October 19, 2020

Volume X, Number 293

October 19, 2020

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CFTC Proposes Capital Rules for Swap Dealers and Major Swap Participants

On December 2, 2016, the Commodity Futures Trading Commission (“CFTC”) proposed rules establishing capital requirements for swap dealers (“SDs”) and major swap participants (“MSPs”). The CFTC’s proposed capital rules would cover those swap dealers and major swap participants that are not subject to prudential regulation. Chairman Timothy Massad noted in his attached statement that the proposed rule attempts to recognize the different types of firms that act as SDs and allow for those differences in setting the capital requirements for each. Commissioner J. Christopher Giancarlo stated that his support of the proposed rule was predicated on the inclusion of several questions that he hopes market participants will specifically address in their comments on the rule. Commissioner Giancarlo’s questions relate to his ongoing concern that capital requirements imposed on financial institutions have worked to constrain markets instead of supporting market strength and stability. His questions also address the scope of the proposed rule and the appropriateness of the proposed capital model review and approval process. Market participants seeking to comment on the rule should focus on responding to the questions raised by Commissioner Giancarlo, as comments addressing these points likely will have a significant impact in shaping the final rule.

Under the CFTC’s proposal, the capital requirements applicable to an entity would depend on the characteristics of that entity. An SD that is also a futures commission merchant (“FCM”) would be required to meet the capital requirements applicable to FCMs.

SDs that are not also FCMs could elect to use the “bank-based approach” or the “net liquid assets approach” to determine minimum capital requirements. SDs that are “not predominantly engaged in financial activities,” i.e., SDs with financial assets that are not more than 15% of its consolidated assets and with revenues from financial activities that are not more than 15% of its consolidated revenues, would have the option of using a “tangible net worth approach.”

In conjunction with the proposal, Commissioner J. Christopher Giancarlo issued a statement requesting comment and raising concerns about several specific aspects of the proposal:

  • Bank-based approach: SD required to maintain a minimum level of capital at least equal to the greatest of: (1) $20 million of common equity tier 1 capital; (2) common equity tier 1 capital equal to or in excess of 8% its risk-weighted assets; (3) common equity tier 1 capital equal to or greater than 8% of the margin required on the SD’s cleared and uncleared swaps, security-based swaps, futures and foreign futures positions; or (4) the amount of capital required by the National Futures Association (“NFA”).

  • Net liquid asset approach: SD required to maintain a minimum level of capital at least equal to the greatest of: (1) $20 million; (2) 8% of the margin required on the SD’s cleared and uncleared swaps, security-based swaps, futures and foreign futures positions; or (3) the amount of capital required by the NFA.

  • Tangible net worth approach: SD required to maintain a minimum level of capital at least equal to the greatest of: (1) $20 million plus market and credit risk charges on its swaps positions that are related to its dealing activities; (2) 8% of the margin required on the SD’s cleared and uncleared swaps, security-based swaps, futures and foreign futures positions; or (3) the amount of capital required by the NFA.
    The CFTC further proposes allowing SDs to use internal models to calculate their regulatory capital, subject to prior approval by either the CFTC or the NFA. Finally, MSPs would be required to maintain a positive tangible net worth, or the minimum amount of capital required by the NFA.

Commissioner Giancarlo’s statement is especially significant because, as the sole Republican currently on the Commission, he likely will be named the Acting Chair either after Chairman Massad’s term expires in April 2017 or if Chairman Massad steps down earlier upon the Inauguration of President-elect Trump.

  • Smaller swap dealers: Commissioner Giancarlo is “particularly interested how the proposed capital requirements will affect smaller swap dealers and how much additional capital they may have to raise to comply with the proposal.” Commissioner Giancarlo also is requesting comment on the impact of the proposal on potential new registrants if the swap dealer de minimis falls to $3 billion.

  • Scope: Commissioner Giancarlo raises several questions about the “broad scope” of the proposal. For example, the proposed capital minimum requirements are based upon 8% of the margin on the SD’s cleared and uncleared swaps, security-based swaps, futures and foreign futures positions. However, the Commodity Exchange Act only cites the risk of uncleared swaps in setting standards for capital.

  • Model approval: Commissioner Giancarlo raises concerns about the proposal that the NFA review and approve the internal models of SD’s. Specifically, Commissioner Giancarlo worries that, given “the large number of models that will need to be reviewed, the complexity of those models and the practical resource constraints at the NFA, I am concerned that the proposed process will be unworkable.”

© 2020 Covington & Burling LLPNational Law Review, Volume VI, Number 363

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About this Author

Jason Grimes, corporate lawyer, Covington
Associate

Jason Grimes is an associate in the firm’s financial institutions and futures and derivatives practice groups. He advises clients on a wide range of regulatory matters, including compliance with various state and federal banking laws, and compliance with the Commodity Exchange Act.

Representative Matters

  • Advised a CFTC-registered swap dealer on compliance issues related to trading on swap execution facilities
  • Advised a major financial institution in connection with the treatment of non-deliverable...
202-662-5846
Anne M. Termine, Covington, securities litigation attorney
Of Counsel

Anne Termine is a member of the firm’s Global Futures and Derivatives Practice and leads the Derivatives Enforcement Team. She is also a member of the white collar defense and investigations practice. Ms. Termine advises clients in handling internal investigations and regulatory enforcement inquiries related to the derivatives markets and the cryptocurrency markets.

Prior to joining Covington, Ms. Termine was a Chief Trial Attorney in the U.S. Commodity Futures Trading Commission's (CFTC) Division of Enforcement, where she was responsible for investigating and prosecuting alleged violations of federal laws dealing with commodities, futures, options, swaps, and other derivatives. While in this role, Ms. Termine designed and led the CFTC’s landmark enforcement program involving the manipulation and false reporting of LIBOR, Euribor and TIBOR - critical, international benchmark interest rates. She spearheaded negotiations that resulted in settlements with nine international financial institutions, imposing penalties totaling over $2.8 billion. In managing this massive, global investigation, Ms. Termine was instrumental in developing relationships and coordinating with diverse foreign regulatory and law enforcement agencies throughout Europe and Asia, as well as with divisions of the United States Department of Justice and a coalition of over 40 State Attorneys General. She received the Chairman’s Award for Excellence, the CFTC’s highest award, for her work on and leadership in handling the LIBOR investigations.

202-662-5827
Stephen Humenik, regulatory and public policy lawyer, Covington
Of Counsel

Stephen M. Humenik leads the firm’s futures and derivatives practice. He has extensive experience on cross-border regulatory, compliance and enforcement matters involving the U.S. Commodity Futures Trading Commission (CFTC) and markets for derivatives and physical and financial commodities. Mr. Humenik applies his business, operational, and government experience to the implementation of CFTC regulations, including the registration, trading, clearing and other compliance obligations of the Dodd-Frank Act and other global regulatory reforms.

202-662-5803