regulations thereunder become applicable to a Title VII Instrument.
For instance, certain duties apply to swaps prior to execution. See
Daily Trading Records under Rule 23.202 under the CEA, 17 CFR
23.202, and Subpart H of Part 23 of the CFTC's regulations, 17 CFR
Part 23, Subpart H (Business Conduct Standards for Swap Dealers and
Major Swap Participants Dealing with Counterparties, Including
Special Entities).
    \626\ See infra part III.G.5(a), for a discussion regarding the
evaluation of Title VII Instruments on security indexes that move
from broad-based to narrow-based or narrow-based to broad-based.
---------------------------------------------------------------------------

    Classifying a Title VII instrument as a swap or security-based swap
is straightforward for most instruments. However, the Commissions
provided an interpretation in the Proposing Release to clarify the
classification of swaps and security-based swaps in certain areas and
to provide an interpretation regarding the use of certain terms and
conditions in Title VII instruments. The Commissions are restating the
interpretation set out in the Proposing Release with certain
modifications to the interpretation regarding TRS.

B. Title VII Instruments Based on Interest Rates, Other Monetary Rates,
and Yields

    Parties frequently use Title VII instruments to manage risks
related to, or to speculate on, changes in interest rates, other
monetary rates or amounts, or the return on various types of assets.
Broadly speaking, Title VII instruments based on interest or other
monetary rates would be swaps, whereas Title VII instruments based on
the yield or value of a single security, loan, or narrow-based security
index would be security-based swaps. However, market participants and
financial professionals sometimes use the terms ``rate'' and ``yield''
in different ways. The Commissions proposed an interpretation in the
Proposing Release regarding whether Title VII instruments that are
based on interest rates, other monetary rates, or yields would be swaps
or security-based swaps and are restating the interpretation, but with
a modification to the list of examples of reference rates to include
certain secured lending rates under money market rates.\627\ The
Commissions find that this interpretation is an appropriate way to
address Title VII instruments based on interest rates, other monetary
rates, or yields and is designed to reduce costs associated with
determining whether such instruments are swaps or security-based
swaps.\628\
---------------------------------------------------------------------------

    \627\ These secured lending rates are the Eurepo, The Depository
Trust & Clearing Corporation's General Collateral Finance Repo
Index, the Repurchase Overnight Index Average Rate and the Tokyo
Repo Rate.
    \628\ See supra part I, under ``Overall Economic
Considerations''.
---------------------------------------------------------------------------

1. Title VII Instruments Based on Interest Rates or Other Monetary
Rates That Are Swaps
    The Commissions believe that when payments exchanged under a Title
VII instrument are based solely on the levels of certain interest rates
or other monetary rates that are not themselves based on one or more
securities, the instrument would be a swap and not a security-based
swap.\629\ Often swaps on interest rates or other monetary rates
require the parties to make payments based on the comparison of a
specified floating rate (such as the London Interbank Offered Rate
(``LIBOR'')) to a fixed rate of interest agreed upon by the parties. A
rate swap also may require payments based on the differences between
two floating rates, or it may require that the parties make such
payments when any agreed-upon events with respect to interest rates or
other monetary rates occur (such as when a specified interest rate
crosses a threshold, or when the spread between two such rates reaches
a certain point). The rates referenced for the parties' obligations are
varied, and examples of such rates include the following:
---------------------------------------------------------------------------

    \629\ See infra part III.F, regarding the use of certain terms
and conditions.
---------------------------------------------------------------------------

    Interbank Offered Rates: An average of rates charged by a group of
banks for lending money to each other or other banks over various
periods of time, and other similar interbank rates,\630\ including, but
not limited to, LIBOR (regardless of currency); \631\ the Euro

Interbank Offered Rate (``Euribor''); the Canadian Dealer Offered Rate
(``CDOR''); and the Tokyo Interbank Offered Rate (``TIBOR''); \632\
---------------------------------------------------------------------------

    \630\ Interbank lending rates are measured by surveys of the
loan rates that banks offer other banks, or by other mechanisms. The
periods of time for such loans may range from overnight to 12 months
or longer.
     The interbank offered rates listed here are frequently called
either a ``reference rate,'' the rate of ``reference banks,'' or by
a designation that is specific to the service that quotes the rate.
For some of the interbank offered rates listed here, there is a
similar rate that is stated as an interbank bid rate, which is the
average rate at which a group of banks bid to borrow money from
other banks. For example, the bid rate similar to LIBOR is called
LIBID.
    \631\ Today, LIBOR is used as a rate of reference for the
following currencies: Australian Dollar, Canadian Dollar, Danish
Krone, Euro, Japanese Yen, New Zealand Dollar, Pound Sterling,
Swedish Krona, Swiss Franc, and U.S. Dollar.
    \632\ Other interbank offered rates include the following (with
the country or city component of the acronym listed in parentheses):
AIDIBOR (Abu Dhabi); BAIBOR (Buenos Aires); BKIBOR (Bangkok);
BRAZIBOR (Brazil); BRIBOR/BRIBID (Btatislava); BUBOR (Budapest);
CHIBOR (China); CHILIBOR (Chile); CIBOR (Copenhagen); COLIBOR
(Columbia); HIBOR (Hong Kong); JIBAR (Johannesburg); JIBOR
(Jakarta); KAIBOR (Kazakhstan); KIBOR (Karachi); KLIBOR (Kuala
Lumpur); KORIBOR ((South) Korea); MEXIBOR (Mexico); MIBOR (Mumbai);
MOSIBOR (Moscow); NIBOR (Norway); PHIBOR (Philippines); PRIBOR
(Prague); REIBOR/REIBID (Reykjavik); RIGIBOR/RIGIBID (Riga); SHIBOR
(Shanghai); SIBOR (Singapore); SOFIBOR (Sofia); STIBOR (Stockholm);
TAIBOR (Taiwan); TELBOR (Tel Aviv); TRLIBOR and TURKIBOR (Turkey);
VILIBOR (Vilnius); VNIBOR (Vietnam); and WIBOR (Warsaw).
---------------------------------------------------------------------------

    Money Market Rates: A rate established or determined based on
actual lending or money market transactions, including, but not limited
to, the Federal Funds Effective Rate; the Euro Overnight Index Average
(``EONIA'' or ``EURONIA'') (which is the weighted average of overnight
unsecured lending transactions in the Euro-area interbank market); the
EONIA Swap Index; the Eurepo (the rate at which, at 11.00 a.m. Brussels
time, one bank offers, in the euro-zone and worldwide, funds in euro to
another bank if in exchange the former receives from the latter the
best collateral within the most actively-traded European repo market);
the Australian dollar RBA 30 Interbank Overnight Cash Rate; the
Canadian Overnight Repo Rate Average (``CORRA''); The Depository Trust
& Clearing Corporation's General Collateral Finance (``GCF'') Repo
Index (an average of repo rates collateralized by U.S. Treasury and
certain other securities); the Mexican interbank equilibrium interest
rate (``TIIE''); the NZD Official Cash Rate; the Sterling Overnight
Interbank Average Rate (``SONIA'') (which is the weighted average of
unsecured overnight cash transactions brokered in London by the
Wholesale Markets Brokers' Association (``WMBA'')); the Repurchase
Overnight Index Average Rate (``RONIA'') (which is the weighted average
rate of all secured overnight cash transactions brokered in London by
WMBA); the Swiss Average Rate Overnight (``SARON''); the Tokyo
Overnight Average Rate (``TONAR'') (which is based on uncollateralized
overnight average call rates for interbank lending); and the Tokyo Repo
Rate (average repo rate of active Japanese repo market participants).
    Government Target Rates: A rate established or determined based on
guidance established by a central bank including, but not limited to,
the Federal Reserve discount rate, the Bank of England base rate and
policy rate, the Canada Bank rate, and the Bank of Japan policy rate
(also known as the Mutan rate);
    General Lending Rates: A general rate used for lending money,
including, but not limited to, a prime rate, rate in the commercial
paper market, or any similar rate provided that it is not based on any
security, loan, or group or index of securities;
    Indexes: A rate derived from an index of any of the foregoing or
following rates, averages, or indexes, including but not limited to a
constant maturity rate (U.S. Treasury and certain other rates),\633\
the interest rate swap rates published by the Federal Reserve in its
``H.15 Selected Interest Rates'' publication, the ISDAFIX rates, the
ICAP Fixings, a constant maturity swap, or a rate generated as an
average (geometric, arithmetic, or otherwise) of any of the foregoing,
such as overnight index swaps (``OIS'')--provided that such rates are
not based on a specific security, loan, or narrow-based group or index
of securities;
---------------------------------------------------------------------------

    \633\ A Title VII instrument based solely on the level of a
constant maturity U.S. Treasury rate would be a swap because U.S.
Treasuries are exempted securities that are excluded from the
security-based swap definition. Conversely, a Title VII instrument
based solely on the level of a constant maturity rate on a narrow-
based index of non-exempted securities under the security-based swap
definition would be a security-based swap.
---------------------------------------------------------------------------

    Other Monetary Rates: A monetary rate including, but not limited
to, the Consumer Price Index (``CPI''), the rate of change in the money
supply, or an economic rate such as a payroll index; and
    Other: The volatility, variance, rate of change of (or the spread,
correlation or difference between), or index based on any of the
foregoing rates or averages of such rates, such as forward spread
agreements, references used to calculate the variable payments in index
amortizing swaps (whereby the notional principal amount of the
agreement is amortized according to the movement of an underlying
rate), or correlation swaps and basis swaps, including but not limited
to, the ``TED spread'' \634\ and the spread or correlation between
LIBOR and an OIS.
---------------------------------------------------------------------------

    \634\ The TED spread is the difference between the interest
rates on interbank loans and short-term U.S. government debt
(Treasury bills or ``T-bills''). The latter are exempted securities
that are excluded from the statutory definition of the term
``security-based swap.'' Thus, neither any aspect of U.S. Treasuries
nor interest rates on interbank loans can form the basis of a
security-based swap. For this reason, a Title VII instrument on a
spread between interbank loan rates and T-bill rates also would be a
swap, not a security-based swap.
---------------------------------------------------------------------------

    As discussed above, the Commissions believe that when payments
under a Title VII instrument are based solely on any of the foregoing,
such Title VII instrument would be a swap.
Comments
    Two commenters believed that constant maturity swaps always should
be treated as swaps, rather than mixed swaps, because they generally
are viewed by market participants as rates trades instead of trades on
securities.\635\ According to the commenters, the ``bulk'' of constant
maturity swaps are based on exempted securities, but the commenters
noted that the constant maturity leg may be based on a number of
different rates or yields, including, among other things, U.S. Treasury
yields, Treasury auction rates, yields on debt of foreign governments,
and debt related to indices of mortgage-backed securities.\636\ As
discussed above, the Commissions are adopting the interpretation as
proposed. The statutory language of the swap and security-based swap
definitions explicitly states that a Title VII instrument that is based
on a non-exempted security should be a security-based swap and not a
swap.\637\
---------------------------------------------------------------------------

    \635\ See CME Letter and SIFMA Letter.
    \636\ Id.
    \637\ See supra note 633.
---------------------------------------------------------------------------

2. Title VII Instruments Based on Yields
    The Commissions proposed an interpretation in the Proposing Release
clarifying the status of Title VII instruments in which one of the
underlying references of the instrument is a ``yield.'' The Commissions
received no comments on the interpretation set out in the Proposing
Release regarding Title VII instruments based on yields and are
restating the interpretation without modification. In cases when a
``yield'' is calculated based on the price or changes in price of a
debt security, loan, or narrow-based security index, it is another way
of expressing the price or value of a debt security, loan, or narrow-
based security index. For example, debt securities often are quoted and
traded on a yield basis rather than on a dollar price, where the yield
relates to a specific date, such as the date of maturity of the debt
security (i.e., yield to maturity) or the date upon which the debt
security may be redeemed or called by the issuer (e.g., yield to first
whole issue call).\638\
---------------------------------------------------------------------------

    \638\ See, e.g., Securities Confirmations, 47 FR 37920 (Aug. 27,
1982).
---------------------------------------------------------------------------

    Except in the case of certain exempted securities, when one of the
underlying

references of the Title VII instrument is the ``yield'' of a debt
security, loan, or narrow-based security index in the sense where the
term ``yield'' is used as a proxy for the price or value of the debt
security loan, or narrow-based security index, the Title VII instrument
would be a security-based swap. And, as a result, in cases where the
underlying reference is a point on a ``yield curve'' generated from the
different ``yields'' on debt securities in a narrow-based security
index (e.g., a constant maturity yield or rate), the Title VII
instrument would be a security-based swap. However, where certain
exempted securities, such as U.S. Treasury securities, are the only
underlying reference of a Title VII instrument involving securities,
the Title VII instrument would be a swap. Title VII instruments based
on exempted securities are discussed further below.
    The above interpretation would not apply in cases where the
``yield'' referenced in a Title VII instrument is not based on a debt
security, loan, or narrow-based security index of debt securities but
rather is being used to reference an interest rate or monetary rate as
outlined above in subsection one of this section. In these cases, this
``yield'' reference would be considered equivalent to a reference to an
interest rate or monetary rate and the Title VII instrument would be,
under the interpretation in this section, a swap (or mixed swap
depending on other references in the instrument).
3. Title VII Instruments Based on Government Debt Obligations
    The Commissions provided an interpretation in the Proposing Release
regarding instances in which the underlying reference of the Title VII
instrument is a government debt obligation. The Commissions received no
comments on the interpretation provided regarding instances in which
the underlying reference of the Title VII instrument is a government
debt obligation and are restating such interpretation without
modification.
    The security-based swap definition specifically excludes any
agreement, contract, or transaction that meets the definition of a
security-based swap only because it ``references, is based upon, or
settles through the transfer, delivery, or receipt of an exempted
security under [section 3(a)(12) of the Exchange Act], as in effect on
the date of enactment of the Futures Trading Act of 1982 (other than
any municipal security as defined in [section 3(a)(29) of the Exchange
Act] * * *), unless such agreement, contract, or transaction is of the
character of, or is commonly known in the trade as, a put, call, or
other option.'' \639\
---------------------------------------------------------------------------

    \639\ Section 3(a)(68)(C) of the Exchange Act, 15 U.S.C.
76c(a)(68)(C).
---------------------------------------------------------------------------

    As a result of this exclusion in the security-based swap definition
for ``exempted securities,''\640\ if the only underlying reference of a
Title VII instrument involving securities is, for example, the price of
a U.S. Treasury security and the instrument does not have any other
underlying reference involving securities, then the instrument would be
a swap. Similarly, if the Title VII instrument is based on the
``yield'' of a U.S. Treasury security and does not have any other
underlying reference involving securities, then the instrument also
would be a swap, regardless of whether the term ``yield'' is a proxy
for the price of the security.
---------------------------------------------------------------------------

    \640\ As of January 11, 1983, the date of enactment of the
Futures Trading Act of 1982, Public Law 97-444, 96 Stat. 2294,
section 3(a)(12) of the Exchange Act, 15 U.S.C. 78c(a)(12), provided
that, among other securities, ``exempted securities'' include: (i)
Securities which are direct obligations of, or obligations
guaranteed as to principal or interest by, the United States; (ii)
certain securities issued or guaranteed by corporations in which the
United States has a direct or indirect interest as designated by the
Secretary of the Treasury; and (iii) certain other securities as
designated by the SEC in rules and regulations.
---------------------------------------------------------------------------

    Foreign government securities, by contrast, were not ``exempted
securities'' as of the date of enactment of the Futures Trading Act of
1982 \641\ and thus do not explicitly fall within this exclusion from
the security-based swap definition. Therefore, if the underlying
reference of the Title VII instrument is the price, value, or ``yield''
(where ``yield'' is a proxy for price or value) of a foreign government
security, or a point on a yield curve derived from a narrow-based
security index composed of foreign government securities, then the
instrument is a security-based swap.
---------------------------------------------------------------------------

    \641\ Public Law 97-444, 96 Stat. 2294 (1983).
---------------------------------------------------------------------------

C. Total Return Swaps

    The Commissions are restating the interpretation regarding TRS set
out in the Proposing Release with certain changes with respect to
quanto and compo equity TRS and loan TRS based on two or more loans,
and to reflect that TRS can overlie reference items other than
securities, loans, and indexes of securities or loans.\642\ The
Commissions find that this interpretation is an appropriate way to
address TRS and is designed to reduce the cost associated with
determining whether a TRS is a swap or a security-based swap.\643\
---------------------------------------------------------------------------

    \642\ While this guidance focuses on TRS overlying securities
and loans, TRS also may overlie other commodities. Such TRS may be
structured differently due to the nature of the underlying.
    \643\ See supra part I, under ``Overall Economic
Considerations.''
---------------------------------------------------------------------------

    As was described in the Proposing Release,\644\ a TRS is a Title
VII instrument in which one counterparty, the seller of the TRS, makes
a payment that is based on the price appreciation and income from an
underlying security or security index.\645\ A TRS also can overlie a
single loan, two or more loans and other underliers. The other
counterparty, the buyer of the TRS, makes a financing payment that is
often based on a variable interest rate, such as LIBOR (or other
interbank offered rate or money market rate, as described above), as
well as a payment based on the price depreciation of the underlying
reference. The ``total return'' consists of the price appreciation or
depreciation, plus any interest or income payments.\646\ Accordingly,
where a TRS is based on a single security or loan, or a narrow-based
security index, the TRS would be a security-based swap.\647\
---------------------------------------------------------------------------

    \644\ See Proposing Release at 29842.
    \645\ Where the underlying security is an equity security, a TRS
is also known as an ``equity swap.'' A bond may also be the
underlying security of a TRS.
    \646\ If the total return is negative, the seller receives this
amount from the buyer. TRS can be used to synthetically reproduce
the payoffs of a position. For example, two counterparties may enter
into a 3-year TRS where the buyer of the TRS receives the positive
total return on XYZ security, if any, and the seller of the TRS
receives LIBOR plus 30 basis points and the absolute value of the
negative total return on XYZ security, if any.
    \647\ However, if the underlying reference of the TRS is a
broad-based security index, it is a swap (and an SBSA) and not a
security-based swap. In addition, a TRS on an exempted security,
such as a U.S. Treasury, under section 3(a)(12) of the Exchange Act,
15 U.S.C. 78c(a)(12), as in effect on the date of enactment of the
Futures Trading Act of 1982 (other than any municipal security as
defined in section 3(a)(29) of the Exchange Act, 15 U.S.C.
78c(a)(29), as in effect on the date of enactment of the Futures
Trading Act of 1982), is a swap (and an SBSA), and not a security-
based swap. Similarly, and as discussed in more detail below, an
LTRS based on two or more loans that are not securities (``non-
security loans'') are swaps, and not security-based swaps.
---------------------------------------------------------------------------

    In addition, the Commissions are providing a final interpretation
providing that, generally, the use of a variable interest rate in the
TRS buyer's payment obligations to the seller is incidental to the
purpose of, and the risk that the counterparties assume in, entering
into the TRS, because such payments are a form of financing reflecting
the seller's (typically a security-based swap dealer) cost of financing
the position or a related hedge, allowing the TRS buyer to receive
payments based on the price appreciation and income of a security or
security index without purchasing the security or security index. As
stated in

the Proposing Release, the Commissions believe that when such interest
rate payments act merely as a financing component in a TRS, or in any
other security-based swap, the inclusion of such interest rate terms
would not cause the TRS to be characterized as a mixed swap.\648\
Financing terms may also involve adding or subtracting a spread to or
from the financing rate,\649\ or calculating the financing rate in a
currency other than that of the underlying reference security or
security index.\650\
---------------------------------------------------------------------------

    \648\ See infra part IV.
    \649\ See, e.g., Moorad Chowdry, ``Total Return Swaps: Credit
Derivatives and Synthetic Funding Instruments,'' at 3-4 (noting that
the spread to the TRS financing rate is a function of: The credit
rating of the counterparty paying the financing rate; the amount,
value, and credit quality of the reference asset; the dealer's
funding costs; a profit margin; and the capital charge associated
with the TRS), available at http://www.yieldcurve.com/Mktresearch/LearningCurve/TRS.pdf.
    \650\ For example, a security-based swap on an equity security
priced in U.S. dollars in which payments are made in Euros based on
the U.S. dollar/Euro spot rate at the time the payment is made would
not be a mixed swap. As the Commissions stated in the Proposing
Release, under these circumstances, the currency is merely
referenced in connection with the method of payment, and the
counterparties are not hedging the risk of changes in currency
exchange rates during the term of the security-based swap See
Proposing Release at 29842, n. 176.
---------------------------------------------------------------------------

    However, where such payments incorporate additional elements that
create additional interest rate or currency exposures that are
unrelated to the financing of the security-based swap, or otherwise
shift or limit risks that are related to the financing of the security-
based swap, those additional elements may cause the security-based swap
to be a mixed swap. For example, where the counterparties embed
interest-rate optionality (e.g., a cap, collar, call, or put) into the
terms of a security-based swap in a manner designed to shift or limit
interest rate exposure, the inclusion of these terms would cause the
TRS to be both a swap and a security-based swap (i.e., a mixed swap).
Similarly, if a TRS is also based on non-security-based components
(such as the price of oil, or a currency), the TRS would also be a
mixed swap.\651\
---------------------------------------------------------------------------

    \651\ See Mixed Swaps, infra part IV.
---------------------------------------------------------------------------

    The Commissions also are providing an additional interpretation
regarding a quanto equity swap, in response to comments raised by one
commenter,\652\ and for illustrative purposes, a similar but
contrasting product, a compo equity swap. A quanto equity swap, which
``can provide a U.S. investor with currency-protected exposure to a
non-U.S. equity index by translating the percentage equity return in
the currency of such non-U.S. equity index into U.S. dollars,'' \653\
can be described as:
---------------------------------------------------------------------------

    \652\ See SIFMA Letter.
    \653\ Id.

    An equity swap in which [(1)] the underlying is denominated in a
currency (the foreign currency) other than that in which the equity
swap is denominated (the domestic currency) * * * [and (2) t]he
final value of the underlying is denominated in the foreign currency
and is converted into the domestic currency using the exchange rate
prevailing at inception[,] result[ing in] the investor * * * not
[being] exposed to currency risk.\654\
---------------------------------------------------------------------------

    \654\ Handbook of Corporate Equity Derivatives and Equity
Capital Markets (``Corporate Equity Derivatives Handbook''), Sec.
1.2.10, at 23, available at http://media.wiley.com/product_data/excerpt/05/11199759/1119975905-83.pdf last visited May 4, 2012.

    While a quanto equity swap, therefore, effectively ``exposes the
dealer on the foreign leg of the correlation product to a variable
notional principal amount that changes whenever the exchange rate or
the foreign index fluctuates,'' \655\ such exposure results from the
choice of hedges for the quanto equity swap, not from the cash flows of
the quanto equity swap itself.\656\ Thus, that exposure could be viewed
as created in the seller by the act of entering into the quanto equity
swap, rather than as a transfer between the parties, as is required by
the third prong of the statutory swap definition. Consequently, the
dealer's exchange rate exposure could be seen as incidental to the
securities exposure desired by the party initiating the quanto equity
swap.
---------------------------------------------------------------------------

    \655\ James M. Mahoney, Correlation Products and Risk Management
Issues, FRBNY Economic Policy Review/October 1995 at 2, available at
http://www.ny.frb.org/research/epr/95v01n3/9510maho.pdf last visited
May 4, 2012.
    \656\ While applicable in general, this logic, which merely
expands upon the principle that the character of a Title VII
instrument as either a swap or a security-based swap should follow
the underlying factors which are incorporated into the cash flows of
the instrument--a security, yield, loan, or other trigger for SEC
jurisdiction or as a commodity triggering CFTC jurisdiction (or both
for joint jurisdiction), should not be extrapolated to other Title
VII instruments, for which other principles may override.
---------------------------------------------------------------------------

    The Commissions view a quanto equity swap as a security-based swap,
and not a mixed swap, where (i) the purpose of the quanto equity swap
is to transfer exposure to the return of a security or security index
without transferring exposure to any currency or exchange rate risk;
and (ii) any exchange rate or currency risk exposure incurred by the
dealer due to a difference in the currency denomination of the quanto
equity swap and of the underlying security or security index is
incidental to the quanto equity swap and arises from the instrument(s)
the dealer chooses to use to hedge the quanto equity swap and is not a
direct result of any expected payment obligations by either party under
the quanto equity swap.\657\
---------------------------------------------------------------------------

    \657\ Although the SIFMA Letter describes quanto equity swaps in
terms of equity indexes, if the underlying reference of a quanto
equity swap is a single security, the result would be the same. The
Commissions also note that if a security index underlying a quanto
equity swap is not narrow-based, the quanto equity swap is a swap.
In that event, it is not a mixed swap because no element of the
quanto equity swap is a security-based swap and, to be a mixed swap,
a Title VII instrument must have both swap and security-based swap
components.
---------------------------------------------------------------------------

    By contrast, in a compo equity swap, the parties assume exposure
to, and the total return is calculated based on, both the performance
of specified foreign stocks and the change in the relevant exchange
rate.\658\ Because the counterparty initiating a transaction can choose
to avoid currency exposure by entering into a quanto equity swap, the
currency exposure obtained via a compo equity swap is not incidental to
the equity exposure for purposes of determining mixed swap status. In
fact, investors seeking synthetic exposure to foreign securities via a
TRS may also be seeking exposure to the exchange rate between the
currencies, as evidenced by the fact that a number of mutual funds
exist in both hedged and unhedged versions to provide investors
exposure to the same foreign securities with or without the attendant
currency

exposure.\659\ Consequently, a compo equity swap is a mixed swap.\660\
---------------------------------------------------------------------------

    \658\ See generally Corporate Equity Derivatives Handbook, supra
note 654, Sec.  1.2.9, at 21-23.
    \659\ See, e.g., Descriptive Brochure: The Tweedy, Browne Global
Value Fund II--Currency Unhedged at 1, available at http://www.tweedy.com/resources/gvf2/TBGVF-II_verJuly2011.pdf (last
visited May 4, 2012) (comparing the Tweedy, Browne Global Value Fund
II--Currency Unhedged and the Tweedy, Browne Global Value Fund
(which hedges its currency exposure) and stating that ``[t]he only
material difference [between the funds] is that the Unhedged Global
Value Fund generally does not hedge currency risk [and] is designed
for long-term value investors who wish to focus their investment
exposure on foreign stock markets, and their associated non-U.S.
currencies'' and ``[b]y establishing the Tweedy, Browne Global Value
Fund II--Currency Unhedged, we were acknowledging that many
investors may view exposure to foreign currency as another form of
diversification when investing outside the U.S., and/or may have
strong opinions regarding the future direction of the U.S.
dollar.''). See also the PIMCO Foreign Bond Fund (Unhedged) Fact
Sheet at 1 (stating that ``[t]he fund seeks to capture the returns
of non-U.S. bonds including potential returns due to changes in
exchange rates. In a declining dollar environment foreign currency
appreciation may augment the returns generated by investments in
foreign bonds.''), available at http://investments.pimco.com/ShareholderCommunications/External%20Documents/Foreign%20Bond%20Fund%20(Unhedged)%20Institutional.pdf last visited
May 4, 2012 and the PIMCO Foreign Bond Fund (U.S. Dollar-Hedged)
INSTL Fact Sheet at 1 (stating that ``[t]he fund seeks to capture
the returns of non-U.S. bonds but generally hedges out most currency
exposure in order to limit the volatility of returns.''), available
at http://investments.pimco.com/ShareholderCommunications/External%20Documents/Foreign%20Bond%20Fund%20(U.S.%20Dollar-
Hedged)%20Institutional.pdf (last visited May 4, 2012).
    \660\ Such swaps are examples of swaps with payments that
``incorporate additional elements that create additional * * *
currency exposures * * * unrelated to the financing of the security-
based swap * * * that may cause the security-based swap to be a
mixed swap.'' See Proposing Release at 29842.
---------------------------------------------------------------------------

    In response to comments,\661\ the Commissions also are providing an
interpretation with respect to the treatment of loan TRS (``LTRS'') on
two or more loans. As noted above, the second prong of the security-
based swap definition includes a swap that is based on ``a single
security or loan, including any interest therein or on the value
thereof.'' Thus, an LTRS based on a single loan, as mentioned above, is
a security-based swap. The Commissions believe, however, that an LTRS
based on two or more non-security loans are swaps, and not security-
based swaps.\662\ An LTRS on a group or index of such non-security
loans is not covered by the first prong of the security-based swap
definition--swaps based on a narrow-based security index--because the
definition of the term ``narrow-based security index'' in both the CEA
and the Exchange Act only applies to securities, and not to non-
security loans.\663\ An LTRS, moreover, is not covered by the third
prong of the security-based swap definition because it is based on the
total return of such loans, and not events related thereto.
Accordingly, an LTRS on two or more loans that are non-security loans
is a swap and not a security-based swap.\664\
---------------------------------------------------------------------------

    \661\ See infra note 667 and accompanying text.
    \662\ Depending on the facts and circumstances loans may be
notes or evidences of indebtedness that are securities. See section
3(a)(10) of the Exchange Act. In this section, the Commissions
address only groups or indexes of loans that are not securities.
    \663\ See CEA section 1a(35), 7 U.S.C. 1a(35), and section
3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55).
    \664\ The same would be true with respect to swaps (e.g.,
options, CFDs, NDFs), other than LTRS or loan index credit default
swaps, on two or more loans that are not securities.
---------------------------------------------------------------------------

Comments
    The Commissions received three comments with respect to the
interpretation provided on TRS in the Proposing Release.\665\ One of
these commenters addressed the Commissions' interpretation on security-
based TRS.\666\ The other two commenters requested that the Commissions
clarify the treatment of LTRS on two or more loans.\667\
---------------------------------------------------------------------------

    \665\ See July LSTA Letter; Letter from David Lucking, Allen &
Overy LLP, dated May 26, 2011 (``Allen & Overy Letter''); and SIFMA
Letter.
    \666\ See SIFMA Letter.
    \667\ See Allen & Overy Letter and July LSTA Letter.
---------------------------------------------------------------------------

    One commenter asserted that the terms of a TRS that create interest
rate or currency exposures incidental to the primary purpose of the TRS
should not cause a transaction that otherwise would be deemed to be a
security-based swap to be characterized as a mixed swap.\668\ This
commenter agreed with the Commissions that the scope of the mixed swap
category of Title VII instruments is intended to be narrow and that,
when variable interest rates are used for financing purposes incidental
to counterparties' purposes, and risks assumed, in entering into a TRS,
the TRS is a security-based swap and not a mixed swap.\669\
---------------------------------------------------------------------------

    \668\ See SIFMA Letter.
    \669\ Id.
---------------------------------------------------------------------------

    This commenter also opined that the Commissions' interpretation
that ``where such payments incorporate additional elements that create
additional interest rate or currency exposures * * * unrelated to the
financing of the [TRS], or otherwise shift or limit risks that are
related to the financing of the [TRS], those additional elements may
cause the [TRS] to be a mixed swap'' could be seen as requiring a
quantitative analysis to determine whether a reference to interest
rates or currencies in a TRS is solely for financing purposes or
creates additional exposure that might be construed as extending beyond
those purposes.\670\
---------------------------------------------------------------------------

    \670\ Id. SIFMA added that such a determination could require
market participants to determine whether a specific interest rate or
spread referenced in the TRS is sufficiently in line with market
rates to constitute a financing leg of a transaction under the
proposed test. SIFMA continues by noting that there are a number of
examples where a TRS can provide for some interest rate or currency
exposure incidental to the primary purpose of the TRS, describing a
quanto equity swap as an example.
---------------------------------------------------------------------------

    The Commissions are clarifying that a quantitative analysis is not
necessarily required in order to determine whether a TRS is a mixed
swap. Any analysis, quantitative or qualitative, clearly demonstrating
the nature of a payment (solely financing-related, unrelated to
financing or a combination of the two) can suffice.\671\
---------------------------------------------------------------------------

    \671\ To the extent a market participant is uncertain as to the
results of such an analysis, it may seek informal guidance from the
Commissions' staffs or use the process established in this release,
see infra part VI, for seeking formal guidance from the Commissions
as to the nature of a Title VII instrument as a swap, security-based
swap or mixed swap.
---------------------------------------------------------------------------

    The Commissions also are clarifying that market participants are
not necessarily required to compare their financing rates to market
financing rates in order to determine whether the financing leg of a
TRS is merely a financing leg or is sufficient to render the TRS a
mixed swap. Because a number of factors can influence how a particular
TRS is structured,\672\ the Commissions cannot provide an
interpretation applicable to all situations. If the financing leg of a
TRS reflects the dealer's financing costs on a one-to-one basis, the
Commissions would view such leg as a financing leg. Adding a spread
would not alter that conclusion if the spread is consistent with the
dealer's course of dealing generally, with respect to a particular type
of TRS or with respect to a particular counterparty. The Commissions
believe that this would be the case even if the spread is ``off-
market,'' if the deviance from a market spread is explained by factors
unique to the dealer (e.g., the dealer has high financing costs), to
the TRS (e.g., the underlying securities are highly illiquid, so
financing them is more costly than would be reflected in a ``typical''
market spread for other TRS) or to then-current market conditions
(e.g., a share repurchase might make shares harder

for a dealer to procure in order to hedge its obligations under a TRS
to pay its counterparty the capital appreciation of a security,
resulting in higher financing costs due to the decrease in shares
outstanding, assuming demand for the shares does not change). If the
spread is designed to provide exposure to an underlying reference other
than securities, however, rather than to reflect financing costs, such
a TRS is a mixed swap.
---------------------------------------------------------------------------

    \672\ For example, the Commissions would expect a dealer
perceived by the market to constitute a higher counterparty risk to
have higher funding costs generally, which might affect its TRS
financing costs. To the extent such a dealer passed through its
higher TRS financing costs to its TRS counterparty, such a pass-
through simply would reflect the dealer's specific circumstances,
and would not transform the TRS from a security-based swap into a
mixed swap.
---------------------------------------------------------------------------

    Market participants are better positioned than are the Commissions
to determine what analysis, and what supporting information and
materials, best establish whether the nature of a particular payment
reflects financing costs alone, or something more. Moreover, the
Commissions expect that a dealer would know if the purpose of the
payment(s) in question is to cover its cost of financing a position or
a related hedge.\673\ In such cases, a detailed analysis should not be
necessary.
---------------------------------------------------------------------------

    \673\ The Commissions expect that dealers know their financing
costs and can readily explain the components of the financing leg
paid by their TRS counterparties.
---------------------------------------------------------------------------

    One commenter noted the nature of quanto equity swaps as TRS and
maintained that such a transaction ``is equivalent to a financing of a
long position in the underlying non-U.S. equity index[]'' and that the
currency protection is incidental to the financing element, which is
the primary purpose of the TRS.\674\ As discussed above, the
Commissions have provided a final interpretation regarding the
appropriate classification of Title VII instruments that are quanto
equity swaps and compo equity swaps.
---------------------------------------------------------------------------

    \674\ Id. SIFMA distinguished quanto equity swaps from the
examples of mixed swaps that the Commissions provided in the
Proposing Release, characterizing them as ``very different.''
---------------------------------------------------------------------------

    Two commenters requested that the Commissions clarify the status of
LTRS on two or more loans.\675\ Both commenters stated that while the
statutory definition of the term ``security-based swap'' provides that
swaps based on a single loan are security-based swaps, it does not
explicitly provide whether swaps on indexes of loans are security-based
swaps.\676\ They requested clarification regarding the treatment of
loan based swaps, including both LTRS and loan index credit default
swaps.\677\
---------------------------------------------------------------------------

    \675\ See Allen & Overy Letter and July LSTA Letter.
    \676\ See Allen & Overy Letter. Allen & Overy notes that a Title
VII Instrument that references two securities is a security-based
swap. It believes that treating an LTRS on two or more loans as a
swap would result in functionally and potentially economically
similar products being treated in an arbitrarily different way,
contrary to the spirit of the Dodd-Frank Act.
    \677\ The Commissions address the comments regarding loan index
credit default swaps below. See infra note 768 and accompanying
text.
---------------------------------------------------------------------------

    The Commissions have provided the final interpretation discussed
above regarding LTRS based on two or more loans that are not
securities. The Commissions acknowledge that this interpretation
results in different treatment for an LTRS on two non-security loans (a
swap), as opposed to a Title VII instrument based on two securities (a
security-based swap). This result, however, is dictated by the statute.

D. Security-Based Swaps Based on a Single Security or Loan and Single-
Name Credit Default Swaps

    The Commissions provided an interpretation in the Proposing Release
regarding security-based swaps based on a single security or loan and
single-name CDS \678\ and are restating such interpretation with
certain modifications in response to commenters.\679\ The second prong
of the statutory security-based swap definition includes a swap that is
based on ``a single security or loan, including any interest therein or
on the value thereof.'' \680\ The Commissions believe that under this
prong of the security-based swap definition, a single-name CDS that is
based on a single reference obligation would be a security-based swap
because it would be based on a single security or loan (or any interest
therein or on the value thereof).
---------------------------------------------------------------------------

    \678\ See Proposing Release at 29843.
    \679\ See infra note 689 and accompanying text.
    \680\ Section 3(a)(68)(A)(ii)(II) of the Exchange Act, 15 U.S.C.
78c(a)(68)(A)(ii)(II). The first prong of the security-based swap
definition is discussed below. See infra part III.G.
---------------------------------------------------------------------------

    In addition, the third prong of the security-based swap definition
includes a swap that is based on the occurrence of an event relating to
a ``single issuer of a security,'' provided that such event ``directly
affects the financial statements, financial condition, or financial
obligations of the issuer.'' \681\ This provision applies generally to
event-triggered swap contracts. With respect to a CDS, such events
could include, for example, the bankruptcy of an issuer, a default on
one of an issuer's debt securities, or the default on a non-security
loan of an issuer.\682\
---------------------------------------------------------------------------

    \681\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15
U.S.C. 78c(a)(68)(A)(ii)(III).
    \682\ The Commissions understand that in the context of credit
derivatives on asset-backed securities or MBS, the events include
principal writedowns, failure to pay principal and interest
shortfalls.
---------------------------------------------------------------------------

    The Commissions believe that if the payout on a CDS on a single
issuer of a security is triggered by the occurrence of an event
relating to that issuer, the CDS is a security-based swap under the
third prong of the statutory security-based swap definition.\683\
---------------------------------------------------------------------------

    \683\ The Commissions understand that some single-name CDS now
trade with fixed coupon payments expressed as a percentage of the
notional amount of the transaction and payable on a periodic basis
during the term of the transaction. See Markit, ``The CDS Big Bang:
Understanding the Changes to the Global CDS Contract and North
American Conventions,'' 3, available at http://www.markit.com/cds/announcements/resource/cds_big_bang.pdf. The Commissions are
restating their view that the existence of such single-name CDS does
not change their interpretation.
---------------------------------------------------------------------------

    In relation to aggregations of transactions under a single ISDA
Master Agreement,\684\ the Commissions are revising the example that
was included in the Proposing Release referring to single-name CDS to
clarify that the interpretation regarding aggregations of transactions
is non-exclusive and thus not limited to either CDS or single-reference
instruments.\685\
---------------------------------------------------------------------------

    \684\ See Proposing Release at 29843.
    \685\ See infra note 689 and accompanying text.
---------------------------------------------------------------------------

    The Commissions believe that each transaction under an ISDA Master
Agreement would need to be analyzed to determine whether it is a swap
or security-based swap. For example, the Commissions believe that a
number of Title VII instruments that are executed at the same time and
that are documented under one ISDA Master Agreement, but in which a
separate confirmation is sent for each instrument, should be treated as
an aggregation of such Title VII instruments, each of which must be
analyzed separately under the swap and security-based swap
definitions.\686\ The Commissions believe that, as a practical and
economic matter, each such Title VII instrument would be a separate and
independent transaction. Thus, such an aggregation of Title VII
instruments would not constitute a Title VII instrument based on one
``index or group'' \687\ under the security-based swap definition but
instead would constitute multiple Title VII instruments. The
Commissions find that this interpretation is an appropriate way to
address CDS, TRS or other Title VII instruments referencing a single
security or loan or entity that is documented under a Master Agreement
or Master Confirmation and is designed to reduce the cost associated
with determining

whether such instruments are swaps or security-based swaps.\688\
---------------------------------------------------------------------------

    \686\ See infra note 691.
    \687\ The security-based swap definition further defines ``index
to include an ``index or group of securities.'' See section
3(a)(68)(E) of the Exchange Act, 15 U.S.C. 78c(a)(68)(E).
    \688\ See supra part I, under ``Overall Economic
Considerations''.
---------------------------------------------------------------------------

Comments
    The Commissions received two comments regarding the interpretation
regarding aggregation of Title VII instruments under a single ISDA
Master Agreement. One commenter requested that the Commissions clarify
that the interpretation applies to other types of instruments, such as
TRS, in addition to CDS.\689\ The commenter also stated that the
interpretation should be helpful with respect to use of a ``Master
Confirmation'' structure, which the commenter described as use of
general terms in a ``Master Confirmation'' that apply to a number of
instruments with separate underlying references but for which a
separate ``Supplemental Confirmation'' is sent for each separate
component.\690\
---------------------------------------------------------------------------

    \689\ See July LSTA Letter.
    \690\ Id.
---------------------------------------------------------------------------

    A second commenter agreed with the Commissions' interpretation that
a number of single-name CDS that are executed at the same time and that
are documented under one ISDA Master Agreement, but in which a separate
confirmation is sent for each CDS, should not be treated as a single
index CDS and stated that this approach is consistent with market
practice.\691\
---------------------------------------------------------------------------

    \691\ See Letter from Richard M. McVey, Chairman and Chief
Executive Officer, MarketAxess Holdings, Inc. (``MarketAxess''),
July 22, 2011 (``MarketAxess Letter'').
---------------------------------------------------------------------------

    As discussed above, in response to comments the Commissions are
expanding the example so it is clear that it applies beyond just
CDS.\692\
---------------------------------------------------------------------------

    \692\ The Commissions believe, based on the July LSTA Letter,
that the ``Master Confirmation'' structure the commenter described
is the same general structure as the aggregation of single-name CDS
the Commissions provided as an example in the Proposing Release, but
that a ``Master Confirmation'' structure may not be limited to
single-reference instruments or to CDS and instead may be used for a
broader range of instruments. See July LSTA Letter. The Commissions
note that the following are examples of ``Master Confirmation''
structure to which the interpretive guidance would apply: 2009
Americas Master Equity Derivatives Confirmation Agreement, Stand-
alone 2007 Americas Master Variance Swap Confirmation Agreement, and
2004 Americas Interdealer Master Equity Derivatives Confirmation
Agreement and March 2004 Canadian Supplement to the Master
Confirmation. The Commissions believe the broader example in this
release provides the clarification the commenter requested.
---------------------------------------------------------------------------

E. Title VII Instruments Based on Futures Contracts

    The Commissions proposed an interpretation in the Proposing Release
regarding the treatment, generally, of swaps based on futures
contracts.\693\ The Commissions are restating the interpretation they
provided in the Proposing Release without modification. The Commissions
also discussed in the Proposing Release the unique circumstance
involving certain futures contracts on foreign government debt
securities and requested comment as to how Title VII instruments on
these futures contracts should be treated.\694\ In response to
commenters,\695\ the Commissions are adopting a rule regarding the
treatment of Title VII instruments on certain futures contracts on
foreign government debt securities.\696\
---------------------------------------------------------------------------

    \693\ See Proposing Release at 29843-44.
    \694\ Id.
    \695\ See infra note 718 and accompanying text.
    \696\ See rule 1.3(bbbb) under the CEA and rule 3a68-5 under the
Exchange Act.
---------------------------------------------------------------------------

    A Title VII instrument that is based on a futures contract will
either be a swap or a security-based swap, or both (i.e., a mixed
swap), depending on the nature of the futures contract, including the
underlying reference of the futures contract. Thus, a Title VII
instrument where the underlying reference is a security future is a
security-based swap.\697\ In general, a Title VII instrument where the
underlying reference is a futures contract that is not a security
future is a swap.\698\ As the Commissions noted in the Proposing
Release,\699\ Title VII instruments involving certain futures contracts
on foreign government debt securities present a unique circumstance,
which is discussed below.
---------------------------------------------------------------------------

    \697\ A security future is defined in both the CEA and the
Exchange Act as a futures contract on a single security or a narrow-
based security index, including any interest therein or based on the
value thereof, except an exempted security under section 3(a)(12) of
the Exchange Act, 15 U.S.C. 78c(a)(12), as in effect on the date of
enactment of the Futures Trading Act of 1982 (other than any
municipal security as defined in section 3(a)(29) of the Exchange
Act, 15 U.S.C. 78c(a)(29), as in effect on the date of enactment of
the Futures Trading Act of 1982).
    The term security future does not include any agreement,
contract, or transaction excluded from the CEA under sections 2(c),
2(d), 2(f), or 2(g) of the CEA, 7 U.S.C. 2(c), 2(d), 2(f), or 2(g),
as in effect on the date of enactment of the Commodity Futures
Modernization Act of 2000 (``CFMA'') or Title IV of the CFMA. See
section 1a(44) of the CEA, 7 U.S.C. 1a(44), and section 3(a)(55) of
the Exchange Act, 15 U.S.C. 78c(a)(55).
    \698\ Depending on the underlying reference of the futures
contract, though, such swaps could be SBSAs. For example, a swap on
a future on the S&P 500 index would be an SBSA.
    \699\ See Proposing Release at 29843.
---------------------------------------------------------------------------

    Rule 3a12-8 under the Exchange Act exempts certain foreign
government debt securities, for purposes only of the offer, sale, or
confirmation of sale of futures contracts on such foreign government
debt securities, from all provisions of the Exchange Act which by their
terms do not apply to an ``exempted security,'' subject to certain
conditions.\700\ To date, the SEC has enumerated within rule 3a12-8 the
debt securities of 21 foreign governments solely for purposes of
futures trading (``21 enumerated foreign governments'').\701\
---------------------------------------------------------------------------

    \700\ Specifically, rule 3a12-8 under the Exchange Act requires
as a condition to the exemption that the foreign government debt
securities not be registered under the Securities Act (or be the
subject of any American depositary receipt registered under the
Securities Act) and that futures contracts on such foreign
government debt securities ``require delivery outside the United
States, [and] any of its possessions or territories, and are traded
on or through a board of trade, as defined in [section 2 of the CEA,
7 U.S.C. 2].'' See rules 3a12-8(a)(2) and 3a12-8(b) under the
Exchange Act, 17 CFR 240.3a12-8(a)(2) and 240.3a12-8(b). These
conditions were ``designed to minimize the impact of the exemption
on securities distribution and trading in the United States. * * *''
See Exemption for Certain Foreign Government Securities for Purposes
of Futures Trading, 49 FR 8595 (Mar. 8, 1984) at 8596-97 (citing
Futures Trading Act of 1982).
    \701\ See rule 3a12-8(a)(1) under the Exchange Act (designating
the debt securities of the governments of the United Kingdom,
Canada, Japan, Australia, France, New Zealand, Austria, Denmark,
Finland, the Netherlands, Switzerland, Germany, Ireland, Italy,
Spain, Mexico, Brazil, Argentina, Venezuela, Belgium, and Sweden).
---------------------------------------------------------------------------

    The Commissions recognize that as a result of rule 3a12-8, futures
contracts on the debt securities of the 21 enumerated foreign
governments that satisfy the conditions of rule 3a12-8 are subject to
the CFTC's exclusive jurisdiction and are not considered security
futures. As a result, applying the interpretation above to a Title VII
instrument that is based on a futures contract on the debt securities
of these 21 enumerated foreign governments would mean that the Title
VII instrument would be a swap.\702\ The Commissions note, however,
that the conditions in rule 3a12-8 were established specifically for
purposes of the offer and sale of ``qualifying foreign futures
contracts'' (as defined in rule 3a12-8) \703\ on the debt securities of
the 21 enumerated foreign governments,\704\ not Title VII instruments
based on futures contracts on the debt securities

of the 21 enumerated governments. Further, the Commissions note that
the Dodd-Frank Act did not exclude swaps on foreign government debt
securities generally from the definition of the term ``security-based
swap.'' Accordingly, a Title VII instrument that is based directly on
foreign government debt securities, including those of the 21
enumerated governments, is a security-based swap or a swap under the
same analysis as any other Title VII instruments based on securities.
---------------------------------------------------------------------------

    \702\ The Commissions note, by contrast, that a Title VII
instrument that is based on the price or value of, or settlement
into, a futures contract on the debt securities of one of the 21
enumerated foreign governments and that also has the potential to
settle directly into such debt securities would be a security-based
swap and, depending on other features of the Title VII instrument,
possibly a mixed swap.
    \703\ Rule 3a12-8(b) under the Exchange Act defines ``qualifying
foreign futures contracts'' as ``contracts for the purchase or sale
of a designated foreign government security for future delivery, as
`future delivery' is defined in 7 U.S.C. 2, provided such contracts
require delivery outside the United States, any of its possessions
or territories, and are traded on or through a board of trade, as
defined at 7 U.S.C. 2.'' 17 CFR 240.3a12-8(b).
    \704\ See supra note 700.
---------------------------------------------------------------------------

    The Commissions indicated in the Proposing Release that they would
evaluate whether Title VII instruments based on futures contracts on
the debt securities of the 21 enumerated foreign governments that
satisfy the conditions of rule 3a12-8 should be characterized as swaps,
security-based swaps, or mixed swaps.\705\ In response to
commenters,\706\ the Commissions are adopting rule 1.3(bbbb) under the
CEA and rule 3a68-5 under the Exchange Act, which address the treatment
of these Title VII instruments.
---------------------------------------------------------------------------

    \705\ See Proposing Release at 29844.
    \706\ See infra note 718 and accompanying text.
---------------------------------------------------------------------------

    The final rules provide that a Title VII instrument that is based
on or references a qualifying foreign futures contract on the debt
securities of one or more of the 21 enumerated foreign governments is a
swap and not a security-based swap, provided that the Title VII
instrument satisfies the following conditions:
     The futures contract on which the Title VII instrument is
based or that is referenced is a qualifying foreign futures contract
(as defined in rule 3a12-8) \707\ on the debt securities of any one or
more of the 21 enumerated foreign governments that satisfies the
conditions of rule 3a12-8;
---------------------------------------------------------------------------

    \707\ See supra note 703.
---------------------------------------------------------------------------

     The Title VII instrument is traded on or through a board
of trade (as defined in section 1a(6) of the CEA);
     The debt securities on which the qualifying foreign
futures contract is based or referenced and any security used to
determine the cash settlement amount pursuant to the fourth condition
below are not covered by an effective registration statement under the
Securities Act or the subject of any American depositary receipt
covered by an effective registration statement under the Securities
Act;
     The Title VII instrument may only be cash settled; and
     The Title VII instrument is not entered into by the issuer
of the securities upon which the qualifying foreign futures contract is
based or referenced (including any security used to determine the cash
payment due on settlement of such Title VII instrument), an affiliate
(as defined in the Securities Act and the rules and regulations
thereunder) \708\ of the issuer, or an underwriter with respect to such
securities.
---------------------------------------------------------------------------

    \708\ See, e.g., rule 405 under the Securities Act, 17 CFR
230.405.
---------------------------------------------------------------------------

    Under the first condition, the final rules provide that the futures
contract on which the Title VII instrument is based or referenced must
be a qualifying foreign futures contract that satisfies the conditions
of rule 3a12-8 and may only be based on the debt of any one or more of
the enumerated 21 foreign governments. If the conditions of rule 3a12-8
are not satisfied, then there cannot be a qualifying foreign futures
contract, the futures contract is a security future, and a swap on such
a security future is a security-based swap.
    The second condition of the final rules provides that the Title VII
instrument on the qualifying foreign futures contract must itself be
traded on or through a board of trade because a qualifying foreign
futures contract on the debt securities of one or more of the 21
enumerated foreign governments itself is required to be traded on a
board of trade. The Commissions believe that swaps on such futures
contracts should be traded subject to rules applicable to such futures
contracts themselves.
    The third condition of the final rules provides that the debt
securities on which the qualifying foreign futures contract is based or
referenced and any security used to determine the cash settlement
amount pursuant to the fourth condition cannot be registered under the
Securities Act or be the subject of any American depositary receipt
registered under the Securities Act. This condition is intended to
prevent circumvention of registration and disclosure requirements of
the Securities Act applicable to foreign government issuances of their
securities. This condition is similar to a condition included in rule
3a12-8.\709\
---------------------------------------------------------------------------

    \709\ See supra note 700.
---------------------------------------------------------------------------

    The fourth condition of the final rules provides that the Title VII
instrument must be cash settled. Although, as the Commissions
recognize, rule 3a12-8 permits a qualifying foreign futures contract to
be physically settled so long as delivery is outside the United States,
any of its possessions or territories,\710\ in the context of Title VII
instruments, only cash settled Title VII instruments based on
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments will be considered swaps. The
Commissions believe that this condition is appropriate in order to
provide consistent treatment of Title VII instruments based on
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments with the Commissions' treatment of swaps
and security-based swaps generally.\711\
---------------------------------------------------------------------------

    \710\ Id.
    \711\ See infra part III.H.
---------------------------------------------------------------------------

    The fifth condition of the final rules provides that for a Title
VII instrument to be a swap under such rules, it cannot be entered into
by the issuer of the securities upon which the qualifying foreign
futures contract is based or referenced (including any security used to
determine the cash payment due on settlement of such Title VII
instrument), an affiliate of the issuer, or an underwriter of the
issuer's securities. The Commissions have included this condition to
address the concerns raised by the SEC in the Proposing Release that
the characterization of a Title VII instrument that is based on a
futures contract on the debt securities of one of the 21 enumerated
foreign governments may affect Federal securities law provisions
relating to the distribution of the securities upon which the Title VII
instrument is based or referenced.\712\
---------------------------------------------------------------------------

    \712\ See Proposing Release at 29844.
---------------------------------------------------------------------------

    The Dodd-Frank Act included provisions that would not permit
issuers, affiliates of issuers, or underwriters to use security-based
swaps to offer or sell the issuers' securities underlying a security-
based swap without complying with the requirements of the Securities
Act.\713\ This provision applies regardless of whether the Title VII
instrument allows the parties to physically settle any such security-
based swap. In addition, the Dodd-Frank Act provided that any offer or
sale of security-based swaps to non-ECPs would have to be registered
under the Securities Act.\714\ For example, if a Title VII instrument
that is based on a futures contract on the debt securities of one of
the 21 enumerated foreign governments is characterized as a swap, and
not a security-based swap, then the provisions of the Dodd-Frank Act
enacted to ensure that there could not be offers and sales of
securities made without compliance with the Securities Act, either by
issuers, their affiliates, or underwriters or to non-ECPs, would not
apply to such swap transactions.
---------------------------------------------------------------------------

    \713\ See section 2(a)(3) of the Securities Act, 15 U.S.C.
77b(a)(3), as amended by the Dodd-Frank Act.
    \714\ See section 5 of the Securities Act, 15 U.S.C. 77e, as
amended by the Dodd-Frank Act.
---------------------------------------------------------------------------

    Only those Title VII instruments that are based on qualifying
foreign futures contracts on the debt securities of the 21

enumerated foreign governments and that satisfy these five conditions
will be swaps, not security-based swaps. The Commissions note that the
final rules are intended to provide consistent treatment (other than
with respect to method of settlement) of qualifying foreign futures
contracts and Title VII instruments based on qualifying foreign futures
contracts on the debt securities of the 21 enumerated foreign
governments.\715\ The Commissions understand that many of the
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments trade with substantial volume through
foreign trading venues under the conditions set forth in rule 3a12-8
\716\ and permitting swaps on such futures contracts subject to similar
conditions would not raise concerns that such swaps could be used to
circumvent the conditions of rule 3a12-8 and the Federal securities
laws concerns that such conditions are intended to protect.\717\
Further, providing consistent treatment for qualifying foreign futures
contracts on the debt securities of the 21 enumerated foreign
governments and Title VII instruments based on futures contracts on the
debt securities of the 21 enumerated foreign governments will allow
trading of these instruments through designated contract markets on
which such futures are listed.
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    \715\ The Commissions note that the final rules provide
consistent treatment of qualifying foreign futures contracts on the
debt securities of the 21 enumerated foreign governments and Title
VII instruments based on qualifying foreign futures contracts on the
debt securities of the 21 enumerated foreign governments unless the
Title VII instrument is entered into by the issuer of the securities
upon which the qualifying foreign futures contract is based or
referenced (including any security used to determine the cash
payment due on settlement of such Title VII instrument), an
affiliate of the issuer, or an underwriter with respect to such
securities.
    \716\ For the quarter that ended December 31, 2011, the trading
volume reported to the CFTC of qualifying foreign futures contracts
on the debt securities of the 21 enumerated foreign governments made
available for trading by direct access from the U.S. on foreign
trading venues granted direct access no-action relief by the CFTC
that exceeded 100,000 contracts per quarter from the U.S. were as
follows: (i) 7,985,959 contracts for 3 Year Treasury Bond Futures on
the Australian Securities Exchange's ASX Trade24 platform; (ii)
1,872,592 contracts for 10-Year Government of Canada Bond Futures on
the Bourse de Montreal; (iii) 47,874,911 contracts for Euro Bund
Futures on Eurex Deutschland (``Eurex''); (iv) 26,434,713 contracts
for Euro Bobl Futures on Eurex; (v) 30,489,427 contracts for Euro
Schatz Futures on Eurex; and (vi) 8,292,222 contracts for Long Gilt
Futures on the NYSE LIFFE.
    \717\ See supra note 712 and accompanying text.
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    The Commissions recognize that the rules may result in a different
characterization of a Title VII instrument that is based directly on a
foreign government debt security and one that is based on a qualifying
foreign futures contract on a debt security of one of the 21 enumerated
foreign governments. However, the Commissions note that this is the
case today (i.e., different treatments) with respect to other
instruments subject to CFTC regulation and/or SEC regulation, such as
futures on broad-based security indexes and futures on a single
security or narrow-based security index.
Comments
    Commenters did not address the interpretation as it applied to
Title VII instruments based on futures contracts generally. Two
commenters addressed Title VII instruments based on futures contracts
on debt securities of the 21 enumerated foreign governments.\718\ Both
commenters requested that the Commissions treat these Title VII
instruments as swaps.\719\ The Commissions agree that these instruments
should be treated as swaps under certain conditions and, therefore, are
adopting rule 1.3(bbbb) under the CEA and rule 3a68-5 under the
Exchange Act as discussed above to treat Title VII instruments based on
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments as swaps, provided such Title VII
instruments satisfy certain conditions.
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    \718\ See CME Letter and SIFMA Letter.
    \719\ Id. Both commenters stated their belief that the range of
factors considered by the SEC in designating the debt securities of
the 21 enumerated foreign governments as exempted securities
indicated that there is sufficient disclosure about the 21
enumerated foreign governments and their securities such that the
further disclosure should not be necessary. Both commenters also
indicated that subjecting futures contracts on the debt securities
of the 21 enumerated foreign governments to CFTC regulation, while
subjecting Title VII instruments based on these futures contracts to
SEC regulation, would be problematic. Id.
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F. Use of Certain Terms and Conditions in Title VII Instruments

    The Commissions provided an interpretation in the Proposing Release
regarding the use of certain fixed terms in Title VII instruments and
are restating that interpretation without modification.\720\ The
Commissions are aware that market participants' setting of certain
fixed terms or conditions of Title VII instruments may be informed by
the value or level of a security, rate, or other commodity at the time
of the execution of the instrument. The Commissions believe that, in
evaluating whether a Title VII instrument with such a fixed term or
condition is a swap or security-based swap, the nature of the security,
rate, or other commodity that informed the setting of such fixed term
or condition should not itself impact the determination of whether the
Title VII instrument is a swap or a security-based swap, provided that
the fixed term or condition is set at the time of execution and the
value or level of that fixed term or condition may not vary over the
life of the Title VII instrument.\721\
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    \720\ See Proposing Release at 29845.
    \721\ This interpretation relates solely to the determination
regarding whether a Title VII instrument is a swap or security-based
swap. The Commissions are not expressing a view regarding whether
such Title VII instrument would be a security-based swap agreement.
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    For example, a Title VII instrument, such as an interest rate swap,
in which floating payments based on three-month LIBOR are exchanged for
fixed rate payments of five percent would be a swap, and not a
security-based swap, even if the five percent fixed rate was informed
by, or quoted based on, the yield of a security, provided that the five
percent fixed rate was set at the time of execution and may not vary
over the life of the Title VII instrument.\722\ Another example would
be where a private sector or government borrower that issues a five-
year, amortizing $100 million debt security with a semi-annual coupon
of LIBOR plus 250 basis points also, at the same time, chooses to enter
into a five-year interest rate swap on $100 million notional in which
this same borrower, using the same amortization schedule as the debt
security, receives semi-annual payments of LIBOR plus 250 basis points
in exchange for five percent fixed rate payments. The fact that the
specific terms of the interest rate swap (e.g., five-year, LIBOR plus
250 basis points, $100 million notional, fixed amortization schedule)
were set at the time of execution to match related terms of a debt
security does not cause the interest rate swap to become a security-
based swap. However, if the interest rate swap contained additional
terms that were in fact contingent on a characteristic of the debt
security that may change in the future, such as an adjustment to future
interest rate swap payments based on the future price or yield of the
debt security, then this Title VII instrument would be a security-based
swap that would be a mixed swap.
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    \722\ However, to the extent the fixed term or condition is set
at a future date or at a future value or level of a security, rate,
or other commodity rather than the value or level of such security,
rate, or other commodity at the time of execution of the Title VII
instrument, the discussion above would not apply, and the nature of
the security, rate, or other commodity used in determining the terms
or conditions would be considered in evaluating whether the Title
VII instrument is a swap or security-based swap.

---------------------------------------------------------------------------

Comments
    One commenter agreed with the Commissions' interpretation
generally, but believed that the Commissions should broaden the
interpretation to allow a swap to reflect ``resets,'' or changes in the
referenced characteristic of a security, where those ``resets'' or
changes are ``intended to effect a purpose other than transmitting the
risk of changes in the characteristic itself,'' without causing a Title
VII instrument that is not a security-based swap to become a security-
based swap.\723\
---------------------------------------------------------------------------

    \723\ See ISDA Letter.
---------------------------------------------------------------------------

    The Commissions are not expanding the interpretation to allow
``resets'' of a fixed rate derived from a security. The interpretation
is consistent with the statutory swap and security-based swap
definitions. The Commissions believe that a Title VII instrument based
on a rate that follows a security, and that may ``reset'' or change in
the future based on changes in that security, is a security-based swap.
Further, any amendment or modification of a material term of a Title
VII instrument would result in a new Title VII instrument and a
corresponding reassessment of the instrument's status as either a swap
or a security-based swap.\724\
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    \724\ See infra part III.G.5(a).
---------------------------------------------------------------------------

G. The Term ``Narrow-Based Security Index'' in the Security-Based Swap
Definition

1. Introduction
    As noted above, a Title VII instrument in which the underlying
reference of the instrument is a ``narrow-based security index'' is a
security-based swap subject to regulation by the SEC, whereas a Title
VII instrument in which the underlying reference of the instrument is a
security index that is not a narrow-based security index (i.e., the
index is broad-based) is a swap subject to regulation by the CFTC. The
Commissions proposed an interpretation and rules regarding usage of the
term ``narrow-based security index'' in the security-based swap
definition, including:
     The existing criteria for determining whether a security
index is a narrow-based security index and the applicability of past
guidance of the Commissions regarding those criteria to Title VII
instruments;
     New criteria for determining whether a CDS where the
underlying reference is a group or index of entities or obligations of
entities (typically referred to as an ``index CDS'') is based on an
index that is a narrow-based security index;
     The meaning of the term ``index'';
     Rules governing the tolerance period for Title VII
instruments on security indexes traded on DCMs, SEFs, foreign boards of
trade (``FBOTs''), security-based SEFs, or NSEs, where the security
index temporarily moves from broad-based to narrow-based or from
narrow-based to broad-based; and
     Rules governing the grace period for Title VII instruments
on security indexes traded on DCMs, SEFs, FBOTs, security-based SEFs,
or NSEs, where the security index moves from broad-based to narrow-
based or from narrow-based to broad-based and the move is not
temporary.\725\
---------------------------------------------------------------------------

    \725\ See Proposing Release at 29845-58.
---------------------------------------------------------------------------

    As discussed below, the Commissions are restating the
interpretation set forth in the Proposing Release with certain further
clarifications and adopting the rules as proposed with certain
modifications.
2. Applicability of the Statutory Narrow-Based Security Index
Definition and Past Guidance of the Commissions to Title VII
Instruments
    The Commissions provided an interpretation in the Proposing Release
regarding the applicability of the statutory definition of the term
``narrow-based security index'' and past guidance of the Commissions
relating to such term to Title VII instruments.\726\ The Commissions
are restating the interpretation set out in the Proposing Release
without modification.
---------------------------------------------------------------------------

    \726\ See Proposing Release at 29845-48.
---------------------------------------------------------------------------

    As defined in the CEA and Exchange Act,\727\ an index is a narrow-
based security index if, among other things, it meets any one of the
following four criteria:
---------------------------------------------------------------------------

    \727\ Sections 3(a)(55)(B) and (C) of the Exchange Act, 15
U.S.C. 78c(a)(55)(B) and (C), include a definition of ``narrow-based
security index'' in the same paragraph as the definition of security
future. See also sections 1a(35)(A) and (B) of the CEA, 7 U.S.C.
1a(35)(A) and (B). A security future is a contract for future
delivery on a single security or narrow-based security index
(including any interest therein or based on the value thereof). See
section 3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55), and
section 1a(44) of the CEA, 7 U.S.C. 1a(44).
---------------------------------------------------------------------------

     It has nine or fewer component securities;
     A component security comprises more than 30 percent of the
index's weighting;
     The five highest weighted component securities in the
aggregate comprise more than 60 percent of the index's weighting; or
     The lowest weighted component securities comprising, in
the aggregate, 25 percent of the index's weighting have an aggregate
dollar value of average daily trading volume of less than $50,000,000
(or in the case of an index with more than 15 component securities,
$30,000,000), except that if there are two or more securities with
equal weighting that could be included in the calculation of the lowest
weighted component securities comprising, in the aggregate, 25 percent
of the index's weighting, such securities shall be ranked from lowest
to highest dollar value of average daily trading volume and shall be
included in the calculation based on their ranking starting with the
lowest ranked security.\728\
---------------------------------------------------------------------------

    \728\ See section 3(a)(55)(B) of the Exchange Act, 15 U.S.C.
78c(a)(55)(B). See also sections 1a(35)(A) and (B) of the CEA, 7
U.S.C. 1a(35)(A) and (B).
---------------------------------------------------------------------------

    The first three criteria apply to the number and concentration of
the ``component securities'' in the index. The fourth criterion applies
to the average daily trading volume of an index's ``component
securities.'' \729\
---------------------------------------------------------------------------

    \729\ The narrow-based security index definition in the CEA and
Exchange Act also excludes from its scope security indexes that
satisfy certain specified criteria. See sections 3(a)(55)(C)(i)-(vi)
of the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(i)-(vi), and sections
1a(35)(B)(i)-(vi) of the CEA, 7 U.S.C. 1a(35)(B)(i)-(vi).
---------------------------------------------------------------------------

    This statutory narrow-based security index definition focuses on
indexes composed of equity securities and certain aspects of the
definition, in particular the evaluation of average daily trading
volume, are designed to take into account the trading patterns of
individual stocks.\730\ However, the Commissions, pursuant to authority
granted in the CEA and the Exchange Act,\731\ previously have extended
the definition to other categories of indexes but modified the
definition to take into account the characteristics of those other
categories. Specifically, the Commissions have previously provided
guidance regarding the application of the narrow-based security index
definition to futures contracts on volatility indexes \732\ and debt
security indexes.\733\ Today, then, there exists guidance for
determining what constitutes a narrow-based security index.
---------------------------------------------------------------------------

    \730\ See Joint Order Excluding Indexes Comprised of Certain
Index Options From the Definition of Narrow-Based Security Index, 69
FR 16900 (Mar. 31, 2004) (``March 2004 Index Options Joint Order'').
    \731\ See section 1a(35)(B)(vi) of the CEA, 7 U.S.C.
1a(35)(B)(vi), and section 3(a)(55)(C)(vi) of the Exchange Act, 15
U.S.C. 78c(a)(55)(C)(vi).
    \732\ See March 2004 Index Options Joint Order.
    \733\ See Joint Final Rules: Application of the Definition of
Narrow-Based Security Index to Debt Securities Indexes and Security
Futures on Debt Securities, 71 FR 39434 (Jul. 13, 2006) (``July 2006
Debt Index Release'').
---------------------------------------------------------------------------

    Volatility indexes are indexes composed of index options. The
Commissions issued a joint order in

2004 to define when a volatility index is not a narrow-based security
index. Under this joint order, a volatility index is not a narrow-based
security index if the index meets all of the following criteria:
     The index measures the magnitude of changes (as calculated
in accordance with the order) in the level of an underlying index that
is not a narrow-based security index pursuant to the statutory criteria
for equity indexes discussed above;
     The index has more than nine component securities, all of
which are options on the underlying index;
     No component security of the index comprises more than 30
percent of the index's weighting;
     The five highest weighted component securities of the
index in the aggregate do not comprise more than 60 percent of the
index's weighting;
     The average daily trading volume of the lowest weighted
component securities in the underlying index (those comprising, in the
aggregate, 25 percent of the underlying index's weighting) have a
dollar value of more than $50,000,000 (or $30,000,000 in the case of an
underlying index with 15 or more component securities), except if there
are 2 or more securities with equal weighting that could be included in
the calculation of the lowest weighted component securities comprising,
in the aggregate, 25 percent of the underlying index's weighting, such
securities shall be ranked from lowest to highest dollar value of
average daily trading volume and shall be included in the calculation
based on their ranking starting with the lowest ranked security;
     Options on the underlying index are listed and traded on
an NSE registered under section 6(a) of the Exchange Act; \734\ and
---------------------------------------------------------------------------

    \734\ 15 U.S.C. 78f(a).
---------------------------------------------------------------------------

     The aggregate average daily trading volume in options on
the underlying index is at least 10,000 contracts calculated as of the
preceding 6 full calendar months.\735\
---------------------------------------------------------------------------

    \735\ See March 2004 Index Options Joint Order. In 2009, the
Commissions issued a joint order that provided that, instead of the
index options having to be listed on an NSE, the index options must
be listed on an exchange and pricing information for the index
options, and the underlying index, must be computed and disseminated
in real time through major market data vendors. See Joint Order To
Exclude Indexes Composed of Certain Index Options From the
Definition of Narrow-Based Security Index, 74 FR 61116 (Nov. 23,
2009) (expanding the criteria necessary for exclusion under the
March 2004 Index Options Joint Order to apply to volatility indexes
for which pricing information for the underlying broad-based
security index, and the options that compose such index, is current,
accurate, and publicly available).
---------------------------------------------------------------------------

    With regard to debt security indexes, the Commissions issued joint
rules in 2006 (``July 2006 Debt Index Rules'') to define when an index
of debt securities \736\ is not a narrow-based security index. The
first three criteria of that definition are similar to the statutory
definition for equities and the order regarding volatility indexes in
that a debt security index would not be narrow-based if:
---------------------------------------------------------------------------

    \736\ Under the rules, debt securities include notes, bonds,
debentures or evidence of indebtedness. See rule 41.15(a)(1)(i)
under the CEA, 17 CFR 41.15(a)(1)(i) and rule 3a55-4(a)(1)(i) under
the Exchange Act, 17 CFR 240.3a55-4(a)(1)(i). See also July 2006
Debt Index Release.
---------------------------------------------------------------------------

     It is comprised of more than nine debt securities that are
issued by more than nine non-affiliated issuers;
     The securities of any issuer included in the index do not
comprise more than 30 percent of the index's weighting; and
     The securities of any five non-affiliated issuers in the
index do not comprise more than 60 percent of the index's weighting.
    In the July 2006 Debt Index Rules, instead of the statutory average
daily trading volume test, however, the Commissions adopted a public
information availability requirement. Under this requirement, assuming
the aforementioned number and concentration criteria were satisfied, a
debt security index would not be a narrow-based security index if the
debt securities or the issuers of debt securities in the index met any
one of the following criteria:
     The issuer of the debt security is required to file
reports pursuant to section 13 or section 15(d) of the Securities
Exchange Act of 1934; \737\
---------------------------------------------------------------------------

    \737\ 15 U.S.C. 78m or 78o(d).
---------------------------------------------------------------------------

     The issuer of the debt security has a worldwide market
value of its outstanding common equity held by non-affiliates of $700
million or more;
     The issuer of the debt security has outstanding securities
that are notes, bonds, debentures, or evidence of indebtedness having a
total remaining principal amount of at least $1 billion;
     The security is an exempted security as defined in section
3(a)(12) of the Securities Exchange Act of 1934 \738\ and the rules
promulgated thereunder; or
---------------------------------------------------------------------------

    \738\ 15 U.S.C. 78c(a)(12).
---------------------------------------------------------------------------

     The issuer of the security is a government of a foreign
country or a political subdivision of a foreign country.\739\
---------------------------------------------------------------------------

    \739\ See July 2006 Debt Index Rules. The July 2006 Debt Index
Rules also provided that debt securities in the index must satisfy
certain minimum outstanding principal balance criteria, established
certain exceptions to these criteria and the public information
availability requirement, and provided for the treatment of indexes
that include exempted securities (other than municipal securities).
---------------------------------------------------------------------------

    In the Dodd-Frank Act, Congress included the term ``narrow-based
security index'' in the security-based swap definition, and thus the
statutory definition of the term ``narrow-based security index'' \740\
also applies in distinguishing swaps (on security indexes that are not
narrow-based, also known as ``broad-based'') and security-based swaps
(on narrow-based security indexes).\741\ The Commissions have
determined that their prior guidance with respect to what constitutes a
narrow-based security index in the context of volatility indexes \742\
and debt security indexes \743\ applies in determining whether a Title
VII instrument is a swap or a security-based swap, except as the rules
the Commissions are adopting provide for other treatment with respect
to index CDS as discussed below.\744\
---------------------------------------------------------------------------

    \740\ See sections 3(a)(55)(B) and (C) of the Exchange Act, 15
U.S.C. 78c(a)(55)(B) and (C). See also sections 1a(35)(A) and (B) of
the CEA, 7 U.S.C. 1a(35)(A) and (B).
    \741\ The statutory definition of the term ``narrow-based
security index'' for equities, and the Commissions' subsequent
guidance as to what constitutes a narrow-based security index with
respect to volatility and debt indexes, is applicable in the context
of distinguishing between futures contracts and security futures
products.
    \742\ See March 2004 Index Options Joint Order.
    \743\ See July 2006 Debt Index Rules.
    \744\ See infra part III.G.3.
---------------------------------------------------------------------------

    To make clear that the Commissions are applying the prior guidance
and rules to Title VII instruments, the Commissions are adopting rules
to further define the term ``narrow-based security index'' in the
security-based swap definition. Under paragraph (1) of rule 1.3(yyy)
under the CEA and paragraph (a) of rule 3a68-3 under the Exchange Act,
for purposes of the security-based swap definition, the term ``narrow-
based security index'' has the same meaning as the statutory definition
set forth in section 1a(35) of the CEA and section 3(a)(55) of the
Exchange Act,\745\ and the rules, regulations, and orders issued by the
Commissions relating to such definition. As a result, except as the
rules the Commissions are adopting provide for other treatment with
respect to index CDS as discussed below,\746\ market participants
generally may use the Commissions' past guidance in determining whether
certain Title VII instruments based on a security index are swaps or
security-based swaps.
---------------------------------------------------------------------------

    \745\ 7 U.S.C. 1a(35) and 15 U.S.C. 78c(a)(55).
    \746\ See infra part III.G.3.
---------------------------------------------------------------------------

    The Commissions also are providing an interpretation and adopting
additional rules establishing criteria for indexes composed of
securities, loans, or issuers of securities referenced by an

index CDS.\747\ The interpretation and rules also address the
definition of an ``index'' \748\ and the treatment of broad-based
security indexes that become narrow-based and narrow-based indexes that
become broad-based, including rule provisions regarding tolerance and
grace periods for swaps on security indexes that are traded on CFTC-
regulated trading platforms and security-based swaps on security
indexes that are traded on SEC-regulated trading platforms.\749\ These
rules and interpretation are discussed below.
---------------------------------------------------------------------------

    \747\ Id.
    \748\ See infra part III.G.4.
    \749\ See infra part III.G.5.
---------------------------------------------------------------------------

3. Narrow-Based Security Index Criteria for Index Credit Default Swaps
(a) In General
    The Commissions provided an interpretation in the Proposing Release
regarding the narrow-based security index criteria for index CDS and
are restating it without modification.\750\ While the Commissions
understand that the underlying reference for most cleared CDS is a
single entity or an index of entities rather than a single security or
an index of securities, the underlying reference for CDS also could be
a single security or an index of securities.\751\ A CDS where the
underlying reference is a single entity (i.e., a single-name CDS), a
single obligation of a single entity (e.g., a CDS on a specific bond,
loan, or asset-backed security, or any tranche or series of any bond,
loan, or asset-backed security), or an index CDS where the underlying
reference is a narrow-based security index or the issuers of securities
in a narrow-based security index is a security-based swap. An index CDS
where the underlying reference is not a narrow-based security index or
the issuers of securities in a narrow-based security index (i.e., a
broad-based index) is a swap.\752\
---------------------------------------------------------------------------

    \750\ See Proposing Release at 29847-48.
    \751\ See, e.g., Markit, ``Markit CDX'' (describing the Markit
CDX indexes and the number of ``names'' included in each index),
available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/cdx/cdx.page; Markit, ``Markit iTraxx Indices,''
(stating that the ``Markit iTraxx indices are comprised of the most
liquid names in the European and Asian markets'') (emphasis added),
available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/itraxx/itraxx.page . Examples of indexes based on
securities include the Markit ABX.HE and CMBX indexes. See Markit,
``Markit ABX.HE,'' (describing the Markit ABX.HE index as ``a
synthetic tradeable index referencing a basket of 20 subprime
mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/abx/abx.page;
and Markit, ``Markit CMBX,'' (describing the Markit CMBX index as
``a synthetic tradeable index referencing a basket of 25 commercial
mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/cmbx/cmbx.page.
    \752\ Similarly, an option to enter into a single-name CDS or a
CDS referencing a narrow-based security index as described above
would be a security-based swap, while an option to enter into a CDS
on a broad-based security index or the issuers of securities in a
broad-based security index would be a swap. Index CDS where the
underlying reference is a broad-based security index would be SBSAs.
The SEC has enforcement authority with respect to swaps that are
SBSAs, as discussed further in section V., infra.
---------------------------------------------------------------------------

    The statutory definition of the term ``narrow-based security
index,'' as explained above, was designed with the U.S. equity markets
in mind.\753\ Thus, the statutory definition is not necessarily
appropriate for determining whether an index underlying an index CDS is
broad or narrow-based. Nor is the guidance that the Commissions have
previously issued with respect to the narrow-based security index
definition discussed above necessarily appropriate, because that
guidance was designed to address and was uniquely tailored to the
characteristics of volatility indexes and debt security indexes in the
context of futures. Accordingly, the Commissions are clarifying that
the guidance that the Commissions have previously issued with respect
to the narrow-based security index definition discussed above does not
apply to index CDS. Instead, the Commissions are adopting rules as
discussed below that include separate criteria for determining whether
an index underlying an index CDS is a narrow-based security index.
---------------------------------------------------------------------------

    \753\ See July 2006 Debt Index Rules.
---------------------------------------------------------------------------

    The Commissions are further defining the term ``security-based
swap,'' and the use of the term ``narrow-based security index'' within
that definition, to modify the criteria applied in the context of index
CDS in assessing whether the index is a narrow-based security index.
The third prong of the security-based swap definition includes a Title
VII instrument based on the occurrence of an event relating to the
``issuers of securities in a narrow-based security index,'' provided
that such event directly affects the ``financial statements, financial
condition, or financial obligations of the issuer.'' \754\ The first
prong of the security-based swap definition includes a Title VII
instrument that is based on a narrow-based security-index.\755\ Because
the third prong of the security-based swap definition relates to
issuers of securities, while the first prong of such definition relates
to securities, the Commissions are further defining both the term
``narrow-based security index'' and the term ``issuers of securities in
a narrow-based security index'' in the context of the security-based
swap definition as applied to index CDS. The Commissions believe it is
important to further define both terms in order to assure consistent
analysis of index CDS.\756\ While the wording of the two definitions as
adopted differs slightly, the Commissions expect that they will yield
the same substantive results in distinguishing narrow-based and broad-
based index CDS.\757\
---------------------------------------------------------------------------

    \754\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15
U.S.C. 78c(a)(68)(A)(ii)(III).
    \755\ Section 3(a)(68)(A)(ii)(I) of the Exchange Act, 15 U.S.C.
78c(a)(68)(A)(ii)(I).
    \756\ Because they apply only with respect to index CDS, the
definitions of ``issuers of securities in a narrow-based security
index'' and ``narrow-based security index'' as adopted do not apply
with respect to other types of event contracts, whether analyzed
under the first or third prong.
    \757\ For example, if the reference entities included in one
index are the same as the issuers of securities included in another
index, application of the two definitions should result in both
indexes being either broad-based or narrow-based.
---------------------------------------------------------------------------

(b) Rules Regarding the Definitions of ``Issuers of Securities in a
Narrow-Based Security Index'' and ``Narrow-Based Security Index'' for
Index Credit Default Swaps
    The Commissions proposed rules to further define the terms
``issuers of securities in a narrow-based security index'' and
``narrow-based security index'' in order to provide appropriate
criteria for determining whether an index composed of issuers of
securities referenced by an index CDS and an index composed of
securities referenced by an index CDS are narrow-based security
indexes.\758\ The Commissions are adopting rules 1.3(zzz) and 1.3(aaaa)
under the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act as
proposed with certain modifications.\759\
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    \758\ See Proposing Release at 29848.
    \759\ The discussion throughout this section refers to
``reference entities'' and ``issuers'' in discussing the final
rules. The term ``reference entity'' is defined in paragraph (c)(3)
of rule 1.3(zzz) under the CEA and rule 3a68-1a under the Exchange
Act and the term ``issuer'' is defined in paragraph (c)(3) of rule
1.3(aaaa) under the CEA and rule 3a68-1b under the Exchange Act. The
final rules provide that the term ``reference entity'' includes: (i)
An issuer of securities; (ii) an issuer of securities that is an
issuing entity of asset-backed securities is a reference entity or
issuer, as applicable; and (iii) an issuer of securities that is a
borrower with respect to any loan identified in an index of
borrowers or loans is a reference entity. The final rules provide
that the term ``issuer'' includes: (i) An issuer of securities; and
(ii) an issuer of securities that is an issuing entity of asset-
backed securities is a reference entity or issuer, as applicable.
See paragraph (c)(3) of rules 1.3(zzz) and 1.3(aaaa) under the CEA
and rule 3a68-1a and 3a68-1b under the Exchange Act.
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    In formulating the criteria in the final rules, and consistent with
the guidance and rules the Commissions have

previously issued and adopted regarding narrow-based security indexes
in the context of security futures, the Commissions believe that there
should be public information available about a predominant percentage
of the reference entities included in the index, or, in the case of an
index CDS on an index of securities, about the issuers of the
securities or the securities underlying the index, in order to reduce
the likelihood that non-narrow-based indexes referenced in index CDS or
the component securities or issuers of securities in that index would
be readily susceptible to manipulation, as well as to help prevent the
misuse of material non-public information through the use of CDS based
on such indexes.
    To satisfy these objectives, the Commissions are adopting rules
that are based on the criteria developed for debt indexes discussed
above \760\ but that tailor these criteria to address index CDS.\761\
These criteria are included solely for the purpose of defining the
terms ``narrow-based security index'' and ``issuers of securities in a
narrow-based security index'' in the first and third prongs of the
security-based swap definition with respect to index CDS and will not
affect any other interpretation or use of the term ``narrow-based
security index'' or any other provision of the Dodd-Frank Act, the CEA,
or the Exchange Act.
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    \760\ See discussion of July 2006 Debt Index Rules.
    \761\ The Commissions note that the language of the rules is
intended, in general, to be consistent with the criteria developed
for debt indexes discussed above. Certain changes from the criteria
developed for debt indexes are necessary to address differences
between futures on debt indexes and index CDS. Certain other changes
are necessary because the rules for debt indexes define under what
conditions an index is not a narrow-based security index, whereas
the rules for index CDS define what is a narrow-based security
index. For example, an index is not a narrow-based security index
under the rule for debt indexes if it is not a narrow-based security
index under either subparagraph (a)(1) or paragraph (a)(2) of the
rule. See July 2006 Debt Index Rules. Under the rules for index CDS,
however, an index is a narrow-based security index if it meets the
requirements of both of the counterpart paragraphs in the rules
regarding index CDS (paragraphs (1)(i) and (1)(ii) of rules 1.3(zzz)
and 1.3(aaaa) under the CEA and paragraph (a)(1) and paragraph
(a)(2) of rules 3a68-1a and 3a68-1b under the Exchange Act), even
though the criteria in the debt index rules and the rules for index
CDS include generally the same criteria and structure.
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    Further, in response to commenters,\762\ the Commissions are
clarifying that if an index CDS is based on an index of loans that are
not securities,\763\ an event relating to a loan in the index, such as
a default on a loan, is an event ``relating to'' the borrower.\764\ To
the extent that the borrower is an issuer of securities, the index CDS
based on such index of loans will be analyzed under the third prong of
the security-based swap definition in the same manner as any other
index CDS.
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    \762\ See infra note 768 and accompanying text.
    \763\ If the loans underlying the index of loans are securities,
the index CDS would be analyzed in the same manner as any other
index CDS based on an index of securities.
    \764\ An index CDS referencing loans also may be based on events
relating to the borrower, such as bankruptcy, and to defaults on any
obligation of the borrower.
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Comments
    The Commissions received two general comments requesting that the
proposed rules further defining the terms ``issuers of securities in a
narrow-based security index'' and ``narrow-based security index'' be
simplified.\765\ One commenter believed that the rules were exceedingly
complicated.\766\ Another commenter thought that the criteria should
allow transactions to be readily and transparently classifiable as a
swap or security-based swap.\767\ The commenters did not provide
analysis supporting their comments or recommend language changes.
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    \765\ See ISDA Letter and MarketAxess Letter.
    \766\ See MarketAxess Letter. This commenter stated that ``The
Proposed Rules layout an exceedingly complex process for determining
whether an index CDS is broad-based or narrow-based.'' Id.
    \767\ See ISDA Letter.
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    The Commissions are adopting the rules regarding index CDS
essentially as proposed with certain modifications to address
commenters' concerns. While the final rules contain a number of
elements that are similar or identical to elements contained in the
statutory narrow-based security index definition, in order to enable
the narrow-based security index definition to apply appropriately to
index CDS, the final rules contain some alternative tests to those set
forth in the statutory definition.
    The Commissions also recognize the diversity of Title VII
instruments. While the final rules for index CDS are based on the July
2006 Debt Index Rules, the substantive differences between the final
rules in the index CDS and the equity or debt security contexts are
intended to reflect the particular characteristics of the CDS
marketplace, in which, for example, index components may be entities
(issuers of securities) as well as specific equity and debt securities.
    The Commissions also received three comments requesting
clarification regarding the applicability of the index CDS rules to CDS
based on indexes of loans.\768\ One commenter noted that the
Commissions did not address in the Proposing Release the question of
whether an index composed exclusively of loans should be treated as a
narrow-based security index.\769\ This commenter noted that because the
first and third prongs of the statutory security-based swap definition
do not explicitly reference loans, the statutory definition does not
expressly categorize Title VII instruments based on more than one loan,
or contingent on events that occur with respect to more than one loan
borrower, unless such borrowers are also ``issuers of securities.''
\770\ Based on this commenter's view of the statutory definition, this
commenter requested that the Commissions clarify the treatment of
indexes composed exclusively of loans.\771\ Another commenter provided
similar comments and also requested clarification regarding the
treatment of CDS based on indexes of loans.\772\ A third commenter
stated its view that the third prong of the statutory security-based
swap definition implies that Title VII instruments on a basket of loans
are security-based swaps if the lenders would satisfy the criteria for
issuers of a ``narrow-based security index'' and encouraged the
Commissions to clarify this issue.\773\ The Commissions agree with
commenters that an index CDS based on an index of loans that are not
securities is analyzed under the third prong of the statutory security-
based swap definition and, therefore, are clarifying the treatment of
these Title VII instruments above.\774\
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    \768\ See Allen & Overy Letter; July LSTA Letter; and SIFMA
Letter.
    \769\ See Allen & Overy Letter.
    \770\ Id.
    \771\ Id.
    \772\ See July LSTA Letter. This commenter noted that prong
(III) of the statutory security-based swap definition does not
clearly reference borrowers of loans or indexes of borrowers.
However, this commenter noted that because most borrowers that are
named as reference entities in loan CDS transactions are corporate
entities that issue equity interests to one or more shareholders
(although they may not issue public securities or become subject to
public reporting requirements), this commenter believes that prong
(III) can be interpreted to include swaps that reference a single
borrower or borrowers of loans in an index. Id.
    \773\ See SIFMA Letter.
    \774\ The Commissions also are providing guidance with respect
to TRS based on two or more loans that are not securities. See supra
part III.C.
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(i) Number and Concentration Percentages of Reference Entities or
Securities
    The Commissions believe that the first three criteria of the debt
security index test (which are based on the statutory narrow-based
security index definition) discussed above (i.e., the number and
concentration weighting requirements) are appropriate to apply to index
CDS,

whether CDS on indexes of securities or indexes of issuers of
securities.\775\ Accordingly, the Commissions are adopting the first
three criteria of rule 1.3(zzz) under the CEA and rule 3a68-1a under
the Exchange Act as proposed with certain modifications in response to
commenters' concerns.\776\ These rules contain the same number and
concentration criteria as proposed, but modify the method of
calculating affiliation among issuers and reference entities in
response to commenters.\777\ Further, in response to commenters,\778\
the Commissions are providing an additional interpretation with respect
to the application of these criteria to two particular types of CDS,
commonly known as ``nth-to-default CDS'' and ``tranched CDS.''
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    \775\ See infra notes 792 and 793 and accompanying text.
    \776\ See paragraphs (a)(1)(i)-(iii) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rules 3a68-1a and 3a68-1b under the
Exchange Act.
    \777\ See infra note 804 and accompanying text.
    \778\ See infra notes 795 and 796 and accompanying text.
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    The first three criteria provide that, for purposes of determining
whether an index CDS is a security-based swap under section
3(a)(68)(A)(ii)(III) of the Exchange Act,\779\ the term ``issuers of
securities in a narrow-based security index'' includes issuers of
securities identified in an index (including an index referencing loan
borrowers) in which:
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    \779\ 15 U.S.C. 78c(a)(68)(A)(ii)(III).
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     Number: There are nine or fewer non-affiliated issuers of
securities that are reference entities included in the index, provided
that an issuer of securities shall not be deemed a reference entity
included in the index unless (i) a credit event with respect to such
reference entity would result in a payment by the credit protection
seller to the credit protection buyer under the index CDS based on the
related notional amount allocated to such reference entity; or (ii) the
fact of such credit event or the calculation in accordance with clause
(i) above of the amount owed with respect to such credit event is taken
into account in determining whether to make any future payments under
the index CDS with respect to any future credit events;
     Single Component Concentration: The effective notional
amount allocated to any reference entity included in the index
comprises more than 30 percent of the index's weighting; or
     Largest Five Component Concentration: The effective
notional amount allocated to any five non-affiliated reference entities
included in the index comprises more than 60 percent of the index's
weighting.\780\
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    \780\ These rules refer to the ``effective notional amount''
allocated to reference entities or securities in order to address
potential situations in which the means of calculating payout across
the reference entities or securities is not uniform. Thus, if one or
more payouts is leveraged or enhanced by the structure of the
transaction (i.e., 2x recovery rate), that amount would be the
``effective notional amount'' for purposes of the 30 percent and 60
percent tests in paragraphs (1)(i)(B) and (1)(i)(C) of rules
1.3(zzz) and 1.3(aaaa) and paragraphs (a)(1)(ii) and (a)(1)(iii) of
rules 3a68-1a and 3a68-1b. Similarly, if the aggregate notional
amount under a CDS is not uniformly allocated to each reference
entity or security, then the portion of the notional amount
allocated to each reference entity or security (which may be by
reference to the product of the aggregate notional amount and an
applicable percentage) would be the ``effective notional amount.''
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    Similarly, the Commissions are adopting as proposed the first three
criteria of rule 1.3(aaaa) under the CEA and rule 3a68-1b under the
Exchange Act. These three criteria provide that, for purposes of
determining whether an index CDS is a security-based swap under section
3(a)(68)(A)(ii)(I) of the Exchange Act,\781\ the term ``narrow-based
security index'' includes an index in which essentially the same
criteria apply, substituting securities for issuers. Under these
criteria, the term ``narrow-based security index'' would mean an index
in which:
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    \781\ 15 U.S.C. 78c(a)(68)(A)(ii)(I).
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     Number: There are nine or fewer securities, or securities
that are issued by nine or fewer non-affiliated issuers, included in
the index, provided that a security shall not be deemed a component of
the index unless (i) a credit event with respect to the issuer of such
security or a credit event with respect to such security would result
in a payment by the credit protection seller to the credit protection
buyer under the index CDS based on the related notional amount
allocated to such security, or (ii) the fact of such credit event or
the calculation in accordance with clause (i) above of the amount owed
with respect to such credit event is taken into account in determining
whether to make any future payments under the index CDS with respect to
any future credit events;
     Single Component Concentration: The effective notional
amount allocated to the securities of any issuer included in the index
comprises more than 30 percent of the index's weighting; or
     Largest Five Component Concentration: The effective
notional amount allocated to the securities of any five non-affiliated
issuers included in the index comprises more than 60 percent of the
index's weighting.
    Thus, the applicability of the final rules depends on conditions
relating to the number of non-affiliated reference entities or issuers
of securities, or securities issued by non-affiliated issuers, as
applicable, included in an index and the weighting of notional amounts
allocated to the reference entities or securities included in the
index, as applicable. These first three criteria of the final rules
evaluate the number and concentration of the reference entities or
securities included in the index, as applicable, and ensure that an
index with a small number of reference entities, issuers, or securities
or concentrated in only a few reference entities, issuers, or
securities is narrow-based, and thus where such index is the underlying
reference of an index CDS, the index CDS is a security-based swap.
Further, as more fully described below,\782\ the final rules provide
that a reference entity or issuer of securities included in an index
and any of that reference entity's or issuer's affiliated entities (as
defined in the final rules) that also are included in the index are
aggregated for purposes of determining whether the number and
concentration criteria are met.
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    \782\ See infra part III.G.3(b)(ii), for a discussion of the
affiliation definition applicable to calculating the number and
concentration criteria. As noted above, the Commissions are
modifying the method of calculating affiliation for purposes of
these criteria.
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    Specifically, the final rules provide that an index meeting any one
of certain identified conditions would be a narrow-based security
index. The first condition in paragraph (1)(i)(A) of rule 1.3(zzz)
under the CEA and paragraph (a)(1)(i) of rule 3a68-1a under the
Exchange Act is that there are nine or fewer non-affiliated issuers of
securities that are reference entities in the index. An issuer of
securities counts toward this total only if a credit event with respect
to such entity would result in a payment by the credit protection
seller to the credit protection buyer under the index CDS based on the
notional amount allocated to such entity, or if the fact of such a
credit event or the calculation of the payment with respect to such
credit event is taken into account when determining whether to make any
future payments under the index CDS with respect to any future credit
events.
    Similarly, the first condition in paragraph (1)(i)(A) of rule
1.3(aaaa) under the CEA and paragraph (a)(1)(i) of rule 3a68-1b under
the Exchange Act provides that a security counts toward the total
number of securities in the index only if a credit event with respect
to such security, or the issuer of such security, would result in a
payment by the credit protection seller to the credit

protection buyer under the index CDS based on the notional amount
allocated to such security, or if the fact of such a credit event or
the calculation of the payment with respect to such credit event is
taken into account when determining whether to make any future payments
under the index CDS with respect to any future credit events.
    These provisions are intended to ensure that an index concentrated
in a few reference entities or securities, or a few reference entities
that are affiliated (as defined in the final rules) or a few securities
issued by issuers that are affiliated, are within the narrow-based
security index definition.\783\ These provisions also are intended to
ensure that an entity is not counted as a reference entity included in
the index, and a security is not counted as a security included in the
index, unless a credit event with respect to the entity, issuer, or
security affects payout under a CDS on the index.\784\
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    \783\ This requirement is generally consistent with the
definition of ``narrow-based security index'' in section 1a(35)(A)
of the CEA, 7 U.S.C. 1a(35)(A), and section 3(a)(55)(B) of the
Exchange Act, 15 U.S.C. 78c(a)(55)(B), and the July 2006 Debt Index
Rules.
    \784\ Id.
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    Further, as this condition is in the alternative (i.e., either
there must be a credit event resulting in a payment under the index CDS
or a credit event is considered in determining future CDS payments),
the tests encompass all index CDS. For example, and in response to a
commenter,\785\ the test would cover an nth-to-default CDS,\786\ in
which default with respect to a specified component of an index (such
as the first default or fifth default) triggers the CDS payment, even