Expiration of Composite Swap Relief

June 24, 2013

Last year, the Commodity Futures Trading Commission (the “CFTC”) and the Securities and Exchange Commission (the “SEC”) issued final rules and interpretations regarding the terms “swap” and “security-based swap” and whether a particular instrument is a swap regulated by the CFTC, a security-based swap regulated by the SEC or a mixed swap regulated by both the CFTC and the SEC.

These interpretations distinguished between quanto equity swaps and compo equity swaps (also known as composite equity swaps). A quanto equity swap is an equity swap in which (i) the underlying instrument is denominated in a currency (the foreign currency) other than that in which the equity swap is denominated (the domestic currency) and (ii) the final value of the underlying instrument is denominated in the foreign currency and is converted into the domestic currency using the exchange rate prevailing at inception, resulting in the investor not being exposed to currency risk. A quanto equity swap is a security-based swap if (i) the purpose of the transaction is to transfer exposure to the return of a security or security index without transferring exposure to any currency or exchange rate risk and (ii) any exchange rate or currency risk exposure incurred by the dealer is incidental to the transaction and arises from the instruments the dealer chooses to hedge. On the other hand, compo equity swaps, where the parties assume exposure to, and the total return is calculated based on, both the performance of specified foreign stocks and the change in the relevant exchange rate, are mixed swaps.

In December 2012, the CFTC released a no action letter that provided that compo equity swaps may be treated solely as security-based swaps until July 1, 2013. Once this relief expires, compo equity swaps will be subject to the joint jurisdiction of the CFTC and the SEC. Compo equity swaps will need to be included in de minimis calculations under the Rule 4.13(a)(3) exemption from registration as a commodity pool operator and will be subject to all CFTC rules. Notwithstanding the foregoing, a bilateral uncleared compo equity swap where at least one party is dually registered both with the CFTC as a swap dealer or major swap participant and with the SEC as a security-based swap dealer or major security-based swap participant will only be subject to certain enumerated provisions of the Commodity Exchange Act and the CFTC’s rules. Swaps that fit into this category do not need to be included in Rule 4.13(a)(3) de minimis calculations.

If you have any questions concerning the foregoing, please contact your primary attorney in Seward & Kissel’s Investment Management Group.