political subdivision thereof, or 
any multinational or supranational entity or any instrumentality, 
agency, or department of any of the foregoing;
    (9) A broker-dealer subject to regulation under the Securities 
Exchange Act of 1934 (15 U.S.C. 78a et seq.) or a foreign person 
performing a similar role or function subject as such to foreign 
regulation, acting on its own behalf or on behalf of another eligible 
participant: Provided, however, that if such broker-dealer is a natural 
person or proprietorship, the broker-dealer must also meet the 
requirements of either paragraph (b)(6) or (11) of this section;
    (10) A futures commission merchant, floor broker, or floor trader 
subject to regulation under the Act or a foreign person performing a 
similar role or function subject as such to foreign regulation, acting 
on its own behalf or on behalf of another eligible participant: 
Provided, however, that if such futures commission merchant, floor 
broker, or floor trader is a natural person or proprietorship, the 
futures commission merchant, floor broker, or floor trader must also 
meet the requirements of paragraph (b)(6) or (b)(11) of this section; 
or
    (11) Any natural person with total assets exceeding at least 
$10,000,000.
    4. Section 35.2 is proposed to be revised to read as follows:


Sec. 35.2  Exemption.

    A contract, agreement or transaction is exempt from all provisions 
of the Act and any person or class of persons offering, entering into, 
rendering advice, or rendering other services with respect to such 
agreement, is exempt for such activity from all provisions of the Act 
(except in each case the provisions enumerated in Sec. 35.3(a)) 
provided the following terms and conditions are met:
    (a) The contract, agreement or transaction is entered into solely 
between eligible participants;
    (b) The contract, agreement or transaction is not entered into and 
traded on or through a multilateral transaction execution facility as 
defined in Sec. 36.1 of this chapter; and
    (c) Except for those contracts, agreements or transactions 
submitted for clearance or settlement to a clearinghouse as provided 
under paragraph (d)(3) of this section, the creditworthiness of any 
party having an actual or potential obligation under the contract, 
agreement or transaction would be a material consideration in entering 
into or determining the terms of the contract, agreement or 
transaction, including pricing, cost, or credit enhancement terms.
    (d) The provisions of paragraphs (b) and (c) of this section shall 
not be deemed to preclude:
    (1) Arrangements or facilities between parties to such contracts, 
agreements or transactions that provide for netting of payment 
obligations resulting from such contracts, agreements or transactions;

[[Page 39036]]

    (2) Arrangements or facilities among parties to such contracts, 
agreements or transactions, that provide for netting of payments 
resulting from such contracts, agreements or transactions;
    (3) The submission of such contracts, agreements or transactions 
for clearance and/or settlement to a clearing organization which is 
authorized under Sec. 39.2 of this chapter; or
    (4) The use of an electronic or non-electronic market or similar 
facility used solely as a means of communicating bids or offers by 
market participants or the use of such a market or facility by a single 
counterparty to offer to enter into or to enter into bilateral 
transactions with multiple counterparties.
    (e) Any person may apply to the Commission for exemption from any 
of the provisions of the Act (except section 2(a)(1)(B)) for other 
arrangements or facilities, on such terms and conditions as the 
Commission deems appropriate, including but not limited thereto, the 
applicability of other regulatory regimes.
    5. Section 35.3 is proposed to be added to read as follows:


Sec. 35.3  Enforceability.

    (a) Notwithstanding the exemption in Sec. 35.2, sections 
2(a)(1)(B), 4b, and 4o of the Act, Sec. 32.9 of this chapter as adopted 
under section 4c(b) of the Act, Sec. 32.13 of this chapter, and 
sections 6(c) and 9(a)(2) of the Act to the extent that they prohibit 
manipulation of the market price of any commodity in interstate 
commerce or for future delivery on or subject to the rules of any 
contract market, continue to apply to transactions and persons 
otherwise subject to those provisions.
    (b) A party to a contract, agreement, or transaction that is with 
an eligible participant (or counterparty reasonably believed by such 
party to be an eligible counterparty) shall be exempt from any claim, 
counterclaim or affirmative defense by such counterparty under section 
22(a)(1) of the Act or any other provision of the Act:
    (1) That such contract, agreement, or transaction is void, voidable 
or unenforceable; or
    (2) to rescind or recover any payment made in respect of such 
contract, agreement, or transaction, based solely on the failure of 
such party or such contract, agreement, or transaction to comply with 
the terms or conditions of the exemption under this part or from the 
terms or conditions of the Statement of Policy Concerning Swap 
Transactions in appendix A to this part 35.
    (c) A party to a contract, agreement or transaction that qualifies 
under the Statement of Policy Concerning Swap Transactions in appendix 
A to this part 35 or the Statutory Interpretation Concerning Hybrid 
Instruments, as the same may be revised by the Commission from time to 
time, shall be exempt from any claim under Section 22(a)(1) of the Act 
or any other provision of the Act:
    (1) That such contract, agreement or transaction is void, voidable, 
or unenforceable; or
    (2) to rescind or recover any payment made in respect of such 
contract, agreement or transaction, based solely on the failure of such 
party, or such contract, agreement or transaction, to comply with any 
provision of the Act or Commission rules, excluding, in the case of 
this paragraph, any claim for manipulation or fraud arising under a 
provision of the Act or Commission rules applicable by its terms to a 
contract, agreement or transaction that is not otherwise subject to 
regulation under the Act.
    6. Part 35 is proposed to be amended by adding new Appendix A to 
read as follows:

Appendix A to Part 35--Policy Statement Concerning Swap Transactions

(a) Background

    (1) Section 2(a)(1)(A) of the Commodity Exchange Act (CEA or 
Act) grants the Commission exclusive jurisdiction over ``accounts, 
agreements (including any transaction which is of the character of * 
* * an `option' * * *), and transactions involving contracts of sale 
of a commodity for future delivery traded or executed on a contract 
market * * * or any other board of trade, exchange, or market. * * 
*'' 7 U.S.C. 2. The CEA and Commission regulations require that 
transactions in commodity futures contracts and commodity option 
contracts, with narrowly defined exceptions, occur on or subject to 
the rules of contract markets designated by the CFTC.\1\ In several 
recent releases \2\ and in response to requests for case-by-case 
review of various proposed offerings,\3\ the Commission has 
addressed the applicability of the Act and Commission regulations to 
various forms of commodity-related instruments offered and sold 
other than on designated contract markets. An overview of off-
exchange transactions and issues was commenced by issuance in 
December 1987 of an Advance Notice of Proposed Rulemaking (Advance 
Notice). The Advance Notice requested comment concerning, among 
other things, a proposed no-action position concerning certain 
commercial transactions, which, as described, would have extended to 
certain categories of swap transactions.
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    \1\ 7 U.S.C. 6(a), 6c(b), 6c(c). Section 4(a) of the CEA 
provides, inter alia, that it is unlawful to enter into a commodity 
futures contract that is not made ``on or subject to the rules of a 
board of trade which has been designated by the Commission as a 
`contract market' for such commodity.'' 7 U.S.C. 6(a). This 
prohibition does not apply to futures contracts made on or subject 
to the rules of a foreign board of trade, exchange or market. 7 
U.S.C. 6(a). The exchange trading requirement reflects Congress's 
view that such an environment would control speculation and promote 
hedging. H.R. Rep. No. 44, 67th Cong., 1st Sess. 2 (1921). See also 
7 U.S.C. 5 (Congressional findings concerning necessity for 
regulation of futures and commodity option transactions). Pursuant 
to Sections 4c(b) and 4c(d), 7 U.S.C. 6c(b) and 6c(d), of the CEA, 
the Commission has authority to permit transactions in commodity 
options which do not take place on contract markets. Currently, only 
two narrow categories of such option transactions exist: trade 
options (in which the offeree is a ``commercial user'' of the 
underlying commodity) and dealer options (in which the grantor 
fulfills the criteria of Section 4c(d)(1) of the CEA). See also 54 
FR 1128 (January 11, 1989) (Proposed Rules Concerning Regulation of 
Hybrid Instruments); Final Rules Concerning Regulation of Hybrid 
Instruments, published elsewhere in this issue.
    \2\ 52 FR 47022 (December 11, 1987) (Advance Notice of Proposed 
Rulemaking); 54 FR 1139 (January 11, 1989) (Statutory Interpretation 
Concerning Certain Hybrid Instruments); 54 FR 1128 (January 11, 
1989) (Proposed Rules Concerning Regulation of Hybrid Instruments). 
See also 50 FR 42963 (October 23, 1985) (Statutory Interpretation 
and Request for Comments Concerning Trading in Foreign Currencies 
for Future Delivery).
    \3\ The Commission staff's Task Force on Off-Exchange 
Instruments has addressed a number of proposed offerings of hybrid 
instruments in a series of published ``no-action'' letters. See, 
e.g., CFTC Advisory No. 39-88, June 23, 1988 [Interpretative Letter 
No. 88-10, June 20, 1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,262] 
(notes indexed to dollar/Yen exchange rate); CFTC Advisory No. 45-
88, July 19, 1988 [Interpretative Letter No. 88-11, July 13, 1988, 2 
Comm. Fut. L. Rep. (CCH) para. 24,284] (notes indexed to dollar/Yen 
exchange rate); CFTC Advisory No. 48-88, July 26, 1988 
[Interpretative Letter No. 88-12, July 22, 1988, 2 Comm. Fut. L. 
Rep. (CCH) para. 24,285] (notes indexed to dollar/foreign currency 
exchange rate); CFTC Advisory No. 58-88, August 30, 1988 
[Interpretative Letter No. 88-16, August 26, 1988, 2 Com. Fut. L. 
Rep. (CCH) para. 24,312] (federally-chartered corporation issuing 
notes indexed to nationally disseminated measure of inflation 
published by a U.S. government agency); CFTC Advisory No. 63-88, 
September 21, 1988 [Interpretative Letter No. 88-17, September 6, 
1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,320] (fixed-rate 
debentures with additional payments indexed to the price of natural 
gas over an established base price); CFTC Advisory No. 66-88, 
September 23, 1988, 2 Comm. Fut. L. Rep. (CCH) para. 24,321 
(certificates of deposit with interest payable at maturity indexed 
in part to the spot price of gold). See also CFTC Advisory No. 18-
19, March 17, 1989 (letter dated November 23, 1988, concerning 
proposed sale of hay for delayed delivery).
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    (2) Based upon careful review of the comments received in 
response to the Advance Notice, indicating generally a need for 
greater clarity in this area, representations from market users, and 
consultations with other federal regulators concerning the issues 
raised by swap transactions, the Commission is issuing this policy 
statement to clarify its view of the regulatory status of certain 
swap transactions. This statement reflects the Commission's view 
that at this time most swap transactions, although possessing 
elements of futures or options contracts, are not appropriately 
regulated as such under the Act and regulations. This policy 
statement is intended to recognize a non-exclusive safe harbor for 
transactions satisfying the requirements set forth herein.

[[Page 39037]]

(b) Safe Harbor Standards

    (1) In determining whether a transaction constitutes a futures 
contract, the Commission and the courts have assessed the 
transaction ``as a whole with a critical eye toward its underlying 
purpose.'' \4\ Such an assessment entails a review of the ``overall 
effect'' of the transaction as well as a determination as to ``what 
the parties intended.'' \5\ Although there is no definitive list of 
the elements of futures contracts, the CFTC and the courts recognize 
certain elements as common to such contracts.\6\ Futures contracts 
are contracts for the purchase or sale of a commodity for delivery 
in the future at a price that is established when the contract is 
initiated, with both parties to the transaction obligated to fulfill 
the contract at the specified price. In addition, futures contracts 
are undertaken principally to assume or shift price risk without 
transferring the underlying commodity. As a result, futures 
contracts providing for delivery may be satisfied either by delivery 
or offset.
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    \4\ CFTC v. Co. Petro Marketing Group, Inc., 680 F.2d 573, 581 
(9th Cir. 1982).
    \5\ CFTC v. Trinity Metals Exchange, No. 85-1482-CV-W-3 (W.D. 
Mo. January 21, 1986] [citing CFTC v. National Coal Exchange, Inc. 
[1980-1982 Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 21,424 at 
26,046 (W.D. Tenn. 1982)].
    \6\ See generally, 52 FR 47022, 47023 (December 11, 1987) 
(citing In the Matter of First National Monetary Corp., [1984-1986 
Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 22,698 (CFTC 1985)); 
Letter to the Honorable Patrick Leahy and the Honorable Richard 
Lugar, Committee on Agriculture, Nutrition and Forestry, United 
States Senate, from Wendy L. Gramm, Chairman, Commodity Futures 
Trading Commission, dated May 16, 1989 (Attachment at 7-8). The 
Commission has explained that this does not mean that ``all 
commodity futures contracts must have all of these elements * * *'' 
In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) 
para. 20,941 (CFTC 1979). To hold otherwise would permit ready 
evasion of the CEA.
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    (2) In addition to these necessary elements, the CFTC and the 
courts also recognize certain additional elements common to 
exchange-traded futures contracts, including standardized commodity 
units, margin requirements related to price movements, clearing 
organizations which guarantee counterparty performance, open and 
competitive trading in centralized markets, and public price 
dissemination.\7\ These additional elements facilitate the trading 
of futures contracts on exchanges and historically have developed in 
conjunction with the growth of organized contract markets. The 
presence or absence of these additional elements, however, is not 
dispositive of whether a transaction is a futures contract.\8\
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    \7\ E.g., Advance Notice, 52 FR at 47023; Letter to the 
Honorable Patrick Leahy and the Honorable Richard Lugar, Committee 
on Agriculture, Nutrition and Forestry, United States Senate, from 
Wendy L. Gramm, Chairman, Commodity Futures Trading Commission, 
dated May 16, 1989 (Attachment at 8); OGC Statutory and Regulatory 
Interpretation (Regulation of Leverage Transactions and Other Off-
Exchange Future Delivery-Type Instruments), 50 FR 11656, 11657, n.2 
(March 25, 1985); CFTC v. Co Petro Marketing Group, Inc., 680 F.2d 
573 (9th Cir. 1982).
    \8\ In addition, the Commission and the courts have consistently 
recognized that ``the requirement that a futures contract be 
executed on a designated contract market is what makes the contract 
legal, not what makes it a futures contract.'' In the Matter of 
First National Monetary Corp., [1984-1986 Transfer Binder] Comm. 
Fut. L. Rep. (CCH) para. 22,698 at 30,975 (CFTC 1985); In re 
Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 
20,941 at 23,776 (CFTC 1979). See, also, Interpretative Statement, 
``The Regulation of Leverage Transactions and Other Off-Exchange 
Future Delivery Type Investments-Statutory Interpretation,'' 50 FR 
11656 (March 25, 1985).
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    (3) In general, a swap may be characterized as an agreement 
between two parties to exchange a series of cash flows measured by 
different interest rates, exchange rates, or prices with payments 
calculated by reference to a principal base (notional amount).\9\ 
Commenters have described the swap market as one in which the 
customary large transaction size effectively limits the market to 
institutional participants rather than the retail public.\10\ Market 
participants also have noted that swaps typically involve long-term 
contracts, with maturities ranging up to twelve years.\11\ In 
addition to these characteristics, many comparisons between swaps 
and futures contracts have stressed the tailored, non-standardized 
nature of swap terms; the necessity for particularized credit 
determinations in connection with each swap transaction (or series 
of transactions between the same counterparties); the lack of public 
participation in the swap markets; and the predominantly 
institutional and commercial nature of swap participants. Other 
commenters have stressed that, despite these distinctions in the 
manner of trading of swaps and exchange products, the economic 
reality of swaps nevertheless resembles that of futures contracts.
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    \9\ See generally, Bank for International Settlements, Recent 
Innovations in International Banking at 37-60 (April 1986); S. K. 
Henderson, ``Swap Credit Risk: A Multi-Perspective Analysis,'' 44 
Business Lawyer 365 (1989). Interest rate swaps have been described 
as having three primary forms: coupon swaps (fixed rate to floating 
rate swaps); basis swaps (swap of one floating rate for another 
floating rate); and cross-currency interest rate swaps (swaps of 
fixed rate payments in one currency to floating rate payments in 
another currency). Currency swap transactions involve agreements 
between two parties providing for exchanges of amounts in different 
currencies which are calculated on the basis of a pre-established 
interest rate, a specified exchange rate, and a specified notional 
amount. Commodity swaps generally include swap transactions similar 
in structure to interest rate swaps, except that payments are 
calculated by reference to the price of a specified commodity, such 
as oil.
    \10\ The average notional amount for swaps has been estimated at 
$24 million. Letter from the New York Clearing House to CFTC, dated 
April 6, 1989, commenting on Proposed Rule and Statutory 
Interpretation Concerning Certain Hybrid and Related Instruments.
    \11\ E.g., Letter to CFTC from the International Swap Dealers 
Association, Inc., dated April 8, 1988, concerning Advance Notice; 
letter to CFTC from Morgan Guaranty Trust Company of New York, dated 
April 11, 1988, concerning Advance Notice.
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    (4) The Commission recognizes that swaps generally have 
characteristics, such as individually-tailored terms, predominantly 
commercial and institutional participants, and expectation of being 
held to maturity, rather than offset during the term of the 
agreement, that may warrant distinguishing them from futures 
contracts. The criteria set forth below identify certain swaps for 
which regulation under the CEA and Commission regulations is 
unnecessary. These safe harbor standards are consistent with 
policies reflected in the CEA's jurisdictional exclusion for forward 
contracts,\12\ the Treasury Amendment,\13\ and the trade option 
exemption,\14\ and are otherwise consistent with Section 2(a)(1)(A) 
of the CEA. Although these jurisdictional and exemptive or 
exclusionary provisions are not sufficiently broad to provide clear 
exemptive boundaries for many swaps, they reflect policies relevant 
to the safe harbor policy set forth herein and may encompass certain 
swap transactions.\15\
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    \12\ Section 2(a)(1)(A) of the CEA provides that the term 
``future delivery'' does not include sales of any cash commodity for 
deferred shipment or delivery. 7 U.S.C. 2. Sales of cash commodities 
for deferred delivery, or forward contracts, generally have been 
recognized to be commercial, merchandising transactions in physical 
commodities entered into by commercial counterparties who have the 
capacity to make or take delivery of the underlying commodity but in 
which delivery ``may be deferred for purposes of convenience or 
necessity.'' 52 FR 47027; In re Stovall, [1977-1980 Transfer Binder] 
Comm. Fut. L. Rep. (CCH) para. 20,941 at 23,777-78 (CFTC 1979). The 
forward contract exclusion may apply to certain types of swap 
transactions.
    \13\ The Treasury Amendment provides that ``[n]othing in this 
Act shall be deemed to govern or in any way be applicable to 
transactions in foreign currency, security warrants, security 
rights, resales of installment loan contracts, repurchase options, 
government securities, or mortgages and mortgage purchase 
commitments, unless such transactions involve the sale thereof for 
future delivery conducted on a board of trade.'' 7 U.S.C. 2. See 
generally, 50 FR 42963 (October 23, 1985) (CFTC Statutory 
Interpretation). See also, Commodity Futures Trading Commission v. 
American Board of Trade, 473 F. Supp. 117 (S.D.N.Y. 1979), aff'd, 
803 F.2d 1242 (2d Cir. 1986). The Treasury Amendment may apply to 
some types of transactions also characterized as swaps.
    \14\ The trade option exemption, which is set forth in Rule 
32.4(a), 17 CFR 32.4(a) (1988), authorizes commodity option 
transactions, other than those on commodities specified in rule 
32.2(a), that are not executed on a designated contract market and 
that are:
    Offered by a person which has a reasonable basis to believe that 
the option is offered to a producer, processor, or commercial user 
of, or a merchant handling the commodity which is the subject of the 
commodity option transaction, or the products or byproducts thereof, 
and that such producer, processor, commercial user or merchant is 
offered or enters into the commodity option transaction solely for 
purposes related to its business as such.
    It should be noted that under Rule 32.4(a), only the offeree of 
the trade option need qualify as a ``commercial user'' or 
``merchant.'' Rule 32.4(a) is silent concerning which party to a 
trade option may be the option buyer of a put or call or ``long,'' 
and which party may be the option seller of a put or call or 
``short.'' As a result, provided that the qualifying commercial 
offeree is entering the trade option transaction solely for non-
speculative purposes demonstrably related to its commercial business 
in the commodity which is the subject of the option transaction, the 
requirements of Rule 32.4(a) are met.
    \15\ The forward contract inclusion facilitates commodity 
transactions within the commercial merchandising chain. The trade 
option exemption similarly may be viewed as facilitating principal-
to-principal transactions in which the offeree is a commercial party 
with respect to the underlying commodity. The Treasury Amendment 
reflects Congressional intent to avoid duplicative regulation of 
foreign currency transactions and other transactions in the 
interbank market supervised by bank regulatory agencies.

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[[Page 39038]]

    (5) Consequently, the Commission has determined that a greater 
degree of clarity may be achieved through safe harbor guidelines 
establishing specific criteria for swap transactions to which the 
Commission's regulatory framework will not be applied. Swaps 
satisfying the requirements set forth below will not be subject to 
regulation as futures or commodity option transactions under the Act 
and regulations. This policy statement addresses only swaps settled 
in cash, with foreign currencies considered to be cash.\16\
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    \16\ As noted previously, certain categories of swap 
transactions may be subject to the forward contract exclusion, the 
Treasury Amendment and the trade option exemption. The safe harbor 
criteria set forth herein apply equally to options on swaps.
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    (i) Individually-Tailored Terms
    (A) Individual tailoring of the terms of swap agreements is 
frequently cited as indispensable to the operation of the swap 
market. Commenters have indicated that swap agreements are based 
upon individualized credit determinations and are tailored to 
reflect the particular business objectives of the counterparties. 
Tailoring occurs through private negotiations between the parties 
and may involve not only financial terms but issues such as 
representations, covenants, events of default, term to maturity, and 
any requirement for the posting of collateral or other credit 
enhancement. Such tailoring and counterparty credit assessment 
distinguish swap transactions from exchange transactions, where the 
contract terms are standardized and the counterparty is unknown. In 
addition, the tailoring of swap terms means that, unlike exchange 
contracts, which are fungible, swap agreements are not fully 
standardized.
    (B) To qualify for safe harbor treatment, swaps must be 
negotiated by the parties as to their material terms, based upon 
individualized credit determinations, and documented by the parties 
in an agreement or series of agreements that is not fully 
standardized.\17\ This requirement is intended to exclude from safe 
harbor treatment instruments which are fungible and therefore may be 
readily transferred and traded.
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    \17\ Formation of swaps pursuant to a master agreement between 
two counterparties that establishes some or all contract terms for 
one or more individual swap transactions between those 
counterparties is not precluded by this requirement, provided that 
material terms of the master agreement and transaction 
specifications are individually tailored by the parties.
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    (ii) Absence of Exchange-Style Offset
    (A) Exchange-traded futures contracts generally may be 
terminated by offset,\18\ that is, liquidated through establishment 
of an equal and opposite position. For exchange-traded futures 
contracts, the universal counterparty to each cleared position is 
the clearing organization. Prior consent of the clearing 
organization, as counterparty, is unnecessary to offset.\19\
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    \18\ In the context of exchange-traded futures, offset refers to 
the liquidation of a futures position through the acquisition of an 
opposite position. Availability of such offset, resulting in the 
liquidation of the position, typically is established by exchange 
rules governing exchange members' relationships with the clearing 
house. See, e.g., Chicago Mercantile Exchange Rule 808 (``a clearing 
member long or short any commodity to the Clearing House as a result 
of substitution may liquidate the position by acquiring an opposite 
position for its principal''); Board of Trade Clearing Corporation 
Regulation 705.00 (``Where a member buys and sells the same 
commodity for the same delivery, and such contracts are cleared 
through the Clearing House, the purchases and sales shall be offset 
to the extent of their equality, and the member shall be deemed a 
buyer from the Clearing House to the extent that his purchases 
exceed his sales, or a seller to the Clearing House to the extent 
that his sales exceed his purchases''); New York Futures Exchange 
Rule 3-4 (``As between the Clearing Corporation and the original 
parties to futures contracts and option contracts, such contracts 
shall be binding upon the original parties until liquidated by 
offset, delivery, exercise or expiration, as the case may be''). Of 
course, the ability to offset in any given case depends upon the 
availability of a counterparty to enter into an offsetting 
transaction at an acceptable price.
    \19\ However, the ability to liquidate contractual positions 
through offset is established by clearing organization rules to 
which all clearing members consent.
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    (B) In contrast, swap transactions have been described as 
transactions which create performance obligations terminable only 
with counterparty consent and which generally are expected to be 
maintained to maturity. A swap counterparty who seeks to eliminate 
the economic effect of a swap agreement may enter into a reverse 
swap agreement, that is, a second swap with the same maturity and 
payment requirements, with the same or a new counterparty, but in 
which the party seeking to eliminate its economic exposure assumes 
the reverse position (in this case the obligations of each party to 
both transactions continue to maturity). A swap counterparty who 
seeks to terminate, absent default, its obligations under a swap 
agreement may: (1) Undertake a swap sale in which, based upon 
consent of the counterparty, it assigns its rights and obligations 
under the swap to a third party; or (2) negotiate an early 
termination of the transaction, or swap ``closeout,'' in which it 
negotiates a lump-sum payment with its counterparty to terminate the 
swap.\20\ In the latter two cases, termination of the obligations 
created by a swap is dependent upon consent of the counterparty.
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    \20\ Swap parties may agree in advance upon a termination 
formula or price for the swap.
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    (C) To qualify for safe harbor treatment, the swap must create 
obligations that are terminable, absent default, only with the 
consent of the counterparty. If consent to termination is given at 
the outset of the agreement and a termination formula or price 
fixed, the consent provision must be privately negotiated. This 
requirement is intended to confine safe harbor treatment to 
instruments that are not readily used as trading vehicles, that are 
entered into with the expectation of performance, and that are 
terminated as well as entered into based upon private negotiation.
    (iii) Absence of Clearing Organization or Margin System
    (A) As noted above, the necessity for individualized credit 
determinations has been described as a hallmark of swap 
transactions. A number of commenters have stressed both the 
dependence of the current swap market on such determinations and the 
absence of a multilateral ``credit support'' mechanism, such as a 
clearing organization, for swaps. In accordance with the concept of 
swaps as dependent upon private negotiation and individualized 
credit determinations as to the capacity of certain parties to 
perform, this safe harbor is applicable only to swap transactions 
that are not supported by the credit of a clearing organization and 
that are not primarily or routinely supported by a market-to-market 
margin and variation settlement system designed to eliminate 
individualized credit risk.\21\ The ability to impose individualized 
credit enhancement requirements to secure either changes in the 
credit risk of a counterparty or increases in the credit exposure 
between two counterparties consistent with the above criteria would 
not be affected.
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    \21\ Several commenters urged the Commission to adopt a safe 
harbor for swaps that would be conditioned upon, among other things, 
the absence of a credit support mechanism. See Letter to CFTC from 
Sullivan & Cromwell, dated April 8, 1988, concerning Advance Notice, 
at 41-42; Letter to CFTC from Manufacturers Hanover, dated April 11, 
1988, concerning Advance Notice, at 4. The safe harbor standard is 
based upon individualized credit determinations at the outset and 
during the pendency of the contract.
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    (iv) The Transaction is Undertaken in Conjunction With a Line of 
Business
    (A) The absence of public participation in the swaps market has 
frequently been cited as a factor supporting different regulatory 
treatment of swaps and futures contracts. Swap market participants 
are predominantly institutional and commercial entities such as 
corporations, commercial and investment banks, thrift institutions, 
insurance companies, governments, and government-sponsored or 
chartered entities.\22\
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    \22\ Letter dated April 8, 1988, to CFTC from International Swap 
Dealers Association, Inc. Concerning Advance Notice.
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    (B) The safe harbor set forth herein is limited to swap 
transactions undertaken in conjunction with the parties' line of 
business.\23\ This restriction is intended to preclude public 
participation in qualifying swap transactions and to limit 
qualifying transactions to those based upon individualized credit 
determinations. This restriction does not preclude dealer 
transactions in swaps undertaken in conjunction with a line of 
business, including financial intermediation services.
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    \23\ Swap transactions entered into with respect to exchange 
rate, interest rate, or other price exposure arising from a 
participant's line of business or the financing of its business 
would be consistent with this standard.
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    (v) Prohibition Against Marketing to the Public
    Swap transactions eligible for safe harbor treatment may not be 
marketed to the public. This restriction reflects the institutional 
and commercial nature of the existing swap market and the 
Commission's intention to

[[Page 39039]]

restrict qualifying swap transactions to those undertaken as an 
adjunct of the participant's line of business.
    (c) Conclusion. This policy statement is intended to clarify the 
regulatory treatment of certain transactions in order to facilitate 
legitimate market transactions in a field distinguished by 
innovation and rapid growth. Consequently, the Commission proposes 
to continue to review on a case-by-case basis transactions that do 
not meet the above criteria and that are not otherwise excluded from 
Commission regulation.

    Issued in Washington, D.C., this 8th day of June, 2000, by the 
Commission.
Jean A. Webb,
Secretary of the Commission.

[FR Doc. 00-14917 Filed 6-21-00; 8:45 am]
BILLING CODE 6351-01-U


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