morgan stanley regarding proposed rules relating to definitions contained in title vii of dodd-frank...

8/8/2019 Morgan Stanley regarding Proposed Rules Relating to Definitions Contained in Title VII of Dodd-Frank Wall Street Re

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From:Sent:To:Subject:Attach:

Ostrander, Richard < Richard.Ostrander@m organstanley.com >M onday, Septemb er 20, 2010 4:08 PMrule-com m ents@ sec.gov; dfadefinitions File Number $7-16-10; Morgan Stanley Comments on Title VII DefinitionsM organ Stanley Tit le VII Definitions A NPR Com m ent Letter.pdf

Dear Ms. Murphy and M r . Stawick:Please f ind at tached a le t ter f rom Mo rgan Stanley respon ding to Release No. 34-62717 in which the Secu r it iesa n d E xc h a n g e Co m m i s s io n a n d t h e Co m m o d i ty F u t u re s T ra d in g Co m m i s s i o n s o li c it e d c o m m e n t s o n c e r t a indefinit ions contained in Tit le VI I of the Dodd-Frank W al l Street Reform and C onsum er Protect ion Act .Sincerely,R ichard Ostrander

Richard Ostrander, Manag ing DirectorMorgan Stanley I Legal and Compliance1221 Avenue o f the Amer icas, 34th F loor I NewYork , NY 10020Phone: +1 212 [email protected] OT ICE : I f you have received this communicat ion in error, please destroy all electronic and paper copies and not ify the sender immediately.Mistransmission is not intended to w aive confident iality or priv ilege. Morgan Stanley reserves the right, to the extent permit ted under applicable law, tomonitor electronic communicat ions. This message is subject to terms available at the following link: http://www.morganstanley.com/disclaimers. If youcannot acces s these l inks, please noti fy us by reply message a nd we wil l send the contents to you. By mes saging with Morgan S tanley you consent tothe foregoing.


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S a leySeptember 20, 2010VIA E-MA IL: rule-comm [email protected]; dfadefinit ions@cftc .govMs. Elizabeth M . Murphy, Se cretarySecurities and Exchange Commission100 F S treet, NEWashington, DC 20549-0609

Mr. D avid A. Stawick, SecretaryCom m odity Futures Trading Comm issionThree Lafayette Centre1155 21 st Street, NWWashington, DC 20581Propose d Rules Relating to Definitions Contained in Title VII of Dodd-F rankWall Street Reform and Consumer Protection Act (File No_ . $7~..1...6..7...1..Q)~

Dear M s. Murphy and Mr. Stawick:We are responding to Release No. 34-62717 (the "Proposing Release"), in which theSecurities and Exchange Commission (the "SEC") and the Commodity Futures TradingCommission (the " C F T C " and, together with the SEC, the "Commissions") solicitedcomments on certain definitions contained in Title VII of the Dodd-Frank Wall StreetReform and Consumer Protection Act ("Dodd-Frank").W e appreciate the opportunity to com m ent on the definitions in the P roposing Release. Inlight of the current econ om ic situation, it is imp erative that the Com m issions draft rulesand regulations, including defining the term s discussed below, in a m anner to avoid m arketdisruption and to mitigate systemic risk. In our view, the Com m issions should str ive toprovide m arket part icipants with the con sistency ne cessary to t ransi tion seam lessly intocom pliance with Dodd -Frank. In addition, the Com m issions should attemp t, at all costs, toavoid unintended conseque nces that would imp air , rather than help, the recovery of thefinancial markets and the econom y as a whole.

Recommendations Regarding Swap Dealer and Secut4ty-Based Swap DealerDefinitions

Section 721(a)( 21) of Dodd-Frank am ends Sect ion la of the Com m odities Exchange Act(the " C E A " ) to add a new p aragraph (49) defining "swap dealer;" and Sect ion 761 (a) (6) ofDodd-Frank am ends Section 3(a) of the Securities Exchange Act of 1934, as am ended ( the"E xchange Act") , to add a new paragraph ( 71) defining "securi ty-based swa p dealer ." Thedefinitions are substantially similar and our com m ents apply to both.A. In GeneralThis section of the definitions include a list of four criteria, and it appears that thesatisfaction of any one of those criteria could result in a pe rson m eeting the de finition of aswap de aler (or securi ty-based swap dealer) . W e be l ieve a broad reading of these cri ter ia


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by the C om m issions would likely result in m any m ore persons qualifying as a swap dealer(or security-based swap dealer) than m arket participants currently view as swap dealers (orsecurity-based swap dealers).For example, clause (iii) of the definitions of "swap dealer" and "security-based swapdealer," which reads "regularly enters into [swaps/security-based swaps] withcounterparties as an ordinary course of business for its own account," potentially capturesmany market participants that would not be traditionally viewed as dealers~ This provisionshould be interpreted consistently with the traditional dealer/trader dichotomy used ininterpreting the definition of"dealer" in Section 3(a)(5) of the Exchange Act.Historically, a distinction has been drawn between "dealers" and traders, with the fbrmerbeing subject to registration under the Exchange Act and the latter not. We believe thatthis dichotomy is equally applicable to clause (iii)since its language is substantially similarto the definition of dealer in Section 3(a)(5) of the Exchange Act. Factors that indicate adealer include:

typically accommodating customer demand and generally entering intotransactions to facilitate customer interest,direct transactions with counterparties, as opposed to throughintermediaries,regular turnover of positions,regular or continuous two-way quotes, andarranging or providing credit.

On the other hand , a trader wo uld be an ordinary investor who bu ys and sells for his or herown account with some frequency. If interpreted broadly, clause ( i i i) could be read to pickup virtually all market participants (including individuals and smaller entities) whoarguably trade, but do not deal, in swaps as part of a regular business. This couldpotentially even include entities that would satisfy the "end user" exemption from clearingfound in Section 723(a)(3) of Dodd-Frank - entities that would be trading swaps as part oftheir regular business but also to hedge or m itigate com m ercial r isk. I t would be an od dresult for persons Congre ss exem pted from the clearing requirem ents to have to register asswap dealers.In addition, a broad interpretation of clause (iii) could result in the definitions of "swapdealer" and "security-based swap dealer" being so expansive that they capture practicallyevery "major swap participant" and "major security-based swap participant," respectively.If Congress had intended that result, there would have been no need to create the categoriesof "major swap participant" or "major security-based swap participant" in the first place.We believe the Commissions should incorporate some of the "dealer" factors enumeratedabove in interpreting the scope of clause (iii) to ensure this clause does not inappropriatelycapture persons as swap dealers and securities-based swap dealers.We would also like to point out that the criteria in clause (ii) of the definitions of swapdealer and security-based swap dealer - "makes a market in swaps" - does not necessarilytranslate well from the securities market to the swaps markets. Depending on the liquidity

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and conve ntion for a part icular swap product , "m aking a m arket" can span activi ties fromcontinuously providing live, public bids and offers to being willing to provide a bid oroffer quote from clients upon request. We believe the phrase "makes a market," should beinterpreted in such a way to avoid capturing those enti t ies that do not routinely m ake orstand ready to make two way markets for other market participants. Merely providingoccasional quotes on one side of the m arket for a product should not trigger registration.We would also like to note that the Commissions may need to revisit the guidanceprovided under clause (ii) depending on the rules that are adopted for regulated exchangesor swap execution facilities or security-based swap execution facilities (collectively,"SEI?s"). Depending on what functionality is required or made available by a SEF or aregulated exchan ge to its participants, i t could be the case that m any or all participants oncertain types of platforms could be viewed as dealers when trading on that particularplatform.B. InclusionThis section of the definitions clearly state that an entity should not be treated as a "swapdealer" or "security-based swap dealer" generally, but rather have its status as a "swapdealer" or "security-based swap dealer" assessed with respect to a particular product or in adefined market.1 This approach is both reflective of the realities of the marketplace andconsistent with Congressional intent. In a letter from Senator Christopher Dodd, Chairmanof the Senate Committee on Banking, Housing, and Urban Affairs, and Senator BlancheLincoln, Chairwoman of the Senate Committee on Agriculture, Nutrition, and Forestry, toRepresentative Collin Peterson, Chairman of the Committee on Agriculture, andRepresentative Barney Frank, Chairman of the Financial Services Committee, SenatorsDodd and Lincoln stressed the importance of differentiating amongst products by stating,"[i]t is also imperative that regulators do not assume that all over-the-counter transactionsshare the same risk profile." C ong. Record, June 30, 2010, H5248.W e b el ieve i t necessarily follows from this approach that capi tal requirem ents and otherrules applicable to swap dealers or security-based swap dealers should apply only to thoseactivities of a de aler falling within the swa p categ ories for which it is required to register.Capital calculations and other requirements for swap dealers or security-based swapdealers should not encompass transactions or positions that are not subject to directregulation. This is consistent with the legislative intent of C ongress. Senators D odd andLincoln noted in their letter that "[i]t is im perative that the regu lators do not unnece ssarilydivert working capital from our econom y into margin accounts, in a way that would, ~ .impair economic growth." C ong. Record June 30, 2010, H5248. If the Commissions

Section (C) of the definition of"swap dealer" states that "[a] person may be designated as a swapdealer for a single type or single class or category of swap or activities and considered not to be aswap dealer for other types, classes, or categories of swaps or activities", and Section (B) of thedefinition of"security-based swap dealer" states that "[a] person may be designated as a security-based swap dealer for a single type or single class or category of security-based swap or activitiesand considered not to be a security-based swap dealer for other types, classes, or categories ofsecurity-based swap s or activities."


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were to ap ply capi tal requirem ents in a broader sense than that which we have suggested,funds and capital would be unne cessarily diverted.2, Recommendations Regarding Major Swap Participant and ?glajor Security-Based

Swap Participan~ DefinitionsSection 721(a)(16) of Dodd-Frank amends Section l a of the CEA to add a new paragraph(33) defining "major swap participant," and Section 761(a)(6) of Dodd-Frank amendsSection 3(a) of the Exchange Act to add a new paragraph (67) defining "major security-based swap participant." The definitions are substantially similar and our comments applyto both.A. ~5~ GeneralFirst, the phrase "any person" in these definitions clarifies that the intent is for the test tobe made on an entity basis and that companies managed by a single manager are notaggregated. Chairman Lincoln said as much in a colloquy with Senator Hagan during theSenate floor debate on the Dodd-Frank Conference Committee Report. In response toSenator Hagan asking, "When considering whether an entity maintains a substantialposition in swaps, should the CFTC and the SEC look at the aggregate positions of fundsmanaged by asset managers or at the individual fund level?", Chairman Lincoln responded,"As a general rule, the CFTC and the SEC should look at each entity on an individual basiswhen determining its status as a major swap participant." Congr. Record, June !5, 2010,$5907.Second, the term "substantial position," found in clause (i) of the definitions of "majorswap participant" and "major security-based swap participant," should be limited to thosepositions that are large enough to create a systemic risk in the market. A contrary viewwould be inconsistent with the legislative intent. In our view, the best measure of"substantial" from a systemic risk perspective would be based on the potential risk of thenet positions such market participant holds and potential disruption to the financial marketsif that market participant were to default. Measures based on notional exposures ornumber of trades, while easy to calculate, do not necessarily accurately capture marketrisk. While a risk-based measure would be best, using fair values determined inaccordance with GAAP would be a better approximation than notional amount or tradecount.No matter what measure the Commissions determine to utilize, we believe that anycalculation should be o n a ne t basis and, as is currently the case, ne t t ing should b e giveneffect across all products and transactions subject to a netting arrangement. Further,collateral should also be netted because collateral reduces possible systemic risk.2 Thisview is consistent with Congressional intent, as evidenced by Chairman Lincolns2 In addition to collateral, the proposed regulations should take into account the netting or offsetting

effect of other forms of certain acceptable credit risk mitigation, such as letters of credit that satisfyminimum requirements as to their terms and conditions and the credit quality of the issuer.

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statement during the Senate floor debate on the Dodd-Frank Conference CommitteeReport:When determining whether a person has a "substantial position," the CFTCand the SEC should consider the persons relative position in cleared versusthe uncleared swaps and may take into account the value and quality of thecollateral held against counterparty exposures. The committee wanted tomake it clear that the regulators should distinguish between cleared anduncleared swap positions when defining what a "substantial position" wouldbe. Similarly where a person has uncleared swaps, the regulators shouldconsider the value and quality of such collateral when defining "substantialposition." Bilateral collateralization and proper segregation substantiallyreduces the potential for adverse effects on the stability of the market.Entities that are not excessively leveraged and have taken the necessarysteps to segregate and fully collateralize swap positions on a bilateral basiswith their counterparties should be viewed differently. Id.

W e would also suggest that the Com m issions consider com m itting to revisit this definitiononce more information becomes available about the size and liquidity of the relevantm arkets as the reporting aspects of Dodd-l~rank are im plem ented.Third, the phrase "sub stantial counterparty exp osure," found in clause (ii) of the definitionsof "major swap participant" and "major security-based swap participant," should beinterpreted consistently with "substantial position" in clause (i) discussed abov e.Last, the phrase "highly leveraged," found in clause (iii) of the definitions of "major swapparticipant" and "major security-based swap participant," must be considered in light ofthe industry in which the entity participates. No single leverage test is appropriate due tothe vast differences in business models. For example, the leverage of an entitys peerscould be used as the relevant benchmark in determining whether the level of leverage for aparticular entity is "high."B. Definition of Substantial PositionOur recommendations are discussed above under "Recommendations Regarding MajorSwap Participant and Major Security-Based Swap Participant Definitions--In General."C . Scope of DesignationAs we stated above under "Recommendations Regarding Swap Dealer and Security-BasedSwap Dealer Definitions--Inclusion," we recommend that the Commissions clarify thatcapital requirements and other rules apply only to the category of swaps or security-basedswaps as to which a person is designated as a major swap participant or a major security-based swap participant. Therefore, capital calculations and other requirements should notencompass transactions or positions not subject to direct regulation.


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3. Recomm endations Regarding the Forward Contract Exclusion from the Definitionof a SwapSection 721( a)(21 ) of Dodd-F rank amends S ect ion la of the CEA to add a new paragraph(47) defining the term "swap", including a new subparagraph (47)(B) that provides forspeci fic exclusions f rom the term "swap". Am ong other exclusions, excluded f rom theterm "swap" are "(ii) any sale of a nonfinancial commodity or security for deferredshipm ent or delivery, so long as the transaction is intended to b e ph ysically set t led." Inorder to avoid legal uncertainty, the intent requirem ent should be read consistently with theCF TC s long-standing policy as set forth in i ts E xemption for Certain C ontracts InvolvingE nergy Products, 58 F .R. 21286 ( Apr . 20 , 1993) ( the "E nergy C ontracts Exem ption").As recognized by the CFT C in the Energy C ontracts Exem ption, m any m arket participantshedge price risk by entering into forward contracts that require physical delivery.Subsequently, due to changing m arket conditions, the parties to the contract m ay m utuallyagree to settle or "book out" their delivery obligations such that there is a cash paym ent butno exchange of the physical commodity takes place. The parties may do so in order tom inimize delivery related expenses or to terminate any further gain or loss on the originaltransaction. The phrase "so long as the transaction is intended to be physically settled"m ay introduce unce rtainty as to whether these transactions that initially required physicaldelivery but were subsequently settled financially for legitimate and economicallybeneficial reasons had been excluded from the term "swap".This is consistent with the legislative intent of Congress. Senators Dodd and Lincolnstated in their letter that "[i]n imp lem enting the derivatives ti tle, Congress e ncourage s theCFT C to clarify through rulem aking that the exclusion from the definition of swap for anysale of a nonfinancial comm odity or security for deferred shipm ent or delivery, so long asthe transaction is intended to b e ph ysically set t led is intende d to be co nsistent with theforward contract exclusion that is currently in the Commodity Exchange Act and theCFTCs established policy and orders on this subject, including situations wherecom m ercial parties agree to book-out their physical delivery obligations under a forwardcontract." C ong. Record June 30, 2010, H5248.Thus, to address the risk of legal uncertainty, the CFTC should affirmatively define acontract for the "sale of a nonfinancial commodity or security for deferred shipment ordelivery, so long as the transaction is intended to be physically settled" consistent with thefactors commonly reviewed with respect to the forward contract exclusion to determinewhether the requisite intent existed. For example, the definition could adopt the languagein the Energy Contract Exemption, which includes contracts that "impose bindingobligations on the parties to make and receive delivery of the underlying commodity orcommodities, with no right of either party to effect cash settlement of their obligationswithout the consent of the other party (except pursuant to a bona fide termination right),provided, however, that the parties may enter into a subsequent bookout, book transfer, orother such contract which provides for settlement of the obligation in a manner other thanby physical delivery of the commodity specified in the contract."


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Section 721(a)(21) of D odd-Fra~~k amends Section l a of the CEA to add a new paragraph(47) def ining "swap," and Se c t ion 76 1(a) (6) of D odd-Frank amend s Sec t ion 3 (a) of theExchange A ct to add a new paragraph ( 68) defining "security-based swap." Each of thesesections adds the concept of a "mixed swap," and in both the CEA and Exchange Act,defines the term "securi ty-based swap " to include agreem ents, contracts or t ransactionsthat satisfy the security-based swap definition and which also are based on the value ofcertain enumerated non-securities factors. Section 712(a)(8) of Dodd-Frank requires theCommissions to jointly prescribe such regulations regarding mixed swaps as may benecessary to carry out the purposes of Title VII of Dodd -Frank.In jointly prescribing such. regulations, we do not believe the Commissions shouldestablish a new, third regulatory regim e for over-the-counte r derivatives in addition to theregimes required under Dodd-Frank for swaps and security-based swaps. Had such a thirdcomp lete regime been intended, we b el ieve C ongress would have included m ore specif icguidance in the statutory language itself and would likely have referred to the term m ixedswap more than the four times that the term is used in Dodd-Frank. Comparing thespecif ici ty and com prehensiveness of the regime s for swaps and securi ty-based swap s inDodd-Frank to the handful of references to the term m ixed swap, i t seems clear Congressin tended the Co m m issions to leverage the swap and secur i ty-based swap regime s whenprescribing rules for m ixed swaps:Also, as discussed below, we believe that the scope of transaction types that wouldappropriately qualify as mixed swaps should be relatively small, further supporting theconclusion that a new, third regulatory regime w ould be unwarranted.The first point we would like to make regarding the scope of mixed swaps is that asecurity-based swap (e.g., a total rate of return swap on an equity security) which includesone or more payments calculated by reference to an interest rate (e.g., LIBOR) should notbe treated as a mixed swap. Such a swap would not be properly viewed as "based on" anin terest ra te . The LIBO R based p aym ents ref lec t com pensat ion for the f inancing costsassociated with total rate of return swaps and are not at the core of what is being"swapped" under the contract.The CFTC recognized as much in its adopting release for the Regulation of HybridInstrum ents (58 F ederal Register 5580, Jan. 22 1993). In the adopting release, the CF TCrecognized that a loan or note whose interest payments were calculated based on a floatingrate, or even a formula that included a floating rate, should not be treated as a HybridSecurity, notwithstanding the fact that such rates constituted "commodities" under theCEA. If a security or loan with interest payments based on a formula which referencesfloating rates is not a Hy brid Secu rity, it follows that a security-based swap w ith a floatingrate payment leg should not be viewed as a mixed swap.


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Furthermore, if the m ore expansive reading were applied, only an extremely sm all categoryof security-based swaps w ould not qualify as m ixed swaps. The vast m ajority of security-based swap products also have at least some payment or contingency that is linked tosomething other than the value or yield of a security. Given the detail andcom prehensiveness of the secur ity-based swap regulatory regim e envisioned by D odd-Frank, it is difficult to believe C ongress intended the universe of pure security-based swap sto be a de m inim us portion of the swap m arket .Assum ing security-based swaps with f loating rate paym ent legs are not defined as mixedswaps, we b el ieve the universe of mixed swap s should be relatively sm all. An exam ple ofa mixed swap might be a contract under which one party takes long exposure to thecom m on stock of a US corp oration while simu ltaneously taking short exp osure to the priceof gold. The quest ion then becom es how to determ ine which regulatory regim e - the onefor swaps or the one for securi ty-based swaps - should be ap plied to such a swap. Giventhe relat ively sm all size of this pop ulat ion, and the fact that Dodd-Frank encourages thesubstant ive regulat ion of sw aps and securi ty based sw aps to b e substant ial ly sim ilar , webelieve the p rimary goals for creating a determination process should be sim plicity, clarityand certainty.We believe a preponderance type test would fail to meet those goals. Prior to theenactment of the Com m odi ties Futures Moderniza tion Act in 2000 , the CEA s Par t 34Hybrid instrument exemption utilized such a regime and required that the commoditydependent value of the com m odity dependent comp onent of the hybrid instrum ent be lessthan the com m odity independent value of the comm odity independent com ponent of thehybrid instrument. The test was un wieldy and costly to adm inister for hybrid instruments ,which typically have a longer lead time prior to execution than do swap agreements.Imp osing such a test in the context of fast paced swap m arkets would likely m ake certainm ixed swaps infeasible.As no paym ents may change hands at the inception of a m ixed swap, any assessment of thevalue of a comp onent would probab ly need to be based on a forward looking estimate ofthe l ikely exposure under each com ponent. In our comm on stock-gold swap exam ple, thiscould involve est im ating potent ial expo sure under each leg as i f it were a separate swapand com paring the two. As such est im ates would necessari ly be based o n a partys viewsof volatility and individual models for the particular .asset class, there would be noassurances that each party would come to the same conclusion as to which comp onent wasgreater. More complicated mixed swaps may prove difficult, if not impossible, tobifi~rcate. For example, if we changed the payout formula of our common stock-gold swapsuch that no paym ent is m ade referencing the comm on stock for a part icular day unlessgold prices are within a specific band, bifurcation becom es highly comp lex.With some caveats mentioned below, we think a better approach would be to treat allswaps with securi t ies base d features as solely securi ty-based swaps. In other w ords, theCommissions should prescribe rules that leave mixed swaps under the SECs jurisdiction.


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This is supported by D odd-Frank, which defines m ixed swaps under both the CEA and theExchange Act as security-based swaps. In an indirect and less explicit manner, mixedswaps also fal l under the swap definit ion ( the prov ision excluding a se curi ty-based swapfrom the defini tion of swap e xpressly carves out from the exclusion those swaps fal l ingunder the provision defining mixed swaps as security-based swaps). It would seem,however, that some weight should be given to the fact that Congress took a far morestraightforward path in expressly including mixed swaps in the security-based swapdefinition.Such an approach would be clear, certain and simple to apply. Assuming substantiveregulation is virtually the same, this approach would not result in materially differentregulatory treatment than a predominance test. If the Commissions felt swaps whichincluded references to a particular asset class (for example, agriculture) needed to besubject to direct CFTC oversight, we w ould not be o pposed to a rule that defined all mixedswaps that referenced such an asset class as swaps (and n ot securi ty-based swap s) underDo dd-Frank. Our m ain concern is that any rule be simp le to apply and create a clear andcertain result.Finally, while under our suggestion the bulk of regulatory oversight for mixed swapswou ld fall under a single regulator, joint authori ty with respe ct to certain provisions ofDodd-Frank may still be appropriate. For example, notwithstanding the treatment ofm ixed swaps solely as security-based swaps, we would not be op posed to the CF TC h avinganti-fraud and anti-manipulation authori ty over the non-securi ties com ponen ts of m ixedswaps.

W e apprec ia te the oppor tunity to comm ent to the Com m issions on the def ini tions, andwould be pleased to discuss any quest ions ei ther Com m ission m ay have wi th respec t tothis letter. Any questions about this letter may be directed to Richard Ostrander(richard.ostrander@m organstanley.com; 21 2 762 5346).

morgan stanley regarding proposed rules relating to definitions contained in title vii of dodd-frank...

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