The Securities and Exchange Commission on April 27th voted unanimously to propose rules further defining the terms “swap,” “security-based swap,” and “security-based swap agreement.”
The rules were proposed jointly with the Commodity Futures Trading Commission (CFTC)
The joint proposal of the SEC and the CFTC would add rules under the Securities Exchange Act of 1934 and provide interpretive guidance regarding which products would – and would not – be considered a “swap” or a “security-based swap” (referred to collectively in the proposing release as “Title VII instruments”).
Transactions considered “Swaps” or Security-Based Swaps”
Foreign exchange forwards, foreign exchange swaps, foreign currency options (other than foreign currency options traded on a national securities exchange), non-deliverable forward contracts involving foreign exchange, currency and cross-currency swaps, forward rate agreements, contracts for differences, and certain combinations and permutations of (or options on) swaps and security-based swaps.
In its proposed interpretive guidance, the SEC would clarify whether particular agreements, contracts or transactions are swaps, security-based swaps, or mixed swaps. Among other things, the proposed guidance would provide that such a determination is to be made at the inception of the Title VII instrument and that such a characterization would remain throughout the life of the instrument unless the instrument is amended or modified.
Interest Rates, Other Monetary Rates and Yields: Under the proposed interpretive guidance, Title VII instruments on interest rates and other monetary rates would be swaps. And, Title VII instruments on “yields” – where “yield” is a proxy for the price or value of a debt security, loan, or narrow-based security index – would be security-based swaps, except in the case of certain exempted securities.
Total Return Swaps: Under the proposed interpretive guidance, a Total Return Swap, or TRS, on a single security, loan, or narrow-based security index generally would be a security-based swap. Where counterparties embed interest-rate optionality or a non-securities component into the TRS (e.g., the price of oil, a currency hedge), it would be a mixed swap.
Title VII Instruments Based on Futures: Under the proposed interpretive guidance, Title VII instruments on futures (other than futures on foreign government debt securities) would generally be swaps and Title VII instruments on security futures would generally be security-based swaps.
Swaps and Security-Based Swaps Based on Security Indexes
The SEC proposed rules and interpretive guidance regarding the applicability of the “narrow-based security index” definition to certain products, including proposed rules regarding the definition of “narrow-based security index” and “issuers of securities in a narrow-based security index” for index credit default swaps (index CDS).
The SEC also proposed rules and interpretive guidance regarding the definition of a security index and the evaluation of Title VII instruments based on security indexes that migrate from broad-based to narrow-based and vice versa.
If a broad-based index CDS requires mandatory physical settlement, it would be a mixed swap.
If a broad-based index CDS requires cash settlement or auction settlement, it would be a swap, and would not be considered a security-based swap or a mixed swap solely because the determination of the cash price to be paid is established through a security or loan auction.
Mixed Swaps
The SEC proposed interpretive guidance regarding the scope of the mixed swap category, which both the SEC and CFTC believe to be narrow.
The SEC also proposed rules and interpretive guidance that mixed swaps would remain subject to the entirety of the SEC and CFTC regulatory regimes, but that for bilateral uncleared mixed swaps entered into by at least one dually-regulated swap and security-based swap dealer or major swap and security-based swap participant, certain regulatory requirements would apply.
In addition, the SEC proposed a rule establishing a process, for all other mixed swaps, by which persons may request modified regulatory treatment by joint order of the SEC and CFTC.
Security-Based Swap Agreements
The SEC proposed interpretative guidance regarding certain products that are security-based swap agreements (SBSA). It also proposed a rule requiring market participants to maintain the same books and records for security-based swap agreements as they would under the CFTC’s proposed books and records requirements for swaps.
Interpretation of the Characterization of a Product
The SEC proposed a rule establishing a process that would allow market participants or either the SEC or CFTC to request a determination from the SEC and CFTC of whether a product is a swap, security-based swap, or both (i.e., a mixed swap).
What’s Next?
The proposal seeks public comment and data on a broad range of issues relating to the proposed rules and interpretive guidance, including the costs and benefits associated with the proposal. After careful review of comments, the SEC and the CFTC will consider whether to adopt the proposed rules and interpretive guidance or modify them. Comments should be received on or before 60 days after the date of publication in the Federal Register.
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