Swap Dealers: What They are, How They Work

What Is a Swap Dealer?

A swap dealer is an individual or entity that serves as a swaps broker, makes markets in swaps, or enters into swaps contracts with counterparties.

Swap dealer, as a legal term, was formally defined in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, a piece of legislation born in the aftermath of the 2007-2008 financial crisis.

Understanding Swap Dealers

A swap is a type of derivative contract whereby two parties exchange the cash flows or liabilities from a pair of different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price.

The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties. Since these are OTC products, they are more opaque than exchange-traded products.

Prior to the financial crisis, swaps had been largely unregulated, taking place mainly between firms and financial institutions, in largely unregulated transactions. In 2011 the Securities and Exchange Commission (SEC) finalized proposals requiring security-based swap dealers and participants to register with the commission, as part of the Dodd-Frank legislation.

According to Section 721 of the Dodd-Frank Act, a swap dealer is an entity that:

1. Holds itself out as dealer in swaps;
2. Makes a market in swaps;
3. Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
4. Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps, provided, however, in no event shall an insured depository institution be considered to be a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.

De Minimus Exception

The Republican-led administration took steps in 2017 to repeal the Dodd-Frank Act. The legislation is comprehensive, touching on many aspects of banking and finance. The definition of a swap dealer is not controversial, but there is one provision in the Dodd-Frank Act that Republicans sought to address—the de minimus exception rule. This rule exempts swap dealer designation of an entity that engages in de minimus quantity of swap dealing in connection with transactions with or on behalf of its customers.

The threshold for aggregate gross notional amount (AGNA) that a swap dealer must have completed has been set to $8 billion, as of November 2018. It was supposed to fall to $3 billion, a much lower level that would have brought many more entities into the realm of regulatory oversight. However, the CFTC voted on a bipartisan basis to set $8 billion as the permanent threshold in a November 2018 meeting. The federal agency cited the increased regulatory coverage for $8 billion as well as the potential for lower liquidity at a lower threshold figure for nonfinancial commodity swaps. In addition, the agency stated that it wanted to signal long-term stability of the de minimus threshold to allow market participants to plan for the long term.