Spending Bill Modifies Treasury Affiliate Exemption from Swaps Mandatory Clearing

Commentary by Nihal Patel

The recently-enacted Consolidated Appropriations Act, 2016 included amendments to the exemption from swaps mandatory clearing for hedging affiliates in the CEA and SEA.

In particular, Section 705 modifies the exemption from mandatory clearing provided to so-called "treasury affiliates" in CEA Section 2(h)(7)(D) ("Mandatory Clearing Requirements for Swaps - Treatment of Affiliates"). The amendments modify the application of the exemption by:

  • removing the requirement that the affiliate be acting as "agent" in the transaction;
  • requiring that the commercial risk must have been actually transferred to a wholly-owned affiliate;
  • requiring that the affiliate must not be an insured depository institutions, credit union or bank holding company;
  • requiring that the affiliate may not enter into any swap other than for the purpose of hedging or mitigating commercial risk;
  • requiring that the affiliate and persons affiliated with the affiliate that is not a financial entity may not enter into swaps on behalf of any affiliate that is a financial entity and may not "assume, net, combine, or consolidate" the risk of swaps entered by such financial entity except one that is using the exemption;
  • requiring that swaps entered into in reliance on the exemption must be subject to a centralized risk management program of the affiliate; and
  • requiring that that the affiliate not be "affiliated" with a swap dealer.

Section 705 also amends SEA Section 3C(g)(4) ("Clearing for Security-Based Swaps - Treatment of Affiliates") by similarly modifying the use of the affiliate exemption for security-based swaps.

Commentary

The most significant change made by these amendments is the removal of the requirement that the affiliate be acting "as an agent." Those three words severely limited the ability for many "treasury affiliates" of hedgers to rely on the exclusion, as such entities more frequently enter into uncleared swaps as principal and use a "back-to-back" structure to transfer the risk back to the hedging entity. The CFTC previously addressed this statutory problem by providing no-action relief in Letters 13-22 and 14-144 to exempt certain treasury affiliates acting as principal from mandatory clearing.

This agent/principal issue arose again in the context of margin requirements for uncleared swaps, as other statutory amendments incorporated various clearing exemptions by reference. In their margin requirements for uncleared swaps, the "Prudential Regulators" did not extend relief from margin to treasury affiliates acting as principal (though they indicated their relief would apply if the CFTC provided an exemption from mandatory clearing to such entities by rule). In turn, the CFTC said it would implement the approach it took in the previous staff no-action letters by "rule or staff no-action letter" in a separate procedure rather than in the margin rulemaking.

The House GOP website has an analysis of H.R. 1317, a predecessor bill to the final Section 705, that suggests that the agent/principal issue was the primary impetus for the amendments. However, Section 705 also makes a number of other changes to CEA Section 2(h)(7)(D) that seem to be intended to ensure that "financial" users of swaps may not rely on the exemption. While these changes are not necessarily illogical, they add further complication to what had been relatively settled law (at least in the clearing context, if not as to margin for uncleared swaps).

The statutory requirements will require firms using 2(h)(7)(D) to determine if they can still use the exemption in light of the new requirements, particularly that the affiliate have no non-hedging swaps and that it have a centralized risk management program. Further, counterparties of entities relying on the exemption will likely want to reassess how they document compliance with the exemption, particularly given the heightened sensitivity baked into Dodd-Frank relating to abuse of the clearing exemptions.

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