[Federal Register Volume 65, Number 240 (Wednesday, December 13, 2000)]
[Rules and Regulations]
[Pages 78030-78038]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-30270]


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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: Final rules.

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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC) 
is adopting final rules to clarify the operation of the current swaps 
exemption. In addition, in a companion notice of final rulemaking 
published in this edition of the Federal Register, the Commission is 
adopting rules that provide for the clearing of transactions under the 
revised exemption. The Commission, in other companion releases, also is 
adopting a new regulatory framework to apply to multilateral 
transaction execution facilities and to market intermediaries. This new 
framework establishes a number of new market categories, including a 
category of exempt multilateral transaction execution facility. Nothing 
in these releases, however, affects the continued vitality of the 
Commission's exemption for swaps transactions in effect before December 
13, 2000, or any of its other existing exemptions, policy statements or 
interpretations.

EFFECTIVE DATE: February 12, 2001.

FOR FURTHER INFORMATION CONTACT: Paul M. Architzel, Chief Counsel, or 
Nancy E. Yanofsky, Assistant Chief Counsel, Division of Economic 
Analysis, Commodity Futures Trading Commission, Three Lafayette Centre, 
1155 21st Street, NW., Washington, DC 20581. Telephone: (202) 418-5260. 
E-mail: <a href="/cdn-cgi/l/email-protection#24746556474c4d505e414864474250470a434b52"><span class="__cf_email__" data-cfemail="61312013020908151b040d21020715024f060e17">[email protected]</span></a> or <a href="/cdn-cgi/l/email-protection#56180f37383930253d2f163530223578313920"><span class="__cf_email__" data-cfemail="d59b8cb4bbbab3a6beac95b6b3a1b6fbb2baa3">[email protected]</span></a>.

SUPPLEMENTARY INFORMATION:

I. The Proposed Rules

    On June 22, 2000, the Commission published proposed amendments to 
its part 35 swaps exemption to expand and to clarify its operation, 
including the availability of clearing for these transactions.\1\ These 
amendments were proposed in order to provide greater legal certainty to 
the over-the-counter (OTC) markets and to reduce systemic risk. The 
President's Working Group on Financial Markets (PWG) \2\ and the 
chairmen of the Commission's Congressional oversight committees 
encouraged the Commission in this undertaking.
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    \1\ 65 FR 39033 (June 22, 2000).
    \2\ Recognizing the importance of the OTC derivatives markets, 
the chairmen of the Senate and House Agriculture Committees 
requested that the PWG conduct a study of OTC derivatives markets. 
After studying the existing regulatory framework of 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 Derivatives Markets and the Commodity Exchange 
Act, Report of the President's Working Group on Financial Markets 
(PWG Report). The PWG Report focused on promoting innovation, 
competition, efficiency, and transparency in OTC derivatives markets 
and in reducing systemic risk.
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    The Commission proposed the amendments to part 35 in light of the 
changes that have occurred in the 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 $90 
trillion.\3\ OTC derivatives have transformed finance, increasing the 
range of financial products available for managing risk.
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    \3\ See Our Estimates of Global Size Market (visited Oct. 10, 
2000), http://www.swapsmonitor.com.
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    The Commission proposed making several changes to part 35. First, 
the Commission proposed deleting 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. Moreover, as suggested by the PWG Report, the Commission 
proposed to delete the requirement that exempt transactions not be 
fungible or standardized and to make clear that insofar as such exempt 
transactions may be cleared, creditworthiness of the counterparty is 
not a condition of the exemption. PWG Report at 17. In addition, the 
Commission proposed, 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.
    In proposing the rules, the Commission affirmed the continuing 
vitality of the exemptive relief that it had previously granted to 
transactions in the OTC market, including the part 35 exemption, the 
Policy Statement Concerning Swap Transactions (54 FR 30694 (July 21, 
1989)) (Swaps Policy Statement), the Statutory Interpretation 
Concerning Forward Transactions (55 FR 39188 (Sept. 25, 1990)) (Energy 
Interpretation), and the Exemption for Certain Contracts Involving 
Energy Products (58 FR 21286 (April 20, 1993)) (Energy Exemption). 
Moreover, in recognition of its continuing vitality and to assist the 
public in locating it, the Commission proposed publishing the Swaps 
Policy Statement as Appendix A to part 35.

II. Comments Received

    The Commission received 31 comment letters on the proposed 
rulemaking.\4\ The commenters included

[[Page 78031]]

nine trade associations,\5\ three future exchanges,\6\ two brokerage 
firms,\7\ a coalition of commercial and investment banks,\8\ four law 
firms,\9\ four representatives of the energy services community,\10\ an 
agricultural firm \11\ and others.\12\
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    \4\ In addition to these 31, a significant number of letters 
commenting on aspects of the regulatory framework in companion 
notices were also submitted to the Commission. In this and three 
companion Notices of Final Rulemaking which are being published in 
this edition of the Federal Register, comment letters (CLs) are 
referenced by file number, letter number and page. Comments filed in 
response to the notice of proposed rulemaking on multilateral 
transaction execution facilities, parts 36-38, are contained in file 
No. 21, on the notice of proposed rulemaking on intermediaries in 
file No. 22, on the notice of proposed rulemaking on clearing 
organizations in file No. 23 and on the notice of proposed 
rulemaking on the part 35 exemption in file No. 24. These letters 
are available through the Commission's internet web site, http://www.cftc.gov.
    \5\ The associations that filed comment letters are the Managed 
Funds Association, the International Swaps and Derivatives 
Association, Inc., the National Grain and Feed Association, the 
Futures Industry Association, the Commodity Floor Brokers & Traders 
Association, the Silver Users Association, the Weather Risk 
Management Association, the Association for Investment Management 
and Research, Advocacy Advisory Committee, Derivatives Subcommittee, 
and the Securities Industry Association, OTC Derivatives Products 
Committee.
    \6\ The futures exchanges that filed comment letters are the 
Chicago Board of Trade, the New York Mercantile Exchange and the 
Chicago Mercantile Exchange.
    \7\ The brokerage firms that filed comment letters are Merrill 
Lynch & Co. Inc. and J.P. Morgan Securities Inc.
    \8\ The coalition of commercial and investment banks (the 
Coalition) consists of the following financial institutions: The 
Chase Manhattan Bank, Citigroup Inc., Credit Suisse First Boston 
Inc., Goldman Sachs & Co., Merrill Lynch & Co., Inc. and Morgan 
Stanley Dean Witter & Co.
    \9\ The law firms that filed comment letters are Covington & 
Burling, McDermott, Will & Emery, on behalf of Virginia Electric & 
Power Company, Vinson and Elkins, and Gardner, Carter and Douglas.
    \10\ The representatives of the energy services community that 
filed comment letters are Williams Energy Marketing and Trading 
Company, the California Power Exchange, Oxy Energy Services, Inc. 
and Petrocosm Corporation.
    \11\ The agricultural firm that filed a comment letter is 
Cargill.
    \12\ The others filing comment letters are the National Futures 
Association, the Financial Markets Lawyers Group, the Federal 
Reserve Bank of Chicago, the U.S. Department of the Treasury, the 
Regulatory Studies Program of the Mercatus Center, Reuters Group 
PLC, and The EBS Partnership.
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    The majority of commenters strongly supported the Commission's 
proposed amendments and expressed the view that the amendments, among 
other things, would increase legal certainty for the OTC market. Two 
commenters took the opposite view, expressing jurisdictional concerns. 
The commenters also raised a number of technical issues concerning the 
operation of the exemption, the definition of ``eligible participant'' 
and other matters. The comments are addressed in the final rules 
section below.

III. The Final Rules

A. The Exemption

    Except for certain technical changes, the Commission is adopting 
the proposed rules expanding and clarifying the operation of the swaps 
exemption as final rules. As noted above, the majority of commenters 
strongly supported the amendments, expressing the view that they will 
increase legal certainty for the OTC market and reduce systemic risk. 
See, e.g., CL 24-6; CL 24-8; CL 24-25; CL 24-29; CL 24-30; CL 24-31; CL 
24-34; CL 24-36. The International Swaps and Derivatives Association 
(ISDA) views the proposed amendments as necessary to ensuring that new 
and evolving risk management tools will enjoy legal certainty 
comparable to that which has been available to transactions covered by 
the Commission's swaps exemption since 1993. CL 24-8 at 2. See also CL 
24-6 at 3; CL 24-29 at 3-4. ISDA specifically commented that: The 
proposed expansion of the exemption to cover all bilateral agreements 
would ``enable market participants to focus on legal and economic 
substance rather than labels'' (CL 24-8 at 3); that the elimination of 
the requirement that exempt transactions not be standardized or 
fungible would ``eliminate a potential source of uncertainty with 
respect to the scope of the exemption'' (id.); that the authorization 
of clearing would ``eliminate the `Hobson's Choice' that now exists 
between legal certainty and the use of clearing to reduce systemic 
risk'' (id.); and that the nonrepudiation provisions would deal 
directly with the ``main source of legal risk under the CEA'' (id. at 
5). As ISDA noted, the substantial growth of the OTC swaps market since 
the Commission first promulgated part 35 in 1993:

did not occur in a vacuum. It was fostered by this Commission in an 
earlier regulatory initiative commencing with the release of the 
Swaps Policy Statement in 1989 and continuing with the promulgation 
of the Swaps Exemption * * * and the Hybrids Exemption * * * These 
latter actions were of course entirely consistent with the intent of 
Congress, as reflected in the enactment of the Futures Trading 
Practices Act of 1992. * * * The pivotal role that OTC derivatives 
transaction [sic] now play in our economy is an outgrowth of these 
earlier policies of the Commission and the continuing expressions of 
support for those policies by Congress. ISDA believes that the 
proposed regulatory initiative now under consideration can and 
should be viewed as a vital and positive step in carrying out the 
Commission's long-standing policy with respect to OTC derivatives.
    ISDA believes that * * * the proposed regulatory initiative is 
an important change for the better. We applaud the sensitivity of 
both the Commission and its professional staff to the need to avoid 
structuring the proposals in ways that could result in legal 
uncertainty, and we believe that the proposals will not have this 
effect. We likewise applaud the decision of the Commission to 
propose specific actions intended to increase, within the parameters 
of the CEA, legal certainty and we believe the proposals will have 
this effect. * * *

(CL 24-8 at 2; emphasis in original).
    One commenter, however, the Regulatory Studies Program of the 
Mercatus Center (Mercatus), expressed the view that, by expanding the 
category of products to which the exemption applies, the Commission may 
exacerbate rather than reduce legal uncertainty. CL 24-21 at 4-5. 
Mercatus is concerned about the ``implications'' of the broad 
definitions used, commenting that, if adopted as proposed, the 
Commission could attempt to exercise its antifraud authority over 
contracts, agreements and transactions as to which it has no 
jurisdiction. Id. Mercatus suggests that the Commission instead limit 
the scope of part 35 to instruments over which the Act vests the 
Commission with jurisdiction, such as ``contracts of sale of a 
commodity for future delivery.'' Id. at 9.\13\
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    \13\ J.P. Morgan Securities Inc. (J.P. Morgan) raises 
jurisdictional issues similar to those raised by Mercatus, while 
specifically focusing on the Commission's proposed rules concerning 
exempt multilateral transaction execution facilities and recognized 
clearing organizations. CL 24-19 at 2-5. The Commission is 
responding to those comments more thoroughly in its companion 
releases on those matters.
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    These amendments, however, do not expand the Commission's 
jurisdiction. To the contrary, the substance of part 35's scope 
provision remains unchanged from the current part 35 exemption.\14\ 
Furthermore, the Commission's antifraud authority in rule 35.3, as 
proposed and as being adopted herein, is limited to ``transactions and 
persons otherwise subject to those [antifraud] provisions'' (emphasis 
added). Thus, the antifraud provisions will continue to apply only to 
those transactions already covered by them. The Commission's approach 
is consistent with how Congress intended the Commission to exercise its 
exemptive authority.\15\
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    \14\ Commission rule 35.1(a) provides that the provisions of the 
exemption apply to any transaction ``which may be subject to the 
Act'' (emphasis added). The final rules amend this scope provision 
to incorporate a technical amendment which substitutes the phrase 
``any contract, agreement or transaction'' for ``any swap 
agreement.'' This change merely conforms the formal statement of 
scope in rule 35.1(a) to the substantive provisions of the rule.
    \15\ 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.
    H.R. Rep. No. 978, 102d Cong., 2d Sess. 82-83 (1992). The 
Commission did not make a determination in 1993 that the 
transactions that it was exempting under part 35 were or were not 
subject to its jurisdiction. The Commission similarly declined to 
make any such determination in proposing the current amendments to 
part 35 and will not make any such determination now.

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[[Page 78032]]

    Moreover, the contract nonrepudiation provision that the Commission 
is adopting today further removes any potential legal uncertainty. As 
one commenter, McDermott, Will & Emery, on behalf of Virginia Electric 
& Power Company, noted, this provision ``would prevent economically 
disappointed counterparties from bringing a private cause of action 
seeking to void the contract on the theory that it is illegal.'' CL 24-
25 at 2. This provision, as ISDA commented, will reduce legal 
uncertainty because ``[it] deal[s] directly with the main source of 
legal risk under the CEA.'' CL 24-8 at 5.
    The expansion of the exemption to cover all bilateral ``contracts, 
agreements and transactions'' was endorsed by most other commenters. As 
one commenter, Reuters Group PLC, noted, this amendment should permit a 
``substantially broader range of transactions to enjoy a new level of 
legal certainty.'' CL 24-30 at 2. In this regard, the Commission 
believes that certain pending matters may now be considered within the 
context of the new regulatory framework.
    Two commenters, a coalition of commercial and investment banks (the 
Coalition)\16\ and the OTC Derivatives Products Committee of the 
Securities Industry Association (SIA), recommended two changes 
regarding the operation of the exemption. CL 24-31; CL 24-36. First, 
they suggested that the Commission delete the requirement of the 
exemption that, in cases where a transaction is not submitted for 
clearing,\17\ the creditworthiness of the counterparty be a material 
consideration in entering into the transaction. These commenters 
believe that retention of the creditworthiness requirement for non-
cleared transactions will create uncertainty and confusion as to what 
types of non-cleared transactions are permissible. The Commission 
agrees and has deleted the creditworthiness requirement from part 35.
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    \16\ See note 8, supra.
    \17\ For rules pertaining to clearing, see part 39 which the 
Commission is adopting in a companion release in this edition of the 
Federal Register.
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    The Coalition and SIA also recommended that rule 35.2(d) be amended 
to authorize explicitly the netting of deliveries or delivery 
obligations in connection with transactions pursuant to part 35. 
Currently, part 35 permits bilateral arrangements for the netting of 
payment obligations. It also permits multilateral arrangements for the 
netting of payments ``provided that the underlying gross obligations 
among the parties are not extinguished until all netted obligations are 
fully performed.'' 58 FR at 5591. SIA commented that many categories of 
OTC derivatives require or permit settlement by delivery, that it can 
see no policy reason for excluding netting of such deliveries while 
permitting netting of payments, and that permitting such netting would 
be consistent with the goal of reducing systemic risk for OTC 
derivatives. CL 24-36 at 10. In light of these comments, the Commission 
is clarifying that the types of netting agreements that are permissible 
under part 35 include arrangements for the netting of delivery 
obligations or deliveries, respectively. As is currently the case for 
multilateral netting of payments, multilateral netting of deliveries 
would be permitted provided that the underlying gross obligations among 
the parties are not extinguished until all netted obligations are fully 
performed.
    ISDA, the Coalition and SIA suggested that the Commission clarify 
that the determination whether a party is an eligible participant is to 
be determined by whether there was a reasonable belief at the time the 
transaction was entered into that a party was an eligible participant. 
CL 24-8 at 3; CL 24-31 at 8; CL 24-36 at 8. The language of the 
exemption currently tracks the language of the statute, which provides 
that the Commission shall not grant an exemption under section 4(c) of 
the Act unless the Commission determines that the exempted transaction 
``will be entered into solely between appropriate persons.'' 7 U.S.C. 
6(c)(2)(B)(i). However, as the Commission noted when it adopted the 
swaps exemption in 1993 (58 FR at 5589; footnotes omitted):

    As the Act specifies that the swap agreement may only be 
``entered into'' by appropriate persons, this determination is to be 
made at the inception of the transaction. Further, it is sufficient 
that the parties have a reasonable basis to believe that the other 
party is an eligible swap participant at such time.

Furthermore, the Commission notes that the nonrepudiation provision 
specifically exempts a party from a rescission action based solely on 
the failure of the agreement to comply with the terms of the exemption 
when that party entered into the agreement with an eligible participant 
or with a counterparty ``reasonably believed by such party at the time 
the transaction was entered into'' to be an eligible counterparty.\18\
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    \18\ The Commission has made a technical change to the 
nonrepudiation provision in rule 35.3(b) to make clear that the 
reasonable belief is to exist at the time the transaction is entered 
into. In addition, the Commission has reorganized the nonrepudiation 
provisions of section 35.3.
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    As part of its proposed amendments to part 35, the Commission 
proposed to publish its Swaps Policy Statement as Appendix A to part 35 
and to include its Swaps Policy Statement and its Statutory 
Interpretation Concerning Certain Hybrid Instruments (55 FR 13582 
(April 11, 1990)) (Hybrid Interpretation) within the nonrepudiation 
provision. The commenters generally supported these proposals, but 
recommended that the Commission update the Swaps Policy Statement, 
provide additional relief regarding the Treasury Amendment (7 U.S.C. 
2(ii)) and revise and update the Hybrid Interpretation. CL 24-31 at 14-
16; CL 24-36 at 3-7. As the Commission has noted, nothing in these 
rules affects the continuing vitality of the Commission's existing 
exemptions, policy statements or interpretations. The Commission is 
persuaded, however, that these commenters have raised important issues 
which, although outside the scope of this rulemaking, should be 
addressed expeditiously. The Commission plans to address these issues 
through a separate rulemaking or other appropriate action.

B. Eligible Participants

    A number of commenters suggested changes to the definition of 
``eligible participant'' in rule 35.1. The Commission proposed applying 
the definition of eligible participant set forth in the 1993 swaps 
exemption\19\ to the revised and amended bilateral transaction 
exemption in part 35. Two commenters, the Managed Funds Association 
(MFA) and the Futures

[[Page 78033]]

Industry Association (FIA), suggested that the Commission create a new 
category of eligible participant that would include certain large 
commodity trading advisors. CL 24-4 at 4; CL 24-12 at 11. Specifically, 
MFA and FIA suggested that commodity trading advisors (CTAs) with at 
least $25 million in assets under management be permitted to trade in 
all exempt markets on behalf of their customers, without regard to the 
individual customers' financial qualifications. FIA also suggested that 
registered investment advisers (IAs) with at least $25 million in 
assets under management be included in this category of eligible 
participant.
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    \19\ That definition generally uses the list of ``appropriate 
persons'' set forth in section 4(c)(3)(A) through (J) of the Act, 
and utilizes the authority granted by section 4(c)(3)(K) to 
determine other persons to be appropriate persons (specifically, 
natural persons with total assets exceeding at least $10 million). 
The Commission placed certain financial and other limitations on 
various categories of appropriate persons, consistent with Congress' 
intent that the Commission may limit the terms of an exemption to 
some, but not all, of the listed categories of appropriate persons. 
See H.R. Rep. No. 978, 102nd Cong., 2d Sess. 79 (1992).
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    Several other commenters suggested additional modifications to the 
definition of eligible participant. ISDA, the Coalition, The EBS 
Partnership and SIA recommended that the definition of eligible 
participant be expanded to include several additional categories of 
financial institutions and to include agency transactions by eligible 
participants on behalf of other eligible participants. CL 24-8; CL 24-
31; CL 24-34; CL 24-36. Certain commenters, including the California 
Power Exchange, the National Grain and Feed Association (NGFA) and the 
Weather Risk Management Association, suggested that the financial 
thresholds for corporations and other entities were too restrictive. CL 
24-5; CL 24-10; CL 24-28. Other commenters, including the FIA, the 
Coalition and SIA, commented that the financial threshold for natural 
persons who enter into exempt transactions for risk management purposes 
should be reduced from a total asset test of $10 million to a total 
asset test of $5 million. CL 24-12; CL 24-31; CL 24-36. Finally, the 
National Futures Association suggested that the Commission impose a $5 
million asset test on investment companies to conform the standard for 
those collective investment vehicles to that which applies to commodity 
pools. CL 24-4.\20\
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    \20\ Many commenters also suggested modifications to the 
Commission's proposed definition of ``multilateral transaction 
execution facility'' in part 36. These comments are addressed in a 
companion release being issued by the Commission today adopting 
final rules governing multilateral transaction execution facilities. 
In this regard, the Commission notes that the use of the term 
``bilateral'' in the title of part 35 does not import any 
independent requirements regarding the exemption. Taken together, 
however, part 35 governing bilateral transactions and parts 36 
through 38 governing multilateral transactions execution facilities 
are intended to be seamless in the sense that transactions that do 
not fall within the definition of multilateral transaction execution 
facility in part 36 will be considered to be bilateral.
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    After careful consideration of these comments, the Commission is 
modifying the definition of eligible participant to permit agency 
transactions by eligible participants on behalf of other eligible 
participants,\21\ to include foreign banks and their U.S. branches and 
agencies and the regulated subsidiaries and affiliates of insurance 
companies within that definition and to include a $5 million asset test 
for investment companies (as is required for investment companies under 
the current part 36). The Commission will consider MFA's and NFA's 
suggestion that a new category of eligible participant be added for 
registered CTAs and IAs with at least $25 million in assets under 
management in conjunction with its subsequent review of relief for CPOs 
and CTAs.\22\
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    \21\ In light of this general agency authorization by eligible 
participants on behalf of other eligible participants, the 
Commission is deleting the language in paragraphs 35.1(b)(2)(i), 
(ix) and (x) which specifically authorizes certain entities such as 
banks and futures commission merchants that are eligible 
participants to act in an agency capacity on behalf of other 
eligible participants. See 7 U.S.C. 6(c)(3)(A), (I) and (J). This 
specific authorization is now unnecessary.
    \22\ In a companion release being issued in this edition of the 
Federal Register, however, the Commission has modified the access 
standards for CTAs to provide that CTAs with at least $25 million 
under management may trade on a recognized derivatives transaction 
facility through any registered futures commission merchant. 
Moreover, in response to the comments of the futures exchanges, in 
the same companion release being issued today, the Commission has 
modified the eligibility standards for recognized derivatives 
transaction facilities to include certain registered floor brokers 
and floor traders. The Commission, however, is retaining the 
existing eligibility standards for floor brokers and floor traders 
when entering into bilateral transactions under part 35 (and when 
trading on exempt multilateral transaction execution facilities).
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    In response to the comments regarding expanding the categories of 
eligible financial institutions and reducing the financial thresholds 
for corporations and other entities, the Commission notes that the 
current definition of eligible participant contains a general corporate 
category, which itself contains alternative means of qualifying, and 
that this general corporate category enables many different types and 
sizes of entities (including financial institutions) to qualify as 
eligible participants under part 35. As the Coalition acknowledges (CL 
24-31 at 6), many financial institutions that are not specifically 
encompassed by the definition of eligible participant fall within this 
general corporate category. The Commission believes that this general 
corporate category is an appropriate standard to determine corporate 
eligibility.\23\
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    \23\ Furthermore, with regard to the comments suggesting that 
some of the financial thresholds in the definition are too 
restrictive, the Commission notes that the part 35 definition of 
eligible participant has worked well over the years and that the 
amounts in real terms are less restrictive than when the exemption 
was first adopted.
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C. Agricultural Trade Options

    Finally, the NGFA and Cargill opined that the bilateral transaction 
exemption should be available for all transactions in the agricultural 
commodities enumerated in section 1a(3) of the Act, including 
agricultural trade options. CL 24-10 at 3; CL 24-15 at 1-2. The 
Commission is retaining in part 35 its reservation of rule 32.13 which 
governs trading in certain agricultural trade options at this time.\24\ 
The Commission has not yet had sufficient experience with rule 32.13, 
which the Commission recently reconsidered and adopted (64 FR 68011 
(December 6, 1999)), to determine whether the $10 million net worth 
level should be modified. Furthermore, at the time the Commission 
adopted that exemptive level it noted the lack of industry consensus on 
the issue. Id. at 68015. The Commission has no reason to believe that a 
greater level of consensus has been reached since that time.
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    \24\ Rule 32.13 includes its own exemption which imposes a 
different financial threshold than part 35. Under rule 32.13(g), an 
option is exempt from various regulatory requirements if, among 
other things, each party to the option has a net worth of not less 
than $10 million. The Commission has reserved the application of 
rule 32.13 in part 35, see rule 35.3(a), and it is that reservation 
to which NGFA and Cargill object.
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    The Commission reiterates that these amendments to the part 35 
exemption are designed to enhance legal certainty. In adopting these 
amendments to part 35, the Commission is not making 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.\25\

    \25\ H.R. Rep. No. 978, 102d Cong., 2d Sess. 82-83 (1992).

    Moreover, these changes in no way call into question any 
transaction undertaken under part 35 before the adoption of these 
amendments. In recognition of its continuing vitality and to assist the 
public in locating it, the Commission as proposed is incorporating its 
1989 Swaps Policy

[[Page 78034]]

Statement as Appendix A to part 35.\26\ Finally, the Commission again 
affirms the continuing applicability of its Energy Interpretation and 
its Energy Exemption which are not being changed or altered in any way 
by these part 35 amendments.
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    \26\ The Swaps Policy Statement originally was published at 54 
FR 30694 (July 21, 1989). In this republication, the Commission has 
corrected certain typographical errors that appeared in the original 
publication.
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III. Section 4(c) Findings

    These rule amendments are being promulgated 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 
from any of the requirements of any provision of the Act. For any 
exemption granted pursuant to section 4(c), the Commission must find 
that the exemption would be consistent with the public interest. For 
any exemption granted pursuant to section 4(c) from the requirements of 
section 4(a), the Commission must further find that the section 4(a) 
requirements should not be applied to the agreement, contract or 
transaction to be exempted, that the exemption would be consistent with 
the public interest and the purposes of the Act, 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.\27\
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    \27\ See 7 U.S.C. 6(c).
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    No one commented directly on the Commission's section 4(c) 
findings. Two U.S. futures exchanges, the Chicago Board of Trade and 
the Chicago Mercantile Exchange, however, cautioned the Commission to 
ensure that traditional exchange markets would not be put at an unfair 
competitive disadvantage within this new regulatory regime contemplated 
by this and the Commission's companion Federal Register releases. CL 
24-7 at 12-13; CL 24-17 at 13-14. In this regard, the Commission 
believes that the regulatory lines that it has drawn are necessary and 
appropriate to protect the public interests embodied in the Act. Under 
the framework as a whole, the degree of regulation will turn on whether 
the market is multilateral, whether the market participants are 
eligible and whether or not the commodity is susceptible to 
manipulation. The Commission believes that these are appropriate 
factors on which to base regulatory differences and that, within the 
framework, the exchanges will be able to fairly compete with the OTC 
market.
    The proposed exemption for bilateral transactions is available only 
to appropriate persons. Moreover, these amendments to part 35 will 
promote financial innovation and fair competition 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. Finally, the Commission finds that 
these amendments are consistent with the public interest.

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. A small entity is defined to include, 
inter alia, a ``small business'' and a ``small organization.'' 5 U.S.C. 
601(6).\28\ The Commission previously has formulated its own standards 
of what constitutes a small business with respect to the types of 
entities regulated by it. The Commission has determined that contract 
markets, futures commission merchants, registered commodity pool 
operators, and large traders should not be considered small entities 
for purposes of the RFA.\29\
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    \28\ ``Small organization,'' as used in the RFA, means ``any 
not-for-profit enterprise which is independently owned and operated 
and is not dominant in its field * * *.'' 5 U.S.C. 601(4). The RFA 
does not incorporate the size standards of the Small Business 
Administration for small organizations. Agencies are expressly 
authorized to establish their own definition of small organization. 
Id.
    \29\ 47 FR 18618-20 (Apr. 20, 1982).
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    The Commission believes that it is unlikely that firms defined as 
small businesses under Section 3 of the Small Business Act could offer 
or be offered transactions subject to the part 35 exemption and thus be 
affected by the rules exempting such transactions. See 58 FR 5587, 5593 
(January 22, 1993). Further, the amendments to part 35 that the 
Commission is adopting today remove the requirement that the exempt 
transactions not be fungible or standardized as to their material 
economic terms and makes the expanded relief available to a broader 
category of transactions.
    Accordingly, the Chairman, on behalf of the Commission, certifies 
pursuant to section 3(a) of the RFA, 5 U.S.C. 605(b), that the 
amendments to part 35 will not have a significant economic impact on a 
substantial number of small entities. In this regard, the Commission 
notes that it did not receive any comments regarding the RFA 
implications of the amendments to part 35.

B. Paperwork Reduction Act

    The Paperwork Reduction Act (PRA) of 1995 (44 U.S.C. 3507(d)) 
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. As the Commission 
noted in proposing these amendments, it has determined that the PRA 
does not apply to these amendments because they do not contain 
information collection requirements which require the approval of the 
Office of Management and Budget. No comments were received concerning 
the Commission's determination in this regard.

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, 4c, and 8a thereof, 7 U.S.C. 2, 6, 6c, and 12a, the Commission 
hereby revises part 35 of title 17 of the Code of Federal Regulations 
to read as follows:

PART 35--EXEMPTION OF BILATERAL AGREEMENTS

Sec.
35.1  Scope and definitions.
35.2  Exemption.
35.3  Enforceability.
Appendix A to Part 35--Policy Statement Concerning Swap Transactions

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


Sec. 35.1  Scope and definitions.

    (a) Scope. The provisions of this part shall apply to any contract, 
agreement or transaction which may be subject to the Act, and which has 
been entered into on or after October 23, 1974.
    (b) Definition. As used in this part, ``eligible participant'' 
means, and shall be limited to, the following persons or classes of 
persons, either trading for their own account or through another 
eligible participant:
    (1) A bank or trust company or a foreign bank or a branch or agency 
of a

[[Page 78035]]

foreign bank (as defined in section 1(b) of the International Bank Act 
of 1978 (12 U.S.C. 3101(b));
    (2) A savings association or credit union;
    (3) An insurance company that is regulated by a State or that is 
regulated by a foreign government and is subject to comparable 
regulation (including a regulated subsidiary or affiliate of such 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 and has total assets exceeding $5,000,000;
    (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 contract, agreement or 
transaction are guaranteed or otherwise supported by a letter of credit 
or keepwell, support, or other agreement by any such entity referenced 
in paragraph (b)(6) 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: 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: 
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.


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 
contract, agreement or transaction, 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 either trading for their own account or 
through another eligible participant;
    (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) The contract, agreement or transaction, if cleared, is 
submitted for clearance or settlement to a clearinghouse that is 
authorized under Sec. 39.2 of this chapter.
    (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 or 
delivery obligations resulting from such contracts, agreements or 
transactions;
    (2) Arrangements or facilities among parties to such contracts, 
agreements or transactions that provide for netting of payments or 
deliveries resulting from such contracts, agreements or transactions; 
or
    (3) 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.


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 a 
counterparty that is an eligible participant (or counterparty 
reasonably believed by such party at the time the contract, agreement 
or transaction was entered into to be an eligible participant) 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.
    (c) A party to a contract, agreement or transaction that is entered 
into pursuant to the Statement of Policy Concerning Swap Transactions 
in appendix A to

[[Page 78036]]

this part 35 or the Statutory Interpretation Concerning Certain 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 the 
Statement of Policy Concerning Swap Transactions in appendix A to this 
part 35 or the Statutory Interpretation Concerning Certain Hybrid 
Instruments, as the same may be revised by the Commission from time to 
time, respectively, or with any provision of the Act or other 
Commission rule or exemption, 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.

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.
    \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 Comm. 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 in this Appendix.
    (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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    (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

[[Page 78037]]

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 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 in this Appendix 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 in this Appendix 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 exclusion 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.
---------------------------------------------------------------------------

    (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 in this Appendix 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\
---------------------------------------------------------------------------

    \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 in this Appendix apply equally to options on 
swaps.
---------------------------------------------------------------------------

    (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

[[Page 78038]]

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: 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 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 in paragraph (b)(5)(ii) of this Appendix, 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 
marked-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 
criteria in paragraph (b)(5)(ii) 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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    (B) [Reserved]
    (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 Associations, Inc. concerning Advance Notice.
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    (B) The safe harbor set forth in this Appendix 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 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 criteria set out in this Appendix and that are not 
otherwise excluded from Commission regulation.

    Issued in Washington, DC, this 21st day of November, 2000, by 
the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 00-30270 Filed 12-12-00; 8:45 am]
BILLING CODE 6351-01-P


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