CFTC Finalizes Definition of “Swap”

Summary. On July 18, 2012, the Commodity Futures Trading Commission released final rules and interpretations (the “Final Rules”) defining the term “swap.” The Dodd-Frank Act established a framework for regulating derivatives, granting the CFTC regulatory authority over “swaps,” the SEC regulatory authority over “security-based swaps,” and the agencies joint authority over “mixed swaps.” Although Dodd-Frank defined those terms, it directed the CFTC and the SEC to interpret and apply the definitions to clarify the treatment of specific types of agreements, contracts and transactions. The Final Rules discuss in detail the categories of derivatives that will be treated as “swaps” and regulated by the CFTC.

The definition of “swap” is important to investment advisers because Dodd-Frank expanded the definitions of “commodity pool operator” and “commodity trading adviser” to include advisers that invest in swaps. Previously, only advisers that invested in futures and commodity-related instruments (together, “commodity interests”) were CPOs and CTAs and subject to regulation by the CFTC. Under the Final Rules, an investment adviser that invests in swaps will be a CPO or CTA, or both, even if it does not invest in commodity interests. As such, it must register with the CFTC by December 31, 2012, unless it qualifies for an exemption.

Therefore, all investment advisers — including those that have not previously had to consider CFTC registration because they do not invest in commodity interests — must now determine whether the instruments in which they invest include “swaps,” as defined in the Final Rules.

Definitions. The definition of “swap” is complex. Some instruments that are commonly called swaps are not treated as “swaps” under the Final Rules, and some instruments that are not traditionally called swaps are treated as “swaps.” The Final Rules spend 450 pages analyzing whether various types of contracts fall within the definition, based on the characteristics of their underlying reference instruments and the nature and purpose of the risk exposures they create.

Although the particular characteristics of each instrument must be examined carefully to classify it reliably, under the Final Rules, the following generally will be “swaps” that are regulated by the CFTC:

  • swaps on broad-based security indices;
  • swaps on U.S. government securities, including swaps on rates or yields of US Treasuries;
  • swaps based solely on interest rates or other monetary rates that are not based on securities (such as LIBOR and other interbank rates, money market rates, the Federal Reserve discount rate, prime rates and the CPI);
  • swaps on yields based on interest rates or monetary rates;
  • credit default swaps, other than single-name credit default swaps;
  • certain index credit default swaps on security indices that are not narrow-based;
  • total return swaps based on two or more non-security loans, or based on broad-based security indices;
  • non-deliverable foreign exchange forwards;
  • deliverable foreign exchange swaps and forwards, unless the Treasury Department makes a written determination to exempt them (to date, Treasury has proposed, but not finalized, an exemption for such transactions);
  • forward rate agreements;
  • foreign currency options, foreign exchange options and foreign exchange rate options (excluding foreign exchange or currency options traded on a national securities exchange);
  • currency swaps and cross-currency swaps;
  • swaps on futures other than futures on single securities or narrow-based security indices; and
  • options on instruments that are “swaps” under the Final Rules (“swaptions”).

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