Treatise on the Definition of Swap*

Almost two years after the Dodd-Frank Act was enacted into law, on 10 July 2012 the US CFTC voted 4-1 to approve a 600-page final rule, jointly developed with the US Securities and Exchange Commission (SEC), to further define the statutory term “swap”.  Not only does the definition provide greater clarity on which financial products can be expected to fall within regulatory oversight, and thus become subject to reporting, clearing, capital and margin requirements, but passage of the rule also sets the compliance dates for a string of other Commission rules governing the $650 trillion over-the-counter global swaps markets. Those include rules on swap dealers (SD) and major swap participants (MSP) registration, SD and MSP swap data reporting and recordkeeping, registration of swap data depositories, large trader reporting for registered SDs and MSPs, real time reporting of swap transactions and pricing data, internal and external business conduct standards and position limits.

The Commission had been criticised for finalising other rules without first defining the term ‘swap’. Critics argued that defining a swap should have been the first rulemaking by the regulators rather than one of the last. Others countered however that it was arbitrary deadlines imposed on the regulators by the Dodd-Frank Act that led the US CFTC to delay the product definition rule. Furthermore, the Commission, along with the SEC, might have postponed the swap definition rule to ensure that market participants were ready for the new regulatory requirements that the final rule would trigger.

What is a “Swap”?

The final rule, consistent with the Dodd-Frank Act statute, defines a broad range of derivatives as swaps: interest rate swaps, currency swaps, commodity swaps, including energy, metals, and agricultural swaps, commodity options, currency options, cross-currency swaps, forward rate agreements, options to enter into swap (swaptions) and broad-based index swaps, such as index credit default swaps. The final rule also treats foreign exchange swaps and forwards as swaps except those exempted by the Department of Treasury.

What is not a “Swap”? 

The final rule clarifies that insurance products, loan participations, certain consumer and commercial transactions, such as consumer mortgage rate locks, consumer and commercial loans, and service contracts will not be considered swaps. In line with the Dodd-Frank Act, the final rule excludes non-financial forward contracts that are intended to be physically settled from the statutory swap definition. Clearly, the scope of this exclusion or exemptions will have the greatest impact on energy market participants.

Exclusions for Energy Companies

The US CFTC also issued a guidance clarifying the extent of forward contract exclusion and its relevance to the new swap definition. The Dodd-Frank Act specifically excludes “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled” from its statutory swap definition. If the transaction is to be physically settled, even if settled at different agreed prices, then it will not be considered a swap. Book-out transactions in nonfinancial commodities would not be considered as swap as long as the underlying contracts meet the requirement specified in the Brent interpretation, which requires that the contracts  (a) create a binding obligation to make or take delivery without providing any right to offset, cancel, or settle on a payment-of-differences basis and (b) are between market participants that regularly make or take delivery of the referenced commodity in their ordinary course of business. If the parties settle their delivery obligations through a subsequent, separately-negotiated agreement, these contracts still qualify for the forward exclusion from the swap definition.

Furthermore, the interpretation keeps forward contracts with price optionality, where parties can adjust forward contract prices during the course of the agreement, as forward rather than swap contracts. The final rule also excludes forward contracts with volumetric optionality, where parties have the option to adjust the volume specified in the underlying contract, from being classified as swaps provided that the underlying contracts satisfy the seven-part test. The CFTC has, however, requested public comment on the interpretation of forward contracts with volumetric optionality.

The final rule also excludes environmental commodities, such as carbon offset credits, emission allowance and renewable energy credits from the statutory definition of swap. The Commission guidance also excludes certain types of arrangements, such as fuel delivery agreements and physical exchange transactions, from being classified as swaps.

IEA Oil Market Report, August 2012