of ``substantial position''; (iii) the meaning of ``hedging or
mitigating commercial risk''; (iv) the meaning of ``substantial
counterparty exposure that could have serious adverse effects on the
financial stability of the United States banking system or financial
markets''; and (v) the meanings of ``financial entity'' and ``highly
leveraged.'' The proposal also addressed the period of time that a
major participant would have to register (as well as the minimum length
of time for being a major participant), the limited purpose
designations of major participants, the exclusion for ERISA plan
hedging positions, and certain additional interpretive issues.
    After considering commenters' views, the Commissions are adopting
final rules further defining the meaning of major participant.
    As discussed below, the Commissions also are directing their
respective staffs to report separately as to whether changes are
warranted to any of the rules implementing the major participant
definitions. These staff reports will help the Commissions evaluate the
``major swap participant and ``major security-based swap participant''
definitions, including whether new or revised tests or approaches would
be appropriate for identifying major participants.\762\
---------------------------------------------------------------------------

    \762\ See part V, infra.
---------------------------------------------------------------------------

A. ``Major'' Categories of Swaps and Security-Based Swaps

1. Proposed Approach
    The first and third tests of the statutory major participant
definitions encompass entities that maintain a substantial position in
a ``major'' category of swaps or security-based swaps.\763\
---------------------------------------------------------------------------

    \763\ See CEA section 1a(33)(A)(i), (iii); Exchange Act section
3(a)(67)(a)(2)(i), (iii).
---------------------------------------------------------------------------

    In the Proposing Release, the Commissions proposed to designate
four ``major'' categories of swaps and two ``major'' categories of
security-based swaps. These categories sought to reflect the risk
profiles of the various types of swaps and security-based swaps, and
the different purposes for which end-users use those instruments. The
Proposing Release also noted the importance of not parsing the
``major'' categories so finely as to base the ``substantial position''
thresholds on unduly narrow risks and reduce those thresholds'
effectiveness as risk measures.\764\
---------------------------------------------------------------------------

    \764\ See Proposing Release, 75 FR at 80186-87.
---------------------------------------------------------------------------

    The proposed four ``major'' categories of swaps were rate swaps,
credit swaps, equity swaps and other commodity swaps.\765\ Rate swaps
would encompass any swap which is primarily based on one or more
reference rates, such as swaps of payments determined by fixed and
floating interest rates, currency exchange rates, or other monetary
rates. Credit swaps would encompass any swap that is primarily based on
default, bankruptcy and other credit-related risks related to, or the
total returns on, instruments of indebtedness (including loans),
including but not limited to any swap primarily based on one or more
broad-based indices related to debt instruments, and any swap that is a
broad-based index credit default swap or total return swap. Equity
swaps would encompass any swap that is primarily based on equity
securities, such as any swap primarily based on one or more broad-based
indices of equity securities, including any total return swap on one or
more broad-based equity indices. Other commodity swaps would encompass
any swap not included in any of the first three categories, and would
generally include, for example and not by way of limitation, any swap
for which the primary underlying item is a physical commodity or the
price or any other aspect of a physical commodity. The four categories
were intended to cover all swaps, and each swap would be in the
category that most closely describes the primary item underlying the
swap.\766\
---------------------------------------------------------------------------

    \765\ See proposed CFTC Regulation Sec.  1.3(iii).
    \766\ The statutory definition of ``swap'' lists 22 different
types of swaps.
---------------------------------------------------------------------------

    The Commissions proposed to designate two ``major'' categories of
security-based swaps.\767\ The first category would encompass any
security-based swap that is based, in whole or in part, on one or more
instruments of indebtedness (including loans), or a credit event
relating to one or more issuers or securities, including but not
limited to any security-based swap that is a credit default swap, total
return swap on one or more debt instruments, debt swaps, or debt index
swaps. The second category would encompass any other security-based
swaps not included in the first category, including for example, swaps
on equity securities or narrow-based security indices comprised of
equity securities.\768\ These proposed categories were based on the
different uses of these types of security-based swaps, and were
consistent with market statistics and infrastructures that distinguish
between those types of security-based swaps.\769\
---------------------------------------------------------------------------

    \767\ See proposed Exchange Act rule 3a67-2.
    \768\ The second category also encompasses all security-based
swaps on narrow based indices that are comprised of both debt and
equity components.
    \769\ See Proposing Release, 75 FR at 80187.
---------------------------------------------------------------------------

2. Commenters' Views
    Certain commenters requested clarification regarding how the major
categories would be applied. One commenter particularly requested
additional clarity as to how the proposed categories will apply to
mixed swaps and to swaps that are based on debt that is convertible to
equity,\770\ while another commenter requested additional clarity as to
the status of certain mortgage-related transactions.\771\
---------------------------------------------------------------------------

    \770\ See letter from ISDA I.
    \771\ See letter from Freddie Mac.
---------------------------------------------------------------------------

    One commenter suggested that the final rules should include a
catch-all provision to allow the Commissions to review large positions
that appear to be structured to evade proper categorization, and that
market participants should suggest the protocols for categorization of
swaps or security-based swaps.\772\
---------------------------------------------------------------------------

    \772\ See meeting with Professor Darrell Duffie, Stanford
University Graduate School of Business (``Duffie'') on February 2,
2011.
---------------------------------------------------------------------------

    One commenter suggested that the rate swap category should be
divided between interest rates and currencies, and that energy,
agriculture and metals swaps should be separate categories.\773\
Another commenter expressed the view that creation of a separate
category for cross currency swaps could lead to confusion among market
participants who may feel obligated to bifurcate cross currency swaps
between two categories.\774\ Some commenters expressed general support
for the major categories as proposed.\775\
---------------------------------------------------------------------------

    \773\ See letter from Better Markets I.
    \774\ See letter from ACLI.
    \775\ See letters from Barnard, ISDA I and MetLife; see also
letter from American Insurance Association (``AIA'') (agreeing that
the defined major categories would cover substantially all
significant swaps and security-based swaps).
---------------------------------------------------------------------------

3. Final Rules
    After considering the issue in light of comments received, the
Commissions are adopting final rules designating ``major'' categories
of swaps and security-based swaps consistent with the proposal.
Accordingly, the final rules provide that the four ``major'' categories
of swaps are rate swaps,

credit swaps, equity swaps and other commodity swaps.\776\ The two
``major'' categories of security-based swaps are debt security-based
swaps \777\ and other security-based swaps.\778\
---------------------------------------------------------------------------

    \776\ See CFTC Regulation Sec.  1.3(iii). The four major
categories of swaps are the same as the asset classes used in the
CFTC Regulations relating to SDRs and reporting, except that the
asset classes for interest rate swaps and foreign exchange
transactions are combined into the single rate swap major category
of swaps. See CFTC, Swap Data Repositories: Registration Standards,
Duties and Core Principles; Final Rule, 76 FR 54538 (Sept. 1, 2011)
and Swap Data Recordkeeping and Reporting Requirements; Final Rule,
77 FR 2136 (Jan. 13, 2012).
    \777\ The name of the first major category of security-based
swaps has been changed to ``debt security-based swaps'' in this
Adopting Release from ``security-based credit derivatives'' in the
Proposing Release. This change more accurately reflects the products
encompassed by this category, particularly total return swaps on
debt instruments. See Exchange Act rule 3a67-2(a).
     In addition, the final rules defining the major categories for
purposes of the major participant definitions remove a cross-
reference to the corresponding dealer definitions under the CEA or
the Exchange Act to clarify that the rules apply only in the context
of the major participant definitions, and not the dealer
definitions. See CFTC Regulation Sec.  1.3(iii); Exchange Act rule
3a67-2.
    \778\ See Exchange Act rule 3a67-2(b).
---------------------------------------------------------------------------

    The Commissions believe that it is not necessary to further divide
the proposed categories or add new categories for swaps and security-
based swaps for purposes of the major participant definitions. We
believe that maintaining a large number of narrow categories of swaps
and security-based swaps would increase the possibility of confusion by
market participants with regard to categorizing the swaps and security-
based swaps in which they transact. The Commissions also continue to
believe that it is important not to parse the ``major'' categories so
finely as to base the ``substantial position'' thresholds on unduly
narrow groupings that would reduce those thresholds' effectiveness as
risk measures. Categories that are broad and clearly delineated further
should help prevent action to evade designation as a major participant
in a particular ``major'' category.
    While we believe that these rules in general are sufficiently clear
to allow each swap and security-based swap to be placed in the
appropriate category, we are mindful of the commenters' request for
guidance with regard to certain circumstances. In the case of mixed
swaps, we would expect that the instrument would be placed in the
``swap'' and ``security-based swap'' categories that are consistent
with the underlying attributes that cause such instrument to be a mixed
swap.\779\ Also, swaps or security-based swaps that are based on more
than one item, instrument or risk, should be placed in the category
that most closely describes the primary item, instrument or risk
underlying the swap or security-based swap.\780\
---------------------------------------------------------------------------

    \779\ The Commissions have proposed rules regarding the
regulation of mixed swaps. See Product Definitions Proposal, note 3,
supra.
    \780\ In the case of instruments on debt securities that are
convertible into equity, in general we would expect the instrument
to be categorized based on its status (as debt or equity) at the
time of evaluation.
---------------------------------------------------------------------------

B. ``Substantial Position''

1. Proposed Approach
    The major participant definitions require that the Commissions
define a ``substantial position'' in swaps or security-based swaps at a
threshold that we determine to be ``prudent for the effective
monitoring, management, and oversight'' of entities that are
systemically important or can significantly impact the U.S. financial
system. The definitions further require that we consider a person's
relative position in uncleared and cleared swaps or security-based
swaps, and permit us to consider the value and quality of collateral
held against counterparty exposure.\781\
---------------------------------------------------------------------------

    \781\ See CEA section 1a(33)(B); Exchange Act section
3(a)(67)(B).
---------------------------------------------------------------------------

    The proposed rules provided that a person would have a
``substantial position'' in swaps or security-based swaps if the daily
average current uncollateralized exposure associated with its swap or
security-based swap positions in a major category in a calendar quarter
amounted to $1 billion or more (or $3 billion in the case of rate
swaps).\782\ A person also would have a ``substantial position'' if the
daily average of the sum of the current uncollateralized exposure plus
the potential future exposure associated with its positions in a major
category in a calendar quarter amounted to $2 billion or more (or $6
billion for the rate swap category).\783\
---------------------------------------------------------------------------

    \782\ See proposed CFTC Regulation Sec.  1.3(jjj)(1); proposed
Exchange Act rule 3a67-3(a)(1), (d).
    \783\ See proposed CFTC Regulation Sec.  1.3(jjj)(1); proposed
Exchange Act rule 3a67-3(a)(2), (d).
---------------------------------------------------------------------------

    The proposed rules did not prescribe any particular methodology for
measuring current exposure or valuing collateral posted, and instead
provided that the method used should be consistent with counterparty
practices and industry practices generally.\784\ The proposed rules
also provided that an entity could calculate its current
uncollateralized exposure by accounting for netting agreements on a
counterparty-by-counterparty basis,\785\ and the Proposing Release set
forth a method for allocating any residual uncollateralized exposure to
a counterparty that remains following netting.\786\
---------------------------------------------------------------------------

    \784\ See proposed CFTC Regulation Sec.  1.3(jjj)(2)(ii);
proposed Exchange Act rule 3a67-3(a)(2)(i).
    \785\ See proposed CFTC Regulation Sec.  1.3(jjj)(2)(iii);
proposed Exchange Act rule 3a67-3(b)(3).
    \786\ See Proposing Release, 75 FR at 80190.
---------------------------------------------------------------------------

    The proposed potential future exposure test was based on the risk-
adjusted notional amount of the entity's swap and security-based swap
positions, consistent with a test used by bank regulators for purposes
of setting capital standards.\787\ The test also excluded or lowered
the potential exposure associated with certain lower-risk
positions.\788\ In addition, the measures of potential future exposure
would be discounted by up to 60 percent to reflect the risk mitigation
provided by netting agreements,\789\ and would further be decreased by
80 percent for positions subject to central clearing or daily mark-to-
market margining.\790\
---------------------------------------------------------------------------

    \787\ See id. at 80191-92.
    \788\ See proposed CFTC Regulation Sec.  1.3(jjj)(3)(iii);
proposed Exchange Act rule 3a67-3(c)(2)(i)(C), (D).
    \789\ See proposed CFTC Regulation Sec.  1.3(jjj)(3)(ii)(B);
proposed Exchange Act rule 3a67-3(c)(2)(ii).
    \790\ See proposed CFTC Regulation Sec.  1.3 (jjj)(3)(iii)(A);
proposed Exchange Act rule 3a67-3(c)(3)(i). This discount for daily
margining would be available even in the presence of a threshold or
a minimum transfer amount, so long as the threshold and the minimum
transfer amount (if the latter exceeds $1 million) are separately
added to the entity's current exposure for purposes of the current
exposure plus potential future exposure test. See proposed CFTC
Regulation Sec.  1.3(jjj)(3)(iii)(B); proposed Exchange Act rule
3a67-3(c)(3)(ii).
---------------------------------------------------------------------------

2. Commenters' Views
a. Basis for Regulating Major Participants and Alternative Approaches
for Identifying ``Substantial Positions''
    Several commenters expressed the view that the major participant
definition is intended to address entities whose swap or security-based
swap positions pose systemic risk,\791\ while one commenter took the
contrary view that the definition also is intended to address the
significance of an entity's swap or security-based swap positions (as
well as the risk those positions pose).\792\
---------------------------------------------------------------------------

    \791\ E.g., letters from BlackRock I and MFA I.
    \792\ See letter from Better Markets I.
---------------------------------------------------------------------------

    One commenter stated that the proposal inappropriately sought to
account for the risk posed by the potential default of multiple
entities, rather than a single entity.\793\ Some commenters suggested
that the analysis should account for the concentration of the risk
posed by an entity's

positions,\794\ and one commenter suggested that the analysis should
not account for individual categories of swaps or security-based
swaps.\795\
---------------------------------------------------------------------------

    \793\ See letter from BlackRock I.
    \794\ See letters from Black Rock I (suggesting a two-step
process that accounts for the reduced risk associated with entities
whose positions are distributed among several counterparties); CCMR
I and APG Algemene Pensioen Groep NV (``APG'').
    \795\ See letter from NYCBA Committee.
---------------------------------------------------------------------------

b. Levels of Proposed ``Substantial Position'' Thresholds
    A number of commenters expressed the view that the proposed
thresholds are inappropriately low.\796\ Some commenters stated the
thresholds initially should be high, with later revisions based on
market data.\797\
---------------------------------------------------------------------------

    \796\ See letters from ABC/CIEBA (indirectly referring to AIG
Financial Products, and noting that it had $400 billion in notional
positions and defaulted when it was required to post approximately
$100 billion in collateral); BG LNG I (alluding to lack of systemic
impact associated with Enron's failure, and suggesting that the
Commissions convene an advisory committee to develop thresholds);
NCGA/NGSA I (alluding to corporate financial losses involving
derivatives that have exceeded the proposed thresholds without
significantly impacting the U.S. financial system); ACLI (supporting
increase in proposed thresholds under the CEA to $4 billion current
uncollateralized exposure and $8 billion current uncollateralized
exposure plus potential future exposure); and Chesapeake Energy.
    \797\ See letters from MFA dated February 25, 2011 (``MFA II'')
(stating that thresholds initially should be set higher, while later
survey-based thresholds should be based on potential systemic risk
impact and the cost of performing the calculations); CCMR I (stating
that the Commissions presently have insufficient data to determine
appropriate thresholds, and that thresholds initially should be
high); BlackRock I (stating that the Commissions should refrain from
establishing thresholds if sufficient information is not available);
and Freddie Mac. Two commenters particularly addressed the proposed
thresholds applicable to rate swaps. See letters from ACLI and
MetLife.
---------------------------------------------------------------------------

    Some commenters did not oppose the proposed thresholds or expressed
support for the thresholds (though many of those commenters separately
raised issues about the underlying tests),\798\ while two commenters
supported lowering the proposed thresholds.\799\ Some commenters took
the position that the thresholds should be adjusted over time to
reflect factors such as inflation or market characteristics.\800\
---------------------------------------------------------------------------

    \798\ See, e.g., letters from ACLI, Fidelity, SIFMA AMG dated
Feb. 22, 2011 (``SIFMA AMG II'') and Vanguard (supporting proposed
limits for credit swaps, equity swaps and other commodity swaps, but
not rate swaps).
    \799\ See letters from AFR (supporting use of a $500 million
uncollateralized exposure threshold, or a $1 billion current
exposure plus potential future exposure threshold, with higher
thresholds for rate swaps) and Greenberger.
    \800\ See, e.g., letters from MFA I (referring to inflation and
measures such as the amount of equity in the U.S. banking system)
and ISDA I (referring to evolution of the size and fundamental
characteristics of the markets, and changes to valuation
methodologies and economic conditions).
---------------------------------------------------------------------------

c. Current Uncollateralized Exposure Test
    Measures of exposure and valuation of collateral--A number of
commenters supported the Proposing Release's position that the current
exposure analysis not prescribe any methodology for measuring exposure
or valuing collateral.\801\ On the other hand, some commenters
requested explicit approval of particular methodologies,\802\ a good
faith safe harbor,\803\ or regulator-prescribed measurement
standards.\804\ Some commenters emphasized the need to be able to post
non-cash collateral in connection with positions.\805\ Two commenters
requested codification of the proposal's position that operational
delays associated with the daily exchange of collateral would not lead
to current uncollateralized exposure for purposes of the analysis.\806\
---------------------------------------------------------------------------

    \801\ See letters from Fidelity, ICI I, ISDA I and MFA I.
    \802\ See letter from BlackRock I. Consistent with the proposal,
the final rules contemplate the use of industry standard practices
in the calculation of current exposure and potential future
exposure. As with other rules adopted by the Commissions, a market
participant may raise questions with the Commissions about the
participant's approach to addressing the final rules--including its
use of particular methodologies--for further guidance as may be
necessary or appropriate.
    \803\ See letter from FSR I (particularly noting difficulty of
valuing illiquid or bespoke positions).
    \804\ See letter from Better Markets I.
    \805\ See, e.g., letters from ACLI, CDEU and MetLife.
    \806\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

    Netting issues--Some commenters stated that the proposed netting
provisions should be expanded to encompass additional products that may
be netted for bankruptcy purposes.\807\ One commenter took the view
that these provisions should be expanded across multiple netting
agreements to the extent that offsets are permitted.\808\ One commenter
asked for clarification as to the scope of the netting provisions,\809\
and one commenter expressed general support for the proposed netting
provisions.\810\
---------------------------------------------------------------------------

    \807\ See letters from ISDA I (specifically addressing
securities contracts and forward contracts); NRG Energy
(specifically addressing forwards); and APG (specifically addressing
securities options and forwards).
    \808\ See letter from FSR I.
    \809\ See letter from Fidelity (seeking confirmation that
``master netting agreement'' can include an ISDA Master Agreement).
    \810\ See letter from ACLI.
---------------------------------------------------------------------------

    Allocation of uncollateralized exposure--Some commenters requested
that the final rules incorporate the principles, articulated in the
Proposing Release, for allocating any uncollateralized exposure that
remains following netting.\811\ Other commenters raised concerns that
those principles were based on an unwarranted assumption that
collateral is specifically earmarked to particular transactions.\812\
---------------------------------------------------------------------------

    \811\ See letters from SIFMA AMG II and Vanguard.
    \812\ See letters from FSR I and ISDA I; see also letter from
MetLife (suggesting pro rata allocation of uncollateralized current
exposure among each major category with current exposure).
---------------------------------------------------------------------------

d. Potential Future Exposure Test
    General concerns and suggested alternative approaches--Some
commenters disagreed with the Proposing Release's statement that the
potential future exposure analysis would evaluate potential changes in
the value of a swap or security-based swap over the remaining life of
the contract; those commenters stated that the test instead should
focus on potential volatility during the time it would take for a non-
defaulting party to close out a defaulting party's positions.\813\
---------------------------------------------------------------------------

    \813\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

    Some commenters criticized the tables setting forth the risk
adjustments used to calculate potential future exposure.\814\
Commenters further suggested using, as alternatives, value-at-risk
measures or other models,\815\ or the ``standardized method'' under
Basel II.\816\ Commenters also argued that risk adjustments should
provide a greater discount to credit swaps on ``investment grade''
instruments than to other credit swaps, that index CDS should be
subject to a greater discount than single name CDS, and that there
should be a lower discount factor for CDS of shorter maturity.\817\ One
commenter generally supported the proposed conversion factors and
adjustments.\818\
---------------------------------------------------------------------------

    \814\ See letters from Riverside Risk Advisors LLC (``Riverside
Risk Advisors'') (criticizing, among other aspects, discontinuities
in table, a failure to account for how far a swap is in or out of
the money, the use of a single discount factor for credit default
swaps, the fact that the risk factor for short-term equity swaps is
lower than the risk factor for credit swaps, and the fact that
equity swaps do not distinguish between high-volatility and low-
volatility stocks, as well as the failure to address portfolio
effects of diversification and correlation, and ``wrong-way'' risk
in the form of ``an adverse correlation between counterparty default
risk and the value of its derivatives contracts''); and ISDA I
(noting that the conversion factors were calibrated more than 15
years ago and were not designed for later instruments such as credit
products).
    \815\ See letters from Riverside Risk Advisors (supporting
giving end-users the option to use a model-based approach); and
Better Markets I (supporting use of a value-at-risk calculation).
    \816\ See letter from ISDA I.
    \817\ See letters from AIMA I and MFA I.
    \818\ See letter from MetLife.
---------------------------------------------------------------------------

    Some commenters expressed the view that measures of potential
future exposure should be superseded by negotiated independent amounts
or regulator-required initial margin.\819\ Some commenters also argued
that

excess posted collateral or net in-the-money positions should be offset
against potential future exposure.\820\
---------------------------------------------------------------------------

    \819\ See letters from SIFMA AMG II and Vanguard.
    \820\ See, e.g., letters from AIMA I, Fidelity, MFA I, SIFMA AMG
II and Vanguard.
---------------------------------------------------------------------------

    Potential future exposure measures for lower-risk positions--Some
commenters stated that the proposal to cap potential future exposure
when a person buys credit protection using a credit default swap should
be expanded to apply to any position with a fixed downside risk.\821\
Commenters also suggested that the potential future exposure associated
with purchases of credit protection be further discounted,\822\ while
one commenter took the position that purchases of credit default swaps
should be excluded from the potential future exposure test.\823\
Commenters also addressed the appropriate discount rate for calculating
the net present value of unpaid premiums.\824\
---------------------------------------------------------------------------

    \821\ See letters from MFA I (citing fixed portions of interest
rate swaps), MetLife (citing purchased options as well as CDS), ACLI
and Ropes & Gray.
    \822\ See letters from MFA I (arguing that the tightening of
credit spreads would imply a healthy credit environment) and AIMA;
see also meeting with MFA on February 14, 2011.
    \823\ See letter from Vanguard.
    \824\ See letter from MFA I (suggesting the possible use of the
LIBOR/Swap rate) and AIMA I.
---------------------------------------------------------------------------

    Netting issues--One commenter stated that the proposal's netting
provisions did not adequately account for the risk mitigation
associated with hedged positions,\825\ while another commenter asked
that the proposed netting provisions be clarified and simplified.\826\
One commenter supported the proposed netting approach.\827\
---------------------------------------------------------------------------

    \825\ See letter from ISDA I.
    \826\ See letter from SIFMA AMG II.
    \827\ See letters from ACLI.
---------------------------------------------------------------------------

    Discount for cleared or margined positions--Several commenters took
the view that cleared positions should be excluded entirely from the
potential future exposure analysis, rather than only being subject to
an 80 percent discount,\828\ and some commenters also supported a
complete exclusion for positions subject to daily mark-to-market
margining.\829\ One commenter suggested a minimum 98 percent reduction
for positions subject to central clearing or mark-to-market
margining,\830\ while one commenter suggested that there be a higher
discount for positions subject to the posting of initial margin.\831\
---------------------------------------------------------------------------

    \828\ See, e.g., letters from MFA I, SIFMA AMG II and Vanguard.
    \829\ See letters from BG LNG I, Fidelity and ICI I.
    \830\ See letter from ISDA I.
    \831\ See letter from FHLB I (suggesting 90 percent discount for
cleared swaps and for uncleared swaps for which initial margin has
been posted; alternatively suggesting that posted initial margin be
subtracted from the calculated amount).
---------------------------------------------------------------------------

    Some commenters also stated that there should be a partial discount
provided in connection with positions for which mark-to-market
margining is done less than daily,\832\ and that there should be a
discount for positions that are margined using security interests or
liens.\833\ On the other hand, one commenter stated that there is no
basis for providing any discount for marked-to-market positions.\834\
---------------------------------------------------------------------------

    \832\ See letters from Fidelity and Canadian Master Asset
Vehicle I and Master Asset Vehicle II (``Canadian MAVs'').
    \833\ See letter from FHLB I (giving as an example swaps
collateralized by security interests in real estate, oil or gas
interests, or by first liens on financial assets).
    \834\ See letter from Better Markets I; see also letter from AFR
(generally opposing use of risk adjustments, but suggesting that any
such discounts should be larger for cleared positions).
---------------------------------------------------------------------------

    One commenter requested that the rule language codify language in
the Proposing Release as to when a position is subject to daily mark-
to-market margining.\835\ A number of commenters addressed proposed
rule language that was intended to clarify that the discount for daily
mark-to-market margining would be available even in the presence of
thresholds and minimum transfer amounts.\836\
---------------------------------------------------------------------------

    \835\ See letter from SIFMA AMG II.
    \836\ See letter from CDEU (stating that the proposal could
overstate an entity's future exposure, and favoring use of the lower
of the calculated potential future exposure or the CSA threshold);
see also letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

    Two commenters supported the proposed approach in general.\837\ One
commenter specifically supported the proposed 80 percent reduction for
positions subject to daily mark-to-market margining,\838\ and one
commenter specifically supported a reduction for cleared
positions.\839\
---------------------------------------------------------------------------

    \837\ See letters from ACLI and MetLife.
    \838\ See letter from Vanguard.
    \839\ See letter from Better Markets I.
---------------------------------------------------------------------------

    Additional issues regarding the potential future exposure test--
Some commenters argued that the Commissions should clarify how the
categories in the proposed potential future exposure tables would be
applied, given how those differ from the proposed ``major'' categories
of swaps and security-based swaps.\840\
---------------------------------------------------------------------------

    \840\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

    Some commenters raised concerns that the proposed use of an
instrument's ``effective notional'' amount is ambiguous.\841\
Commenters also took the position that for purposes of the potential
future exposure calculation, notional amounts should be adjusted to
reflect delta weighting,\842\ that the measure of duration for options
on swaps should consider whether the underlying swap is cash-
settled,\843\ and that the adopting release should set forth examples
of potential future exposure calculations.\844\
---------------------------------------------------------------------------

    \841\ See letters from FSR I, SIFMA AMG II and Vanguard.
    \842\ See letters from MFA I and Ropes & Gray.
    \843\ See letter from MFA I.
    \844\ See id.
---------------------------------------------------------------------------

e. Cost Concerns
    Some commenters emphasized the need to avoid an overbroad major
participant definition, \845\ and highlighted concerns about being
subject to unnecessary regulation.\846\
---------------------------------------------------------------------------

    \845\ See joint letter from Representatives Bachus and Lucas.
    \846\ See, e.g., letters from SIFMA AMG II (stating that the
commenter's suggested changes in connection with the substantial
position analysis would reduce burdens and costs to market
participants, and more closely align the tests with the objectives
they are meant to achieve) and ABC/CIEBA; see also letter from
NFPEEU (reserving the right to dispute the cost-benefit analysis
associated with the proposed dealer and major participant rules
until all relevant Dodd-Frank Act releases could be analyzed as a
whole).
---------------------------------------------------------------------------

f. Additional Issues
    One commenter suggested there be an explicit presumption against
imposing major participant (or dealer) regulation on end-users.\847\
Some commenters requested that the current uncollateralized exposure
test explicitly exclude cleared positions, net in-the-money positions,
and fully collateralized out-of-the-money positions,\848\ and one
commenter also supported excluding those positions from the potential
future exposure analysis.\849\ That commenter also supported excluding
swaps on government securities from the substantial position
analysis.\850\
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    \847\ See letter from CDEU.
    \848\ See letters from ICI I, SIFMA AMG II and Vanguard.
    \849\ See letter from ICI I.
    \850\ See letter from ICI I (noting size of government security
market and Federal Reserve control over supply and demand, and
stating that the proposed thresholds are ill-suited to address the
``vast'' government securities market).
---------------------------------------------------------------------------

    One commenter requested confirmation that dealers and major
participants would not be required to compute, assist with, or verify
computations for counterparties that may be major participants, and
also that market participants can enlist third-party services to assist
in performing the calculations.\851\ One commenter requested
clarification that the proposed focus on uncollateralized exposure does
not mean that end-users themselves

should not demand collateral from dealers.\852\
---------------------------------------------------------------------------

    \851\ See letter from ISDA I.
    \852\ See letter from FHLB I.
---------------------------------------------------------------------------

3. Final Rules
a. Guiding Principles
    The final rules defining ``substantial position'' focus on
identifying persons whose large swap and security-based swap positions
pose market risks that are significant enough that it would be
``prudent'' to regulate those persons. In developing these rules we
have been mindful of the costs associated with regulating major
participants, and have considered cost and benefit principles as part
of the analysis of what level of swap and security-based swap positions
reasonably form the lower bounds for identifying when it would be
``prudent'' that particular entities be subject to monitoring,
management and oversight of entities that may be systemically important
or may significantly impact the U.S. financial system.\853\
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    \853\ At the same time, as discussed above in the context of the
de minimis exception to the dealer definitions, we are mindful that
the benefits of financial regulation cannot be quantified. For
example, while the regulation of major participants will comprise
one component of Title VII's comprehensive regulatory framework that
should be expected to help lessen the amount and frequency of
financial crises, we cannot place a dollar figure on the
contribution of major participant regulation to those benefits. In
light of those factors, we believe that it would be ``prudent'' to
regulate, as major participants, those persons whose swap or
security-based swap positions are large enough to pose a material
potential of causing significant counterparty impacts, consistent
with the levels set forth in the final rules. The Commissions will
further address the comparative costs and benefits associated with
regulating major participants in the context of the substantive
rules applicable to major participants.
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    The final rules implementing the ``substantial position''
definition follow the basic approach that the Commissions proposed,
including the combined use of current exposure and potential future
exposure tests.\854\ While we have carefully considered the views of
commenters who suggested alternative approaches, we have concluded that
it is appropriate to adopt the basic approach that was proposed, as
described below.
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    \854\ As with the proposal, the final rules apply these tests to
swap and security-based swap positions in a ``major'' category. See
CFTC Regulation Sec.  1.3(jjj)(1); Exchange Act rule 3a67-3(a). The
final rules have been modified from the proposal, however, by
removing a reference to ``positions excluded from consideration.''
We have concluded that this reference is unnecessary because the
first statutory major participant test explicitly provides that
positions that are subject to the commercial risk hedging and the
ERISA hedging exclusions of the first major participant test need
not be considered for purposes of that test.
---------------------------------------------------------------------------

     Focus on default-related credit risks. The final rules
implement tests that seek to reflect the credit risk that a person's
swap or security-based swap positions would pose in the event of
default. In arguing that the analysis should consider factors in
addition to default-related risks, commenters have noted that certain
regulations applicable to major participants address business conduct
issues that are distinct from systemic risk issues.\855\ We nonetheless
believe that the statutory definition of ``substantial position''
indicates that the analysis should focus on default-related credit
risks, because a default-related approach is more closely linked to the
statutory criteria that the definition focus on entities that are
``systemically important'' or can ``significantly impact'' the U.S.
financial system than would be an approach that focuses on the
potential for disruptive market movements.\856\
---------------------------------------------------------------------------

    \855\ See, e.g., letter from Better Markets I.
    \856\ We also believe that the statutory definition should focus
on all default-related credit risks associated with swap or
security-based swap positions. We do not see a basis for excluding
any class of risks (e.g., risks associated with swaps based on
government securities) from the analysis.
---------------------------------------------------------------------------

     Failure of multiple entities close in time. The final
rules that implement the ``substantial position'' definition seek to
reflect the risks that would be posed by the default of multiple
entities close in time. Although one commenter took the view that the
purpose of major participant regulation is to prevent the credit
exposure of a single person from having a systemic impact,\857\ we do
not believe that the major participant definitions should be construed
so narrowly. The events of recent years demonstrate that market stress
may lead to the failure and near-failure of multiple entities with
large financial positions over a relatively short time period. We do
not believe that it would be prudent or well-reasoned to presume that
recent history cannot repeat itself, and to assume that future failures
of entities with large financial positions will be isolated events.
---------------------------------------------------------------------------

    \857\ See letter from BlackRock I.
---------------------------------------------------------------------------

     Aggregate risk. The final rules address the aggregate risk
posed by an entity's swap or security-based swap positions, rather than
seeking to focus on principles of concentration (such as by using a
threshold that addresses an entity's largest exposure to an individual
counterparty) or on converse principles of interconnection. The
statutory ``substantial position'' definition is specifically written
in terms of market risk concerns (i.e., ``systemically important'' and
``can significantly impact the financial system of the United
States''), and measures of aggregate risk appear to be best geared to
reflect this standard.\858\
---------------------------------------------------------------------------

    \858\ Moreover, a test that focuses on the concentration of an
entity's swap or security-based swap exposure toward one or a few
individual parties potentially poses a tension with the view that
interconnections of exposure among multiple parties are important to
establishing systemic risk.
---------------------------------------------------------------------------

     Use of objective, quantitative criteria. The final rules
provide for a ``substantial position'' analysis that is based on
objective, quantitative criteria that would permit a market participant
to determine which level of swap or security-based swap positions would
cause it to be a major participant. Although one commenter has
suggested the use of a two-step approach that uses thresholds as a safe
harbor and that would be accompanied by a second-level
determination,\859\ we do not believe that such an approach would be
consistent with the statutory language or with principles of regulatory
efficiency.\860\ Accordingly, a person whose swap or security-based
swap positions satisfy the applicable thresholds will be a major
participant, with no further layer of review provided.\861\
---------------------------------------------------------------------------

    \859\ See letter from BlackRock I.
    \860\ The major participant definitions specifically require
that the term ``substantial position'' be defined ``by rule or
regulation'' via a ``threshold.'' That language would not appear to
anticipate the use of a multi-tier approach that accounts for
subjective criteria.
     In this respect, the major participant definitions may be
compared with section 113 of the Dodd-Frank Act, which authorizes
the Financial Stability Oversight Council (``FSOC'') to provide for
a non-bank financial company to be supervised by the Board if the
FSOC ``determines that material financial distress at the U.S.
nonbank financial company, or the nature, scope, size, scale,
concentration, interconnectedness, or mix of the activities of the
U.S. nonbank financial company, could pose a threat to the financial
stability of the United States.'' Section 113 further provides that
these designations will result from a vote of the FSOC based on a
variety of factors. The ``major participant'' definition does not
provide for this type of entity-specific determination, and we
believe that the ``major participant'' definition more appropriately
is implemented by objective factors that allow market participants
to determine whether they will fall within the definition.
    \861\ In addition, the final rules provide that the
``substantial position'' analysis that implements the first (and
third) major participant test will be based on the ``major''
categories of swaps and security-based swaps. Notwithstanding
commenter concerns that this approach will require market
participants to analyze their swaps and security-based swaps in new
ways and will result in additional costs, this focus on ``major''
categories is dictated by the plain language of the statute.
---------------------------------------------------------------------------

b. Current Uncollateralized Exposure Test
    Consistent with the proposal, the final rules implementing the
``substantial position'' definition include a test that accounts for
the current uncollateralized exposure posed by an entity's swap or
security-based swap positions in a major

category.\862\ This provides a measure of the amount of potential risk
that an entity would pose to its counterparties if the entity currently
were to default.\863\
---------------------------------------------------------------------------

    \862\ CFTC Regulation Sec.  1.3(jjj)(1); Exchange Act rule 3a67-
3(b)(2). The final rules contain technical changes from the proposal
to clarify the steps entailed by this calculation.
    \863\ See Proposing Release, 75 FR at 80188.
---------------------------------------------------------------------------

    As with the proposal, a person would apply this test by examining
the positions it maintains with each of its counterparties in a
particular major category of swaps or security-based swaps. For each
counterparty, the person would determine the dollar value of the
aggregate current exposure arising from each of its swap or security-
based swap positions with negative value in that major category by
marking-to-market using industry standard practices, and deduct from
that amount the aggregate value of the collateral the entity has posted
with respect to the swap or security-based swap positions.\864\ The
``aggregate uncollateralized outward exposure'' would be the sum of
those uncollateralized amounts over all counterparties with which the
person has entered into swaps or security-based swaps in that major
category.\865\
---------------------------------------------------------------------------

    \864\ As we noted in the Proposing Release, we recognize that
there may be operational delays between changes in exposure and the
resulting exchanges of collateral, and in general we would not
expect that operational delays associated with the daily exchange of
collateral would be considered to lead to uncollateralized exposure
for these purposes. See Proposing Release, 75 FR at 80189 n.92.
Although we are not codifying this principle within the final rules,
we will be mindful of the principle when enforcing those rules.
    \865\ CFTC Regulation Sec.  1.3(jjj)(2); Exchange Act rule 3a67-
3(b)(2).
---------------------------------------------------------------------------

    The final rules implementing this test largely are the same as the
rules the Commissions proposed, but with certain modifications to
address issues raised by commenters.
i. Measure of Exposure and Valuation of Collateral
    Consistent with the proposal, the final rules do not prescribe any
particular methodology for measuring current exposure or for valuing
collateral posted, but instead require the use of industry standard
practices.\866\ In this regard we do not concur with commenter requests
that we approve or prescribe particular methodologies, or provide a
safe harbor for measures or valuations made in good faith.\867\
Instead, it is appropriate that the final rules provide market
participants with the flexibility to use the same methodologies that
they use in connection with their business activities. Accordingly, we
would expect entities to value current uncollateralized exposure based
on the amounts that would be payable if the transaction were
terminated.
---------------------------------------------------------------------------

    \866\ CFTC Regulation Sec.  1.3(jjj)(2); Exchange Act rule 3a67-
3(b)(1). As we noted in the Proposing Release, collateral may be
posted to a third-party custodian, directly to the counterparty, or
in accordance with the rules of a derivatives clearing organization
or clearing agency. See Proposing Release, 75 FR at 80189 n.94.
    \867\ See letters from BlackRock I, Better Markets I and FSR I.
---------------------------------------------------------------------------

    To the extent the measure of exposure or the valuation of
collateral is subject to other rules or regulations, we also would
expect those measures and valuations for purposes of the major
participant calculations to be consistent with those other applicable
rules.\868\ In addition, the ``substantial position'' analysis may take
into account the posting of non-cash collateral to the extent that the
posting of such collateral, and the valuation of that collateral, is
consistent with industry standard practices or applicable
regulation.\869\
---------------------------------------------------------------------------

    \868\ These principles should apply even in the case of valuing
illiquid or bespoke positions. Market participants have the
flexibility to use commercially reasonable approaches that are
consistent with their financial statements, tax calculations and
compliance with other regulations.
    \869\ For non-cash collateral to be considered for purposes of
these calculations, the collateral must be available for the
counterparty's use if the entity posting the collateral were to
default. At a minimum, this would require that the counterparty
possess a perfected security interest in that collateral. As we
noted in the Proposing Release, while we expect that other
regulatory requirements applicable to the valuation of swap or
security-based swap positions and collateral would be relevant to
certain calculations relating to major participant status, these
rules would not necessarily be relevant for other purposes, such as
in the context of capital and margin requirements. See Proposing
Release, 75 FR at 80189 n.95.
---------------------------------------------------------------------------

ii. Netting
    The final rules build upon the proposal with regard to the measure
of uncollateralized current exposure in the presence of netting
arrangements. In particular, to address commenter concerns these
provisions have been modified from the proposal to account for the fact
that two counterparties may have multiple netting agreements for which
offsets are permitted, and to extend the netting principles to any
financial instruments that may be netted for purposes of applicable
bankruptcy law (rather than limiting those instruments to swaps,
security-based swaps and securities financing transactions).
    Accordingly, the final rules provide that an entity may calculate
its exposure on a net basis by applying the terms of one or more master
netting agreements with a counterparty. The entity may account for
offsetting positions entered into with that particular counterparty
involving swaps or security-based swaps as well as securities financing
transactions (consisting of securities lending and borrowing,
securities margin lending and repurchase and reverse repurchase
agreements), and other financial instruments and agreements that are
subject to netting offsets for purposes of applicable bankruptcy law,
to the extent consistent with the offsets provided by those master
netting agreements.\870\ These revisions should permit the current
uncollateralized exposure test to more accurately reflect the degree of
credit risk that an entity poses to its counterparty in the event of
default.
---------------------------------------------------------------------------

    \870\ CFTC Regulation Sec.  1.3(jjj)(2)(iii); Exchange Act rule
3a67-3(b)(3)(i). This provision provides for netting under the
master netting agreement of any instruments, contracts or agreements
(including contracts on physical commodities), that would qualify
for netting under applicable bankruptcy law. As we noted in the
Proposing Release, the proposed rules regarding possible offsets of
various positions are for purposes of determining major participant
status only. Other rules proposed by the Commissions may address the
extent to which, if any, persons such as dealers and major
participants may offset positions for other purposes. See Proposing
Release, 75 FR at 80189 n.98. As proposed, Exchange Act rule 3a67-
3(b)(3)(i) referred to ``security-based swaps (in any swap
category)''; this reference has been revised in the final rule to
``security-based swaps (in any security-based category).''
---------------------------------------------------------------------------

    As discussed in the proposal, these netting provisions apply only
to offsetting positions with a single counterparty.\871\ The provisions
do not extend to the market risk offsets associated with an entity's
positions with multiple counterparties, because such offsets would not
directly mitigate the risks that an individual counterparty would face
in the event of the entity's default.\872\
---------------------------------------------------------------------------

    \871\ CFTC Regulation Sec.  1.3(jjj)(2)(iii); Exchange Act rule
3a67-3(b)(3)(ii).
    \872\ The fact that positions with third parties do not offset
exposure to a particular counterparty was recently highlighted by a
decision finding that the Bankruptcy Code does not permit excess
collateral held by one creditor to offset amounts that the debtor
owed to the creditor's affiliates. See In re Lehman Brothers Inc.,
Case No. 08-01420 (JMP) (SIPA), slip op. (Bankr. S.D.N.Y Oct. 4,
2011).
---------------------------------------------------------------------------

iii. Allocation of Uncollateralized Exposure Following Netting
    The final rules build upon the proposal by codifying the method,
discussed in the Proposing Release, related to the allocation of any
uncollateralized exposure that remains following netting and the
posting of collateral. This type of allocation can be necessary
because, with netting, it otherwise may not be possible to directly
attribute residual uncollateralized exposure to a particular major
category of swap or security-based

swap.\873\ Some commenters have requested that the final rules codify
this method to provide more certainty to market participants.\874\
---------------------------------------------------------------------------

    \873\ Such allocation would not be necessary, of course, to the
extent that an entity has no current uncollateralized exposure to a
counterparty following netting and the posting of collateral.
    \874\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

    Accordingly, the final rules incorporate a formula which, for
purposes of the substantial position analysis, provides that the amount
of net uncollateralized exposure that is attributable to a particular
major category of swap or security-based swap would be allocated pro
rata in a manner that compares the amount of the entity's out-of-the-
money positions in that major category to its total out-of-the-money
positions in all categories that are subject to the netting
arrangements with that counterparty.\875\ This approach does not
require that any collateral be specifically earmarked to particular
swaps or security-based swaps, and can be followed so long as
collateral is posted based on the net exposure associated with all
instruments subject to the applicable netting agreements with that
particular counterparty.\876\
---------------------------------------------------------------------------

    \875\ CFTC Regulation Sec.  1.3(jjj)(2)(iii)(A); Exchange Act
rule 3a67-3(b)(4). Under this formula, for example, if an entity's
exposure to a particular counterparty is $120 million after
accounting for netting and the posting of collateral, and, subject
to netting, the entity has $40 million in out-of-the-money positions
in security-based credit derivatives, $90 million in out-of-the-
money positions in other security-based swaps, and $120 million in
out-of-the money positions in swaps and other instruments subject to
the netting agreements, then $19.2 million in net uncollateralized
exposure would be attributed to the ``security-based credit
derivatives'' category (equal to $120 million [middot] ($40 million/
($40 million + $90 million + $120 million)), and $43.2 million in
net uncollateralized exposure would be attributed to the ``other
security-based swaps'' category (equal to $120 million [middot] ($90
million/($40 million + $90 million + $120 million)).
    \876\ Although one commenter suggested that the analysis should
further consider whether there are collateral posting requirements
that are specific to a particular position, we believe that the test
we are adopting is flexible enough to address that possibility. To
the extent that the parties' collateral arrangements provide that
collateral be earmarked to particular swap or security-based swap
positions, an entity may calculate its potential future exposure
with respect to that counterparty with regard to the applicable
major category of swaps or security-based swaps, without accounting
for netting across categories or instruments.
---------------------------------------------------------------------------

iv. Application of Current Exposure Test to Cleared, Fully
Collateralized or Net In-the-Money Positions
    Although certain commenters have requested that the current
uncollateralized exposure test explicitly exclude swap or security-
based swap positions that are cleared, fully collateralized or net in-
the-money,\877\ the final rules do not provide such exclusions. As we
recognized in the Proposing Release, centrally cleared swaps and
security-based swaps are subject to mark-to-market margining that would
largely eliminate the uncollateralized exposure associated with a
position, effectively resulting in the cleared position being excluded
from the analysis.\878\ Also, by definition, fully collateralized
positions are not associated with current uncollateralized exposure,
and thus would be excluded from the analysis. As such, we do not
believe that it would be necessary to explicitly exclude such positions
from the analysis.\879\
---------------------------------------------------------------------------

    \877\ See letters from ICI I, SIFMA AMG II and Vanguard.
    \878\ See Proposing Release, 75 FR at 80189 n.92.
    \879\ Moreover, to the extent that such positions are associated
with uncollateralized amounts, such as those that arise from
thresholds or minimum transfer amounts pursuant to the applicable
credit support annex, then those amounts present counterparty risk
that should be considered as part of the major participant analysis.
---------------------------------------------------------------------------

    Similarly, we do not believe that it is necessary for the rules to
explicitly exclude net in-the-money swap or security-based swap
positions. If an entity does not have any current uncollateralized
exposure to a particular counterparty--after accounting for the
entity's netting agreement with that counterparty and the posting of
collateral--then the entity may disregard its positions with that
counterparty for purposes of calculating current uncollateralized
exposure. Otherwise, it is appropriate to consider the contribution of
all swaps or security-based swaps to current uncollateralized exposure,
as determined by the allocation methodology discussed above.\880\
---------------------------------------------------------------------------

    \880\ Under that allocation approach, if none of the entity's
swap or security-based swap positions in a major category with that
counterparty are out-of-the-money, then none of the current exposure
resulting from the netting agreement would be attributed to that
major category.
---------------------------------------------------------------------------

c. Potential Future Exposure Analysis
    The ``substantial position'' analysis also will consider an
entity's ``aggregate potential outward exposure,'' which would reflect
the potential exposure of the entity's swap or security-based swap
positions in the applicable ``major'' category of swap or security-
based swaps, subject to certain adjustments.\881\ The final rules
implementing this test in general follow the proposed approach, but
have been revised to address commenter concerns.
---------------------------------------------------------------------------

    \881\ CFTC Regulation Sec.  1.3(jjj)(3); Exchange Act rule 3a67-
3(c).
---------------------------------------------------------------------------

i. Purpose Underlying the Potential Future Exposure Test
    As discussed in the proposal, a potential future exposure test
addresses the fact that a sole focus on current uncollateralized
exposure could fail to identify risky entities until some time after
they begin to pose the level of risk that should subject them to
regulation as major participants.\882\ A potential future exposure test
would allow the substantial position analysis to account for this risk
by addressing how the value of an entity's swap or security-based swap
positions may move against the entity over time.\883\
---------------------------------------------------------------------------

    \882\ See Proposing Release, 75 FR at 80188.
    \883\ See id. at 80191.
---------------------------------------------------------------------------

    Accordingly, consistent with the proposal, the final rules
incorporate a potential future exposure test that seeks to estimate how
much the value of swaps or security-based swaps might change against an
entity over the remaining life of the contract. Although some
commenters took the view that this test should only address potential
volatility during the period of time it would take for a non-defaulting
party to close out positions and liquidate collateral,\884\ we believe
that it is more appropriate for the analysis to consider the risks that
swaps or security-based swap positions pose over the lives of those
positions. An exclusive focus on short-term risks would fail to account
for the possibility that an entity's large swap or security-based swap
positions can readily produce large losses in adverse market
circumstances, potentially leading either to large uncollateralized
exposure (if the posting of collateral is not required), or to large
collateral calls that may lead to the entity's default (or to calls for
extraordinary action) and that can threaten non-defaulting parties with
significant costs and challenges in connection with liquidating and
replacing those positions. The analysis should give appropriate weight
to those risks.
---------------------------------------------------------------------------

    \884\ See letters from SIFMA AMG II and Vanguard.
---------------------------------------------------------------------------

ii. Risk Multipliers
    Subject to modifications addressed below, the final rules
implementing the ``substantial position'' analysis incorporate a
potential future exposure test based on the proposal's general approach
of adjusting notional positions using risk multipliers.\885\ This
approach incorporates and builds upon tests used by bank regulators for
the purposes of setting prudential capital.\886\ Through

this methodology, the final rules implement an objective approach that
readily can be replicated by market participants.
---------------------------------------------------------------------------

    \885\ See CFTC Regulation Sec.  1.3(jjj)(3)(ii)(A)(1); Exchange
Act rule 3a67-3(c)(2)(i).
    \886\ See 12 CFR part 3, app. C, section 32 (Office of the
Comptroller of the Currency capital adequacy guidelines for banks);
12 CFR part 325, app. D, section 32 (Federal Deposit Insurance Corp.
capital adequacy guidelines for banks); 12 CFR part 208, app. F,
section 32 (Federal Reserve System capital adequacy guidelines for
banks); 12 CFR part 225, app. G, section 32 (Federal Reserve System
capital adequacy guidelines for bank holding companies).
---------------------------------------------------------------------------

    Although some commenters have suggested the use of value-at-risk
measures or internal models to evaluate potential future exposure,\887\
we do not believe that such approaches would be well tailored to be
implemented by a range of market participants, or would lead to
comparable results across market participants with identical swap or
security-based swap portfolios.
---------------------------------------------------------------------------

    \887\ See letters from Riverside Risk Advisors and Better
Markets I.
---------------------------------------------------------------------------

    In adopting this approach, we are mindful of the significance of
commenter concerns about the adequacy of the tables that set forth the
risk multipliers that would be applied to notional positions. These
comments address, among other issues: discontinuities in the tables;
the failure to account for whether, and how much, a swap or security-
based swap is in-the-money or out-of-the money; the failure of the
multipliers applicable to interest rate swaps to distinguish between
counterparties who pay floating rates and counterparties who pay fixed
rates; the failure of the multipliers in the credit category to account
for the volatility of the underlying instrument or the duration of the
swap or security-based swap; the failure of the multipliers for equity
and commodity swaps to distinguish between high-volatility and low-
volatility stocks and commodities; the adequacy of how the test
addresses diversification and correlation; the fact that the approach
does not provide for delta weighting of options positions; and the fact
that the factors do not distinguish between index and single-name
credit default swaps.\888\ While we acknowledge that it may be possible
to develop revised risk multipliers that are more finely tuned to
reflect relevant risk factors, at this time we believe that it would be
most appropriate to implement the ``substantial position'' analysis by
building upon an existing regulatory approach that is comparatively
simpler to implement and leads to reproducible results, rather than
seeking to develop a brand new approach.\889\
---------------------------------------------------------------------------

    \888\ See, e.g., letters from Riverside Risk Advisors and MFA I.
    \889\ We also are not following a commenter suggestion to
incorporate the ``standardized method'' prescribed as part of the
``Basel II'' bank capital methodology. See letter from ISDA I. The
standardized method relies on counterparty credit ratings provided
by external credit rating agencies for purposes of calculating risk-
weighted capital measurements. See ``International Convergence of
Capital Measurement and Capital Standards, A Revised Framework,
Comprehensive Version,'' the Basel Committee on Banking Supervision,
June 2006. Incorporating this reliance on credit ratings provided by
external credit rating agencies into these final rules would be
inconsistent with Section 939A of the Dodd-Frank Act, which required
all Federal agencies to review and modify existing regulations ``to
remove any reference to or requirement of reliance on credit ratings
and to substitute in such regulations such standard of credit-
worthiness as each respective agency shall determine as appropriate
for such regulations.''
---------------------------------------------------------------------------

    The final rules implementing the ``major security-based swap
participant'' definition, however, modify the proposed risk multipliers
in response to commenter concerns about how the ``major'' categories of
security-based swaps should be applied to the risk multiplier
categories. In particular, the final risk multiplier category for
security-based swaps in the ``equity and other'' category encompasses
all security-based swaps that are not credit derivatives, and the final
rules eliminate the proposed category for ``other'' types of security-
based swaps.\890\
---------------------------------------------------------------------------

    \890\ See Exchange Act rule 3a67-3(c)(2)(i). Aside from making
the risk multipliers consistent with the ``major'' categories of
security-based swaps, this change also should allow total return
swaps on debt to be subject to the same risk multipliers as total
return swaps on equity, rather than causing the debt swaps to be
subject to higher multipliers (which may not accurately reflect the
comparative risks of those instruments).
---------------------------------------------------------------------------

iii. Potential Future Exposure Measures for Certain Lower-Risk
Positions
    Consistent with the proposal, the potential future exposure
calculation will exclude purchases of options and other positions for
which a person has prepaid or otherwise satisfied its payment
obligations.\891\ Also, in response to commenter concerns, the final
rules expand on the proposal with regard to capping the potential
future exposure associated with certain lower-risk swap and security-
based swap positions. The final rules particularly cap--at the net
present value of the unpaid premiums--the potential future exposure
associated with positions by which a person buys credit protection
using a credit default swap, and positions by which a person purchases
an option for which the person retains additional payment obligations
under the position.\892\ This reflects the reduced risk associated with
such positions. The final rules do not prescribe a particular discount
rate for purposes of this analysis, and market participants instead
should use a commercially appropriate discount rate.
---------------------------------------------------------------------------

    \891\ See CFTC Regulation Sec.  1.3(jjj)(3)(ii)(A)(3)(ii);
Exchange Act rule 3a67-3(c)(2)(i)(C).
    \892\ See CFTC Regulation Sec.  1.3(jjj)(3)(ii)(A)(4); Exchange
Act rule 3a67-3(c)(2)(i)(D). The proposed rules would have applied
this net present value caps only to the purchase of credit
protection. The final rules expand this provision by also capping
the potential future exposure associated with the purchases of
options in which an entity retains payment obligations, to reflect
the reduced risk associated with those positions.
---------------------------------------------------------------------------

    In addition, to better align the results of the potential future
exposure analysis with the risks that a person presents, the final
rules have been modified from the proposal to also exclude swap or
security-based swap positions for which, pursuant to regulatory
requirement, a person has placed in reserve an amount of cash or
Treasury securities that is sufficient to pay the person's maximum
possible liability under the position, when the person is prohibited
from using that cash or those securities without also liquidating the
swap or security-based swap position.\893\
---------------------------------------------------------------------------

    \893\ CFTC Regulation Sec.  1.3(jjj)(3)(ii)(A)(3)(iii); Exchange
Act rule 3a67-3(c)(2)(i)(C)(3). This exclusion of such positions
from the major participant analysis may apply, for example, to
certain swap or security-based swap positions of insurers where
applicable law requires an amount equal to the maximum possible
exposure of the insurer be segregated.
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iv. Adjustments for Netting
    Consistent with the proposal, and with the bank regulator standards
that form the basis for these potential future exposure measures, the
final rules provide that an entity may reduce the measure of its
potential future exposure in a major category by up to 60 percent to
reflect the risk mitigation effects of master netting agreements. We
believe that this approach appropriately reflects the risk mitigating
attributes of netting on potential future exposure. Moreover, in light
of commenter requests for clarification of how these netting provisions
would be applied,\894\ the final rules have been revised from the
proposal to provide that the risk reduction associated with netting
should be estimated using the same pro rata allocation methodology that
will be used to measure current exposure.\895\
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    \894\ See letter from SIFMA AMG II.
    \895\ Consistent with the proposal, the effects of netting are
to be estimated using the formula: P Net = 0.4 x P Gross + 0.6 x NGR
x P Gross. Under that equation, P Net is the potential exposure
adjusted for bilateral netting; P Gross is that potential outward
exposure without adjustment for bilateral netting; and NGR is the
net to gross ratio. The final rule has been revised from the
proposal to clarify that the net to gross ratio equals the current
exposure associated with the major category as calculated using the
pro rata methodology discussed above, divided by what the measure of
current exposure in connection with those out-of-the-money positions
would be in the absence of that methodology.
     Accordingly, for the example set forth in note 875, supra, the
NGR for ``security-based credit derivatives'' and ``other security-
based swaps'' both would equal 0.48 (equal to $19.2 million net
exposure divided by $40 million in out-of-the-money positions in the
case of ``security-based credit derivatives,'' or $43.2 million net
exposure divided by $90 million in out-of-the-money positions in the
case of ``other security-based swaps''). If an entity has no current
exposure to a counterparty following the application of netting
arrangements and collateralization, the NGR for those positions
would equal zero, and the potential exposure would equal 40 percent
of what it would equal otherwise.

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

v. Adjustments for Cleared and Margined Positions
    The final rules also provide for the measure of potential future
exposure to be adjusted in the case of swap and security-based swap
positions that are centrally cleared or that are subject to daily mark-
to-market margining. This is consistent with the purpose of the
potential future exposure test, which is to account for the extent to
which the current outward exposure of positions (though possibly low or
even zero at the time of measurement) might grow to levels that can
lead to high counterparty risk to counterparties or to the markets
generally. The practice of the periodic exchange of mark-to-market
margin between counterparties helps to mitigate the potential for large
future increases in current exposure.
    Consistent with the proposal, the final rules reflect this ability
to mitigate risk by providing that the potential future exposure
associated with positions that are subject to daily mark-to-market
margining will equal 0.2 times the amount that otherwise would be
calculated. However, in response to commenters' opinions about the
risk-mitigating effects of central clearing, and the additional level
of rigor that clearing agencies may have with regards to the process
and procedures for collecting daily margin, the final rules further
provide that the potential future exposure associated with positions
that are subject to central clearing will equal 0.1 (rather than the
proposed 0.2) times the potential future exposure that would otherwise
be calculated.\896\
---------------------------------------------------------------------------

    \896\ See CFTC Regulation Sec.  1.3(jjj)(3)(iii)(A); Exchange
Act rule 3a67-3(c)(3)(i). The final rules further have been revised
to clarify that the 0.1 factor applies to positions cleared by a
registered clearing agency or by a clearing agency that has been
exempted from registration.
---------------------------------------------------------------------------

    Although some commenters supported the complete exclusion of
cleared positions from the potential future exposure analysis,\897\ and
we are mindful of the risk mitigating attributes of central clearing,
we also recognize that central clearing cannot reasonably be expected
to entirely eliminate counterparty risk.\898\ We conclude, however,
that the use of a 0.1 factor (in lieu of the proposed 0.2) would be
appropriate for cleared positions, reflecting the strong risk
mitigation features associated with central clearing, particularly the
procedures regarding the collection of daily margin and the use of
counterparty risk limits, while recognizing the presence of some
remaining counterparty risk.
---------------------------------------------------------------------------

    \897\ See, e.g., letters from MFA I and SIFMA AMG II.
    \898\ Central clearing helps to mitigate counterparty credit
risk by improving risk management and, among other things,
mutualizing the risk of counterparty failure. If multiple members of
a central counterparty fail beyond the level to which such risk is
managed, however, the central counterparty would also be at risk of
failure. Cf. Basel Committee on Banking Supervision, Consultative
Document, ``Capitalisation of bank exposures to central
counterparties,'' Nov. 25, 2011 (available at: http://www.bis.org/publ/bcbs206.pdf) (proposing that the capital charge for trade
exposures to a qualifying central counterparty should carry a low
risk weight, reflecting the relatively low risk of default of the
qualifying central counterparty). In addition, as we discussed in
the Proposing Release, see 75 FR at 80192 n.115, for example,
central counterparties that clear credit default swaps do not
necessarily become the counterparties of their members' customers
(although even absent direct privity those central counterparties
benefit customers by providing for protection of collateral they
post as margin, and by providing procedures for the portability of
customer positions in the event of a member's default). As a result,
central clearing may not eliminate the counterparty risk that the
customer poses to the member, although required mark-to-market
margining should help control that risk, and central clearing would
be expected to reduce the likelihood that an entity's default would
lead to broader market impacts.
---------------------------------------------------------------------------

    Moreover, although some commenters opposed any deduction from the
measure of potential future exposure for uncleared positions that are
margined on a daily basis,\899\ we believe that the risk-mitigating
attributes of daily margining warrant an adjustment given that the goal
of the potential future exposure test is to account for price movements
over the remaining life of the contract.\900\ The use of a 0.2 factor
also reflects our expectation that the risk mitigation associated with
uncleared but margined positions would be less than the risk mitigation
associated with cleared positions.
---------------------------------------------------------------------------

    \899\ See letter from Better Markets I; see also letter from
AFR.
    \900\ We do not believe that it is appropriate to have this type
of discount when mark-to-market margining is done less than daily,
however.
---------------------------------------------------------------------------

    While higher or lower alternatives to the 0.1 and 0.2 factors may
also be reasonable for positions that are cleared or margined on a
daily basis, we believe that the factors of the final rules reasonably
reflects the risk mitigating (but not risk eliminating) features of
those practices. The final rules also retain and clarify provisions
addressing when daily mark-to-market margining occurs for purposes of
this discount.\901\
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    \901\ We recognize that at times, market participants whose
agreements provide for the daily exchange of variation margin in
connection with swaps or security-based swaps in practice may not
exchange collateral daily, if the amounts at issue are relatively
small (such as through the use of collateral thresholds and minimum
transfer amounts). We do not believe that such practices would be
inconsistent with providing a discount for daily margining
practices. The proposed rules sought to accommodate those practices
by providing that positions would be considered to be subject to
daily mark-to-market margining for purposes of the
``uncollateralized outward exposure'' plus ``potential outward
exposure'' analysis, so long as the total of such thresholds, and
the total of such minimum transfer amounts above $1 million are
deemed to be ``uncollateralized outward exposure'' for those
purposes.
    In light of commenter concerns, which indicated that the
proposal was not fully clear about the mechanics and purpose of this
approach, the relevant rule language has been revised to clarify
that this attribution of thresholds and minimum transfer amounts is
solely for the purpose of determining whether certain positions are
subject to daily mark-to-market margining for purposes of the
analysis. In addition, the final rules have been revised from the
proposal to provide that the attribution of thresholds as
``uncollateralized outward exposure'' for these purposes will be
reduced by initial margin posted, up to the amount of the threshold.
See CFTC Regulation Sec.  1.3(jjj)(iii)(B); Exchange Act rule 3a67-
3(c)(3)(ii).
---------------------------------------------------------------------------

vi. Application of ``Effective Notional'' Amounts
    Consistent with the proposal (as well as the rules implementing the
de minimis exception to the dealer definitions), the potential future
exposure test is based on the ``effective notional'' amount of the swap
or security-based swap when the stated notional is leveraged or
enhanced by the structure of the swap or security-based swap.\902\
---------------------------------------------------------------------------

    \902\ As discussed above, this may occur, for example, if the
exchange of payments associated with an equity swap is based on a
multiple of the return associated with the underlying equity. As is
the case for measuring current exposure, the final rules do not
prescribe any particular methodology for calculating the notional
amount or effective notional amount used in the calculation of
potential future exposure, but instead contemplate the use of
industry standard practices.
---------------------------------------------------------------------------

    Moreover, as discussed in the Proposing Release,\903\ in the case
of positions that represent the sale of an option on a swap or
security-based swap (other than the sale of an option permitting the
person exercising the option to purchase a credit default swap), we
would view the effective notional amount of the option as being equal
to the effective notional amount of the underlying swap or security-
based swap, and in general we would view the duration used for purposes
of the formula as being equal to the sum of the duration of the option
and the duration of the underlying swap or security-based swap.\904\
---------------------------------------------------------------------------

    \903\ See Proposing Release, 75 FR 80192 n.110.
    \904\ The effective notional amount of the underlying instrument
is used for these purposes because that amount fairly reflects the
basis for measuring the potential counterparty risk associated with
the instrument. The sum of the duration of the option and the
underlying instrument is used for these purposes because that sum
reflects the length of time of the potential counterparty risk
associated with the instrument.
    At the same time, we agree with a commenter's view that if the
underlying swap or security-based swap is cash settled, the
calculation of duration will only include the duration of the
option, and not the duration of the swap, because counterparty
exposure would exist only until the option expiration date. See
letter from MFA I.

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

vii. Treatment of Initial Margin or Overcollateralization
    The final rules retain the proposed approach of not modifying the
measure of potential future exposure to reflect collateral that a
person has posted to its counterparty in excess of current exposure.
Although we recognize that the posting of excess collateral may
mitigate the future credit risk that the potential future exposure
measure is intended to estimate, that mitigating effect is not certain,
and any such mitigation may not reflect the full value of the excess
collateral. Moreover, while we believe that the measure of potential
future exposure associated with swap or security-based swap positions
reasonably estimates the credit risk that may be posed by those
positions for purposes of the substantial position analysis, we also
recognize that particular positions may prove to pose a far higher
amount of credit risk.\905\ Given how the credit risk associated with a
swap or security-based swap position can far exceed the associated
measure of potential future exposure, we do not believe that it would
be appropriate to offset that measure to account for
overcollateralization.\906\
---------------------------------------------------------------------------

    \905\ For example, if a person writes a CDS that provides $10
billion in protection on a reference entity, with the CDS being
subject to daily mark-to-market margining, then for purposes of the
substantial position analysis that CDS would be associated with a
potential future exposure measure of no more than $200 million
(reflecting the 0.1 conversion factor and the additional 0.2
multiplier for margined positions), even before accounting for
netting. Yet if the reference entity were to default, the writer of
the CDS could pose up to $10 billion in credit risk to its
counterparty.
    \906\ However, as discussed above, see note 901, supra, initial
margin may be considered when determining if a collateral threshold
is to be attributed to current uncollateralized exposure for
purposes of determining whether certain positions are subject to
daily mark-to-market margining for purposes of the substantial
position analysis.
---------------------------------------------------------------------------

d. Thresholds
    The final rules retain the proposed thresholds for the amount of
current uncollateralized exposure and potential future exposure that
will cause an entity to be deemed to be a major participant.
Accordingly, for a person to have a ``substantial position'' in a major
category of swaps, it would be necessary for that person to have a
daily average current uncollateralized exposure of at least $1 billion
(or $3 billion for the rate swap category), or a daily average current
uncollateralized exposure plus potential future exposure of $2 billion
(or $6 billion for the rate swap category).\907\ To have a
``substantial position'' in a major category of security-based swaps,
it would be necessary for the person to have a daily average current
uncollateralized exposure of at least $1 billion, or a daily average
current uncollateralized exposure plus potential future exposure of at
least $2 billion.\908\
---------------------------------------------------------------------------

    \907\ CFTC Regulation Sec.  1.3(jjj)(1).
    \908\ Exchange Act rule 3a67-3(a).
---------------------------------------------------------------------------

    As the Proposing Release noted, the proposed thresholds sought to
reflect: (i) The financial system's ability to absorb losses of a
particular size; (ii) the recognition that it would not be appropriate
for the substantial position test to encompass entities only after they
pose significant risks to the market through their swap or security-
based swap activity; and (iii) the need to account for the possibility
that multiple market participants may fail close in time.\909\ While
some commenters took the position that the proposed thresholds were
inappropriately low, those commenters did not present empirical data or
analysis in support of that view. Moreover, the Commissions do not
concur with the suggestion \910\ that the major participant definitions
can reasonably be read to require that we defer this rulemaking until
we have gathered additional data. Instead, the definitions direct us to
set a standard that is ``prudent,'' which is what we have sought to do.
---------------------------------------------------------------------------

    \909\ As discussed above, we do not believe it would be prudent
to presume that entity failures will be separated in time during
periods of financial stress.
    \910\ See letters from BlackRock I and CCMR I.
---------------------------------------------------------------------------

    Some commenters who supported an increase in the proposed
thresholds attempted to support their positions via analogy to past
events, with the most significant of these being an analogy to AIG
Financial Products (``AIG FP'').\911\ The analogy to AIG FP \912\
actually argues against an increase in these thresholds, however,
particularly given that the credit derivative portfolio that
significantly contributed to the liquidity problems that AIG FP faced
amounted to $72 billion in notional amount.\913\ Under the final rules,
in the presence of central clearing or daily marking to market it would
take a credit derivative portfolio in excess of that amount to trigger
the potential future exposure threshold under the ``substantial
position'' analysis.\914\ This indicates that the thresholds are not
inappropriately low, particularly given our view that the major
participant definition is intended to encompass entities before their
swap or security-based swap positions pose significant market
threats.\915\ Conversely, while

additional data and analysis may warrant a reduction of these
thresholds in the future, commenters who supported a reduction in those
thresholds have not persuaded us that the proposed thresholds should be
lowered.
---------------------------------------------------------------------------

    \911\ See letter from ABC/CIEBA. One commenter's analogy to
Enron also is unpersuasive. See letter from BG LNG I. In particular,
the $18.7 billion in Enron derivatives exposure cited by that
commenter does not account for collateral posted in connection with
those positions. Also, the market impact of Enron's bankruptcy was
substantially mitigated by the sale of Enron's derivatives trading
arm to a third party.
    Moreover, although one commenter generally alluded to corporate
financial losses in the derivatives markets that exceeded the
proposed $1 billion and $2 billion thresholds, see letter from NCGA/
NGSA II, the relevant question does not focus on losses that market
participants have incurred, but instead focuses on what degree of
credit risk to counterparties in the swap and security-based swap
markets presents such a potential to cause significant market impact
that it would be prudent to regulate persons who pose that degree of
credit risk in connection with their swap or security-based swap
positions.
    \912\ Our discussion of how the major participant analysis may
apply to an entity that has a portfolio of a size equivalent to that
of AIG FP should not be read to imply that a person may engage in
swap and security-based swap activities akin to those of AIG FP
without registering as a swap dealer or security-based swap dealer.
    \913\ See, e.g., Congressional Oversight Panel, The AIG Rescue,
Its Impact on Markets, and the Government's Exit Strategy 22-24
(2010) (discussing how the risk in AIG's CDS business largely was
the result of a ``multi-sector'' CDO book that amounted to $72
billion notional as of September 2008, and how the losses to AIG
were driven by 125 of the roughly 44,000 contracts entered into by
AIG FP).
    \914\ For cleared security-based credit default swaps (in which
we assume daily margining requirements result in no current
uncollateralized exposure) achieving $2 billion of potential future
exposure would require writing $200 billion notional of credit
default swap protection (reflecting the 0.10 multiplier in the risk
adjustment tables, and the additional 0.10 multiplier for positions
that are cleared). Similarly, it would take a $100 billion notional
portfolio of uncleared but marked-to-market security-based credit
default swaps to meet that same threshold (reflecting the 0.20
multiplier for positions that are subject to daily mark-to-market
margining). The total might be even higher if such instruments were
subject to counterparty netting agreements.
    Even in the absence of clearing or daily mark-to-market
margining, it would take a minimum $20 billion notional portfolio of
written protection on credit (reflecting the 0.10 multiplier in the
risk adjustment tables) to meet the $2 billion potential future
exposure threshold. Accounting for netting (which can reduce
potential future exposure measures by up to 60 percent) could
materially increase that required amount.
    \915\ The case of Long-Term Capital Management (``LTCM'') also
is instructive in connection with the current exposure thresholds of
the major participant analysis. Had LTCM failed, its top 17
counterparties would have suffered estimated total losses of between
$3 and $5 billion. See President's Working Group on Financial
Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital
Management (April 1999) at 17 (http://www.treasury.gov/resource-center/fin-mkts/Documents/hedgfund.pdf). The government acted in
connection with LTCM because the rushed close-out of LTCM's
positions would have affected other market participants, and the
spread of losses would have led to market uncertainty, likely
causing a number of credit and interest rate markets to experience
extreme price moves and possibly not function for a period of time.
See Statement by William J. McDonough, President Federal Reserve
Bank of New York before the Committee on Banking and Financial
Services U.S. House of Representatives (October 1, 1998) (http://www.newyorkfed.org/newsevents/speeches_archive/1998/mcd981001.html).
---------------------------------------------------------------------------

e. Additional Issues
    The final rules applying the ``substantial position'' analysis and
the major participant definitions generally apply to all types of swaps
or security-based swaps that a person maintains. Although one commenter
suggested that swaps on government securities should be excluded from
the analysis, the rules will not provide such an exclusion. To the
extent that a person presents credit risk as a result of swaps
referencing government securities, there is no basis for disregarding
that risk when determining whether the person is a major participant.
    In addition, in light of one commenter's concern,\916\ the
Commissions believe that it is important to emphasize that these rules
should not be interpreted to deter end-users from requesting margin
from dealers or major participants who are their counterparties to
swaps or security-based swaps.
---------------------------------------------------------------------------

    \916\ See letter from FHLB I.
---------------------------------------------------------------------------

    Also, in light of a point raised by another commenter,\917\ the
Commissions note that these rules implementing the major participant
definitions do not place any independent calculation or other
obligations upon counterparties to potential major participants, and
that the rules do not preclude a potential major participant from
seeking the assistance of a third party to perform the relevant
calculation.
---------------------------------------------------------------------------

    \917\ See letter from ISDA I.
---------------------------------------------------------------------------

C. ``Hedging or Mitigating Commercial Risk''

1. Proposed Approach
a. General Availability of the Proposed Exclusion
    The first test of the major participant definitions excludes
positions held for ``hedging or mitigating commercial risk'' from the
substantial position analysis.\918\ In the Proposing Release, we
preliminarily concluded that positions that hedge or mitigate a
person's commercial risk may qualify for this exclusion regardless of
whether the entity is financial or non-financial in nature.\919\ That
conclusion in part was prompted by the fact that the statutory major
participant definitions do not explicitly make the exclusion
unavailable to financial entities; in contrast to the Title VII
exceptions from mandatory clearing requirements in connection with
hedging commercial risk,\920\ which explicitly are unavailable to
financial entities.\921\ The conclusion also was prompted by the
presence of the third major participant test--which specifically
applies the substantial position analysis to certain non-bank financial
entities but (unlike the first test) does not exclude commercial risk
hedging positions from the analysis.\922\
---------------------------------------------------------------------------

    \918\ See CEA section 1a(33)(A)(i)(I); Exchange Act section
3(a)(67)(A)(i)(I).
    \919\ See Proposing Release, 75 FR at 80194.
    \920\ See CEA section 2(h)(7)(A); Exchange Act section
3C(g)(1)(B).
    \921\ As we discussed in the Proposing Release, had the Dodd-
Frank Act intended the phrase ``hedge or mitigate commercial risk''
to apply only to activities of, or positions held by, non-financial
entities, it would not have been necessary for the mandatory
clearing exceptions to include additional provisions generally
restricting the availability of the exceptions to non-financial
entities. See Proposing Release, 75 FR at 80194.
    \922\ As we discussed in the Proposing Release, the third
statutory major participant test would be redundant if the hedging
exclusion in the first major participant test were entirely
unavailable to financial entities. See Proposing Release, 75 FR at
80194 n.125.
---------------------------------------------------------------------------

    In the Proposing Release, we also preliminarily concluded that the
question of whether an activity is commercial in nature should not be
determined solely by a person's organizational status as a for-profit,
non-profit or governmental entity, but instead should depend on whether
the underlying activity is commercial in nature.\923\
---------------------------------------------------------------------------

    \923\ See Proposing Release, 75 FR at 80194.
---------------------------------------------------------------------------

    The proposal did not preclude the exclusion from being available in
connection with hedges of a person's ``financial'' or ``balance sheet''
risks. In addition, the proposal solicited comment as to whether the
exclusion should extend to activities in which a person hedges an
affiliate's risk.
b. Proposed Definition Under the CEA Exception
    The proposed interpretation of ``hedging or mitigating commercial
risk'' for purposes of the CEA's definition of ``major swap
participant'' premised the exclusion on the principle that swaps
necessary to the conduct or management of a person's commercial
activities should not be included in the calculation of the entity's
substantial position.\924\
---------------------------------------------------------------------------

    \924\ The scope of the proposed exclusion is based on our
understanding that when a swap or security-based swap is used to
hedge a person's commercial activities, the gains or losses
associated with the swap or security-based swap itself will
generally be offset by losses or gains in the person's commercial
activities, and hence the risks posed by the swap or security-based
swap to counterparties or the industry will generally be mitigated.
---------------------------------------------------------------------------

    The CFTC noted first that the phrase ``hedging or mitigating
commercial risk'' as used with respect to the major swap participant
definition is virtually identical to Dodd-Frank provisions granting an
exception from the mandatory clearing requirement to non-financial
entities that are using swaps to hedge or mitigate commercial
risk.\925\ Also noted was that although only non-financial entities
that use swaps or security-based swaps to hedge or mitigate commercial
risk generally may qualify for the clearing exemption, no such
statutory restriction applies with respect to the exclusion for hedging
positions in the first test of a major participant. We therefore
concluded that positions established to hedge or mitigate commercial
risk may qualify for the exclusion, regardless of the nature of the
entity--i.e., whether or not the entity is financial (including a bank)
or non-financial.\926\
---------------------------------------------------------------------------

    \925\ See CEA section 2(h)(7)(A); Exchange Act section
3C(g)(1)(B) (exception from mandatory clearing requirements when one
or more counterparties are not ``financial entities'' and are using
swaps or security-based swaps to ``hedge or mitigate commercial
risk'').
    \926\ The presence of the third major participant test suggests
that financial entities generally may not be precluded from taking
advantage of the hedging exclusion in the first test. The third
test, which does not account for hedging, specifically applies to
non-bank financial entities that are highly leveraged and have a
substantial position in a major category of swaps or security-based
swaps. That test would be redundant if the hedging exclusion in the
first major participant test were entirely unavailable to financial
entities.
---------------------------------------------------------------------------

    The CFTC preliminarily believed that whether a position hedges or
mitigates commercial risk should be determined by the facts and
circumstances at the time the swap is entered into, and should take
into account the entity's overall hedging and risk mitigation
strategies. However, the swap could not be held for a purpose that is
in the nature of speculation, investing or trading. We anticipated that
a person's overall hedging and risk management strategies would help
inform whether or not a particular position is properly considered to
hedge or mitigate commercial risk. Further, the exclusion under the
Proposing Release included swaps hedging or mitigating any of a
person's business risks, regardless of the

swap's status under accounting guidelines or the bona fide hedging
exemption.
c. Proposed Definition Under the Exchange Act Exception
    For purposes of the Exchange Act's ``major security-based swap
participant'' definition, the proposed rule defining ``hedging or
mitigating commercial risk'' would require that a security-based swap
position be ``economically appropriate'' to the reduction of risks in
the conduct and management of a commercial enterprise, where those
risks arise from the potential change in the value of assets,
liabilities and services connected with the ordinary course of business
of the enterprise.\927\ The Proposing Release stated that the SEC
preliminarily planned to interpret the concept of ``economically
appropriate'' based on whether a reasonably prudent person would
consider the security-based swap to be appropriate for managing the
identified commercial risk. It further stated that the SEC also
preliminarily believed that for a security-based swap to be deemed
``economically appropriate'' in this context, it should not introduce
any new material quantum of risks (i.e., it could not reflect over-
hedging that could reasonably have a speculative effect) and it should
not introduce any basis risk or other new types of risk (other than the
counterparty risk that is attendant to all security-based swaps) more
than reasonably necessary to manage the identified risk.\928\
---------------------------------------------------------------------------

    \927\ See proposed Exchange Act rule 3a67-4(a).
    \928\ See Proposing Release, 75 FR at 80195 n.129.
---------------------------------------------------------------------------

    The proposed rules further provided that the security-based swap
position could not be held for a purpose that is in the nature of
speculation or trading--a limitation that would make the exclusion
unavailable to security-based swap positions that are held
intentionally for the short term and/or with the intent of benefiting
from actual or expected short-term price movements or to lock in
arbitrage profits, including security-based swap positions that hedge
other positions that themselves are held for the purpose of speculation
or trading.\929\ The proposal also provided that a security-based swap
position could not be held to hedge or mitigate the risk of another
security-based swap position or swap position unless that other
position itself is held for the purpose of hedging or mitigating
commercial risk.\930\ Finally, the proposal would have conditioned the
entity's ability to exclude these security-based swap positions on the
entity engaging in certain specified activities related to documenting
the underlying risks and assessing the effectiveness of the hedge in
connection with the security-based swap positions.\931\
---------------------------------------------------------------------------

    \929\ See proposed Exchange Act rule 3a67-4(b)(1), and Proposing
Release, 75 FR at 80195 n.131.
    \930\ See proposed Exchange Act rule 3a67-4(b)(2).
    \931\ See proposed Exchange Act rule 3a67-4(c).
---------------------------------------------------------------------------

2. Commenters' Views
a. In General
    Several commenters generally supported the broad concepts
underlying the proposed rules for identifying hedges of commercial
risk, and particularly supported the proposed use of an ``economically
appropriate'' standard instead of the ``highly effective'' standard
that is used to identify hedges for accounting purposes.\932\ On the
other hand, one commenter stated that the definition should incorporate
all manner of risks associated with commercial operations, including
interest rate and currency risks, risks from incidental activities to
commercial activities and risks from financial commodities.\933\ One
commenter further stated that the definition should encompass positions
that facilitate asset optimization and dynamic hedging.\934\
---------------------------------------------------------------------------

    \932\ See letters from ACLI, Barnard, CDEU, COPE I, EEI/EPSA,
FSR I, ISDA I, Kraft, MetLife, NAIC, Philip Morris International
Inc. (``Philip Morris'') and Utility Group.
    \933\ See letter from CDEU.
    \934\ See letter from Peabody.
---------------------------------------------------------------------------

    Commenters further stated that the exception should include any
position taken as part of a bona fide risk mitigation strategy,\935\
and that Congress included ``mitigation'' in the exception for the
purpose of covering risk reduction strategies that may not clearly be
hedges but mitigate risk.\936\ Some commenters also criticized the
Proposing Release's position equating the terms ``hedging'' and
``mitigating.'' \937\ One commenter also expressed concern that
entities would find it difficult to analyze their positions with
respect to the Proposing Release's statement, in the context of the
Exchange Act definition, that ``economically appropriate'' security-
based swaps would not add a new quantum of risk.\938\
---------------------------------------------------------------------------

    \935\ See letter from ISDA I.
    \936\ See letter from CDEU.
    \937\ See letters from APG, CDEU and ISDA I.
    \938\ See letter from SIFMA AMG II.
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    Conversely, some commenters suggested that the proposed
interpretation was too broad,\939\ and that a broad interpretation
could allow evasion,\940\ or permit corporate end users to accumulate
very large positions without becoming major swap participants.\941\ One
commenter stated that to include ``financial risks'' within the
exclusion's scope would be improper because a ``commercial risk'' is
one that is inherent in a person's commercial activities, while
interest rate and currency risks arise from choices about how a person
structures and finances its operations.\942\ Some commenters stated
that the rule should not include hedging of financial risks because
Congress deleted the reference in an earlier version of the Dodd-Frank
Act to hedging of ``balance sheet risk.'' \943\ One commenter urged
that we consider using accounting hedge treatment or the bona fide
hedging exemption as guideposts for determining the availability of the
exclusion.\944\ Commenters also raised concerns about differences
between the proposed approaches under the CEA and Exchange Act
definitions of the terms.\945\
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    \939\ See letters from AFR and AFSCME. The CFTC also received
submissions of a substantially identical letter from approximately
193 individuals and small businesses urging the CFTC to define
commercial risk narrowly to include only risks arising from physical
commodity price fluctuations, and not financial risks, and to
construe the exception for captive finance companies narrowly. See,
e.g., letter from Needham Oil & Air, LLC. In addition, the CFTC
received submissions from approximately 535 individuals of a
different letter, which also urged the CFTC to define commercial
risk narrowly. See, e.g., letter from Christie Hakim.
    \940\ See letters from Sen. Carl Levin (``Senator Levin''),
Commodity Markets Oversight Coalition (``CMOC'') and Greenberger and
meeting with MFA on February 14, 2011.
    \941\ See meeting with SIFMA AMG on February 4, 2011.
    \942\ See meeting with AFR and Better Markets on March 17, 2011.
    \943\ See letters from AFR and CMOC, and meeting with Duffie on
February 2, 2011.
    \944\ See letter from Senator Levin.
    \945\ See letters from Senator Levin, NAIC and SIFMA AMG II.
---------------------------------------------------------------------------

    One commenter suggested that the definition should be expanded to
include as commercial risks the risks faced by government entities
because their need to manage risk is no different than the need of
commercial firms.\946\ Additional commenters suggested that commercial
risk be interpreted to include risks faced by non-profit firms.\947\
---------------------------------------------------------------------------

    \946\ See letter from Milbank, Tweed, Hadley & McCloy LLP
(``Milbank'').
    \947\ See letters from CDEU and NFPEEU.
---------------------------------------------------------------------------

    Some commenters also supported modification of the rule text for
specific purposes such as including risks from ``transmitting'' to
cover activities of electricity companies,\948\ to encompass risks
``arising from'' an asset rather than just risks arising from changes
in value

of the asset,\949\ and to encompass the use of swaps by structured
finance special purpose vehicles to hedge interest rate risk in
structured financing.\950\
---------------------------------------------------------------------------

    \948\ See letter from Edison Int'l.
    \949\ See letter from Milbank.
    \950\ See letter from American Securitization Forum (``ASR'').
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b. Availability of Exclusion to Financial Entities
    Several commenters supported making the exclusion available to
financial companies.\951\ Some commenters further stated that there
should be no special limits on financial entities with regard to the
exclusion,\952\ and that commercial risk should be defined broadly to
include all of the commercial activities of a person, whether or not
those activities relate to financial or non-financial commodities.\953\
Two commenters discussing the use of swaps by insurance companies
stated that making the exclusion available to financial companies is
consistent with CFTC practice in the futures markets, that there is no
fundamental difference in how an insurance company or a commercial
enterprise uses swaps to reduce its risk, and that commercial risk
encompasses financial risk.\954\ In addition, these commenters noted
that insurance regulators allow insurance companies to use swaps to
hedge risk.\955\
---------------------------------------------------------------------------

    \951\ See letters from ACLI, American Express Company
(``Amex''), California State Teachers' Retirement System
(``CalSTRS'') dated Feb. 28, 2011 (``CalSTRS I''), ISDA I, MetLife,
NAIC and Peabody.
    \952\ See letters from Amex, CalSTRS I and Peabody.
    \953\ See letter from Amex.
    \954\ See letters from ACLI and MetLife.
    \955\ Id.
---------------------------------------------------------------------------

    On the other hand, some commenters opposed allowing financial
entities to avail themselves of the exclusion, arguing that there is no
benefit from allowing a financial firm to avoid major participant
regulation through the hedging exclusion,\956\ that the exclusion would
allow financial companies to engage in risky trades,\957\ and that the
exclusion should be narrowly interpreted to cover hedging of only risks
related to products.\958\
---------------------------------------------------------------------------

    \956\ See letter from Senator Levin (further highlighting the
need to add strict standards and controls to prevent evasion).
    \957\ See letters cited in note 939, supra.
    \958\ See letter from AFR.
---------------------------------------------------------------------------

c. Hedging Risks of Affiliates and Third Parties
    Some commenters expressed support for allowing persons to take
advantage of the hedging exclusion when they use swaps to hedge the
commercial risks of affiliates or third parties. Some commenters
suggested that a person that aggregates and hedges risk within a
corporate group should be allowed to use the exclusion despite the fact
that it is the affiliates' risks that are hedged.\959\ One commenter
further stated that providers of risk management services should be
allowed to take advantage of the exclusion because they are hedging
commercial risk on behalf of their clients.\960\
---------------------------------------------------------------------------

    \959\ See letters from CDEU, EDF Trading, Kraft, Metlife and
Philip Morris.
    \960\ See letter from EDF Trading.
---------------------------------------------------------------------------

    One commenter, on the other hand, stated that the exclusion should
be read narrowly for captive finance companies because the hedging
entity may have to liquidate positions rapidly without access to
affiliate's funds.\961\
---------------------------------------------------------------------------

    \961\ See meeting with Duffie on February 2, 2011.
---------------------------------------------------------------------------

d. Hedge Effectiveness and Documentation
    Many commenters suggested that the rule should not test hedge
effectiveness, explaining that requiring demonstration of hedge
effectiveness would impose a subjective standard and would not reduce
systemic risk.\962\ In this regard, some commenters that addressed the
proposed procedural requirements in the Exchange Act definition argued
that these procedures would place unnecessary regulatory burdens on
entities not regulated under the Dodd-Frank Act.\963\ Conversely, one
commenter that supported testing hedge effectiveness stated that the
subdivided parts of a hedge should line up exactly with the subdivided
parts of the risk.\964\
---------------------------------------------------------------------------

    \962\ See letters from EEI/EPSA and EDF Trading; see also
letters from CDEU, Kraft Metlife, NRG Energy and Philip Morris (that
such a test would be overly prescriptive).
    \963\ See letters from FSR I and SIFMA AMG I.
    \964\ See letter from Better Markets I.
---------------------------------------------------------------------------

    Some commenters agreed that the relationship between hedging and
risk should be documented. One commenter expressed the view that
documentation would facilitate audits.\965\ Others took the view that a
person should be required to demonstrate that the hedge does not create
additional risk, that the risk may be hedged by swaps, and that there
is a link between the swap and the risk.\966\
---------------------------------------------------------------------------

    \965\ See letter from Metlife (but opposing ongoing evaluation
of hedge effectiveness).
    \966\ See letters from AFR and Senator Levin.
---------------------------------------------------------------------------

    Several commenters suggested that once initiated, a hedge should
not be retested over time, regardless of whether the position continues
to serve a hedging purpose.\967\ Other commenters disagreed, stating
that a position that is no longer a hedge should not be covered by the
exclusion.\968\
---------------------------------------------------------------------------

    \967\ See letters from CDEU, EDF Trading, EEI/EPSA, Kraft,
Metlife, NRG Energy and Philip Morris.
    \968\ See letters from Better Markets I and Senator Levin.
---------------------------------------------------------------------------

e. Swaps That Hedge Positions Held for Speculative, Investment or
Trading Purposes
    Many commenters took the view that swaps or security-based swaps
used to hedge positions held for speculative, investment or trading
purposes should qualify as hedges of commercial risk.\969\ A few
commenters stated that speculation, investment and trading are
fundamental to commercial activity, and thus cannot be differentiated
from other types of commercial activity.\970\ Other commenters
suggested the exclusion should cover swap positions that hedge other
swap or security-based swap positions that are not themselves hedging
positions.\971\ Some commenters asserted that trading is different from
speculating (taking an outright view on market direction) and investing
(entering into a swap for appreciation in value of the swap position),
and that swaps held for ``trading'' should be able to qualify for the
exclusion.\972\
---------------------------------------------------------------------------

    \969\ See letters from BG LNG II, COPE I, EPSA, FSR I, Metlife,
Peabody, Vitol and WGCEF dated February 22, 2011 regarding the major
swap participant definition (``WGECF II''), and meeting with Bunge;
see also letter from ISDA I (taking the view that swaps and
security-based swaps used to hedge speculative positions should
qualify as hedges and stating that failure to treat them as hedges
would ``invariably result in there being more unhedged speculative
risk in the market'').
    \970\ See letters from Vitol and WGCEF II and meeting with
Bunge.
    \971\ See letters from BG LNG II, FSR I, ISDA I and Metlife.
    \972\ See letters from COPE I, EPSA and Peabody.
---------------------------------------------------------------------------

    Some commenters requested that the definition under the CEA clarify
how swaps that qualify as bona fide hedges are treated for the major
swap participant definition if the underlying position had a
speculative, investment or trading purpose,\973\ and clarify that while
the hedging exclusion would not apply to swap positions that hedge
other swap positions that are held for speculation or trading, the
hedging provision would apply to swap positions that hedge other non-
swap positions held for speculation or trading.\974\ Commenters also
requested that the final rules provide that the hedging exclusion be
available for physical positions in exempt or agricultural commodities
and arbitrage positions relating to price differences between physical
commodities at

different locations.\975\ One commenter, on the other hand, suggested
that even swap positions that hedge other swap positions which are not
hedging positions should be treated as hedging commercial risk because
they are risk reducing.\976\
---------------------------------------------------------------------------

    \973\ See letters from Vitol and WGCEF dated June 3, 2011
regarding the major swap participant definition (``WGECF VI'').
    \974\ See letter from BG LNG II.
    \975\ See letters from BGLNG II and WGCEF VI.
    \976\ See letters from MetLife.
---------------------------------------------------------------------------

    Four commenters took the position that swaps held for a purpose
that is in the nature of speculation, investing or trading should not
qualify as hedges of commercial risk.\977\ One commenter pointed out
that experience has shown that market participants sometimes
inaccurately characterize positions as hedges (e.g., the inaccurate
characterization occurs because the nature of positions change over
time), and that excluding swap positions that hedge speculative,
investment or trading positions would be especially inappropriate for
financial firms that frequently use swaps to speculate, invest or
trade.\978\ One commenter stated that any swap position hedging another
swap position could never be considered to be hedging commercial risk
because the second swap is only adjusting the first swap position,
meaning that neither swap would be congruent with risk reduction.\979\
Another commenter stated that the hedging exclusion should not cover
any swap hedging a speculative position.\980\
---------------------------------------------------------------------------

    \977\ See letters from AFR, Better Markets I and Senator Levin
and meeting with Duffie on February 2, 2011.
    \978\ See letter from Senator Levin.
    \979\ See letter from Better Markets I.
    \980\ See meeting with Duffie on February 2, 2011.
---------------------------------------------------------------------------

3. Final Rules--General Availability of the Exclusions
    As with the proposed rules, the final CEA and Exchange Act rules
implementing this exclusion are different in certain regards to reflect
the different ways that swaps and security-based swaps may be expected
to be used to hedge commercial risk, as well as differences in existing
regulations under the CEA and the Exchange Act. Notwithstanding these