Each swap dealer must invest substantial resources and time to put in place policies that comply with the maze of intricate new rules. For example, most swap reporting—which involves tracking and reporting on hundreds of data fields for every swap—must be handled by the swap dealer counterparty, and swap dealers must comply with complex rules governing the means by which they conduct swaps business and the disclosures they provide to their counterparties.

Given the central role that swap dealers play in this new regulatory regime, the definition of "swap dealer" is among the most important definitions under Dodd-Frank. Unfortunately, it is not always clear-cut. The CFTC does allow market participants to engage in a limited amount of swap dealing without registering as a swap dealer. However, some of the terminology in the definition is subject to interpretation, and the CFTC staff is currently considering changes in how it determines which entities are swap dealers.

The CFTC has indicated repeatedly that it does not intend for this definition to capture commercial end users of swaps. In practice, though, comparing a particular entity's activities with these four bullet points may still leave room for debate about whether that organization is a swap dealer. Such a comparison will, necessarily, be highly subjective because the descriptions of activities on this list include terms that are themselves subject to interpretation.

The third bullet point has caused particular consternation within the end-user community, as it seems like it might capture some typical commercial end users that are trading swaps for risk management purposes. The CFTC has provided that "a person that enters into swaps for such person's own account, either individually or in a fiduciary capacity, but not as a part of regular business" is not a swap dealer. This seems to be a helpful statement—but whether it sufficiently clarifies the treatment of end users that are active swaps-market participants remains to be seen.

Other CFTC rules that either expressly include or expressly exclude certain types of swap activities from the definition of a "swap dealer" introduce further ambiguity. And the determination of exactly which entities are swap dealers is made even more difficult by the large number of CFTC staff no-action letters and written interpretations that have been published over the past half-decade. For example, the CFTC has refused to explicitly say whether all hedging activity is, per se, "non-dealer" activity. In addition, although certain types of "physical hedging" activity have been expressly carved out of the "swap dealer" definition, that carve-out is narrow and subject to interpretation.

Banks have their own interpretive issues when determining whether they are acting as swap dealers, as the swaps regulatory regime gives no deference to whether a would-be dealer is regulated as a bank. So, for example, banks must consider whether the swaps they enter into with customers can be excluded from the "swap dealer" determination under the CFTC's "loan origination" exception. The treatment of swap novations under the "swap dealer" definition is also unclear.

All of these interpretive issues are made even more difficult when there is a cross-border aspect to a swap transaction, as one must consider the extent to which the CFTC's regulatory regime applies extra-territorially. Determinations are further complicated when there are back-to-back swaps between related entities.

The de minimis Exception

Having built a definition of "swap dealer" that raises a number of ambiguities, the CFTC then mitigated those ambiguities, to a degree, by setting a minimum threshold level of swap dealing; persons whose swap dealing doesn't reach this threshold do not have to register.

A person who engages in swap dealing activity—i.e., any activity described on the four-pronged list—is carved out from the label of "swap dealer" if the swap positions connected with those dealing activities into which the person (or any other entity controlling, controlled by, or under common control with the person) enters over the course of 12 months have an aggregate gross notional value of US$8 billion or less, and if the swaps in which the counterparty is a "special entity" have a notional value of $25 million or less. ("Special entities" include federal, state, and local governments; employee pension plans; and endowments—each of which is entitled to special protections under Dodd-Frank.) 

These so-called "de minimis thresholds" allow a swaps end user some leeway in structuring its swap trading. An organization doesn't have to evaluate each swap transaction to determine whether the purchase might cause the organization to be viewed as a swap dealer. Instead, most end users can be reasonably comfortable that even if a handful of their swaps could be characterized as swap dealing when viewed with 20/20 hindsight, at most those transactions would constitute a de minimis level of swap dealing insufficient to breach the thresholds set by the CFTC. 

The $25 million special-entity threshold is very low, but it should not affect commercial end users. In contrast, $8 billion is a relatively large number for the notional value of a corporate entity's swaps deals. A company whose swap dealing was approaching a volume of $8 billion during any rolling 12-month period should be aware of the issue far enough in advance to either reduce its "dealing" footprint or register as a swap dealer.

That said, the $8 billion de minimis threshold was always intended to be temporary. It is scheduled to be in place until the end of 2017, at which time it will automatically reset to $3 billion unless the CFTC makes an affirmative determination to leave the $8 billion threshold in place, or to change the threshold to some other number.

Congress enacted a spending bill in December 2014 that included, in an explanatory note, a direction to the CFTC to conduct a formal rule-making before lowering the de minimis threshold. This "de-automation" of the decrease in the threshold was not included in the spending bill itself, so it is not legally binding on the CFTC. Versions of other bills that are being considered by Congress would include similar "de-automation" language in binding legislative text, but the fate of those bills remains uncertain.

Nevertheless, the CFTC appears to be proceeding toward an affirmative determination, by rule, of where to set the long-term de minimis threshold; it seems unlikely that the CFTC will simply allow the de minimis threshold to reset to $3 billion at the end of 2017. A $3 billion threshold would provide much less protection for companies that engage in substantial hedging activities, when some of their transactions may constitute swap dealing.

Currently 100 or so firms are registered as swap dealers. If the de minimis threshold is lowered substantially, that number might increase significantly, or smaller dealers whose trading volume doesn't currently require registration might be forced out of the market.

End users should care both about whether they may eventually be required to register as swap dealers due to ambiguities in definitions, and about whether the result of these rules will be an increase or a reduction in the number of swap dealers providing risk management products to the end-user market in the future.

The de minimis Exception Report

The CFTC staff is required by rule to publish a report on the swap dealer de minimis threshold. This report must address, among other things, the potential impact of modifying the de minimis threshold and whether the threshold should be increased or decreased. By rule, nine months after the CFTC staff publishes this report, the agency may (a) terminate the initial $8 billion phase-in threshold, which would automatically reduce the threshold to $3 billion; (b) propose new rules that would set a new de minimis threshold, which could be higher or lower than $8 billion; or (c) take no further action, which would result in the $8 billion threshold lowering to $3 billion automatically as of January 1, 2018.

On November 25, 2015, the CFTC published a preliminary version of the long-delayed swap dealer de minimis report. The staff indicated that it is not yet in a position to publish a final report, due to a lack of sufficient data. But the preliminary report considers the possible impact of raising or lowering the swap dealer de minimis threshold and several alternatives to the current de minimis exception, including:

• a notional de minimis threshold specific to each asset class of swaps;
• a multi-factor approach that would potentially include the number of counterparties and/or transactions as relevant factors in determining whether the de minimis threshold has been breached;
• a multi-tiered approach in which the CFTC puts in place scaled compliance obligations, with a heavier compliance burden falling on larger dealers and a lighter compliance burden for smaller dealers; and
• a possible exclusion from the swap dealer de minimis thresholds for all swaps traded on a regulated market and/or submitted for central clearing.

When the CFTC staff drafts its final report, it will make that report available for public comment—and the final report will inform the CFTC's determination of the proper level of the de minimis threshold and manner of calculating the threshold going forward.

The CFTC's final determinations with respect to the de minimis thresholds will ultimately impact not only whether certain end users need to register as swap dealers, but also the number of participants and structure of the swaps markets going forward, and the availability of hedging products from registered swap dealers. Thus, this is a conversation of significant interest to financial risk managers in large and midsize companies nationwide.

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Nathan Howell is a partner in the Chicago office of international law firm Sidley Austin LLP. He advises a broad range of financial services clients on regulatory and transactional matters, with a particular focus on issues arising under the Dodd-Frank Act. Howell represents major investment advisory firms, futures commission merchants, derivatives clearing organizations, clearing agencies, commodity pool operators, commodity trading advisors, exchanges, and other financial companies in a variety of matters relating to derivatives.

Michael Sackheim is a partner in the New York office of international law firm Sidley Austin LLP. He focuses on futures and derivatives regulatory, transactional, and enforcement matters. Sackheim concentrates on advising end users on compliance with the new derivatives financial reform laws and regulations.

This article has been prepared for informational purposes only and does not constitute legal advice.  This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship.  Readers should not act upon this without seeking advice from professional advisers.  The content herein does not reflect the views of Sidley Austin LLP.