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News July 16, 2012 Issue

SEC and CFTC Approve Definitions for Swaps, Security-Based Swaps, and Mixed Swaps

Regulation of the OTC derivatives markets took a big leap forward last week, when the SEC and CFTC approved "rules and interpretations" for defining swaps, security-based swaps, and mixed swaps.

The 601-page adopting release is not for the faint of heart, and on its face illustrates the complexity of bringing these wide-ranging private transactions into regulated territory.

Certain transactions will clearly fall into one bucket or another. Many others will have to be parsed through with your favorite expert. (Remember the presidential answer that famously depended on what the definition of "is" is?)

However an instrument is identified, the SEC noted that the determination is to be made at the inception of the agreement, contract, or transaction, and that determination attaches to the instrument over its life unless the instrument is otherwise amended or modified.

Here’s the view of the new definitions from about 35,000 feet (which may be as close as you ever want to get).

Swaps

Instruments based on futures other than security futures generally are swaps. Instruments based on interest rates and other monetary rates generally are swaps. Swaps also include instruments based on rates and yields for U.S. Treasuries, but not for municipal securities. Instruments based on futures on certain foreign government debt securities can go either way, and the adopting release provides the analysis for making the determination.

Broad-based index credit default swaps that require cash or auction settlement are considered swaps.

Security-based swaps

Instruments based on yields, where that yield is a proxy for the price or value of a debt security, loan, or a narrow-based security index, are security-based swaps. Certain securities are exempted from this category.

Total return swaps are generally security-based swaps. Embedding other features in the total return swap however, will make it a mixed swap (see below).

Mixed swaps

Total return swaps with embedded interest rate optionality or a non-securities component such as the price of oil or a currency hedge are one example of a mixed swap. Broad-based index credit default swaps that require mandatory physical settlement are considered mixed swaps.

The SEC and CFTC each noted that they believe the scope of the category of mixed swaps is narrow. Mixed swaps remain subject to the entirety of both SEC and CFTC regulation, although the rules allow a person to obtain modified regulatory treatment for these instruments by joint order of the two agencies.

Products that are not swaps or security-based swaps:

Insurance products will not be considered swaps or security-based swaps provided such products meet one of the following three criteria:

  • Grandfathered insurance products – Existing insurance agreements, contracts, or transactions that were entered into prior to the effective date of the rules will be excluded so long as the product was provided by a person or entity passing the "provider" test. The provider test names permitted persons, entities, federal and state governments and their instrumentalities, re-insurance providers and non-admitted insurance providers (Providers).
  • Safe harbor insurance products – Insurance agreements, contracts, or transactions will be excluded if provided by a Provider and meet conditions such as bearing the risk of loss of an insurable interest over the life of the instrument, and not be traded separately from the insured interest on an organized market or over-the-counter.
  • Enumerated safe harbor insurance products –The following specified products will not be considered a swap or security-based swap if provided by a Provider: surety bonds, fidelity bonds, life insurance, health insurance, long term care insurance, title insurance, property and casualty insurance, annuities, disability insurance, insurance against default on individual residential mortgages, and finally, reinsurance (including "retrocession") of any of the foregoing products.

Security forwards now fall outside the definitions of swap and security-based swap. "This includes the treatment of mortgage-backed securities that are eligible to be sold in the ‘to-be-announced’ or ‘TBA’ market," said the SEC in its press release.

Consumer and commercial transactions coming within stated interpretations will not be considered swaps or security-based swaps. Mortgages, real estate and intellectual property transactions, employment contracts, retirement benefit arrangements, warehouse lending arrangements and commercial loans are examples of these transactions.

Effective and compliance dates.

The final rules become effective 60 days after they are published in the Federal Register, estimated currently to be the end of September or early October.

However, with respect to the final rules further defining security-based swap, the compliance date will be 180 days after the rules are published in the Federal Register, a date estimated to be sometime early next year.

The SEC said the extended compliance deadline for security-based swaps is "solely for the purposes of certain interim relief granted and exemptions adopted under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Trust Indenture Act of 1939."