[Federal Register Volume 84, Number 32 (Friday, February 15, 2019)]
[Proposed Rules]
[Pages 4614-4675]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-27979]
[[Page 4613]]
Vol. 84
Friday,
No. 32
February 15, 2019
Part II
Securities and Exchange Commission
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17 CFR Part 240
Risk Mitigation Techniques for Uncleared Security-Based Swaps;
Proposed Rule
Federal Register / Vol. 84 , No. 32 / Friday, February 15, 2019 /
Proposed Rules
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-84861; File No. S7-28-18]
RIN 3235-AL83
Risk Mitigation Techniques for Uncleared Security-Based Swaps
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``SEC'' or
``Commission'') is proposing rules that would require the application
of specific risk mitigation techniques to portfolios of security-based
swaps not submitted for clearing. In particular, the proposal would
establish requirements for each registered security-based swap dealer
(``SBS dealer'') and each registered major security-based swap
participant (``major SBS participant'') (each SBS dealer and each major
SBS participant hereafter referred to as an ``SBS Entity'' and together
referred to as ``SBS Entities'') with respect to, among other things,
reconciling outstanding security-based swaps with applicable
counterparties on a periodic basis, engaging in certain forms of
portfolio compression exercises, as appropriate, and executing written
security-based swap trading relationship documentation with each of its
counterparties prior to, or contemporaneously with, executing a
security-based swap transaction. In addition, the Commission is
proposing an interpretation to address the application of the portfolio
reconciliation, portfolio compression, and trading relationship
documentation requirements to cross-border security-based swap
activities and is proposing to amend Rule 3a71-6 to address the
potential availability of substituted compliance in connection with
those requirements. Moreover, the proposed rules would make
corresponding changes to the recordkeeping, reporting, and notification
requirements applicable to SBS Entities. Finally, the Commission is
requesting comment on how certain aspects of the proposed rules address
how a security-based swap data repository (``SDR'') could potentially
satisfy its obligation to verify the terms of each security-based swap
with both counterparties to the transaction.
DATES: Comments should be received on or before April 16, 2019.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an email to [email protected]. Please include
File Number S7-28-18 on the subject line; or
Paper Comments
Send paper comments to Brent J. Fields, Secretary,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-1090.
All submissions should refer to File Number S7-28-18. This file number
should be included on the subject line if email is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
internet website (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for website viewing and printing in the Commission's
Public Reference Room, 100 F Street NE, Washington, DC 20549 on
official business days between the hours of 10:00 a.m. and 3:00 p.m.
Persons submitting comments are cautioned that we do not redact or edit
personal identifying information from comment submissions. You should
submit only information that you wish to make available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the SEC's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Carol McGee, Assistant Director, or
Andrew Bernstein, Senior Special Counsel, at (202) 551-5870, Office of
Derivatives Policy, Division of Trading and Markets, Securities and
Exchange Commission, 100 F Street NE, Washington, DC 20549-8010.
SUPPLEMENTARY INFORMATION: The Commission is proposing for public
comment the following new rules:
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Commission reference CFR citation (17 CFR)
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Securities Exchange Act of 1934
(``Exchange Act''): \1\
Rule 15Fi-3............................. Sec. 240.15Fi-3.
Rule 15Fi-4............................. Sec. 240.15Fi-4.
Rule 15Fi-5............................. Sec. 240.15Fi-5.
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The Commission also is proposing for comment amendments to:
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\1\ 15 U.S.C. 78a et seq.
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Commission reference CFR citation (17 CFR)
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Exchange Act:
Rule 3a71-6............................. Sec. 240.3a71-6.
Rule 15Fi-1............................. Sec. 240.15Fi-1.
Rule 17a-3 \2\.......................... Sec. 240.17a-3.
Rule 17a-4.............................. Sec. 240.17a-4.
Rule 18a-5 (proposed)................... Sec. 240.18a-5 (proposed).
Rule 18a-6 (proposed)................... Sec. 240.18a-6 (proposed).
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Finally, the Commission is requesting comment under:
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\2\ In April 2014, the Commission proposed new Rules 18a-5 and
18a-6, and amendments to existing Rules 17a-3 and 17a-4. See
Recordkeeping and Reporting Requirements for Security-Based Swap
Dealers, Major Security-Based Swap Participants, and Broker-Dealers;
Capital Rule for Certain Security-Based Swap Dealers, Exchange Act
Release No. 71958 (Apr. 17, 2014), 79 FR 25194 (May 2, 2014) (``SBS
Books and Records Proposing Release''). Although those proposed
rules and rule amendments have not yet been adopted by the
Commission, all of the relevant proposals included in this release
are based on the proposed regulatory text contained in the SBS Books
and Records Proposing Release.
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Commission reference CFR or U.S.C. citation
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Exchange Act:
Section 13(n)(5)(B)..................... 15 U.S.C. 78m(n)(5).
Rule 13n-4(b)(3)........................ 17 CFR 240.13n-4(b)(3).
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Table of Contents
I. Proposed Rules and Rule Amendments
A. Background
B. Rule 15Fi-3 (Portfolio Reconciliation)
1. Overview of Portfolio Reconciliation
2. Scope of the Portfolio Reconciliation Requirements
3. Proposed Rule 15Fi-3(a): Portfolio Reconciliation With Other
SBS Entities
4. Proposed Rule 15Fi-3(a): Resolution of Discrepancies With
Other SBS Entities
5. Proposed Rule 15Fi-3(b): Portfolio Reconciliation With Other
Counterparties
6. Reporting of Valuation Disputes
7. Application of Proposed Rule 15Fi-3 to Cleared Security-Based
Swaps
8. Comments Requested
C. Rule 15Fi-4 (Portfolio Compression)
1. Overview of Portfolio Compression
2. Scope of Proposed Rule 15Fi-4--Portfolio Compression
Exercises
3. Scope of Proposed Rule 15Fi-4--Bilateral Offset
4. Application of Proposed Rule 15Fi-4 to Cleared Security-Based
Swaps
5. Comments Requested
D. Rule 15Fi-5 (Trading Relationship Documentation)
1. Overview of Trading Relationship Documentation
2. Scope of Proposed Rule 15Fi-5
3. Proposed Rule 15Fi-5(b)(4): Documenting Valuation
Methodologies
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4. Proposed Rule 15Fi-5(b)(5) and (6): Other Disclosure
Requirements
5. Proposed Rule 15Fi-5(c): Audit of Security-Based Swap Trading
Relationship Documentation
6. Exceptions to the Trading Relationship Documentation
Requirements
7. Comments Requested
E. Verification of Transaction Data by SDRs
1. Reconciliation of Terms Submitted to an SDR
2. Documentation of Regulatory Reporting Obligations
3. Comments Requested
F. Recordkeeping Requirements
1. Proposed Amendments to Recordkeeping Rules
2. Comments Requested
II. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5
A. Background on the Cross-Border Application of Title VII
Requirements
B. Proposed Cross-Border Interpretation
C. Comments Requested
III. Availability of Substituted Compliance for Rules 15Fi-3 Through
15Fi-5
A. Existing Substituted Compliance Rule
B. Proposed Amendment to Rule 3a71-6
1. Basis for Substituted Compliance in Connection With the
Portfolio Reconciliation, Portfolio Compression, and Trading
Relationship Documentation Requirements
2. Comparability Criteria, and Consideration of Related
Requirements
3. Comments Requested
IV. General Request or Comment
V. Paperwork Reduction Act
A. Summary of Collections of Information
1. Proposed Rule 15Fi-3: Portfolio Reconciliation
2. Proposed Rule 15Fi-4: Portfolio Compression
3. Proposed Rule 15Fi-5: Written Trading Relationship
Documentation
4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6:
Books and Records Requirements
5. Proposed Amendment to Rule 3a71-6: Substituted Compliance
B. Proposed Use of Information
1. Proposed Rule 15Fi-3: Portfolio Reconciliation
2. Proposed Rule 15Fi-4: Portfolio Compression
3. Proposed Rule 15Fi-5: Written Trading Relationship
Documentation
4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6:
Books and Records Requirements
5. Proposed Amendment to Rule 3a71-6: Substituted Compliance
C. Respondents
D. Total Annual Recordkeeping Burden
1. Portfolio Reconciliation Activities Generally
2. Establishing, Maintaining, and Enforcing Written Policies and
Procedures
3. Reporting of Certain Valuation Disputes
4. Proposed Rule 15Fi-4: Portfolio Compression
5. Proposed Rule 15Fi-5: Written Trading Relationship
Documentation
6. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6:
Books and Records Requirements
7. Proposed Amendment to Rule 3a71-6: Substituted Compliance
E. Collection of Information Is Mandatory
F. Confidentiality
G. Request for Comment
VI. Economic Analysis
A. Broad Economic Considerations
B. Economic Baseline
1. Security-Based Swap Market Activity and Participants
a. Available Data From the Security-Based Swap Market
b. Affected SBS Entities
c. Other Market Participants
d. Outstanding Positions
2. Current Portfolio Reconciliation Practices
3. Current Portfolio Compression Practices
4. Current Trading Relationship Documentation Practices
C. Economic Costs and Benefits, Including Impact on Efficiency,
Competition, and Capital Formation
1. Effects on Efficiency, Competition, and Capital Formation
a. Broad Market Effects
b. Substituted Compliance
2. Portfolio Reconciliation
a. Requirements
b. Benefits
c. Costs
d. Alternatives
3. Portfolio Compression
a. Requirements
b. Benefits
c. Costs
d. Alternatives
4. Trading Relationship Documentation
a. Requirements
b. Benefits
c. Costs
d. Alternatives
5. Recordkeeping Requirements
a. Requirements
b. Benefits
c. Costs
d. Alternatives
6. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5.
a. Requirements
b. Benefits
c. Costs
D. Request for Comment
VII. Consideration of Impact on the Economy
VIII. Regulatory Flexibility Act Certification
IX. Statutory Basis and Text of Proposed Rules
I. Proposed Rules and Rule Amendments
A. Background
Section 15F(i)(1) of the Exchange Act, as added by Section 764(a)
of Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act''),\3\ requires each SBS Entity to
conform with such standards as may be prescribed by the Commission, by
rule or regulation, that relate to timely and accurate confirmation,
processing, netting, documentation, and valuation of all security-based
swaps.\4\ Section 15F(i)(2) of the Exchange Act provides that the
Commission shall adopt rules governing documentation standards for SBS
Entities.\5\
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\3\ Public Law 111-203, 124 Stat. 1376 (2010). Unless otherwise
indicated, references to ``Title VII'' in this release are to
Subtitle B of Title VII of the Dodd-Frank Act.
\4\ 15 U.S.C. 78o-10(i)(1).
\5\ 15 U.S.C. 78o-10(i)(2).
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The Commission previously adopted rules requiring SBS Entities to
provide trade acknowledgments and to verify those trade acknowledgments
with their counterparties to security-based swap transactions,\6\ but
has not proposed rules concerning portfolio reconciliation, portfolio
compression, or trading relationship documentation. By contrast, the
Commodity Futures Trading Commission (``CFTC'') has implemented rules
setting forth standards for the timely and accurate confirmation of
swaps, addressing the reconciliation and compression of swap
portfolios, and setting forth requirements for documenting the swap
trading relationship between swap dealers or major swap participants
(each swap dealer and each major swap participant hereafter referred to
as a ``Swap Entity'' and together referred to as ``Swap Entities'') and
their counterparties.\7\
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\6\ See Trade Acknowledgment and Verification of Security-Based
Swap Transactions, Exchange Act Release No. 78011 (June 8, 2016), 81
FR 39807 (June 17, 2016) (``Trade Acknowledgment and Verification
Adopting Release'').
\7\ See Confirmation, Portfolio Reconciliation, Portfolio
Compression, and Swap Trading Relationship Documentation
Requirements for Swap Dealers and Major Swap Participants, 77 FR
55904 (Sept. 11, 2012) (``CFTC Risk Mitigation Adopting Release'').
The European Commission (``EC'') has implemented similar measures.
See Commission Delegated Regulation (EU) No. 149/2013 (Dec. 18,
2012) supplementing Regulation (EU) No. 648/2012 of the European
Parliament and of the Council with regard to regulatory technical
standards on indirect clearing arrangements, the clearing
obligation, the public register, access to a trading venue, non-
financial counterparties, and risk mitigation techniques for over-
the-counter (``OTC'') derivatives contracts not cleared by a central
counterparty (Feb. 23, 2013), available at: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:052:0011:0024:en:PDF. Regulatory
authorities in other jurisdictions (e.g., the Hong Kong Monetary
Authority and the Monetary Authority of Singapore) have also
proposed requirements similar to those adopted by the CFTC and the
EC. In addition, the Canadian Securities Administrators (``CSA'')
published a consultation paper in 2016 proposing a requirement that
financial institutions enter into a written agreement documenting
the material terms and conditions of any non-centrally cleared
derivative, including standards related to the maintenance, review,
and contents of that documentation. See CSA Consultation Paper 95-
401--Margin and Collateral Requirements for Non-Centrally Cleared
Derivatives (Jul. 7, 2016), available at: http://www.osc.gov.on.ca/documents/en/Securities-Category9/csa_20160707_95-401_collateral-requirements-cleared-derivatives.pdf.
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Accordingly, the Commission is today proposing requirements
applicable to SBS Entities addressing, among other things, reconciling
and compressing portfolios of uncleared security-based swaps and
executing written trading relationship documentation with each
counterparty prior to or contemporaneously with executing an uncleared
security-based swap. In developing this proposal, we have consulted and
coordinated with the CFTC, the prudential regulators,\8\ and foreign
regulatory authorities in accordance with the consultation mandate of
the Dodd-Frank Act.\9\ We also have consulted and coordinated with
foreign regulatory authorities through Commission staff participation
in numerous bilateral and multilateral discussions with foreign
regulatory authorities addressing the regulation of OTC
derivatives.\10\ Through these multilateral and bilateral discussions
and the Commission staff's participation in various international task
forces and working groups, we have gathered information about foreign
regulatory reform efforts and their effect on, and relationship with,
the U.S. regulatory regime. The Commission has taken, and will continue
to take, these discussions into consideration in developing rules,
forms, and interpretations for implementing Title VII of the Dodd-Frank
Act.
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\8\ For purposes of this statement, the term ``prudential
regulator'' is defined in Section 1a(39) of the CEA, 7 U.S.C.
1a(39), and that definition is incorporated by reference into
Section 3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74). Pursuant
to that definition, the Board of Governors of the Federal Reserve
System (``Federal Reserve Board''), the Office of the Comptroller of
the Currency, the Federal Deposit Insurance Corporation (``FDIC''),
the Farm Credit Administration, or the Federal Housing Finance
Agency (collectively, the ``prudential regulators'') is the
``prudential regulator'' of an SBS Entity if the entity is directly
supervised by that regulator. Separately, we are proposing a
definition of ``prudential regulator,'' to be used for purposes of
the proposed portfolio reconciliation and trading relationship
documentation requirements. See infra note 48. That proposed
definition also references Section 3(a)(74) of the Exchange Act and
includes the same list of agencies as noted above.
\9\ Section 712(a)(2) of the Dodd-Frank Act provides in part
that the Commission shall ``consult and coordinate to the extent
possible with the Commodity Futures Trading Commission and the
prudential regulators for the purposes of assuring regulatory
consistency and comparability, to the extent possible.''
In addition, Section 752(a) of the Dodd-Frank Act provides, in
part, that ``[i]n order to promote effective and consistent global
regulation of swaps and security-based swaps, the Commodity Futures
Trading Commission, the Securities and Exchange Commission, and the
prudential regulators . . . as appropriate, shall consult and
coordinate with foreign regulatory authorities on the establishment
of consistent international standards with respect to the regulation
(including fees) of swaps.''
\10\ Staff participates in a number of international standard-
setting bodies and workstreams working on OTC derivatives reforms.
For example, Commission staff participated in the International
Organization of Securities Commissions' (``IOSCO'') preparation of a
report regarding risk mitigation standards for non-centrally cleared
OTC derivatives. See Risk Mitigation Standards for Non-centrally
Cleared OTC Derivatives (Jan. 28, 2015), available at: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD469.pdf. IOSCO developed
those standards in consultation with the Basel Committee on Banking
Supervision and the Committee on Payments and Market
Infrastructures.
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Finally, the Commission recognizes that the CFTC rules pertaining
to portfolio reconciliation, portfolio compression, and written trading
relationship documentation have been in effect since 2012, and that any
SBS Entity that also is registered with the CFTC as a Swap Entity will
already have incurred systems and compliance costs in connection with
the corresponding CFTC requirements. In order to minimize compliance
burdens on such potential dual registrants in connection with the rules
we are proposing today, we have attempted to harmonize this proposal
with the existing CFTC rules wherever possible. There are, however, a
limited number of provisions where we preliminarily believe it is
appropriate to diverge from a particular aspect of the CFTC rules. Each
of those differences is described below, along with the preliminary
reasons for the different approaches. To the extent that no such
substantive difference is described, it is because we have
preliminarily determined that none exists. However, below we welcome
and solicit comment on any potential substantive differences between
the proposed rules and the corresponding CFTC rules, as well as on the
decision to harmonize with the CFTC, both as an overall approach and
with respect to any specific provisions of the proposed rules.
B. Rule 15Fi-3 (Portfolio Reconciliation)
1. Overview of Portfolio Reconciliation
In the Trade Acknowledgement and Verification Adopting Release, the
Commission noted the importance of confirming trades in a timely
manner, explaining that the process of confirming the terms of a
transaction is essential for SBS Entities ``to effectively measure and
manage market and credit risk.'' \11\ The Commission further explained
that ``a backlog of unconfirmed trades could hinder the settlement
process, particularly if errors go undetected or a counterparty
disputes the terms of a transaction.'' \12\ Such disruptions in the
settlement process could, in turn, lead to broader market instability
in the case of a credit event involving a reference entity on which
many different counterparties have, in the aggregate, a large notional
outstanding exposure.\13\
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\11\ Trade Acknowledgement and Verification Adopting release, 81
FR at 39833.
\12\ Id.
\13\ Id.
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In this regard, portfolio reconciliation addresses many of these
same issues, but unlike the confirmation process, which occurs at the
outset of a transaction, reconciliation operates throughout the life of
the transaction. If a security-based swap transaction is accurately
confirmed by both parties during the trade acknowledgement and
verification process, reconciliation helps to identify any
discrepancies in terms that do not remain constant throughout the life
of a trade. Furthermore, if a discrepancy is not identified during the
trade acknowledgement and verification process, it could be identified
during a subsequent reconciliation exercise.
The Commission preliminarily believes that portfolio reconciliation
serves as an important mechanism for promoting risk mitigation by
requiring security-based swap counterparties to have established
processes for identifying and resolving discrepancies involving key
terms of their transactions. To illustrate this point, if a term
necessary for calculating the market value of a security-based swap is
not properly confirmed during the trade acknowledgment and verification
process, such as due to some form of systems or human error, that
discrepancy could lead to complications at various points throughout
the life of the transaction, which could become particularly
problematic if it remains undetected until such time as the parties are
required to perform on their obligations.\14\ Thus, portfolio
reconciliation could help to mitigate the possibility of a discrepancy
unexpectedly affecting performance under the security-based swap
transaction by increasing the likelihood
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that the parties are and remain in agreement with respect to all
material terms.
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\14\ See Summary of OTC Commitments, Attachment to the July 31,
2008 letter from the Operations Management Group to Timothy
Geithner, President, Federal Reserve Bank of New York (``FRBNY''),
available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2008/CommitmentSummaryTable.pdf (``Positive
affirmation of trade economics is a key risk mitigation technique
for OTC derivatives because it assures that each counterparty's risk
management system accurately reflect the economic details of trades
that have not yet been matched.''). Although this particular
commitment was made in the context of the trade affirmation process,
we believe that the same basic principle supports the need to
reconcile terms throughout the life of a trade, even if a term is
accurately reflected in a firm's system as a result of the
affirmation process. This is particularly true for terms that do not
remain constant during the life of a trade.
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This practice is particularly relevant with respect to terms used
to perform a valuation of the financial instrument. Specifically,
unresolved discrepancies regarding the value of a security-based swap
can lead to, among other things, difficulties in the application of any
processes that depend on the valuation being accurate, such as
determining the amount of margin that must be posted or collected
during the life of a security-based swap transaction. In the aggregate,
such errors and other complications could result in significant
uncollateralized exposure in the uncleared security-based swap markets
(or alternatively, potentially inefficient overcollateralization).
In addition, valuation discrepancies identified during
reconciliation could help to identify problems with one or both of the
counterparties' internal valuation systems and models, or possibly even
with a firm's internal controls. For example, in a report analyzing
federal assistance to American International Group, Inc. (``AIG'')
following the events of September 2008, the General Accountability
Office (``GAO'') noted that in structuring this relief one of the many
open issues the FRBNY had to address was the number of collateral
disputes AIG had with its counterparties.\15\ GAO further explained
that ``[t]o the extent that lower valuations (more CDO value lost)
produced greater collateral postings, counterparties had an interest in
seeking lower valuations. Similarly, to the extent that higher
valuations (less CDO value lost) meant smaller collateral postings, AIG
had an interest in seeking higher valuations.'' \16\
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\15\ See GAO, Financial Crisis: Review of Federal Reserve System
Financial Assistance to American International Group, Inc., GAO-11-
616 (Sept. 2011), available at http://www.gao.gov/assets/590/585560.pdf (``According to information we reviewed, on a
[collateralized debt obligation (``CDO'')] portfolio of $71 billion
. . . , AIG and its counterparties had valuation differences
totaling $4.3 billion. Among a group of 15 counterparties, 9 had
valued their assets differently than AIG.'').
\16\ Id. at 82.
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In light of this information, the Commission preliminarily believes
that the use of portfolio reconciliation to help maintain an agreed-
upon valuation of a security-based swap throughout the lifecycle of a
transaction should be a hallmark of prudent risk mitigation practices
within the operations of an SBS Entity. Accordingly, the Commission is
proposing new Rule 15Fi-3 under the Exchange Act,\17\ which generally
would require those entities, in connection with security-based swaps
not submitted for clearing, to (1) engage in portfolio reconciliation
with counterparties who are SBS Entities and (2) establish, maintain,
and follow written policies and procedures reasonably designed to
ensure that they engage in portfolio reconciliation with counterparties
who are not SBS Entities. In both cases, the frequency of the portfolio
reconciliation would be based on the number of outstanding transactions
with the applicable counterparty.
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\17\ Unless otherwise noted, all references to rules (both
proposed and existing) without an accompanying statutory reference
are to rules adopted (or proposed to be adopted) under the Exchange
Act.
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2. Scope of the Portfolio Reconciliation Requirements
For purposes of proposed Rule 15Fi-3,\18\ the Commission is
proposing to amend existing Rule 15Fi-1 to add a definition of
``portfolio reconciliation.'' \19\ As proposed, this term would be
defined to mean any process by which the counterparties to one or more
uncleared security-based swaps:
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\18\ The corresponding CFTC rule is 17 CFR 23.502. The structure
of the CFTC rule, including the subsections, mirrors the structure
of proposed Rule 15Fi-3.
\19\ See proposed Rule 15Fi-1(l). The corresponding CFTC
definition is in 17 CFR 23.500(i).
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(i) Exchange the material terms of all security-based swaps in the
security-based swap portfolio between the counterparties;
(ii) Exchange each counterparty's valuation of each security-based
swap in the security-based swap portfolio between the counterparties as
of the close of business on the immediately preceding business day; and
(iii) Resolve any discrepancy in valuations or material terms.
For purposes of this proposed definition, the Commission also is
proposing to amend Rule 15Fi-1 to add the terms ``security-based swap
portfolio,'' which would be defined to mean all security-based swaps
currently in effect between a particular SBS Entity and a particular
counterparty,\20\ and ``valuation,'' which would be defined to mean the
current market value or net present value of a security-based swap.\21\
Both of these definitions help to establish the scope of the portfolio
reconciliation requirements in proposed Rule 15Fi-3, with the former
defining which security-based swaps are subject to the rule and the
latter defining one of the two categories of information that must be
exchanged during a reconciliation (the other being ``material terms'').
Moreover, for consistency with the corresponding CFTC rules applicable
to Swap Entities, these definitions are substantively identical to the
CFTC's corresponding definitions, which we preliminarily believe are
appropriately scoped and clear for purposes of proposed Rule 15Fi-3.
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\20\ See proposed Rule 15Fi-1(o). The corresponding CFTC
definition is in 17 CFR 23.500(k)
\21\ See proposed Rule 15Fi-1(q). The corresponding CFTC
definition is in 17 CFR 23.500(m).
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With respect to the phrase ``material terms,'' the proposed
definition would follow a similar approach to the one taken by the CFTC
in that it would base the definition on the terms required to be
reported to an SDR pursuant to Regulation SBSR.\22\ Unlike the approach
taken by the CFTC, however, which has adopted a single definition of
``material terms,'' the definition in proposed Rule 15Fi-1(i) would be
bifurcated depending on whether a security-based swap transaction had
already been included in a security-based swap portfolio and reconciled
pursuant to proposed Rule 15Fi-3.\23\ With respect to any security-
based swap that has not yet been reconciled as part of a security-based
swap portfolio, ``material terms'' would be defined to mean each term
that is required to be reported to a registered SDR pursuant to Rule
901 under the Exchange Act.\24\ With respect to all other security-
based swaps within a security-based swap portfolio, the definition of
``material terms'' would continue to be based on the reporting
requirements in Rule 901, but would exclude any term that is not
relevant to the ongoing rights and obligations of the
[[Page 4618]]
parties and the valuation of the security-based swap.\25\
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\22\ 17 CFR 242.900 to 242.909.
\23\ CFTC Rule 23.500(g) defines ``material terms'' to include
the minimum primary economic terms (as defined in Appendix 1 of part
45 of the CFTC's regulations) of a swap, other than the 24 specific
data fields identified in that rule. See 17 CFR 23.500(g). Among the
excluded fields are: (1) The status of either counterparty as a swap
dealer, major swap participant, financial entity, or U.S. person;
(2) an indication that the swap will be allocated and certain
information regarding the agent and the original swap; (3) an
indication that the swap is a multi-asset swap and a further
indication of its primary and secondary asset class; (4) an
indication that the swap is a mixed swap and the identification of
any non-CFTC registered swap data repository to which it is also
reported (if applicable); (5) the block trade indicator, execution
timestamp, and timestamp for submission to a swap data repository;
(6) the clearing indicator and clearing venue; and (7) certain
information regarding the application of the end user exception from
mandatory clearing.
\24\ See proposed Rule 15Fi-1(i)(1) (referencing 17 CFR
242.901).
\25\ See proposed Rule 15Fi-1(i)(2).
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The Commission preliminarily believes that the data set submitted
to an SDR under Rule 901 is an appropriate measure for determining
which terms should be reconciled pursuant to proposed Rule 15Fi-3. As
noted above, the Commission believes that one of the fundamental goals
of the portfolio reconciliation process is to help ensure that both
counterparties to a security-based swap are in agreement on all of the
terms necessary for developing a comprehensive understanding of each of
their rights and obligations under the security-based swap, and that
they remain in such agreement throughout the life of the transaction.
To effect that objective, we are proposing that the term ``portfolio
reconciliation'' be defined in part as the exchange of the ``material
terms'' of all security-based swaps in the security-based swap
portfolio between the counterparties. Similarly, in adopting Regulation
SBSR the Commission explained that the Title VII regulatory reporting
requirement ``is designed to allow the Commission and other relevant
authorities to have access to comprehensive information about security-
based swap activity in registered SDRs.'' \26\ The Commission therefore
preliminarily believes that the terms that must be reported to an SDR
under Regulation SBSR are a good proxy for identifying the ``material
terms'' that should be subject to the portfolio reconciliation
requirements.
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\26\ See Regulation SBSR--Reporting and Dissemination of
Security-Based Swap Information; Final Rule, Exchange Act Release
No. 74244 (Feb. 11, 2015), 80 FR 14563, 14646 (Mar. 19, 2015)
(``Regulation SBSR Adopting Release'').
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The Commission also preliminarily believes that basing the
definition of ``material terms'' on what is required to be reported to
an SDR provides certainty for SBS Entities regarding what information
must be reconciled, which should in turn reduce the burdens on those
entities without lessening the benefits of the proposed rule (which are
described earlier in this section and in the Economic Analysis section
below). Furthermore, the proposed approach is designed to allow
affected counterparties to leverage the same systems used for SDR
reporting for purposes of the portfolio reconciliation requirements,
should such synergies exist. Moreover, this proposed approach would
promote the same policy goals that underpin a particular requirement
imposed on SDRs to verify the terms of each security-based swap with
both counterparties to the transaction, as discussed in detail in
Section I.E below.
The Commission preliminarily believes that the proposed rule is
reasonably tailored to avoid unnecessary burdens while still promoting
important risk mitigation goals inherent to the portfolio
reconciliation process. That said, certain terms of a security-based
swap transaction may be material the first time that a transaction is
reconciled, but might not be material during a subsequent
reconciliation. This could be true, for example, with respect to any
term of a transaction that does not affect any ongoing rights or
obligations of the parties and that has no effect on the valuation of
the security-based swap. Accordingly, the definition of ``material
terms'' in proposed Rule 15Fi-1(i)(2) provides that with respect to any
subsequent reconciliations, SBS Entities may exclude any term that is
not relevant to the ongoing rights and obligations of the parties and
the valuation of the security-based swap, regardless of the fact that
the term was required to be reported to an SDR under Regulation
SBSR.\27\ For example, the Commission preliminarily believes that the
24 terms excluded from the CFTC definition could be excluded from the
proposed definition of ``material terms'' in the context of security-
based swaps that have previously been reconciled.\28\
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\27\ The Commission does not, however, believe that a term would
be appropriately excluded from the definition of ``material terms''
if it was resubmitted to an SDR because of an error in how it was
initially reported or due to a lifecycle event. In those
circumstances, the Commission preliminarily believes that such term
would continue to be material for the same reasons that every term
subject to a reporting requirement under Rule 901 would be material
the first time that a transaction is reconciled. Once the updated
term is reconciled, however, an SBS Entity would be able to exclude
that term from subsequent reconciliations to the extent that it
determines that it is not relevant to the ongoing rights and
obligations of the parties and the valuation of the security-based
swap.
\28\ See supra note 23 (discussing CFTC Rule 23.500(g)). We
further recognize that when the CFTC adopted amendments to Rule
23.500(g) to exclude these terms, it noted that ``removal of these
terms from reconciliations would alleviate the burden of resolving
discrepancies in terms of a swap that are not relevant to the
ongoing rights and obligations of the parties and the valuation of
the swap without impairing the [CFTC's] regulatory mission.'' See
Definitions of ``Portfolio Reconciliation'' and ``Material Terms''
for Purposes of Swap Portfolio Reconciliation, 81 FR 27309, 27311
(May 6, 2016).
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Finally, the Commission recognizes that our proposed definition of
``material terms'' would differ from the corresponding CFTC definition
in that Swap Entities would never need to reconcile the 24 terms
excluded from the definition of ``material terms'' in CFTC Rule
23.500(g). Nevertheless, we are proposing to require all reported terms
to be reconciled at least initially because, among other things, such
requirement could potentially help to address an issue related to how
registered SDRs can verify the information that they receive, as
discussed in detail in Section I.E below. However, below we solicit
comment on our approach, and particularly welcome comments on any
trade-offs that may exist as between our efforts to address the SDR-
related issue and any additional burdens resulting from a definition of
``material terms'' that departs from the corresponding CFTC rule,
particularly in the context of CFTC-regulated Swap Entities that also
may register with the Commission as SBS Entities.
3. Proposed Rule 15Fi-3(a): Portfolio Reconciliation With Other SBS
Entities
The Commission is proposing to bifurcate proposed Rule 15Fi-3 based
on the particular type of counterparty with which the SBS Entity
transacts. For transactions between two SBS Entities, proposed Rule
15Fi-3(a) would require the two sides to engage in portfolio
reconciliation at frequencies that are based on the size of the
security-based swap portfolio between the two parties, expressed in
ranges (or tiers).\29\
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\29\ See proposed Rule 15Fi-3(a).
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Under this tiered approach, if the two SBS Entity counterparties
maintain a security-based swap portfolio that includes 500 or more
security-based swaps, portfolio reconciliation would need to occur once
each business day for as long as the portfolio exceeds this threshold.
If a security-based swap portfolio between two SBS Entities includes
more than 50 but fewer than 500 security-based swaps on any business
day during a week, portfolio reconciliation would be required to occur
on a weekly basis. For a security-based swap portfolio between two SBS
Entities that includes no more than 50 security-based swaps at any time
during the calendar quarter, portfolio reconciliation would be required
on a quarterly basis.\30\
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\30\ See proposed Rule 15Fi-3(a)(3). For the avoidance of doubt,
if a security-based swap portfolio between two SBS Entity
counterparties crosses from one threshold to another, both sides
would be required to comply with the proposed rule as of the date
that the requirement applies. For example, if two SBS Entities that
have long maintained a portfolio of 50 or fewer security-based swaps
(and accordingly reconcile on a quarterly basis) exceed the 50
transaction threshold, the two sides would become subject to the
weekly reconciliation requirement as of the first day that the
portfolio exceeds 50 security-based swaps (or the daily
reconciliation requirement if the portfolio increases to 500 or more
security-based swaps). By contrast, if two SBS Entities that
maintain a security-based swap portfolio of more than 500
transactions fall below that threshold, they could begin reconciling
on a weekly basis as of the first business day after the date on
which they were able to verify that their security-based swap
portfolio has fallen below 500 transactions.
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[[Page 4619]]
The Commission preliminarily believes that the proposed tiering of
obligations, whereby the frequency of the portfolio reconciliation
would be based on the number of outstanding transactions with the
applicable counterparty, represents a reasonable attempt to calibrate
the costs to the benefits expected from reconciling a person's
security-based swap portfolio at regular intervals. All other things
being equal, a larger and more complex portfolio represents a greater
potential for loss than a smaller, less complex portfolio. Therefore,
the proposed rule would require more frequent reconciliation of the
larger, more complex portfolio. We also note that the CFTC has adopted
rules that utilize identical levels as our proposal, and that
divergence from those thresholds could lead to additional costs and
other inefficiencies for SBS Entities that are also registered with the
CFTC as Swap Entities.\31\
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\31\ When it adopted the same numerical thresholds in 2012, the
CFTC noted that the requirement to reconcile portfolios with 500 or
more swaps on a daily basis was consistent with the commitments made
by the OTC Derivatives Steering Group's 14 major dealers (``G-14
dealers'') in December 2008 as well as international regulatory
efforts underway at the time of the CFTC's release. See CFTC Risk
Mitigation Adopting Release, 77 FR at 55928 nn. 35 and 36. See also
Summary of OTC Commitments, Attachment to the June 2, 2009 letter
from G-14 dealers and certain buy-side participants to William C.
Dudley, President, FRBNY, available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2009/060209table.pdf
(committing, ``[b]y June 30, 2009, [to] execute daily collateralized
portfolio reconciliations for collateralized portfolios in excess of
500 trades between [Operations Management Group] dealers as detailed
in the December 31, 2008 Collateral Update letter''). See also
Attachment to the Mar. 31, 2011 letter from the G-14 dealers and
certain buy-side participants to William C. Dudley, President,
FRBNY, available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2011/SCL0331.pdf (``We commit to reduce the
threshold for routine portfolio reconciliation of collateralized
portfolios from those exceeding 1,000 transactions to those
exceeding 500 transactions starting June 30, 2011. These portfolios
will be reconciled at least monthly.'') (internal citation omitted).
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In addition to the requirements regarding the frequency of the
reconciliation, proposed Rule 15Fi-3(a)(1) would require SBS Entities
to agree in writing with each of their counterparties on the terms of
the portfolio reconciliation including, if applicable, agreement on the
selection of any third party service provider who may be performing the
reconciliation.\32\ In practice, the Commission notes that an SBS
Entity could satisfy such requirement by including the terms governing
the portfolio reconciliation process in the written security-based swap
trading relationship documentation that the SBS Entity executes with
its counterparty which, pursuant to proposed Rule 15Fi-5 would be
required to be executed prior to, or contemporaneously with, the two
parties executing any new security-based swap transaction.\33\ This
practice should help to ensure that portfolio reconciliation begins
without delay after execution of the transaction and is designed to
minimize the number of disagreements regarding the portfolio
reconciliation process itself.
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\32\ Proposed Rule 15Fi-3(a)(2) provides that portfolio
reconciliation may be performed either on a bilateral basis by the
counterparties or by a third party selected by the counterparties in
accordance with paragraph (a)(1) of the proposed rule. The
Commission notes that CFTC Rule 23.502(a)(2), which is comparable to
proposed Rule 15Fi-3(a)(2), uses the term ``qualified third party.''
When it adopted the above provision in 2012, the CFTC explained that
it ``expects that parties will determine if the third-party is
qualified based on their own policies.'' See CFTC Risk Mitigation
Release, 77 FR at 55929. In addition, the CFTC's portfolio
reconciliation requirements for transactions between Swap Entities
and counterparties that are not Swap Entities do not require the
relevant third party to be ``qualified'' and, instead, provide that
``[t]he portfolio reconciliation may be performed on a bilateral
basis by the counterparties or by one or more third parties selected
by the counterparties.'' See 17 CFR 23.502(b)(2) (emphasis added).
Accordingly, the Commission has decided not to refer to a
``qualified third party'' and, instead, uses the term ``third party
selected by the counterparties'' for purposes of proposed Rule 15Fi-
3(a)(2). We preliminarily believe that it is sufficient for our
purposes to refer solely to the fact that a third party has been
selected.
\33\ Once the two parties have agreed in writing on the terms of
the portfolio reconciliation for the first time, the requirement
could then be satisfied in connection with any new security-based
swap transaction executed by the two sides merely by agreeing in
writing to abide by the existing agreement regarding the
reconciliation process.
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Finally, the Commission has preliminarily determined not to propose
the CFTC's definition of ``business day'' and to rely on the definition
in existing Rule 15Fi-1, which was adopted in 2016 in connection with
the trade acknowledgement and verification requirements in Rule 15Fi-2.
That definition includes ``any day other than a Saturday, Sunday, or
legal holiday.'' \34\ Specifically, we believe that the existing
definition of ``business day'' is broadly consistent with other uses of
the term within the Commission's rules.\35\ We also do not believe it
necessary to have two different definitions of the same term
promulgated under the same legal authority (i.e., Section 15F(i) of the
Exchange Act), one for purposes of the portfolio reconciliation rules
and the other for purposes of the trade acknowledgement and
verification rules.\36\ Moreover, we believe that this definition
provides market participants with the flexibility to determine which
holidays are ``legal holidays'' for purposes of the portfolio
reconciliation requirements in proposed Rule 15Fi-3, which should be
particularly useful given the cross-border nature of the OTC
derivatives market.\37\ However, below we solicit comment on our
approach.
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\34\ Under this proposal, the definition of ``business day''
currently in Rule 15Fi-1(a) would be renumbered as proposed Rule
15Fi-1(b).
\35\ See, e.g., 17 CFR 270.2a-7(a)(4) (``Business day means any
day other than Saturday, Sunday, or any customary business
holiday.'') and 17 CFR 230.261(b) (``Business day [means] [a]ny day,
except Saturdays, Sundays or United States federal holidays.'').
\36\ By contrast, the applicable definition of ``business day''
for purposes of the CFTC's portfolio reconciliation rules is
contained in CFTC Rule 1.3(b), and includes ``any day other than a
Sunday or holiday.'' That definition also provides instructions for
computing time periods for CFTC rules that include notice
requirements.
\37\ As a reminder, the proposal would require SBS entities to
agree in writing with each of their counterparties on the terms of
the portfolio reconciliation pursuant to proposed Rule 15Fi-3(a)(1)
(in the case of security-based swap portfolios with other SBS
Entities) and Rule 15Fi-3(b)(1) (in the case of security-based swap
portfolios with all other counterparties). Accordingly, such
agreement between an SBS Entity and its counterparty could include a
determination as to which holidays would be considered ``legal
holidays'' for purposes of any applicable portfolio reconciliation
exercises involving those two parties.
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4. Proposed Rule 15Fi-3(a): Resolution of Discrepancies With Other SBS
Entities
Proposed Rule 15Fi-3(a) also would require each SBS Entity to take
additional actions in the event of a discrepancy with a counterparty
that is an SBS Entity. First, proposed Rule 15Fi-3(a)(4) would require
the two SBS Entities to resolve immediately any discrepancy in a
material term, whether identified directly as part of the portfolio
reconciliation or otherwise. We preliminarily believe that this
timeframe is appropriate given the ongoing nature of security-based
swap transactions, as well as the potential for disagreements between
the counterparties regarding the terms of a transaction to compound
over the course of the security-based swap transaction. We have not,
however, proposed a fixed definition of ``immediately'' as we believe
that the amount of time that will be needed to resolve a discrepancy
will depend on the particular facts and circumstances involved,
including the complexity of the material term in question and the
[[Page 4620]]
magnitude of the discrepancy. We have, however, solicited comment on
this approach.
At the same time, we also recognize that discrepancies related to
the valuation of a security-based swap could be particularly difficult
to resolve in a short period of time. Accordingly, proposed Rule 15Fi-
3(a)(5) would require SBS Entities to have policies and procedures
reasonably designed to resolve valuation discrepancies no later than
five business days from the date they were discovered, which we
preliminarily believe to be both a reasonable and appropriate amount of
time to resolve such discrepancies. As a condition to this requirement,
however, proposed Rule 15Fi-3(a)(5) would require each SBS Entity to
establish, maintain, and follow written policies and procedures
reasonably designed to identify how it will comply with any variation
margin requirements under Section 15F(e) of the Exchange Act \38\ and
any related regulations pending resolution of the valuation
discrepancy. Although we preliminarily believe that counterparties
should be given sufficient time to resolve valuation discrepancies, we
also believe it to be important for those counterparties to take
reasonable steps during the pendency of the resolution to ensure that
they are continuing to manage their credit risk to each other by way of
exchanging variation margin.
---------------------------------------------------------------------------
\38\ 15 U.S.C. 78o-10(e).
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Moreover, proposed Rule 15Fi-3(a)(5) provides that for purposes of
the requirement to resolve valuation discrepancies within five business
days of being identified, a difference between the lower valuation and
the higher valuation of less than 10% of the higher valuation need not
be deemed a discrepancy. This 10% threshold would apply on a
transaction-by-transaction basis and not on a portfolio level. As
discussed in the immediately preceding paragraph, the Commission
recognizes that valuation discrepancies could be challenging and costly
to resolve. Accordingly, we preliminarily believe that providing SBS
Entities with a clear understanding of exactly which valuation
discrepancies would need to be resolved within five business days will
help focus the internal resources of both counterparties on the largest
discrepancies. At the same time, however, the Commission believes that,
in most cases, prudent risk mitigation of a firm's security-based swap
portfolio and proper governance over an entity's operations would
involve ensuring that, at least to a certain degree, most valuation
discrepancies are ultimately resolved.\39\
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\39\ For the avoidance of doubt, an SBS Entity that identifies a
valuation discrepancy in excess of 10% would be in compliance with
the proposed rule if it resolves such discrepancy to a level below
10%, even if the entire discrepancy is not completely eliminated.
Thus, an SBS Entity would not be required to reduce an 11% valuation
discrepancy down to zero, in contrast to an SBS Entity with a 9%
valuation discrepancy, who would have no further obligations under
proposed Rule 15Fi-3(a)(5).
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5. Proposed Rule 15Fi-3(b): Portfolio Reconciliation With Other
Counterparties
Proposed Rule 15Fi-3(b) would establish reconciliation requirements
for security-based swap portfolios between an SBS Entity and a
counterparty that is not an SBS Entity. Although there is some broad
similarity between proposed Rule 15Fi-3(b) and the rules applicable to
security-based swap portfolios between two SBS Entities, we have
preliminarily determined to take a more streamlined approach with
respect to security-based swaps between an SBS Entity and its non-SBS
Entity counterparties, similar to the CFTC's approach. This approach
reflects our preliminary view that a dealer-to-dealer portfolio may be
associated with a degree of market interconnectedness and volume that
could potentially carry considerable market-wide risks, at least as
compared to a security-based swap portfolio that involves only one SBS
Entity. Moreover, the Commission preliminarily believes it to be
appropriate to impose more prescriptive requirements in cases where
both entities are subject to the SEC's requirements for registered
entities. Accordingly, there are differences in both the application of
the portfolio reconciliation requirements with non-SBS Entity
counterparties as well as in the thresholds governing the frequency of
the required reconciliation exercises.
Specifically, the proposal would require each SBS Entity to
establish, maintain, and follow written policies and procedures
reasonably designed to ensure that it engages in portfolio
reconciliation with non-SBS Entity counterparties as set forth in the
rule.\40\ This is in contrast to proposed Rule 15Fi-3(a), which
expressly requires portfolio reconciliation with respect to
transactions where both counterparties are SBS Entities. In addition,
the policies and procedures would require that the portfolio
reconciliation be performed no less frequently than: (1) Once each
calendar quarter for each security-based swap portfolio that includes
more than 100 security-based swaps at any time during the calendar
quarter and (2) once annually for each security-based swap portfolio
that includes no more than 100 security-based swaps at any time during
the calendar year.\41\
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\40\ See proposed Rule 15Fi-3(b). Additionally, proposed Rule
15Fi-3(b) contains a slight deviation from corresponding CFTC Rule
23.502(b) to eliminate language that we believe to be redundant. We
do not intend for such clarification to signify any substantive
differences between proposed rule Rule15Fi-3(b) and CFTC Rule
23.502(b).
\41\ See proposed Rule 15Fi-3(b)(3).
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As we previously explained, the Commission preliminarily believes
that basing the required frequency of the portfolio reconciliation on
the number of outstanding transactions with the applicable counterparty
represents a reasonable attempt to calibrate the costs to the benefits
expected from reconciling a person's security-based swap portfolio at
regular intervals. As we also noted above, all other things being equal
a larger and more complex portfolio represents a greater potential for
loss than a smaller, less complex portfolio. As before, in selecting
the specific levels we recognize that the CFTC has adopted rules with
identical thresholds and frequencies and that divergence from those
thresholds could lead to additional costs and other inefficiencies for
SBS Entities that are also registered with the CFTC as Swap
Entities.\42\
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\42\ See supra note 31 (discussing how the CFTC arrived at
setting the numerical thresholds for the requirement to engage in
portfolio reconciliation as between two Swap Entities.).
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In addition, paragraph (b)(1) of proposed Rule 15Fi-3 would require
that the applicable policies and procedures be reasonably designed to
ensure that each SBS Entity agrees in writing with each of its non-SBS
Entity counterparties on the terms of the portfolio reconciliation
including, if applicable, agreement on the selection of any third party
service provider who may be performing the reconciliation, and
paragraph (b)(2) provides that under such required policies and
procedures, the portfolio reconciliation may be performed on a
bilateral basis by the counterparties or by one or more third parties
selected by the counterparties.\43\ To the extent that the
counterparties elect to use a third party to provide these services,
the policies and procedures should be reasonably designed to ensure
that the SBS Entity and its counterparty agree on the selection of that
third party in writing in accordance with the requirements set forth in
proposed Rule 15Fi-3(b)(1).\44\
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\43\ See proposed Rules 15Fi-3(b)(1) and (2).
\44\ See proposed Rule 15Fi-3(b)(2). As noted in the discussion
of the corresponding provision in Rule 15Fi-3(a)(1), an SBS Entity
could in practice satisfy such requirement by including the terms
governing the portfolio reconciliation process in the written
security-based swap trading relationship documentation that it
executes with its counterparty which, pursuant to proposed Rule
15Fi-5 would be required to be executed prior to, or
contemporaneously with, the two parties executing any new security-
based swap transaction. In addition, once the two parties have
agreed in writing on the terms of the portfolio reconciliation for
the first time, the requirement could then be satisfied in
connection with any new security-based swap transaction executed by
the two sides merely by agreeing in writing to abide by the existing
agreement regarding the reconciliation process. See supra notes 32
and 33 and accompanying text.
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[[Page 4621]]
Finally, proposed Rule 15Fi-3(b)(4) would require each SBS Entity
to establish, maintain, and follow written procedures reasonably
designed to resolve any discrepancies in the valuation or a material
term of each security-based swap identified as part of a portfolio
reconciliation or otherwise with a non-SBS Entity counterparty in a
timely fashion.\45\ We are reluctant to provide a fixed definition of
``timely fashion'' in the context of resolving discrepancies with
counterparties who are not SBS Entities due to the fact that such
counterparties may vary considerably in terms of their size,
sophistication, and background. Although it may be possible to resolve
most valuation discrepancies with large hedge funds and pension funds
within the five-business-day period applicable to transactions between
two SBS Entities, that timeframe may be much more challenging with
respect to transactions with smaller buy-side firms. Accordingly, below
we request comment on the amount of time SBS Entities should be
provided to resolve discrepancies in the valuation or a material term
with respect to transactions with a non-SBS Entity counterparty.
Commenters are particularly encouraged to explain how any recommended
time period appropriately balances the importance of quickly resolving
valuation discrepancies to the greatest extent possible, with an
understanding that more complex discrepancies could involve the need
for additional discussion and time for resolution.
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\45\ Similar to the requirement in paragraph (a) of the proposed
rule for portfolio reconciliation with counterparties that are also
SBS Entities, proposed Rule 15Fi-3(b)(4) provides that a difference
between the lower valuation and the higher valuation of less than
10% of the higher valuation need not be deemed a discrepancy for
purposes of that paragraph. See supra note 39 and accompanying text
(discussing the 10% threshold in the context of Rule 15Fi-3(a)(5)).
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6. Reporting of Valuation Disputes
Valuation is one of the most fundamental elements for determining
the economic rights and obligations of each of the counterparties to a
security-based swap transaction. For example, market participants
manage their credit risks to their counterparties by exchanging margin
with each other in an amount determined using the value of the
underlying security-based swap. If those valuations are not accurate
for any reason, such as human or system errors, problems with the
valuation methodology, or an issue affecting the timeliness of the
calculation, that error could result in one of the counterparties
having an uncollaterialized credit exposure and a potential for loss in
the event of a default.
Given those risks, proposed Rule 15Fi-3(c) would require each SBS
Entity to promptly notify the Commission of any security-based swap
valuation dispute in excess of $20,000,000 (or its equivalent in any
other currency), at either the transaction or portfolio level,\46\ if
not resolved within: (1) Three business days, if the dispute is with a
counterparty that is an SBS Entity; or (2) five business days, if the
dispute is with a counterparty that is not an SBS Entity. Such
notification would be required to be in a form and manner acceptable to
the Commission,\47\ and would also be required to be sent to any
applicable prudential regulator (i.e., in the case of any SBS Entity
that is also a bank).\48\
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\46\ The language ``at either the transaction or portfolio
level'' is not included in CFTC Rule 23.502(c), which is the
corresponding requirement applicable to Swap Entities. The specific
requirements as to the operation of CFTC Rule 23.502(c) are
contained in the rules of the National Futures Association
(``NFA''), which the CFTC has authorized to, among other things,
receive and review notices of reportable swap valuation disputes.
See Performance of Certain Functions by the National Futures
Association Related to Notices of Swap Valuation Disputes Filed by
Swap Dealers and Major Swap Participants, 81 FR 3390 (Jan. 21,
2016). A detailed discussion of the NFA requirements, including with
respect to whether notices of swap valuation disputes should be
filed at either the transaction or portfolio level, is set forth at
the end of this Section I.B.6.
\47\ With respect to the language addressing the form and manner
of submitting such notices, our intention is to provide SBS Entities
with flexibility to determine the most efficient and cost-effective
means of making such submissions, so long as it is deemed to be
acceptable by the Commission. At the same time, we also understand
that SBS Entities may prefer to have more specific direction as to
how to report these disputes to the Commission (and any applicable
prudential regulator). Accordingly, below we solicit comment on the
form of notice that would be required to be submitted pursuant to
the proposal.
\48\ Additionally, the Commission is proposing to amend Rule
15Fi-1 to add the term ``prudential regulator,'' which would be
defined to have the same meaning given to the term in Section
3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74), and would
include the Federal Reserve Board, the Office of the Comptroller of
the Currency, the FDIC, the Farm Credit Association, and the Federal
Housing Finance Agency, as applicable to the specific type of SBS
Entity. See proposed Rule 15Fi-1(m).
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We note that the CFTC has adopted a nearly identical requirement
with the same $20,000,000 threshold and timeframes, and that divergence
from those requirements could lead to additional costs and other
inefficiencies for SBS Entities that are also registered with the CFTC
as Swap Entities.\49\ In addition, when the CFTC adopted this
requirement, it explained that ``the $20,000,000 materiality threshold
for reporting is sufficiently high to eliminate unnecessary `noise'
from over-reporting, but not so high as to eliminate reporting that the
[CFTC] may find of regulatory value, such as a large number of
relatively small disputes that in aggregate could provide the [CFTC]
with information regarding a widespread market disruption.'' \50\ We
preliminarily concur with that justification, and also note that such
notifications could assist the Commission in identifying potential
issues with respect to an SBS Entity's internal valuation methodology.
That said, we also invite public comment as to whether the dollar
threshold or reporting periods should be modified in any way.\51\
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\49\ See CFTC Risk Mitigation Adopting Release 77 FR at 55914.
\50\ Id. The CFTC has a nearly identical requirement in its Rule
23.502(c), except that it also requires Swap Entities to send such
notices to the Commission when the dispute involves a swap that is
also a security-based swap agreement, of which a material term is
based on the price, yield, value, or volatility of any security or
any group or index of securities, or any interest therein. See 17
CFR 23.502(c) (citing the inclusion of security-based swap
agreements in the definition of ``swap'' in 7 U.S.C. 1a(47)(v)).
Because there is no corresponding inclusion of swap agreements in
the definition of ``security-based swap agreement'' in Section
3(a)(68) of the Exchange Act (15 U.S.C. 78c(a)), proposed Rule 15Fi-
3(c) does not contain a requirement to provide notices of any
security-based swap valuation disputes to the CFTC.
\51\ We have preliminarily determined not to provide a fixed
definition of the term ``promptly'' in the context of when the SBS
Entity would need to provide the Commission of an applicable
security-based swap valuation dispute. Although we would expect that
SBS Entities would be able to provide these notices to the
Commission as soon as the disputes exceed the applicable timeframes
(e.g., the beginning of fourth business day in the case of a dispute
between two SBS Entities), we also understand that some notices may
take longer to prepare, such as in cases when the counterparties are
unable to agree even on the size of the dispute.
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Finally, the Commission notes that on January 2, 2018, the NFA's
Interpretive Notice entitled, ``NFA Compliance Rule 2-49: Swap
Valuation Dispute Filing Requirements'' went into effect.\52\ Among
other things, that interpretive notice describes the types of disputes
that would trigger a notice requirement. Specifically, if the swap
dealer and its counterparty exchange collateral, NFA
[[Page 4622]]
Interpretive Notice to Rule 2-49 provides that the swap dealer would be
required to file notice of any dispute regarding (1) the amount of
initial margin to be posted or collected pursuant to a collateralized
eligible master netting agreement \53\ if the dispute exceeds the $20
million reporting threshold and (2) the amount of variation margin to
be posted or collected pursuant to such master netting agreement if the
dispute exceeds the $20 million reporting threshold. Because master
netting agreements by definition operate at the portfolio level, such
notices also would apply to the relevant swap portfolio.
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\52\ See NFA Interpretive Notice to Rule 2-49, available at:
https://www.nfa.futures.org/rulebook/rules.aspx?Section=9&RuleID=9072.
\53\ NFA Interpretive Notice to Rule 2-49 defines
``collateralized eligible master netting agreement'' to include an
eligible master agreement, including any applicable schedule and
credit support annex.
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To the extent that a swap dealer and its counterparty do not
exchange collateral, NFA Interpretive Notice to Rule 2-49 requires the
swap dealer to submit a notice to the NFA upon being notified by its
counterparty that such counterparty is disputing any valuation provided
by the swap dealer if the dispute exceeds the $20 million reporting
threshold. Such notices would either be at the portfolio or transaction
level, depending on the particular valuation in question. That is, if
the counterparty disputes a valuation provided by the swap dealer
related to a particular transaction, the notice provided by the swap
dealer to the NFA also would need to be at the transaction level. By
contrast, if the counterparty disputes a portfolio valuation provided
by the swap dealer, the notice provided by the swap dealer to the NFA
also would need to be at the portfolio level.\54\
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\54\ See id. See also Transcript of the NFA Swap Valuation
Dispute Notices and Swap Dealer Risk Data Reports Webinar (Oct. 12,
2017), available at: https://www.nfa.futures.org/members/member-resources/files/transcripts/svdwebinar-transcriptoct2017.pdf.
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NFA Interpretive Notice to Rule 2-49 also provides that swap
dealers should not file a daily notice of a previously reported dispute
even if the valuation dispute amount changes. Instead, swap dealers are
required to notify the NFA of certain changes to the dispute amount on
the 15th (or the following business day if the 15th is a weekend or
holiday) and last business day of each month by amending any previously
filed notice where the dispute amount has increased in $20 million
incremental bands.\55\ NFA Notice to Interpretive Rule 2-49 also
requires swap dealers to file termination notices of disputes that are
no longer reportable under CFTC Rule 23.502(c).\56\ In addition, on
July 20, 2017, NFA issued a Notice to Members (I-17-13) outlining the
types of disputes that must be reported under the Interpretive Notice
to Rule 2-49 and specifying the information that will be required in
NFA's dispute form.\57\ Below we solicit comment on whether the
Commission should incorporate some or all of the NFA's approach,
including with respect to any of the specific requirements described
above, directly into proposed Rule 15Fi-3(c).
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\55\ See NFA Interpretive Notice to Rule 2-49, supra note 52.
NFA Interpretive Notice to Rule 2-49 provided an example of a swap
dealer that filed a notice of a $30 million dispute, noting that an
amended notice updating the dispute amount would be required if that
dispute increases to $40 million or more and each subsequent $20
million increment (i.e., the dispute amount increases to $60 million
or more, $80 million or more, etc.), or if the amount decreases at
these $20 million increments.
\56\ See id. Under NFA Interpretive Notice to Rule 2-49, the
termination notice would be due on the 15th (or the following
business day if the 15th is a weekend or holiday) and the last
business day of the month based on the dispute amount on the
reporting date.
\57\ See NFA Notice to Members I-17-30, available at https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4827. That notice
provided that all swap valuation disputes must include: (1) The swap
dealer's NFA ID and legal entity identifier (``LEI''), (2) the
dispute reportable date, (3) the dispute type, (4) the dispute
termination date, (5) the receiver/payer, (6) the disputed amount,
in U.S. Dollars (``USD''), (7) the counterparty name, and (8)
counterparty LEI or Privacy Law Identifier. For initial and
variation margin disputes, the swap dealer would also be required to
provide (1) the unique swap identifier, (2) the base currency
notional amount, (3) the base currency code, (4) the notional value
USD equivalent, (5) the asset type, and (6) the product type. For
disputes where no collateral is exchange, the notice also would need
to include the credit support annex/netting agreement ID.
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7. Application of Proposed Rule 15Fi-3 to Cleared Security-Based Swaps
Pursuant to proposed Rule 15Fi-3(d), the new requirements regarding
portfolio reconciliation would not apply to a ``clearing transaction''
which, pursuant to existing Rule 15Fi-1(c) under the Exchange Act, is
defined as a security-based swap that has a clearing agency as a direct
counterparty.\58\ Notwithstanding this provision, the Commission
understands that some parties may offer portfolio reconciliation
services with respect to OTC derivative transactions novated to a
clearing agency. Although the Commission recognizes the importance of
reconciling the terms of security-based swap transactions between a
clearing member (either acting on its own behalf or for the benefit of
a customer) and the clearing agency, we preliminarily believe that the
issue of reconciling the terms of cleared trades is more appropriately
addressed by the rules governing a clearing agency's risk management
practices, as well as by the documentation governing the relationship
between a clearing agency and its members.
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\58\ See proposed Rule 15Fi-3(d). Under existing Rule 15Fi-1(b)
under the Exchange Act (which would be renumbered as Rule 15Fi-1(c)
under the proposed rules), the term ``clearing agency'' means a
clearing agency registered with the Commission pursuant to Section
17A of the Exchange Act and provides central counterparty services
for security-based swap transactions. See also Trade Acknowledgement
and Verification Adopting release, 81 FR at 39820-21 (explaining the
agency and principal models of clearing in the context of providing
a comparable exception from the trade acknowledgement and
verification requirements).
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8. Comments Requested
The Commission generally requests comments on all aspects of
proposed Rule 15Fi-3, as well as any definitions in Rule 15Fi-1 that
are used in proposed Rule 15Fi-3. In addition, the Commission requests
comments on the following specific issues:
Do commenters agree with the three activities comprising
the scope of the Commission's proposed definition of ``portfolio
reconciliation''? Why or why not?
Do you agree that the scope of the proposed definition of
``material terms'' for purposes of the portfolio reconciliation
requirements in proposed Rule 15Fi-3 should be coterminous with the
terms of a security-based swap that must be reported to an SDR under
Regulation SBSR? Why or why not? Do you believe that there are any
terms that must be reported to an SDR that should not be subject to the
proposed portfolio reconciliation requirements? If so, which term(s)
and why?
As opposed to using a fixed definition of ``material
terms,'' should the Commission adopt a more flexible definition? For
example, are there other uses of materiality, such as with regard to
the disclosure of information in registration statements (including
accounting statements) or proxy solicitations that would be useful to
include? Why or why not?
Do you agree with the Commission's preliminary approach of
allowing SBS Entities to exclude certain information from the
definition of ``material terms'' after a transaction is reconciled the
first time so long as the excluded terms are not relevant to the
ongoing rights and obligations of the parties and the valuation of the
security-based swap? Alternatively, should the definition be revised to
conform to the corresponding CFTC definition, which excludes certain
terms for purposes of all portfolio reconciliations? Why or why not?
With respect to either approach, which terms should be excluded and
why? For example, should the final definition include as rule text some
or all of the specific data elements
[[Page 4623]]
excluded from the CFTC's definition? Which ones and why? By contrast,
are there any terms that would be excluded for purposes of subsequent
reconciliations under the proposed approach that should also be
excluded from the initial reconciliation? Which ones and why?
Do commenters agree with the decision to use the existing
definition of ``business day'' (as currently in effect for the
security-based swap trade acknowledgement and verification
requirements) for purposes of the portfolio reconciliation requirements
in proposed Rule 15Fi-3? If not, why not and how should that definition
be modified for purposes of the proposed portfolio reconciliation
requirements? For example, should the definition specify which
jurisdiction's legal holidays are the default for specifying which
holidays are not included in the definition of ``business days''? Would
the differences between the proposed definition of ``business day'' and
the corresponding CFTC definition (which includes ``any day other than
a Sunday or holiday'') create any practical difficulties for dual SEC-
CFTC registrants? If so, what are they? Should the Commission instead
adopt a definition of ``business day'' that mirrors the CFTC
definition? Why or why not?
Do commenters agree with the proposed approach of basing
the required frequency of portfolio reconciliation in proposed Rule
15Fi-3 on the type of counterparty involved (i.e., its status as an SBS
Entity) and on the size of the security-based swap portfolio? If not,
why not? If commenters believe that the proposed approach should be
retained, should any of the particular frequencies proposed (e.g.,
daily, weekly, quarterly, or annually) be modified to be either more or
less frequent?
Proposed Rule 15Fi-3 permits the portfolio reconciliation
exercises required thereunder to be performed by a third party, with
the only qualification being that the selection of that third party has
been agreed to by both of the parties in writing. As an alternative
approach, should the Commission instead establish specific requirements
for qualifying third parties that offer portfolio reconciliation
services used for compliance with the rule? If so, how should a third
party be deemed to be qualified to provide portfolio reconciliation
services and who should make such a determination?
Should the Commission's rules require two SBS Entities to
resolve a discrepancy in a material term ``immediately''? Why or why
not? Should the Commission define or provide an interpretation of the
term ``immediately,'' such as ``without undue delay,'' or, as an
alternative, specify a fixed period of time in the rule text within
which SBS Entities would be required to comply with proposed Rule 15Fi-
3(a)(4)? Why or why not and, if so, how much time should be provided?
Are there any current industry practices that relate to
how counterparties to swaps and security-based swaps resolve
discrepancies in a material term in the case of a dealer-to-dealer
transaction? If any such practices exist, please describe them,
including with regard to the length of time that it typically takes to
resolve these types of discrepancies. Are there particular material
terms for which a discrepancy typically takes a longer (or shorter)
amount of time to resolve? If so, which ones?
Should the Commission require SBS Entities to have
policies and procedures reasonably designed to resolve any discrepancy
in a valuation (with another SBS Entity) identified as part of a
portfolio reconciliation or otherwise as soon as possible, but in any
event within five business days after the date on which the discrepancy
is first identified? Why or why not? Should SBS Entities be provided
with more days to resolve these discrepancies? Should they have fewer
days?
Are there any current industry practices that relate to
how counterparties to swaps and security-based swaps resolve valuation
discrepancies in the case of a dealer-to-dealer transaction? If any
such practices exist, please describe them, including with regard to
the length of time that it typically takes to resolve these types of
discrepancies. Are there particular circumstances that typically make
valuation disputes more (or less) difficult and time-consuming to
resolve? If so, which ones?
Should the Commission require SBS Entities to have
policies and procedures reasonably designed to resolve any discrepancy
in a valuation or material term with a counterparty that is not an SBS
Entity (identified either as part of a portfolio reconciliation or
otherwise) in a timely fashion? Why or why not? Should the Commission
define or provide an interpretation of the term ``timely fashion,'' or,
as an alternative, specify a fixed period of time in the rule text
within which SBS Entities would be required to comply with proposed
Rule 15Fi-3(b)(4)? Why or why not and, if so, how much time should be
provided? In suggesting potential timeframes, we note that the period
for resolving discrepancies in a valuation or material term with non-
SBS Entities should likely not be shorter than the five business days
provided in the parallel requirement applicable to valuation
discrepancies between two SBS Entities. Should the Commission look at
any other similar provisions under the federal securities laws
addressing dispute resolution procedures as a guide for determining the
amount of time that an SBS Entity should be provided to resolve
discrepancies pursuant to proposed Rule 15Fi-3(b)(4)? If so, which
ones?
Are there any current industry practices that relate to
how counterparties to swaps and security-based swaps resolve
discrepancies in a valuation or material term in the case of a
transaction between a dealer and a non-dealer? If any such practices
exist, please describe them, including with regard to the length of
time that it typically takes to resolve these types of discrepancies.
Are there particular terms for which a discrepancy typically takes a
longer (or shorter) amount of time to resolve? If so, which ones? In
this context, should valuation discrepancies be treated differently
than discrepancies in some (or all) material terms? If so, which ones
and why?
Do you agree with the Commission's proposed approach of
deeming valuation differences of less than 10% not to be discrepancies
for purposes of requiring resolution under either proposed Rule 15Fi-
3(a)(5) or (b)(4)? If not, why not and how should the rules address the
resolution of valuation differences? Should the threshold be based on
the actual dollar amount of the valuation difference (or the related
currency equivalent) instead of being expressed as a percentage of the
difference of the two amounts?
How has the 10% threshold functioned in the context of
CFTC rules applicable to Swap Entities? Has that threshold been under-
inclusive, in the sense that it may not identity a sufficient number of
swap valuation discrepancies that could affect performance under the
swap transaction? Why or why not? By contrast, has the CFTC's 10%
threshold been over-inclusive, in the sense that it has captured swap
valuation discrepancies that typically would not affect performance
under the swap transaction? Why or why not?
Proposed Rule 15Fi-3(c) would require SBS Entities to
promptly notify the Commission, in a form and manner acceptable to the
Commission, and any applicable prudential regulator of any security-
based swap valuation dispute in excess of $20,000,000 (or its
[[Page 4624]]
equivalent in any other currency) if not resolved within either three
business days, if the dispute is with a counterparty that is an SBS
Entity, or five business days, if the dispute is with a counterparty
that is not an SBS Entity. Do commenters agree with this requirement?
Why or why not? As an alternative, should the Commission instead
require SBS Entities to make and keep records of these unresolved
disputes? Why or why not? Is $20,000,000 the appropriate threshold for
notifying the Commission of unresolved disputes? If not, should the
threshold be higher or lower? Should the threshold instead be expressed
as a percentage? Do commenters agree with the proposed timeframes for
submitting such a report? If not, should they be increased or
decreased?
Should the Commission establish a specific process for how
SBS Entities would need to provide notices of valuation disputes to the
Commission pursuant to proposed Rule 15Fi-3(c)? If so, how should such
notices be provided? For example, should the Commission require that
such notices be submitted in electronic format through the EDGAR system
(or any successor system thereto, as designated by the Commission)? Why
or why not? Alternatively, should the Commission create a dedicated
email box to accept such notices in letter format? Why or why not?
Should these notices be submitted on a confidential basis? If so, how
would that affect the potential delivery options?
As discussed above, the NFA has issued an interpretive
notice to NFA Compliance Rule 2-49 and a separate notice to its members
that, together, specify the timing, frequency, and contents for
submitting notices of swap valuation disputes pursuant to CFTC Rule
23.502(c).\59\ Should the Commission consider incorporating some or all
of those requirements into proposed Rule 15Fi-3(c) at adoption? If so,
which ones and why, and should any of the requirements promulgated by
the NFA be modified as part of the process of incorporating them into
the Commission's rules to account for differences between the swap and
security-based swap markets?
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\59\ See supra notes 52-57 and accompanying text.
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Do commenters agree with the proposed exception from the
reconciliation requirement for clearing transactions? Why or why not?
Because the definition of ``clearing transactions'' only includes
transactions cleared at a clearing agency registered with the
Commission pursuant to Section 17A of the Exchange Act, security-based
swaps cleared at a foreign clearing agency that is not registered with
the Commission would not be deemed to be ``cleared'' for these
purposes, and would therefore be subject to proposed Rule 15Fi-3.
Should the Commission modify the scope of the exception for cleared
security-based swaps, such as by including transactions that are
cleared at a clearing agency that is not registered with the Commission
pursuant to Section 17A of the Exchange Act, whether because of an
applicable exemption from registration or because the Exchange Act does
not cover the activities of the clearing agency? Why or why not?
With respect to any Swap Entity that could potentially
register with the Commission as an SBS Entity, would the portfolio
reconciliation protocols (or any other applicable documentation)
already in existence with respect to CFTC Rule 23.502 satisfy the
requirements in proposed Rule 15Fi-3? Why or why not? Should proposed
Rule 15Fi-3 be modified to account for the way that market participants
have designed their existing protocols (or any other applicable
documentation) to be compliant with the CFTC's rules? Why or why not?
For the purposes of compliance with the proposed portfolio
reconciliation rules, should the Commission allow compliance with the
CFTC's parallel requirements for some period of time to allow dual SEC-
CFTC registrants to conform their existing portfolio reconciliation
protocols (or any other applicable documentation) following the
adoption of proposed Rule 15Fi-3? If so, on what factors should that
reliance be conditioned and how long of a compliance period should be
provided? In the alternative, should the Commission delay compliance
with, or establish phased compliance deadlines for, some or all of
these requirements? Please explain the nature of any compliance
challenges (including any additional documentation requirements), and
the basis for any suggested compliance period.
As previously noted, proposed Rule 15Fi-3 has been
designed to be as consistent as possible with CFTC Rule 23.502, which
imposes portfolio reconciliation requirements on Swap Entities, in
order to avoid requiring dual SEC-CFTC registrants to incur additional
systems or compliance costs due to differences between the two
agencies' approaches. To the extent that any such differences remain,
should the Commission consider, for any firm dually-registered as both
an SBS Entity and Swap Entity (regardless of whether such firm is also
registered with the Commission as a broker-dealer or with the CFTC as a
futures commission merchant), permitting such firm to comply with
proposed Rule 15Fi-3 on an ongoing basis by complying with CFTC Rule
23.502, as if such rule applied to security-based swaps? If so, what
conditions, if any, should be placed on such reliance?
Should SBS dealers and major SBS participants be treated
the same for purposes of the portfolio reconciliation requirements in
proposed Rule 15Fi-3? Why or why not?
C. Rule 15Fi-4 (Portfolio Compression)
1. Overview of Portfolio Compression
Portfolio compression generally refers to a post-trade processing
exercise that allows two or more market participants to eliminate
redundant derivatives transactions within their portfolios in a manner
that does not change their net exposure. Compression exercises
typically take place in ``cycles,'' whereby each participating
counterparty designates particular contracts within its portfolio as
being eligible for compression and specifies its risk tolerances with
respect to the composition of its derivatives portfolio following
completion of the cycle.\60\ Following an analysis of the submitted
contracts, counterparties may be provided with the option of
terminating or modifying those contracts and replacing them with a
smaller number of substantially similar contracts. In most cases, the
gross notional value of the replacement and remaining contracts is
reduced, although the counterparty's net exposure typically remains the
same.\61\
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\60\ See, e.g., ISDA Study, Interest Rate Swaps Compression: A
Progress Report, (Feb. 2012), available at: http://www2.isda.org/attachment/NDAzMw==/IRS%20compression%20progress%20report%20-%20Feb%202012.pdf.
\61\ In 2011, the Commission issued an order granting temporary
exemptions from the requirement to register as a clearing agency
under Section 17A of the Exchange Act for entities providing certain
clearing services for security-based swaps including, among other
things, tear-up and compression services. That order contains
general descriptions of the portfolio compression process, based on
discussions between Commission staff and market participants prior
to the issuance of the exemptive order. See Order Pursuant to
Section 36 of the Securities Exchange Act of 1934 Granting Temporary
Exemptions from Clearing Agency Registration Requirements under
Section 17A(b) of the Exchange Act for Entities Providing Certain
Clearing Services for Security-Based Swaps, Exchange Act Release No.
64796 (Jul. 1, 2011), 76 FR 39963 (Jul. 7, 2011) (``Clearing
Services Exemptive Order'').
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By reducing the total number of open contracts, portfolio
compression is intended to help market participants manage their post-
trade risks in a number of important ways. For example, two or more
counterparties
[[Page 4625]]
that are active in the OTC derivatives markets might have built up
positions in the same (or comparable) products that, when analyzed at
the portfolio level across all applicable counterparties, offset each
other. Eliminating these offsetting and redundant uncleared derivatives
transactions through compression--as measured both by the number of
contracts and total notional value--reduces a market participant's
gross exposure to its direct counterparties, including by eliminating
all exposure to certain counterparties.\62\ Reducing the total number
of outstanding contracts within a derivatives portfolio also provides
important operational benefits and efficiencies for market participants
in that there are fewer open contracts to manage, maintain, and settle,
resulting in fewer opportunities for processing errors, failures, or
other problems that could develop throughout the lifecycle of a
transaction.\63\ Accordingly, the Commission preliminarily believes
that the use of portfolio compression by SBS Entities, where
appropriate given the circumstances (and to the extent that such
activity is not already occurring), should provide important processing
improvements consistent with the overall framework of Section 15F(i) of
the Exchange Act.\64\
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\62\ See Darrell Duffie, Ada Li, and Theo Lubke, Policy
Perspectives of OTC Derivatives Market Infrastructure, FRBNY Staff
Report No. 424, dated Jan. 2010, as revised Mar. 2010, available at:
http://www.newyorkfed.org/research/staff_reports/sr424.pdf (``FRBNY
OTC Derivatives Report'') (``In some types of derivatives that are
not cleared, major market participants tend to build offsetting
positions with different counterparties, long with one set of
counterparties, and short with the others. In many cases, these
offsetting positions are redundant. They serve no useful business
purpose and create counterparty risk. Market participants should
continue to engage in regular market-wide portfolio compression
exercises in order to eliminate these redundant positions.''). See
also, John Kiff, et al., Credit Derivatives: Systemic Risks and
Policy Options, IMF Working Paper No. 254 (Nov. 2009), available at:
http://www.imf.org/external/pubs/ft/wp/2009/wp09254.pdf
(``Multilateral netting, typically operationalized via `tear-up' or
`compression' operations that eliminate redundant contracts, reduces
both individual and system counterparty credit risk.'').
\63\ See Portfolio compression platform launched to reduce CDS
operational risk, Hedgeweek (Sept. 8, 2008) (explaining that a
portfolio compression platform ``reduces operational risk while
leaving market risk profiles unchanged,'' which is achieved ``by
terminating existing trades and replacing them with a smaller number
of new replacement trades that carry the same risk profile and cash
flows as the initial portfolio but have less capital exposure'').
\64\ See 15 U.S.C. 78o-8 (requiring SBS Entities to ``conform
with such standards as may be prescribed by the Commission, by rule
or regulation, that relate to timely and accurate confirmation,
processing, netting, documentation, and valuation of all security-
based swaps'').
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2. Scope of Proposed Rule 15Fi-4--Portfolio Compression Exercises
For purposes of proposed Rule 15Fi-4 under the Exchange Act, the
phrase ``portfolio compression exercise'' would generally refer to an
exercise by which security-based swap counterparties wholly terminate
or change the notional value of some or all of the security-based swaps
submitted by the counterparties for inclusion in the portfolio
compression exercise and, depending on the methodology employed,
replace the terminated security-based swaps with other security-based
swaps whose combined notional value (or some other measure of risk) is
less than the combined notional value (or some other measure of risk)
of the terminated security-based swaps in the exercise.\65\ In order to
incorporate that concept into the proposal, the Commission is proposing
to amend Rule 15Fi-1 to create definitions for both ``bilateral
portfolio compression exercise'' \66\ and ``multilateral portfolio
compression exercise.'' \67\ These two definitions are nearly
identical, with the sole difference being that the former would apply
to a portfolio compression exercise that includes only two security-
based swap counterparties, while the latter would refer to a portfolio
compression exercise that includes more than two security-based swap
counterparties.\68\
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\65\ The corresponding CFTC rule is 17 CFR 23.503. The structure
of the CFTC rule, including the subsections, mirrors the structure
of proposed Rule 15Fi-4.
\66\ See proposed Rule 15Fi-1(a). The corresponding CFTC
definition is in 17 CFR 23.500(b).
\67\ See proposed Rule 15Fi-1(j). The corresponding CFTC
definition is in 17 CFR 23.500(h).
\68\ As noted below in Section I.C.4, proposed Rule 15Fi-4 is
applicable only to uncleared security-based swaps.
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Under proposed Rule 15Fi-4(a), SBS Entities would be required to
establish, maintain, and follow written policies and procedures for
periodically engaging in both bilateral portfolio compression exercises
and multilateral portfolio compression exercises, in each case when
appropriate, with any counterparties that are SBS Entities.\69\ To the
extent that an SBS Entity transacts with counterparties that are not
SBS Entities, proposed Rule 15Fi-4(b) provides that the policies and
procedures required under the proposed rule would require that
portfolio compression exercises occur when appropriate \70\ and only to
the extent requested by any such counterparty.\71\
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\69\ See proposed Rules 15Fi-4(a)(2) and (3).
\70\ CFTC Rule 23.503(b), which is the corresponding CFTC
compression rule applicable to transactions with counterparties that
are not SBS Entities does not contain the caveat that the
compression or offset covered by the applicable policies and
procedures would only need to occur ``when appropriate.'' Rather, we
preliminarily believe it to be prudent to allow an SBS Entity to
engage in bilateral offset or compression exercises (to the extent
requested by its non-SBS Entity counterparty) only in circumstances
when doing so was appropriate for the SBS Entity in light of the
particular facts and circumstances involved, recognizing of course
that such discretion should not be used by the SBS Entity
arbitrarily not to honor the request by its counterparty. Below we
solicit comment on this difference.
\71\ See proposed Rule 15Fi-4(b). As we noted in discussing the
proposed portfolio reconciliation requirements, the Commission
preliminarily believes it to be appropriate to impose more
prescriptive requirements in cases where both entities are subject
to the SEC's requirements for registered entities.
\72\ The one exception to this statement is the requirement in
both proposed Rules 15Fi-4(a)(2) and (a)(3) that such policies and
procedures address the evaluation of portfolio compression exercises
that are initiated, offered, or sponsored by any third party. The
Commission preliminarily believes that the decision of which party
to use (or not use) to conduct a compression exercise is of critical
importance to the overall determination of whether to participate in
compression. Although the Commission takes no position with respect
to the type or identity of the party used to conduct a compression
exercise, we recognize that a number of parties are currently
offering such services, including third-party vendors and some self-
regulatory organizations (e.g., clearing agencies). The Commission
also understands that there may be some instances where compression
could be performed without the use of a third-party service
provider.
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The proposed definitions of ``bilateral portfolio compression
exercise'' and ``multilateral portfolio compression exercise'' are
designed to be sufficiently broad as to provide market participants
with maximum flexibility when complying with proposed Rule 15Fi-4,
while also retaining the key elements necessary to achieve the
important risk reducing benefits previously discussed--namely the
reduction of counterparty and operational risk achieved by terminating
offsetting security-based swap transactions. Accordingly, we are not
proposing specific requirements as to the contents of the policies and
procedures created to comply with these rules.\72\ In addition, for
consistency with the rules applicable to Swap Entities, these
definitions are substantively identical to the CFTC's corresponding
definitions, which we preliminarily believe are appropriately scoped
and clear for purposes of proposed Rule 15Fi-4.
[[Page 4626]]
Rather, the Commission recognizes that a decision to engage in a
process that could ultimately result in the termination or modification
of existing contracts, and the potential entry into new ones, should be
made in accordance with policies and procedures that are tailored to
the specific risks and operations of the relevant SBS Entity. Such
policies and procedures should, in the Commission's view, be permitted
to take into account the specific risk tolerances of the regulated
entity, including with respect to such areas as operational, funding,
liquidity, and credit risk, and also reflect the possibility that firms
may have legitimate business reasons for maintaining certain offsetting
security-based swap positions, even if in theory they could be
compressed.
For example, the Commission understands that an SBS Entity might be
unable to participate in a particular portfolio compression exercise
that could result in it transacting with certain counterparties (e.g.,
because a counterparty poses an unacceptable level of credit risk), or
in certain types of transactions. To the extent that such limitations
exist and are reflected in the policies and procedures required
pursuant to proposed Rules 15Fi-4(a) and (b), an SBS Entity would be in
compliance with the proposed rules so long as it follows those policies
and procedures, even if it determines not to engage in a particular
compression exercise.
Finally, in comparing the requirements we are proposing today with
respect to bilateral and multilateral compression exercises with those
previously adopted by the CFTC, we note two differences that we believe
to be minor and technical in nature. First, CFTC Rule 23.503(a)(3)(i)
requires that any policies and procedures related to multilateral
portfolio compression address, among other things, participation in all
multilateral portfolio compression exercises required by CFTC
regulation or order. We have preliminarily determined not to include a
comparable requirement in proposed Rule 15Fi-4(a)(3). Although the
Commission would expect that any comprehensive policy or procedure
would, as a matter of course, reflect any applicable laws and
regulations expressly mandating participation in certain types of
portfolio compression exercises, there are currently no Commission
regulations or orders mandating participation in any particular type of
portfolio compression exercise, and we are reluctant to include a
requirement that could lead to confusion by suggesting that such
regulations or orders exist.
Second, CFTC Rule 23.503(a)(3)(ii) requires that any policies and
procedures related to multilateral portfolio compression exercises
evaluate, among other things, any services that are initiated, offered,
or sponsored by any third party.\73\ The CFTC did not, however, include
such a requirement in the corresponding requirement related to policies
and procedures addressing bilateral portfolio compression
exercises.\74\ Although the inclusion of a specific requirement in the
rule should not be interpreted as creating an exhaustive list of what
we would expect to see included in the policies and procedures, we
understand that bilateral portfolio compression services are currently
being offered by third-party vendors. Evaluating those services would
seem to be a natural part of the process of broadly analyzing the
applicability of bilateral compression in general. Therefore, we are
proposing to expressly include a similar requirement in both proposed
Rules 15Fi-4(a)(2) (policies and procedures regarding bilateral
compression) and 15Fi-4(a)(3) (policies and procedures regarding
multilateral compression).
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\73\ See 17 CFR 23.503(a)(3)(ii).
\74\ See 17 CFR 23.503(a)(2).
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3. Scope of Proposed Rule 15Fi-4--Bilateral Offset
As we previously noted, the Commission has preliminarily made the
determination not to suggest a preference as to the use of any
particular type of compression, or as to the type or identity of the
party conducting the exercise and has, instead, proposed broad
definitions of the terms ``bilateral portfolio compression exercise''
and ``multilateral portfolio compression exercise.'' In addition, the
Commission recognizes that there may be other ways for market
participants to reduce the size of their derivatives portfolios that
may not be considered to be ``portfolio compression exercises'' for
purposes of those two proposed definitions.
In light of those considerations, proposed Rule 15Fi-4(a)(1) would
require each SBS Entity to establish, maintain, and follow written
policies and procedures for terminating each ``fully offsetting
security-based swap'' that it maintains with another SBS Entity in a
timely fashion, when appropriate.\75\ To the extent that an SBS Entity
transacts with a counterparty that is not an SBS Entity, the
requirements of proposed Rule 15Fi-4(b) would be identical to those in
proposed Rule 15Fi-4(a)(1), except that the required policies and
procedures would only need to address engaging in bilateral offset when
appropriate and to the extent requested by the counterparty. The
Commission preliminarily believes that by not proposing prescriptive
requirements as to the form of bilateral offset that would need to be
reflected in an SBS Entity's policies and procedures, the proposed rule
would allow the counterparties flexibility in the manner in which they
reduce the size of their security-based swap portfolios in light of
each counterparty's unique risks and operations.
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\75\ The Commission also is proposing to amend Rule 15Fi-1 to
add the term ``fully offsetting security-based swaps,'' which would
be defined as ``security-based swaps of equivalent terms where no
net cash flow would be owed to either counterparty after the offset
of payment obligations thereunder.'' See proposed Rule 15Fi-1(h).
For consistency with the rules applicable to Swap Entities, this
definition is substantively identical to the CFTC's corresponding
definition in 17 CFR 23.500(f), which we preliminarily believe is
appropriately scoped and clear for purposes of proposed Rule 15Fi-4.
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In addition, the proposed rules regarding bilateral offset have
been designed to reflect the Commission's understanding that firms may
have legitimate business reasons for maintaining fully offsetting
security-based swap transactions. As such, proposed Rules 15Fi-4(a)(1)
and (b) would require a firm's policies and procedures to address the
termination of fully offsetting security-based swaps only ``when
appropriate.''
Finally, for purposes of proposed Rules 15Fi-4(a)(1) and (b), the
Commission would generally consider an SBS Entity to have terminated
each fully offsetting security-based swap in a ``timely fashion'' so
long as (1) termination of the offsetting security-based swaps occurs
within a period that is reasonable in light of the circumstances of
each particular transaction and (2) the relevant SBS Entity is
otherwise in compliance with its policies and procedures regarding
bilateral offset.
4. Application of Proposed Rule 15Fi-4 to Cleared Security-Based Swaps
Pursuant to proposed Rule 15Fi-4(c), the new requirements regarding
portfolio compression would not apply to a ``clearing transaction''
which, pursuant to existing Rule 15Fi-1(c) under the Exchange Act, is
defined as a security-based swap that has a clearing agency as a direct
counterparty.\76\ Notwithstanding this provision, the Commission
recognizes that portfolio compression is not limited to uncleared
[[Page 4627]]
swaps and that compression services may be offered either by a clearing
agency itself or by a third-party vendor that works collaboratively
with the clearing agency.\77\ Although the risk-reducing benefits that
could be realized through the compression of cleared security-based
swaps, we preliminarily believe that the issue of whether and when
compression should occur within a clearing agency is best addressed by
the rules governing the clearing agency's risk management practices, as
well as by the documentation governing the relationship between the
clearing agency and its members.\78\
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\76\ See supra note 58 and accompanying text.
\77\ Notwithstanding the applicability of the requirements of
proposed Rule 15Fi-4, the Commission reminds any third parties
performing compression or offset services to keep in mind any
potential requirements under other provisions of the securities
laws. For example, the Commission has stated that the provision of
tear-up and compression services for security-based swaps would
qualify these participants as clearing agencies and therefore
trigger the statutory requirement to register as clearing agencies
pursuant to Section 17A of the Exchange Act, absent exemptive relief
(which the Commission provided on a conditional temporary basis in
July 2011). See Clearing Services Exemptive Order, 76 FR at 39964.
\78\ The corresponding CFTC rule is 17 CFR 23.503(c).
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5. Comments Requested
The Commission generally requests comments on all aspects of
Proposed Rule 15Fi-4 (and any related definitions). In addition, the
Commission requests comments on the following specific issues:
Do commenters agree with the scope of the Commission's
approach of proposing broad definitions of ``bilateral portfolio
compression exercise'' and ``multilateral portfolio compression
exercise''? Why or why not?
Should SBS Entities be required to have policies and
procedures in place for terminating fully offsetting security-based
swaps in a timely fashion? Why or why not? Do you agree with the
proposed interpretation of the term ``timely fashion'' to mean that the
relevant security-based swaps should be terminated within a period that
is reasonable in light of the circumstances of each particular
transaction (so long as the relevant SBS Entity is otherwise in
compliance with its policies and procedures regarding bilateral
offset)? Why or why not? Should the Commission instead specify a fixed
period of time for the required termination of these security-based
swaps? Why or why not?
With respect to any Swap Entity that could potentially
register with the Commission as an SBS Entity, would the portfolio
compression protocols (or any other applicable documentation) already
in existence with respect to CFTC Rule 23.503 satisfy the requirements
in proposed Rule 15Fi-4? Why or why not? Should proposed Rule 15Fi-4 be
modified to account for the way that market participants have designed
their existing protocols (or any other applicable documentation) to be
compliant with the CFTC's rules? Why or why not? For the purposes of
compliance with the proposed portfolio compression rules, should the
Commission allow compliance with the CFTC's parallel requirements for
some period of time to allow dual SEC-CFTC registrants to conform their
existing portfolio compression protocols (or any other applicable
documentation) following the adoption of proposed Rule 15Fi-4? If so,
on what factors should that reliance be conditioned and how long of a
compliance period should be provided? In the alternative, should the
Commission delay compliance with, or establish phased compliance
deadlines for, some or all of these requirements? Please explain the
nature of any compliance challenges (including any additional
documentation requirements), and the basis for any suggested compliance
period.
As previously noted, proposed Rule 15Fi-4 has been
designed to be as consistent as possible with CFTC Rule 23.503, which
imposes portfolio compression requirements on Swap Entities, in order
to avoid requiring dual SEC-CFTC registrants to incur additional
systems or compliance costs due to differences between the two
agencies' approaches. To the extent that any such differences remain,
should the Commission consider, for any firm dually-registered as both
an SBS Entity and Swap Entity (regardless of whether such firm is also
registered with the Commission as a broker-dealer or with the CFTC as a
futures commission merchant), permitting such firm to comply with
proposed Rule 15Fi-4 on an ongoing basis by complying with CFTC Rule
23.503, as if such rule applied to security-based swaps? If so, what
conditions, if any, should be placed on such reliance?
Do commenters agree with the proposed exception from the
compression requirements in proposed Rule 15Fi-4 for clearing
transactions? Why or why not? Because the definition of ``clearing
transactions'' only includes transactions cleared at a clearing agency
registered with the Commission pursuant to Section 17A of the Exchange
Act, security-based swaps cleared at a foreign clearing agency that is
not registered with the Commission would not be deemed to be
``cleared'' for these purposes, and would therefore be subject to
proposed Rule 15Fi-4. Should the Commission modify the scope of the
exception for cleared security-based swaps, such as by including
transactions that are cleared at a clearing agency that is not
registered with the Commission pursuant to Section 17A of the Exchange
Act, whether because of an applicable exemption from registration or
because the Exchange Act does not cover the activities of the clearing?
Why or why not?
Proposed Rule 15Fi-4(b) requires each SBS Entity to
establish, maintain, and follow written policies and procedures for
periodically terminating fully offsetting security-based swaps and for
engaging in bilateral or multilateral portfolio compression exercises
with respect to security-based swaps in which its counterparty is an
entity other than an SBS Entity, ``when appropriate'' and to the extent
requested by any such counterparty. CFTC Rule 23.503(b) does not
contain the ``when appropriate'' qualifier and provides only that a
Swap Entity's policies and procedures address engaging in bilateral
offset or compression exercises ``to the extent requested'' by a
counterparty that is not a Swap Entity. Would the Commission's proposed
approach create any practical difficulties for dual SEC-CFTC
registrants? If so, what are they? Should the Commission instead strike
the ``when appropriate'' qualifier in order to mirror the corresponding
CFTC requirement? Why or why not? To the extent that the Commission
were to follow the approach of CFTC Rule 23.503(b), should there be a
reasonableness standard to address situations when a request by a non-
SBS Entity counterparty to engage in bilateral offset or compression
exercises would be not be reasonable, such as a situation when doing so
could be detrimental to the SBS Entity? If so, under what conditions
should an SBS Entity be able to refuse a request from a non-SBS Entity
counterparty to engage in such activity pursuant to proposed Rule 15Fi-
4(b)?
What practices, if any, are currently being used (or are
currently under consideration) by market participants with respect to
the use of portfolio compression across asset classes? For example,
could a compression exercise occur with respect to two or more
counterparties maintaining portfolios of both single-name credit
default swaps (``CDS'') and index CDS? If so, should the Commission
modify proposed Rule 15Fi-4, or provide related interpretive guidance
to accommodate portfolio compression across asset classes?
[[Page 4628]]
Should SBS dealers and major SBS participants be treated
the same for purposes of the portfolio compression requirements in
proposed Rule 15Fi-4? Why or why not?
D. Rule 15Fi-5 (Trading Relationship Documentation)
1. Overview of Trading Relationship Documentation
Section 15F(i)(2) of the Exchange Act provides that the Commission
shall adopt rules governing documentation standards for SBS Entities.
Just as portfolio reconciliation is designed to allow counterparties to
manage their internal risks by better ensuring agreement with respect
to the terms of the transaction (and thereby avoiding complications at
various points throughout the life of the transaction),\79\ requiring
each SBS Entity to document the terms of the trading relationship with
each of its counterparties before executing a new security-based swap
transaction should promote sound collateral and risk management
practices by enhancing transparency and legal certainty regarding each
party's rights and obligations under the transaction. This, in turn,
should help to reduce counterparty credit risk and promote certainty
regarding the agreed-upon valuation and other material terms of a
security-based swap.\80\ Having adequate written documentation prior
to, or contemporaneously with, executing a security-based swap should
also facilitate the ability of the counterparties to engage in
portfolio reconciliation, as would be required under these proposed
rules, in an efficient and cost-effective manner.
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\79\ See supra Section I.B.1.
\80\ See, e.g., Sylvie A. Durham, Terminating Derivatives
Transactions: Risk Mitigation and Close-Out Netting Sec. 8:1 (Nov.
2010) (``[L]egal contractual provisions are the foundation on which
the rights and obligations of the parties are based, and sound
collateral and risk management practices may be ineffective if the
legal rights of the parties are not clearly set forth.'').
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2. Scope of Proposed Rule 15Fi-5
In light of the important risk mitigating factors described above,
the Commission is proposing Rule 15Fi-5, which establishes certain
requirements for SBS Entities related to the use of written trading
relationship documentation in connection with their security-based swap
transactions.\81\ Specifically, proposed Rule 15Fi-5(a)(2) would
require each SBS Entity to establish, maintain, and follow written
policies and procedures reasonably designed to ensure that it executes
written security-based swap trading relationship documentation with
each of its counterparties prior to, or contemporaneously with,
executing a security-based swap with any counterparty.\82\ The proposed
rule would further require that the policies and procedures required
thereunder be approved in writing by a senior officer of the SBS
Entity, and that a record of the approval be retained.\83\
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\81\ The corresponding CFTC rule is 17 CFR 23.504. The structure
of the CFTC rule, including the subsections, mirrors the structure
of proposed Rule 15Fi-5.
\82\ Among other exceptions discussed below in Section I.D.6,
proposed Rule 15Fi-5 is applicable only to uncleared security-based
swaps.
\83\ See proposed Rule 15Fi-5(b)(2). For purposes of this
requirement, the Commission preliminarily views the term ``senior
officer'' as covering only the most senior executives in the
organization, such as a firm's chief executive officer, chief
financial officer, chief legal officer, chief compliance officer,
president, or other person at a similar level. This approach is
similar to how the Commission has previously interpreted the term in
the context of other requirements applicable to SBS Entities. See
Registration Process for Security-Based Swap Dealers and Major
Security-Based Swap Participants, Exchange Act Release No. 75611
(Aug. 5, 2015), 80 FR 48964, 48968 n. 29 (Aug.14, 2015) (``SBS
Entity Registration Adopting Release''). By contrast, CFTC Rule
23.504 uses the term ``senior management,'' which is not further
defined in either CFTC Rules 23.500 or 23.504. We preliminarily view
this difference as a clarification and do not believe that it
represents a substantive difference between the two sets of rules,
but below we solicit comment on this issue.
---------------------------------------------------------------------------
Pursuant to proposed Rule 15Fi-5(b)(1), the required policies and
procedures would require that the security-based swap trading
relationship documentation be in writing. The policies and procedures
would also require that the documentation include all terms governing
the trading relationship between the SBS Entity and its counterparty,
including, without limitation, terms addressing payment obligations,
netting of payments, events of default or other termination events,
calculation and netting of obligations upon termination, transfer of
rights and obligations, allocation of any applicable regulatory
reporting obligations (including pursuant to Regulation SBSR),
governing law, valuation, and dispute resolution.\84\
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\84\ We note that CFTC Rule 23.504 does not contain a comparable
provision to the requirement in proposed Rule 15Fi-5(b)(1) that the
trading relationship documentation address ``applicable regulatory
reporting obligations (including pursuant to Regulation SBSR).'' The
Commission is proposing this requirement not only because of our
view that reporting arrangements should be clarified in advance, due
to the importance of ensuring that the transaction is reported
accurately and in a timely manner, but also because the inclusion of
such provision could potentially help to address an issue related to
how SDRs can verify the information that they receive, as discussed
in detail in Section I.E below.
---------------------------------------------------------------------------
For purposes of Rule 15Fi-5(b)(2), all trade acknowledgements and
verifications of security-based swap transactions required under Rule
15Fi-2 would be deemed to be security-based swap trading relationship
documentation, as they often may contain one or more terms contemplated
by the policies and procedures required by proposed Rule 15Fi-5.
Further, the Commission understands that in some transactions, the
parties may choose to document their trading relationship by using a
stand-alone ``long-form confirmation'' that includes all of the terms
governing the relationship. The proposed rule is not intended to
interfere with this practice. Accordingly, we preliminarily believe
that the use of a ``long-form confirmation'' would comply with proposed
Rule 15Fi-5 so long as such document is: (1) In written form and
includes all of the elements of the trading relationship required under
the rule (whether by incorporating them by reference from a standard
master agreement or by expressly restating them in the confirmation)
and (2) executed prior to, or contemporaneously with, the execution of
each relevant security-based swap.
The policies and procedures required by the proposed rule also
would require that the security-based swap trading relationship
documentation include credit support arrangements.\85\ Such credit
support would be required to contain, among other things and in
accordance with applicable requirements under regulations adopted by
the Commission or any prudential regulators,\86\ and without
limitation, the following:
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\85\ See proposed Rule 15Fi-5(b)(3).
\86\ See supra note 48.
---------------------------------------------------------------------------
Initial and variation margin requirements, if any;
types of assets that may be used as margin and asset
valuation haircuts, if any;
investment and re-hypothecation terms for assets used as
margin for uncleared security-based swaps, if any; and
custodial arrangements for margin assets, including
whether margin assets are to be segregated with an independent third
party, in accordance with Section 3E(f) of the Exchange Act, if
any.\87\
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\87\ 15 U.S.C. 78c-5(f).
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As the Commission has previously explained, ensuring that uncleared
OTC derivatives transactions are appropriately collateralized was one
of the key elements of the Title VII reforms.\88\ Accordingly, we
preliminarily believe that policies and procedures requiring
counterparties to
[[Page 4629]]
clearly document the applicable processes and requirements for
calculating and exchanging margin in connection with a security-based
swap transaction is an important step in achieving this broader
regulatory objective.
---------------------------------------------------------------------------
\88\ See supra Section I.B.1.
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3. Proposed Rule 15Fi-5(b)(4): Documenting Valuation Methodologies
As mentioned throughout this release, ensuring that security-based
swaps are accurately valued throughout the duration of a contract
should play an important role in protecting the integrity of the OTC
derivatives market, both at the level of an individual participant and
systemically across the broader financial market.\89\ Accordingly,
proposed Rule 15Fi-5(b)(4) would require that the applicable policies
and procedures provide that the relevant swap trading relationship
documentation between certain types of counterparties include written
documentation in which the parties agree on the process, which may
include any agreed upon methods, procedures, rules, and inputs, for
determining the value of each security-based swap at any time from
execution to the termination, maturity, or expiration of such security-
based swap for the purposes of complying with the margin requirements
under Section 15F(e) of the Exchange Act (and applicable
regulations),\90\ and the risk management requirements under Section
15F(j) of the Exchange Act (and applicable regulations).\91\ To the
maximum extent practicable, such valuations would need to be based on
recently-executed transactions, valuations provided by independent
third parties, or other objective criteria.\92\
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\89\ See id.
\90\ See 15 U.S.C. 78o-10(e). For the avoidance of doubt, the
requirements in proposed Rule 15Fi-5(b)(4) are intended to
facilitate agreement between an SBS Entity and its counterparty as
to how they will determine the value of a security-based swap in
order to, among other things, comply with the margin requirements
promulgated by either the Commission or, with respect to an SBS
Entity that is a bank, the applicable prudential regulator. These
requirements are not intended in any way to supersede those
underlying margin requirements.
\91\ See 15 U.S.C. 78o-10(j).
\92\ See proposed Rule 15Fi-5(b)(4)(i).
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The requirements in proposed Rule 15Fi-5(b)(4) regarding valuation
methodology would apply to security-based swap trading relationship
documentation entered into between: (1) Two SBS Entities; (2) an SBS
Entity and a ``financial counterparty;'' and (3) an SBS Entity and any
other counterparty, if requested by such counterparty. Accordingly, we
are also proposing to amend Rule 15Fi-1 to add a definition of
``financial counterparty,'' which would include any counterparty that
is not an SBS Entity and that is one of the following:
A swap dealer;
a major swap participant;
a commodity pool as defined in Section 1a(10) of the
Commodity Exchange Act (7 U.S.C. 1a(10));
a private fund as defined in Section 202(a)(29) of the
Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a));
an employee benefit plan as defined in paragraphs (3) and
(32) of Section 3 of the Employee Retirement Income Security Act of
1974 (29 U.S.C. 1002); and
a person predominantly engaged in activities that are in
the business of banking or, in activities that are financial in nature,
as defined in Section 4(k) of the Bank Holding Company Act of 1956 (12
U.S.C. 1843k).\93\
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\93\ See proposed Rule 15Fi-1(g). The corresponding definition
in CFTC Rule 23.500(e) is referred to as a ``financial entity.''. We
replaced the word ``entity'' with ``counterparty'' to avoid any
confusion due to the fact that there are other definitions of
``financial entity'' within the Exchange Act and its implementing
regulations. For example, term ``financial entity'' is used in
Section 3C(g) of the Exchange Act for purposes of the statutory
exception to the mandatory clearing requirement in Title VII. See 15
U.S.C. 78c-3(g)(3). Similarly, there is a definition of ``financial
entity'' in Rule 3a67-6 under the Exchange Act, which is used for
one of the tests for determining a person's status under the
definition of ``major security-based swap participant'' in Section
3(a)(67) of the Exchange Act. See 15 U.S.C. 78. Other than the
different titles, we do not believe that there are any substantive
differences between the CFTC's definition of ``financial entity''
and the proposed definition of ``financial counterparty.''
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Further, proposed Rule 15Fi-5(b)(4)(ii) has been designed to help
ensure that the required valuation documentation between SBS Entities
and their counterparties contains sufficient guidance and information
in the event of a problem with determining the value of a security-
based swap. Specifically, the documentation required by the applicable
policies and procedures must include either: (1) Alternative methods
for determining the value of the security-based swap for the purposes
of complying with proposed Rule 15Fi-5(b)(4) in the event of the
unavailability or other failure of any input required to value the
security-based swap for such purposes; or (2) a valuation dispute
resolution process by which the value of the security-based swap shall
be determined for the purposes of complying with the rule.\94\
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\94\ See proposed Rule 15Fi-5(b)(4)(ii).
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To the extent that the prescribed valuation documentation needs to
be updated, revised, or otherwise modified, proposed Rule 15Fi-
5(b)(4)(iv) provides that the parties may agree on changes or
procedures for modifying or amending such documentation at any
time.\95\ Finally, in recognition of the fact that valuation data and
methodologies often include, or may be based on, private information,
proposed Rule 15Fi-5(b)(4)(iii) makes clear that an SBS Entity is not
required to disclose to the counterparty confidential, proprietary
information about any model it may use to value a security-based swap.
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\95\ The text of CFTC Rule 23.504(b)(4)(iv), which is the
corresponding subsection under CFTC rules, provides that ``[t]he
parties may agree on changes or procedures for modifying or amending
the documentation required by this paragraph at any time.'' Proposed
Rule 15Fi-5(b)(4)(iv) does not contain the phrase ``required by this
paragraph.'' We view this to be solely a technical change and do not
intend for it to represent a substantive deviation from the
corresponding CFTC rule. Rather, the difference is intended to avoid
any suggestion that the parties could amend the underlying
requirements contained in proposed Rule 15Fi-5(b)(4).
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4. Proposed Rule 15Fi-5(b)(5) and (6): Other Disclosure Requirements
Proposed Rule 15Fi-5 also would require that the policies and
procedures governing the applicable trading relationship documentation
require an SBS Entity and its counterparty to disclose to each other
certain information regarding their legal and bankruptcy status, and to
include a statement regarding the status of a security-based swap if
accepted for clearing by a CCP. The first requirement relates to
whether the SBS Entity or its counterparty is subject to a particular
legal regime in the event of its failure, such as FDIC receivership for
banks or orderly liquidation for certain financial companies that meet
the requirements set forth in Title II of the Dodd-Frank Act.\96\ As
background, Title II of the Dodd-Frank Act provides for an alternative
insolvency regime for the ``orderly liquidation'' of large financial
companies,\97\ including broker-dealers,
[[Page 4630]]
that meet specified criteria (each a ``covered financial company'') as
set forth in Title II of the Dodd-Frank Act.\98\ If the covered
financial company is (1) a broker or dealer and (2) a member of the
Securities Investor Protection Corporation (``SIPC''), such ``covered
broker or dealer'' would be placed into an orderly liquidation
proceeding with the FDIC appointed as receiver.\99\ Because this
orderly liquidation process, which was modeled on the receivership
process used for failed banks, is different from the liquidation
regimes established under the Securities Investor Protection Act of
1970 \100\ or by the U.S. Bankruptcy Code,\101\ the Commission
preliminarily believes it to be appropriate to require counterparties
to a security-based swap transaction to disclose to each other whether
this alternative regime may potentially apply in the event of an
insolvency.
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\96\ See 12 U.S.C. 5382; 12 U.S.C. 5383.
\97\ The term ``financial company'' is defined in 12 U.S.C.
5381(a)(11) to include any company (as defined in 12 U.S.C.
5381(a)(5)) that--
(A) is incorporated or organized under any provision of Federal
law or the laws of any State;
(B) is--
(i) a bank holding company (as defined in 12 U.S.C. 1841(a));
(ii) a nonbank financial company supervised by the Federal
Reserve Board;
(iii) any company that is predominantly engaged in activities
that the Federal Reserve Board has determined are financial in
nature or incidental thereto for purposes of 12 U.S.C. 1843(k)
(other than a company described in clause (i) or (ii)); or
(iv) any subsidiary of any company described in any of clauses
(i) through (iii) that is predominantly engaged in activities that
the Federal Reserve Board has determined are financial in nature or
incidental thereto for purposes of 12 U.S.C. 1843(k) (other than a
subsidiary that is an insured depository institution or an insurance
company); and
(C) is not a Farm Credit System institution chartered under and
subject to the provisions of the Farm Credit Act of 1971, as amended
(12 U.S.C. 2001 et seq.), a governmental entity, or a regulated
entity, as defined under 12 U.S.C. 4502(20).
\98\ Section 203 of the Dodd-Frank Act sets forth the process
for designating a financial company as a ``covered financial
company.'' In the case of a broker-dealer, or when a financial
company's largest U.S. subsidiary is a broker-dealer, Section
203(a)(1)(B) provides that the Federal Reserve Board and the
Commission (in each case subject to the approval of a two-thirds
majority of each agency's members), in consultation with the FDIC,
may, either on their own initiative or at the request of the
Secretary of the U.S. Treasury (``Secretary''), issue a written
orderly liquidation recommendation to the Secretary. See 12 U.S.C.
5383(a). Section 203(b) requires the Secretary (after consultation
with the President) to take action on the recommendation upon an
affirmative determination that, among other things, the failure of a
financial company would have serious adverse effects on financial
stability in the United States and that taking action under the
orderly liquidation authority with respect to that company would
avoid or mitigate such adverse effects. See 12 U.S.C. 5383(b).
\99\ See 12 U.S.C. 5384. Section 205(a) of the Dodd-Frank Act
requires the FDIC, as the appointed receiver for any covered broker
or dealer, to appoint SIPC as trustee for the liquidation. See 12
U.S.C. 5385(a).
\100\ 15 U.S.C. 78aaa et seq.
\101\ 11 U.S.C. 101 et seq.
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Accordingly, proposed Rule 15Fi-5(b)(5) would require that each SBS
Entity's policies and procedures require that the security-based swap
trading relationship documentation contain a statement as to whether it
or its counterparty is an insured depository institution or financial
company. Further, the documentation also would need to contain a
statement that the orderly liquidation provisions of the Dodd-Frank Act
and the Federal Deposit Insurance Act \102\ may limit the rights of the
parties under their trading relationship documentation should either
party be deemed a ``covered financial company'' or is otherwise subject
to having the FDIC appointed as a receiver. The documentation would
further be required to state that such limitations relate to the right
of the non-covered party to terminate, liquidate, or net any security-
based swap by reason of the appointment of the FDIC as receiver,
notwithstanding the agreement of the parties in the security-based swap
trading relationship documentation, and of certain rights of the FDIC
to transfer security-based swaps of the covered party. Finally, the
policies and procedures would require that the trading relationship
documentation contain an agreement between the SBS Entity and its
counterparty to provide notice if either it or its counterparty becomes
or ceases to be an insured depository institution or a financial
company.\103\
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\102\ 12 U.S.C. 1811 et seq.
\103\ Specifically, proposed Rule 15Fi-5(b)(5) would require
that an SBS Entity's policies and procedures require that the
applicable security-based swap trading relationship documentation
contain:
(A) A statement of whether the SBS Entity is an insured
depository institution (as defined in 12 U.S.C. 1813) or a financial
company (as defined in Section 201(a)(11) of the Dodd-Frank Act, 12
U.S.C. 5381(a)(11));
(B) A statement of whether the counterparty is an insured
depository institution or financial company;
(C) A statement that in the event either the SBS Entity or its
counterparty becomes a covered financial company (as defined in 12
U.S.C. 5381(a)(8)) or is an insured depository institution for which
the FDIC has been appointed as a receiver (the ``covered party''),
certain limitations under Title II of the Dodd-Frank Act or the
Federal Deposit Insurance Act may apply to the right of the non-
covered party to terminate, liquidate, or net any security-based
swap by reason of the appointment of the FDIC as receiver,
notwithstanding the agreement of the parties in the security-based
swap trading relationship documentation, and that the FDIC may have
certain rights to transfer security-based swaps of the covered party
under Section 210(c)(9)(A) of the Dodd-Frank Act, 12 U.S.C.
5390(c)(9)(A), or 12 U.S.C. 1821(e)(9)(A); and
(D) An agreement between the SBS Entity and its counterparty to
provide notice if either it or its counterparty becomes or ceases to
be an insured depository institution or a financial company.
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Second, the policies and procures required pursuant to proposed
Rule 15Fi-5(b)(6) would require the security-based swap trading
relationship documentation of each SBS Entity disclose certain
information regarding the status of a security-based swap accepted for
clearing by a clearing agency. Specifically, such documentation would
need to contain a notice that, upon acceptance of a security-based swap
by a clearing agency:
The original security-based swap is extinguished;
The original security-based swap is replaced by equal and
opposite security-based swaps with the clearing agency; and
All terms of the security-based swap shall conform to the
product specifications of the cleared security-based swap established
under the clearing agency's rules.
The Commission preliminarily believes that this disclosure should
provide important information to counterparties regarding the effects
of clearing a trade at a clearing agency and clarify the status of the
contract following its acceptance and novation at the clearing agency.
5. Proposed Rule 15Fi-5(c): Audit of Security-Based Swap Trading
Relationship Documentation
Proposed Rule 15Fi-5(c) would require each SBS Entity to have an
independent auditor conduct periodic audits sufficient to identify any
material weakness in its documentation policies and procedures required
by the rule. The proposal also would require that a record of the
results of each audit be retained for a period of three years after the
conclusion of the audit.\104\ The Commission preliminarily believes
that requiring periodic audits of a firm's security-based swap trading
relationship documentation is consistent with sound risk mitigation
practices and is designed to reduce the prevalence of discrepancies
during the course of these transactions. This proposed requirement
differs slightly from CFTC Rule 23.504(c), which references an
independent ``internal or external'' auditor.\105\
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\104\ The three year holding period for these records is
contained in the applicable recordkeeping, reporting, and
notification requirements for SBS Entities, as opposed to in
proposed Rule 15Fi-5(c) itself.
\105\ See 17 CFR 23.504(c). In the Commission's experience
overseeing accounting and auditing standards in the context of
certain disclosure requirements under the federal securities laws,
an internal auditor typically reports to the management of the
applicable entity, which would be inconsistent with the Commission's
auditor independence rules. See Rule 2-01(c)(2) of Regulation S-X
(Employment Relationships). 17 CFR 210.2-01(c). At the same time, we
are not foreclosing the possibility that there could be alternative
structures to the typical ``internal'' auditor employment
relationship that could, if structured properly, not be inconsistent
with the Commission's auditor independence rules and request comment
below identifying and describing such potential structures.
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[[Page 4631]]
6. Exceptions to the Trading Relationship Documentation Requirements
Proposed Rule 15Fi-5(a)(1) would establish three different
exceptions from the basic requirement that each SBS Entity establish,
maintain, and follow written policies and procedures reasonably
designed to ensure that it executes written security-based swap trading
relationship documentation with each of its counterparties prior to, or
contemporaneously with, executing a security-based swap with any
counterparty. First, proposed Rule 15Fi-5(a)(1)(i) would provide an
exception for security-based swaps executed prior to the date on which
an SBS Entity is required to be in compliance with the documentation
rule. Although the Commission recognizes the significant risk
mitigation benefits associated with ensuring that all transactions are
supported by comprehensive and accurate documentation, we also
understand that it may be impractical to require SBS Entities to have
policies and procedures to bring existing transactions into compliance
with these proposed rules, particularly when weighing any potential
benefits of doing so against the potential costs. Accordingly, we
preliminarily believe that those transactions should be excepted from
the proposed documentation requirements.\106\
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\106\ As discussed in detail in Section I.F.1 of this release,
the Commission also is proposing amendments to Rule 17a-4 and to
proposed Rule 18a-6 that would, among other things, require SBS
Entities to retain all security-based swap trading relationship
documentation with counterparties required to be created under
proposed Rule 15Fi-5. Because security-based swaps executed prior to
the date on which an SBS Entity is required to be in compliance with
proposed Rule 15Fi-5 would be exempt from the underlying
documentation requirement, any trading relationship documentation
voluntarily entered into in respect of those transactions would not
be deemed to have been created pursuant to proposed Rule 15Fi-5.
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To the extent that an SBS Entity maintains an existing security-
based swap portfolio with a counterparty that pre-dates the compliance
date, proposed Rule 15F-5(a)(1)(i) would provide an exception from the
documentation requirements only with respect to those existing
transactions. This means that the SBS Entity would not be in violation
of Rule 15Fi-5 solely as a result of having policies and procedures
that do not require such SBS Entity to have executed written security-
based swap trading relationship documentation with any counterparty
with respect to those existing transactions, or if the existing
documentation that it maintains with the counterparty does not
otherwise comply with the requirements of the rule. However, if the SBS
Entity enters into new security-based swap transactions with the
counterparty, the exception would not apply to those new trades, even
if trading relationship documentation already existed. Under those
circumstances, the SBS Entity's policies and procedures would be need
to be reasonably designed to ensure that the existing documentation
complies with the proposed rule before using it as the basis to enter
into any new security-based swaps with that counterparty.
Second, proposed Rule 15Fi-5(a)(1)(ii) would provide an exception
for any ``clearing transaction'' which, pursuant to existing Rule 15Fi-
1(c), is defined as a security-based swap that has a clearing agency as
a direct counterparty.\107\ This exception is intended to recognize the
fact that once a security-based swap is cleared, the transaction is
governed primarily by the terms of the agreements in effect between the
clearing member and the clearing agency (as well as between the
clearing member and its customer, if applicable).
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\107\ See supra note 58 and accompanying text.
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Finally, proposed Rule 15Fi-5(a)(1)(iii) would provide an exception
for security-based swaps executed anonymously on a national securities
exchange or a security-based swap execution facility (``SBSEF''),
provided that:
Such security-based swaps are intended to be cleared and
are actually submitted for clearing to a clearing agency;
All terms of such security-based swaps conform to the
rules of the clearing agency; and
Upon acceptance of such security-based swap by the
clearing agency: (1) The original security-based swap is extinguished;
(2) the original security-based swap is replaced by equal and opposite
security-based swaps with the clearing agency; and (3) all terms of the
security-based swap shall conform to the product specifications of the
cleared security-based swap established under the clearing agency's
rules.
The exception in proposed Rule 15Fi-5(a)(1)(iii) is intended to
recognize the fact that the documentation requirements may be largely
impossible to comply with in the context of cleared anonymous
transactions by virtue of the fact that, by definition, the parties to
these transactions would not know the identity their counterparties.
Therefore, trading relationship documentation with any such
counterparty would be unnecessary and impractical.
The exception provided for in proposed Rule 15Fi-5(a)(1)(iii) is
limited--and therefore distinguishable from the exception for cleared
security-based swap transactions--in one important respect to account
for instances where a transaction is not accepted for clearing
following its submission. For example, an SBS Entity may enter into a
security-based swap transaction on an anonymous basis on a national
securities exchange or an SBSEF, fully intending for the transaction to
be submitted to, and cleared by, a clearing agency. In some cases, the
transaction may be rejected by the clearing agency for reasons which
the SBS Entity did not know (or had no reasonable basis to know) prior
to its submission, such as possible operational or clerical errors or
if one of the clearing members unintentionally exceeded its clearing
limits. If a bilateral transaction continues to exist between the two
counterparties (who would no longer be unknown to each other), written
trading relationship documentation governing that transaction might not
exist between them.
Under those circumstances, the Commission preliminarily believes
that the objectives of Rule 15Fi-5 would not be satisfied if the SBS
Entity and its counterparty did not ultimately have written agreement
on the terms of the remaining security-based swap transaction. At the
same time, however, because the transaction was initially entered into
on an anonymous basis, the two sides might need additional time to
agree to the terms of the trading relationship documentation,
particularly if they previously had not engaged in any other
transactions. Accordingly, the Commission is proposing that if an SBS
Entity that is relying on the exception in proposed Rule 15Fi-
5(a)(1)(iii) subsequently receives notice that the relevant security-
based swap transaction has not been accepted for clearing by a clearing
agency, the applicable policies and procedures would need to require
that the SBS Entity be in compliance with the requirements of proposed
Rule 15Fi-5 in all respects promptly after receipt of such notice.\108\
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\108\ The provisions in proposed Rule 15Fi-5(a)(iii) to account
for cleared anonymous transactions that are submitted for clearing,
but ultimately not accepted, are not included in CFTC Rule 23.504.
We have included this provision to account for situations when an
SBS Entity could be otherwise deemed to be not in compliance with
proposed Rule 15Fi-5 due to a transaction being rejected for
clearing for reasons which the SBS Entity did not know (or have a
reasonable basis to know) prior to when the transaction was
submitted to the clearing agency.
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The Commission notes that whether a contract that has not been
accepted for
[[Page 4632]]
clearing by a clearing agency continues to exist may depend on the
rules of the particular SBSEF, national securities exchange, or
clearing agency, or the agreement of the counterparties. If the end
result is that a security-based swap continues to exist despite being
rejected by the clearing agency, then the policies and procedures would
need to require that the SBS Entity be in compliance with the
requirements of Rule 15Fi-5 with respect to that transaction. If the
rejection from clearing results in a termination or voiding of the
original security-based swap, then there is no security-based swap for
which it is necessary to comply with Rule 15Fi-5.
7. Comments Requested
The Commission generally requests comments on all aspects of
Proposed Rule 15Fi-5 (and any related definitions). In addition, the
Commission requests comments on the following specific issues:
Do commenters agree with the scope of the proposed
exception from the trading relationship documentation requirements in
proposed Rule 15Fi-5 for clearing transactions? Why or why not? Because
the definition of ``clearing transactions'' only includes transactions
cleared at a clearing agency registered with the Commission pursuant to
Section 17A of the Exchange Act, security-based swaps cleared at a
foreign clearing agency that is not registered with the Commission
would not be deemed to be ``cleared'' for these purposes, and would
therefore be subject to proposed Rule 15Fi-5. Should the Commission
modify the scope of the exception for cleared security-based swaps,
such as by including transactions that are cleared at a clearing agency
that is not registered with the Commission pursuant to Section 17A of
the Exchange Act, whether because of an applicable exemption from
registration or because Exchange Act does not cover the activities of
the clearing agency? Why or why not?
Do commenters agree with the proposed exception from the
trading relationship documentation requirements for security-based
swaps executed anonymously on a national securities exchange or an
SBSEF? Is it sufficiently comprehensive? Why or why not? The proposed
exception also provides that if a security-based swap executed
anonymously on a platform is subsequently rejected for clearing, the
SBS Entity would then be required to come into compliance with the
documentation requirements ``promptly'' after receipt of the notice of
rejection. Do you agree with this approach? Why or why not? Should the
Commission define or provide an interpretation of the word ``promptly''
for these purposes or, as an alternative, specify a fixed period of
time in the rule text in which SBS Entities would be required to comply
with proposed Rule 15Fi-5? Why or why not and, if so, how much time
should be provided?
Are there any current industry practices that relate to
how counterparties to swaps and security-based swaps treat transactions
executed anonymously on a trading platform, but subsequently rejected
for clearing? If any such practices exist, please describe them,
including with regard to the length of time that it typically takes to
document these transactions, if they remain in effect.
With respect to any Swap Entity that could potentially
register with the Commission as an SBS Entity, would the documentation
protocols (or any other applicable documentation) already in existence
with respect to CFTC Rule 23.504 satisfy the requirements in proposed
Rule 15Fi-5? Why or why not? Should proposed Rule 15Fi-5 be modified to
account for the way that market participants have designed their
existing protocols (or any other applicable documentation) to be
compliant with the CFTC's rules? Why or why not? For the purposes of
compliance with the proposed documentation rules, should the Commission
allow compliance with the CFTC's parallel documentation rules for some
period of time to allow dual SEC-CFTC registrants to conform their
existing documentation protocols (or any other applicable
documentation) following the adoption of proposed Rule 15Fi-5? If so,
on what factors should that reliance be conditioned and how long of a
compliance period should be provided? In the alternative, should the
Commission delay compliance with, or establish phased compliance
deadlines for, some or all of these requirements? Please explain the
nature of any compliance challenges (including any additional
documentation requirements), and the basis for any suggested compliance
period.
As previously noted, proposed Rule 15Fi-5 has been
designed to be as consistent as possible with CFTC Rule 23.504, which
imposes trading relationship documentation requirements on Swap
Entities, in order to avoid requiring dual SEC-CFTC registrants to
incur additional systems or compliance costs due to differences between
the two agencies' approaches. To the extent that any such differences
remain, should the Commission consider, for any firm dually-registered
as both an SBS Entity and Swap Entity (regardless of whether such firm
is also registered with the Commission as a broker-dealer or with the
CFTC as a futures commission merchant), permitting such firm to comply
with proposed Rule 15Fi-5 on an ongoing basis by complying with CFTC
Rule 23.504, as if such rule applied to security-based swaps? If so,
what conditions, if any, should be placed on such reliance?
In addition to the exceptions set forth in the proposed
rule, are there other types of security-based swaps that should not be
subject to the underlying trading relationship documentation
requirements?
Should the Commission require that the policies and
procedures governing the required written security-based swap trading
relationship documentation be approved by a senior officer of the SBS
Entity, as is currently contemplated pursuant to proposed Rule 15Fi-5?
Why or why not? As an alternative to requiring action by a senior
officer, should such approval come instead from the governing body of
the SBS Entity? Why or why not? As an additional alternative, should
the Commission consider requiring approval of those policies and
procedures by someone below the senior officer level? If so, who within
an SBS Entity should approve them?
For purposes of the requirement that a senior officer
approve the policies and procedures required by proposed Rule 15Fi-5,
the Commission has preliminarily interpreted the term ``senior
officer'' as covering only the most senior executives in the
organization, such as a firm's chief executive officer, chief financial
officer, chief legal officer, chief compliance officer, president, or
other person at a similar level. Do commenters agree with such
interpretation? Why or why not? Does the proposed interpretation create
any differences with respect to the manner in which Swap Entities are
required to comply with CFTC Rule 23.504(a)(2), which uses the term
``senior management''? Should the explanation included in the
Commission's proposed interpretation instead be included in the rule
text?
Proposed Rule 15Fi-5 does not contain a comprehensive list
of all of the terms that should be addressed in the required security-
based swap trading relationship documentation. Rather, it provides that
the documentation must include ``all terms governing the trading
relationship'' between the SBS Entity and its counterparty and also
contains a non-exclusive list of terms that must be
[[Page 4633]]
included. Do commenters agree with that approach? Why or why not?
Should the Commission consider modifying the list of terms specifically
identified in proposed Rule 15Fi-5(b)(1)?
Should the Commission provide any additional specificity
and/or guidance as it relates to one or more of the terms identified in
proposed Rule 15Fi-5(b)(1) as required to be included in the trading
relationship documentation? For example, should the rule specify the
types of payment obligation terms that should be addressed in the
documentation? Are there any particular details regarding potential
events of default or termination events that should be specified in the
documentation? Should the information requirements regarding the terms
of the credit support arrangements between the two parties be modified
in any way? In each case, why or why not and what additional details or
guidance should be provided?
Proposed Rule 15Fi-5(b)(1) requires that the security-
based swap trading relationship documentation that SBS Entities execute
with the counterparties include terms addressing dispute resolution.
Should the Commission provide any additional specificity with respect
to this proposed requirement, including by identifying what particular
aspects of the dispute resolution process should be addressed in the
documentation? For example, should the documentation include specific
requirements regarding the methods for identifying, recording, and
monitoring disputes? Should the terms governing dispute resolution
identify specific time periods applicable to the process? Are there
particular aspects regarding communications between the counterparties
that should be specified in connection with the terms related to
dispute resolution, such as the method for providing notice of a
potential or actual dispute? In each case, why or why not, and what
additional details or guidance should be provided?
Proposed Rule 15Fi-5(b)(4) would require SBS Entities to
include in their security-based swap trading relationship documentation
with certain counterparties written agreement on the terms for valuing
security-based swaps for the purposes of complying with the margin and
risk management requirements. Do you agree with the scope of that
requirement? Why or why not? Should these requirements apply to an SBS
Entity's transactions with all counterparties, including non-financial
counterparties, without regard to whether they are requested? Why or
why not? Is there any additional information that should be included in
this requirement, or should any of the proposed requirements be
modified or deleted? Do the provisions related to valuation
discrepancies provide a sufficient basis for helping to ensure that
disputes related to the value of a security-based swap are resolved in
as efficient a manner as possible, or should any changes be made to
these requirements? Should the requirements regarding valuation be
modified in any way to account for the use of internal and/or
proprietary inputs and models? In each case, why or why not, and how
and why should the proposed rule be modified?
Are the protections in the proposed rule regarding the
treatment of confidential, proprietary information in connection with
the required valuation agreement sufficient to meet the needs of both
the party providing the information and the party receiving it? If not,
how should the proposal be revised to address any such concerns?
In addition to the terms governing the valuation agreement
in proposed Rule 15Fi-5(b)(4), are there any other requirements that
should be limited to, or modified for, certain types of counterparties
(e.g., financial counterparties)? If so, which ones, and what
particular requirements should apply?
Do the disclosure requirements in paragraphs (5) and (6)
of proposed Rule 15Fi-5(b), as they relate to the ``insured depository
institution'' or ``financial company'' status of the SBS Entity or its
counterparty and to the status of a security-based swap accepted for
clearing, respectively, provide useful and relevant information to
counterparties to security-based swaps? Why or why not? Should any
other disclosure requirements be modified or deleted? If so, which ones
and how? Should any additional disclosure requirements be added to the
proposed rule? If so, what should be added and why?
Do commenters agree with the scope of the proposed
definition of ``financial counterparty'' in proposed Rule 15Fi-1(g),
which is used for determining when the required security-based swap
trading relationship documentation would need to include the valuation
methodology set forth in proposed Rule 15Fi-5(b)(4)? Should that
definition be expanded to include other types of financial entities,
such as SEC-registered broker-dealers, investment companies, or
investment advisers? If so, which types of entities should be added to
the definition and why?
Do commenters agree with the proposed requirements related
to the performance of periodic audits of the SBS Entity's security-
based swap relationship documentation, as set forth in proposed Rule
15Fi-5(c)? Why or why not? If not, how should they be clarified? Should
the Commission provide any additional specificity regarding what
constitutes ``independence'' for these purposes? If so, how should that
standard be measured and evaluated? For example, the Commission has
extensive experience with respect to determining what constitutes
``independence'' in the context of accountants that audit and review
financial statements and prepare attestation reports filed with the
Commission, including in connection with rules adopted pursuant to
Title II of the Sarbanes-Oxley Act of 2002. Should the Commission
consider leveraging particular aspects of that experience in connection
with refining the requirements in proposed Rule 15Fi-5(c)? If so,
please explain.
Are there any circumstances under which an internal
auditor could be considered to be ``independent'' for purposes of
proposed Rule 15Fi-5(c)? If so, please explain. If not, should the
Commission consider eliminating the requirement that the auditor be
independent in order to allow for internal audits of the SBS Entity's
security-based swap relationship documentation? If so, are there
particular conditions that should be included in the requirement in
order to maintain the integrity of the audit process?
Should the person performing the audit of the SBS Entity's
security-based swap relationship documentation pursuant to proposed
Rule 15Fi-5(c) be subject to any qualification requirements, such as
the requirement to be registered with the Public Company Accounting
Oversight Board (``PCAOB'')? If so, which qualifications should be
required and why? If not, should proposed Rule 15Fi-5(c) be clarified
to state explicitly that PCAOB registration is not a condition of the
rule?
Should SBS dealers and major SBS participants be treated
the same for purposes of the portfolio reconciliation requirements in
proposed Rule 15Fi-5? Why or why not?
E. Verification of Transaction Data by SDRs
In light of certain of the rules we are proposing today, the
Commission believes it to be an appropriate time to revisit and request
comment on an issue previously identified in connection with the rules
applicable to the registration and ongoing regulation of SDRs. As
background, Section 13(n) of the
[[Page 4634]]
Exchange Act establishes a regulatory regime for the operation of and
governance of SDRs.\109\ Among other things, Section 13(n)(5)(B)
requires each registered SDR to ``confirm with both counterparties to
the security-based swap the accuracy of the data that was submitted.''
\110\ On February 15, 2015, the Commission adopted Rules 13n-1 to 13n-
12, which govern the SDR registration process, duties, and core
principles.\111\ Among other core principles governing the registration
and ongoing obligations of SDRs, Rule 13n-4(b)(3) implements the
statutory requirement set forth in Section 13(n)(5)(B) by requiring
SDRs to confirm, as prescribed in Rule 13n-5, with both counterparties
to the security-based swap the accuracy of the data that was
submitted.\112\
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\109\ Section 3(a)(75) of the Exchange Act defines the term
``security-based swap data repository'' to mean ``any person that
collects and maintains information or records with respect to
transactions or positions in, or the terms and conditions of,
security-based swaps entered into by third parties for the purpose
of providing a centralized recordkeeping facility for security-based
swaps.'' 15 U.S.C. 78c(a)(75).
\110\ See 15 U.S.C. 78m(n)(5).
\111\ See Security-Based Swap Data Repository Registration,
Duties, and Core Principles, Exchange Act Release No. 74246 (Feb.
11, 2015), 80 FR 14437 (Mar. 19, 2015) (``SDR Adopting Release'').
\112\ See 17 CFR 240.13n-4(b)(3).
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As part of the process of implementing the SDR rules, at least one
former SDR applicant expressed reservations and concerns about the
burdens of requiring SDRs to reach out to counterparties who are not
its members to verify accuracy of the data.\113\ The Commission
understands these concerns and the difficulty SDRs could face when
attempting to contact counterparties to a security-based swap
transaction with whom the SDR has no existing relationship. At the same
time, however, the Commission also recognizes the importance of
ensuring that the security-based swap data reported to an SDR is
complete and accurate.
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\113\ See, e.g., Letter from Michael C. Bodson, President and
Chief Executive Officer, The Depository Trust & Clearing
Corporation, and Larry E. Thompson, Chairman, DTCC Data Repository
(U.S.) LLC (``DDR''), Managing Director and Vice Chairman, The
Depository Trust & Clearing Corporation, dated Sept. 22, 2017,
regarding DDR's application for registration as an SDR (withdrawn on
Mar. 27, 2018), available at: https://www.sec.gov/comments/sbsdr-2016-02/sbsdr201602-2590214-161092.pdf (noting the difficulty an SDR
faces with respect to outreach to the non-reporting side of a
security-based swap when that non-reporting counterparty is not a
member of an SDR and proposing that Section 13(n)(5)(B) and
corresponding Rule 13n-4(b)(3) be interpreted as requiring SDRs to
confirm the accuracy of the security[hyphen]based swap solely with
counterparties who are its members).
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Accordingly, the Commission preliminarily believes that certain
provisions in proposed Rules 15Fi-3 and 15Fi-5, if adopted and taken
together, could be relevant to SDRs in seeking to meet their
obligations under Section 13(n)(5)(B) and Rule 13n-4(b)(3). As we
explained in connection with adopting the SDR rules, SDRs may be able
to reasonably rely on certain third parties to address the accuracy of
the transaction data.\114\ For example, the Commission previously
stated that if an SDR develops reasonable policies and procedures that
rely on confirmations completed by another entity, such as a third-
party confirmation provider, as long as such reliance is reasonable the
SDR could use such confirmation to fulfill its obligations under
certain SDR rules.\115\ Because the two relevant provisions that we are
proposing today generally relate to the obligation of SBS Entities to
take certain steps in the reconciliation and documentation processes
related specifically to the reporting of the relevant security-based
swap data to an SDR, including by clarifying the reporting obligations
of the counterparties, the Commission believes that, like the previous
example, these measures, taken together, could provide an SDR with a
set of factors to assess the reasonableness of relying on an SBS
Entity's ability to independently provide the definitive report of a
given security-based swap position, thereby providing a basis for the
SDR to satisfy its statutory and regulatory obligations to verify the
accuracy of the reported data when the SBS Entity's counterparty is not
a member of the SDR. The Commission requests comment on whether this
preliminary analysis is accurate.
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\114\ Cf. SDR Adopting Release, 80 FR at 14491.
\115\ See id.
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1. Reconciliation of Terms Submitted to an SDR
As described above in Section I.B.2, the definition of ``material
terms'' in proposed Rule 15Fi-1(i), which identifies the information
that SBS Entities would be required to reconcile with their
counterparties, differs based on whether a security-based swap
transaction had previously been included in a security-based swap
portfolio for purposes of the portfolio reconciliation requirements in
proposed Rule 15Fi-3. With respect to any security-based swap that has
not yet been reconciled as part of, a security-based swap portfolio,
``material terms'' would be defined to mean each term that is required
to be reported to a registered SDR under Rule 901 under the Exchange
Act.\116\ With respect to all other security-based swaps within a
security-based swap portfolio, the definition of ``material terms''
would exclude any term that is not relevant to the ongoing rights and
obligations of the parties and the valuation of the security-based
swap.
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\116\ See proposed Rule 15Fi-1(i)(1) (referencing 17 CFR
242.901).
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As we also previously noted in Section I.B.2, the Commission
preliminarily believes that there are potential benefits, both to SBS
Entities and potentially to the security-based swap market as a whole,
of requiring firms to initially reconcile all of the information
required to be reported to an SDR. Specifically, doing so helps to
ensure that the data reported to an SDR, and ultimately disseminated to
the public, is accurate and complete. Section 13(n)(5)(B) of the
Exchange Act and Rule 13n-4(b)(3) are both intended to accomplish the
same objective of transparency regarding complete and accurate
security-based swap data. Accordingly, like the previous example
involving the third-party confirmation process, it may be appropriate
to allow an SDR to meet its obligations by reasonably relying on an SBS
Entity. Such reliance could be based, at least in part, on that fact
that the SBS Entity would be subject to the portfolio reconciliation
requirements in proposed Rule 15Fi-3 using the proposed definition of
``material terms'' in Rule 15Fi-1(i), were it to be adopted, to
initially reconcile all of the terms of a transaction required to be
reported to an SDR or the Commission pursuant to Rule 901, particularly
in cases when the SBS Entity's counterparty is not onboarded to the
SDR.\117\ The Commission seeks comment on whether this preliminary
analysis is accurate.
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\117\ The Commission also notes that Rule 905(a) of Regulation
SBSR, which was adopted in 2015, generally imposes a duty to correct
on any counterparty to a security-based swap (or any other person
having a duty to report the security-based swap) that discovers an
error in the information reported with respect to that security-
based swap. See 17 CFR 242.905(a). Accordingly, if any discrepancies
are identified in the course of satisfying the portfolio
reconciliation requirements contained in proposed Rule 15F-3 that
resulted in incorrect information having been reported to an SDR,
then the SBS Entity would be required to follow the procedures set
forth in Rule 905(a) to correct any erroneous information with the
SDR.
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2. Documentation of Regulatory Reporting Obligations
As discussed above in Section I.D, proposed Rule 15Fi-5 would
require each SBS Entity to establish, maintain, and follow written
policies and procedures reasonably designed to ensure that it executes
written security-
[[Page 4635]]
based swap trading relationship documentation with each of its
counterparties prior to, or contemporaneously with, executing a
security-based swap with any counterparty. Paragraph (b)(1) of that
rule requires that the trading relationship documentation be in writing
and also sets forth the minimum set of items that must be addressed by
the documentation including, among other things, the allocation of any
applicable regulatory reporting obligations (including pursuant to
Regulation SBSR).\118\
---------------------------------------------------------------------------
\118\ See 17 CFR 242.901(a).
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Rule 901(a) of Regulation SBSR establishes a ``reporting
hierarchy'' that specifies which counterparty to a security-based swap
has the duty to report the transaction. Where possible, the rule
assigns the reporting duty to the side that is registered with the
Commission as an SBS Entity. Thus, if only one of the counterparties to
a security-based swap transaction is an SBS Entity, then such SBS
Entity will be the reporting side. In addition, if one counterparty to
a security-based swap transaction is an SBS dealer and the other is a
major SBS participant, the SBS dealer will be the reporting side.
However, if both counterparties to a security-based swap transaction
are SBS dealers (or both are major SBS participants), the sides are
required to select the reporting side. The selection of the reporting
side is an example of the type of ``applicable reporting obligation''
that proposed Rule 15Fi-5(b)(1) would cover.
Accordingly, the Commission preliminarily believes that requiring
SBS Entities to address any applicable regulatory reporting obligations
in the written trading relationship documentation that it executes with
their counterparties also could be relevant to SDRs in seeking to meet
their obligations under Section 13(n)(5)(B) and Rule 13n-4(b)(3). For
example, to the extent that only one counterparty to a security-based
swap is an SBS Entity, the trading relationship documentation could be
used to memorialize the fact that the SBS Entity is the reporting party
for purposes of Rule 901(a), and that such SBS Entity will be
responsible for verifying the accuracy of each security-based swap
transaction with the SDR.
3. Comments Requested
The Commission generally requests comments on the issues described
above. In addition, the Commission requests comments on the following
specific issues:
Do you agree with the analysis described above,
particularly as to how parts of proposed Rules 15Fi-3 (including the
definition of ``material terms'' in proposed Rule 15Fi-1(i)) and 15Fi-5
could help address the concerns raised by former SDR applicants with
respect to their obligations, pursuant to Section 13(n)(5)(B) of the
Exchange Act and Rule 13n-4(b)(3), to confirm with both counterparties
to a security-based swap the accuracy of the data that was submitted to
the SDR?
[cir] Specifically, do those aspects of the proposed rules provide
a sufficient basis, in whole or in part, for an SDR to assess whether
it can reasonably rely on a SBS Entity's verification of transaction
data as the basis to meet the requirements of Section 13(n)(5)(B) and
Rule 13n-4(b)(3)? Why or why not?
[cir] If not, should the Commission provide an exemption from the
verification requirements described above to SDRs that reasonably rely
on SBS Entities? Why or why not? If so, what specific terms and
conditions should be included in such exemption and why?
[cir] Are there other regulatory actions the Commission should
consider to address the issue? If so, which ones and why?
Should any aspect of the proposed analysis be modified in
any way to account for other situations that may not be fully addressed
here? If so, how and why? For example, would an SDR be able to
reasonably rely on an SBS Entity to independently provide the
definitive report of a given security-based swap position for both
counterparties in situations when the SBS Entity is acting as agent for
one of the two counterparties and is not itself a counterparty? Why or
why not, and how should the analysis be revised to address that
situation?
F. Recordkeeping Requirements
1. Proposed Amendments to Recordkeeping Rules
The Commission also is proposing rule amendments that would modify
certain proposed requirements contained in its April 2014 release
proposing rules for the recordkeeping, reporting, and notification
requirements applicable to SBS Entities.\119\ Those rule amendments
would require each SBS Entity to make and keep current information
relevant to each portfolio reconciliation and portfolio compression
exercise in which it participates, and to retain a record of each
valuation dispute notification required pursuant to proposed Rule 15Fi-
3(c), all security-based swap trading relationship documentation
required to be created under proposed Rule 15Fi-5, a record of the
results of each audit of the SBS Entity's security-based swap trading
relationship documentation policies and procedures, as required
pursuant to proposed Rule 15Fi-5(c), and each policy and procedure
created pursuant to proposed Rules 15Fi-3 through 15Fi-5.
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\119\ See supra note 2. Although we are proposing books and
records requirements that would be additive to an existing proposal,
we are not re-opening the comment period for the entirety of the SBS
Books and Records Proposing Release. Rather, our request for comment
in this section is limited solely to the recordkeeping requirements
related to the rules we are proposing today.
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Specifically, the Commission is proposing to amend: (1) Existing
Rule 17a-3 under the Exchange Act, which applies to SBS Entities that
are also registered with the Commission as broker-dealers under Section
15(b) of the Exchange Act (``broker-dealer SBS Entities''), and (2)
proposed Rule 18a-5 under the Exchange Act, which applies to SBS
Entities that are not also registered with the Commission as broker-
dealers under Section 15(b) of the Exchange Act (``stand-alone and bank
SBS Entities''). These proposed amendments would require each SBS
Entity to make and keep current records of each security-based swap
portfolio reconciliation, whether conducted pursuant to proposed Rule
15Fi-3 or otherwise,\120\ a copy of each valuation dispute notification
required to be provided to the Commission pursuant to proposed
Rule15Fi-3(c),\121\ and a record of each bilateral offset and each
bilateral portfolio compression exercise or multilateral portfolio
compression exercise in which it participates, whether conducted
pursuant to proposed Rule 15Fi-4 or otherwise.\122\
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\120\ See proposed amendments to Rules 17a-3(a)(31)(i), 18a-
5(a)(18)(i), and 18a-5(b)(14)(i).
\121\ See proposed amendments to Rules 17a-3(a)(31)(ii), 18a-
5(a)(18)(ii), and 18a-5(b)(14)(ii).
\122\ See proposed amendments to Rules 17a-3(a)(31)(iii), 18a-
5(a)(18)(iii), and 18a-5(b)(14)(iii).
---------------------------------------------------------------------------
With respect to the reconciliation requirement, the proposed rules
would require that these records include the dates of the security-
based swap portfolio reconciliation, the number of portfolio
reconciliation discrepancies, the number of security-based swap
valuation disputes (including the time-to-resolution of each valuation
dispute and the age of outstanding valuation disputes, categorized by
transaction and counterparty), and the name of the third-party entity
performing the security-based swap portfolio
[[Page 4636]]
reconciliation, if any.\123\ With respect to the valuation notification
requirement, the proposed rules would require the retention of each
notification required to be provided to the Commission pursuant to
proposed Rule 15Fi-3(c).\124\ With respect to compression, the proposed
rules would require that these records include the dates of the offset
or compression, the security-based swaps included in the offset or
compression, the identity of the counterparties participating in the
offset or compression, the results of the compression, and the name of
the third-party entity performing the offset or compression, if
any.\125\ The Commission preliminarily believes that requiring SBS
Entities to make and retain such records will, among other things,
promote compliance with proposed Rules 15Fi-3 and 15Fi-4, assist SBS
Entities in the event that they need to resolve problems that relate to
a previous reconciliation or compression, and assist Commission
examiners in reviewing compliance with those rules.
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\123\ See proposed amendments to Rules 17a-3(a)(31)(i), 18a-
5(a)(18)(i), and 18a-5(b)(14)(i).
\124\ See proposed amendments to Rules 17a-3(a)(31)(ii), 18a-
5(a)(18)(ii), and 18a-5(b)(14)(ii).
\125\ See proposed amendments to Rules 17a-3(a)(31)(iii), 18a-
5(a)(18)(iii), and 18a-5(b)(14)(iii).
---------------------------------------------------------------------------
In addition, the Commission is proposing to amend (1) existing Rule
17a-4 under the Exchange Act, which requires each applicable broker-
dealer, including broker-dealer SBS Entities, to preserve certain
records if the broker-dealer makes or receives the type of record and
(2) proposed Rule 18a-6 under the Exchange Act, which imposes parallel
preservation requirements on stand-alone and bank SBS Entities. In
particular, the proposed amendments to Rule 17a-4 and to proposed Rule
18a-6 would require SBS Entities to retain all of the records required
to be made and kept under the proposed amendments to Rule 17a-3 and
proposed Rule 18a-5 for at least three years, the first two years in an
easily accessible place.\126\ The proposed amendments also would
require each SBS Entity to retain the following:
---------------------------------------------------------------------------
\126\ See proposed amendments to Rules 17a-4(b)(1), 18a-
6(b)(1)(i), and 18a-6(b)(2)(i).
---------------------------------------------------------------------------
the written policies and procedures required pursuant to
proposed Rules 15Fi-3 through 15Fi-5 until three years after
termination of the use of the policies and procedures; \127\
---------------------------------------------------------------------------
\127\ See proposed amendments to Rules 17a-4(e)(10) and 18a-
6(d)(4).
---------------------------------------------------------------------------
each written agreement with counterparties on the terms of
portfolio reconciliation with those counterparties as required to be
created under proposed Rules 15Fi-3(a)(1) and (b)(1) until three years
after the termination of the agreement and all transactions governed
thereby; \128\
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\128\ See proposed amendments to Rules 17a-4(e)(11)(i) and 18a-
6(d)(5)(i).
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security-based swap trading relationship documentation
with counterparties required to be created under proposed Rule 15Fi-5
until three years after the termination of such documentation and all
transactions governed thereby; \129\ and
---------------------------------------------------------------------------
\129\ See proposed amendments to Rules 17a-4(e)(11)(ii) and 18a-
6(d)(5)(ii).
---------------------------------------------------------------------------
a record of the results of each audit required to be
performed pursuant to proposed Rule 15Fi-5(c) until three years after
the completion of the audit.\130\
---------------------------------------------------------------------------
\130\ See proposed amendments to Rules 17a-4(e)(11)(iii) and
18a-6(d)(5)(iii).
---------------------------------------------------------------------------
The Commission preliminarily believes that requiring the retention
of the above records in accordance with the applicable rules will help
ensure that those records are retained in a manner that would allow
them to be readily accessible for Commission examiners.
2. Comments Requested
The Commission generally requests comments on all aspects of the
proposed amendments to Rules 17a-3 and 17a-4 and to proposed Rules 18a-
5, and 18a-6. In addition, the Commission requests comments on the
following specific issues:
Has the Commission provided sufficient guidance regarding
the scope of the proposed recordkeeping amendments? Are there aspects
of the proposed amendments for which the Commission should consider
providing additional guidance? If so, please explain.
How do the types of records that would need to be made and
kept current under Rule 17a-3 and proposed Rule 18a-5, in each case as
proposed to be amended in this release, align with the types of records
that a futures commission merchant or a swap dealer is required to make
pursuant to CFTC regulations?
II. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5.
A. Background on the Cross-Border Application of Title VII Requirements
In 2013, the Commission proposed rules and interpretive guidance to
address the cross-border application of Title VII, including
requirements applicable to SBS Entities.\131\ In that proposal, the
Commission preliminarily interpreted the Title VII requirements
associated with registration to apply generally to the activities of
registered entities.\132\ The Commission further proposed a taxonomy to
classify requirements under Section 15F of the Exchange Act as applying
at either the transaction-level or at the entity-level.\133\ The
Commission took the preliminary view that transaction-level
requirements under Section 15F of the Exchange Act are those that
primarily focus on protecting counterparties to security-based swap
transactions by requiring SBS dealers to, among other things, provide
certain disclosures to counterparties, adhere to certain standards of
business conduct, and segregate customer funds, securities, and other
assets.\134\
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\131\ See Cross-Border Security-Based Swap Activities; Re-
Proposal of Regulation SBSR and Certain Rules and Forms Relating to
the Registration of Security-Based Swap Dealers and Major Security-
Based Swap Participants, Exchange Act Release No. 69490 (May 1,
2013), 78 FR 30968 (May 23, 2013) (``Cross-Border Proposing
Release'') (discussing joint rulemaking to further define various
Title VII terms).
\132\ See id. at 30986 (``We are proposing to apply the Title
VII requirements associated with registration (including, among
others, capital and margin requirements and external business
conduct requirements) to the activities of registered entities to
the extent we have determined that doing so advances the purposes of
Title VII.'') (footnotes omitted).
\133\ See id. at 31009-10.
\134\ Id.
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In contrast to transaction-level requirements, the Commission
preliminarily took the view that entity-level requirements under
Section 15F of the Exchange Act are those that are expected to play a
role in ensuring the safety and soundness of the entity and thus relate
to the SBS Entity as a whole.\135\ Entity-level requirements include
capital and margin requirements, as well as other requirements relating
to a firm's identification and management of its risk exposure, such as
the requirements in Section 15F(i) of the Exchange Act, which provides
the statutory basis for the rules the Commission is proposing in this
release.\136\ Because these requirements relate to the entire entity,
the Commission proposed to apply them to SBS Entities on a firm-wide
basis, without exception.\137\
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\135\ See id. at 31011.
\136\ See id. at 31011-16 (addressing the classification of
capital and margin requirements, as well as of the documentation
standard requirements of Section 15F(i) of the Exchange Act and
other risk management requirements applicable to SBS dealers).
\137\ See id. at 31011, 31024-25. See also id. at 31035
(applying the analysis to major SBS participants). In reaching this
conclusion, the Commission explained that it ``preliminarily
believes that entity-level requirements are core requirements of the
Commission's responsibility to ensure the safety and soundness of
registered security-based swap dealers,'' and that ``it would not be
consistent with this mandate to provide a blanket exclusion to
foreign security-based swap dealers from entity-level requirements
applicable to such entities.'' Id. at 31024 (footnotes omitted). The
Commission further expressed the preliminary view that concerns
regarding the application of entity-level requirements to foreign
SBS dealers would largely be addressed through the proposed approach
to substituted compliance. See id.
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[[Page 4637]]
The Commission first applied this taxonomy with respect to the
rules adopted pursuant to Section 15F(i) of the Exchange Act in 2016
when we adopted rules to implement business conduct standards for SBS
Entities.\138\ The Commission subsequently determined that the trade
acknowledgment and verification rules would apply at the entity-
level.\139\ The Commission has not, however, proposed or adopted a
cross-border interpretation with respect to the portfolio
reconciliation, portfolio compression, and trading relationship
documentation requirements that we are now proposing.
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\138\ See Business Conduct Standards for Security-Based Swap
Dealers and Major Security-Based Swap Participants, Release No.
77617 (Apr. 14, 2016), 81 FR 29960, 30061-69 (May 13, 2016)
(``Business Conduct Standards Adopting Release''). Under this
framework, rules relating to diligent supervision pursuant to
Section 15F(h)(1)(B), those relating to the chief compliance officer
under Section 15F(k) of the Exchange Act, and those relating to
certain risk management requirements under Section 15F(j) of the
Exchange Act were determined to be entity-level requirements that
apply to an SBS Entity's business with foreign counterparties to the
same extent that they apply to the SBS dealer's or major SBS
participant's U.S. business. The remaining rules were determined to
apply at the transaction-level.
\139\ See Trade Acknowledgment and Verification Adopting
Release, 81 FR at 39826.
---------------------------------------------------------------------------
B. Proposed Cross-Border Interpretation
Consistent with its approach in both the Cross-Border Proposing
Release and the Trade Acknowledgement and Verification Adopting
Release, the Commission believes that the requirements being proposed
in this release pursuant to Section 15F(i) of the Exchange Act--as they
relate to portfolio reconciliation, portfolio compression, and trading
relationship documentation--should be treated as entity-level
requirements that apply to an SBS Entity's entire security-based swap
business without exception, including in connection with any security-
based swap business it conducts with foreign counterparties.
The Commission preliminarily believes that the requirements
referenced above play an important role in addressing risks to the SBS
Entity as a whole, including risks related to the entity's safety and
soundness. As we have noted throughout this release in connection with
describing each of the proposed rules, providing SBS Entities and their
counterparties to security-based swap transactions with the ability to
identify and resolve discrepancies involving key terms of their
transactions--which is a key consideration underpinning both the
proposed portfolio reconciliation and trading relationship
documentation requirements--serves as an important mechanism for
allowing SBS Entities and their counterparties to manage their internal
risks.\140\ Similarly, portfolio compression is intended to help SBS
Entities and their counterparties in security-based swap transactions
manage their post-trade risks in a number of important ways, including
by eliminating redundant uncleared derivatives transactions (as
measured both by the number of contracts and total notional value) and
potentially reducing a market participant's credit risk to its direct
counterparties, including by eliminating all outstanding transactions
with some counterparties, without affecting the market participant's
overall economic position.\141\
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\140\ See supra note 14 and accompanying text.
\141\ See supra notes 62-63 and accompanying text.
---------------------------------------------------------------------------
An alternative approach that does not require an SBS Entity to take
steps to manage its internal risk using portfolio reconciliation,
compression, or standards governing trading relationship documentation
could be expected to contribute to operational risk and legal
uncertainty throughout the firm's entire security-based swap business,
affecting the entity's business as a whole, and not merely specific
security-based swap transactions. For example, as we have previously
noted, inaccurate or incomplete trading relationship documentation
could lead to, among other things, a collateral dispute between the
counterparties to a security-based swap transaction. The larger the
dispute, even if confined to a single counterparty, the greater the
risk that an SBS Entity could experience liquidity problems on a
firmwide basis.
Moreover, to the extent that these risks affect the safety and
soundness of the SBS Entity, they also may affect the firm's
counterparties and the functioning of the broader security-based swap
market. Continuing with the previous example, if a collateral dispute
with a foreign counterparty creates liquidity issues throughout an SBS
Entity, the firm could experience difficulty making payments or posting
collateral to its other counterparties, which may include U.S. persons.
Accordingly, the Commission preliminarily believes that it is
appropriate to apply the proposed requirements to the entirety of an
SBS Entity's security-based swap business.\142\
---------------------------------------------------------------------------
\142\ We recognize that the CFTC has taken a different position
with regard to corresponding requirements pursuant to the CEA,
classifying them as what the CFTC has termed ``Category A''
transaction-level requirements. See CFTC Interpretive Guidance and
Policy Statement Regarding Compliance With Certain Swap Regulations,
78 FR 45292, 45334 (Jul. 26, 2013).
---------------------------------------------------------------------------
C. Comments Requested
The Commission generally requests comments on its interpretative
guidance regarding the cross-border application of Proposed Rules15Fi-3
through 15Fi-5. In addition, the Commission requests comments on the
following specific issues:
Does the proposed approach appropriately treat the
proposed portfolio reconciliation, portfolio compression, and trading
relationship documentation requirements as entity-level requirements
applicable to the entire business conducted by foreign SBS Entities? If
not, please identify any particular aspects of those proposed rules
that should not be applied to a foreign SBS Entity, or applied only to
specific transactions, and explain how such an approach would be
consistent with the goals of Title VII.
Should the Commission apply the same cross-border approach
to the application of the proposed portfolio reconciliation, portfolio
compression, and trading relationship documentation requirements for
both SBS dealers and major SBS participants? If you believe that the
approach should vary based on the type of SBS Entity involved, please
describe how the cross-border approach for SBS dealers should differ
from the cross-border approach for major SBS participants, and explain
the justification for any potential differences in approach.
What types of conflicts might a foreign SBS Entity face if
subjected to the proposed portfolio reconciliation, portfolio
compression, and trading relationship documentation requirements in
more than one jurisdiction? In what situations would compliance with
more than one of these requirements be difficult or impossible?
As an alternative to treating the proposed requirements as
entity-level requirements, should the Commission instead follow the
approach taken by the CFTC and treat the proposed portfolio
reconciliation, portfolio compression, and trading relationship
documentation requirements (or some combination of the three) as
transaction-level requirements? If so, to which cross-border security-
based swap
[[Page 4638]]
transactions should these requirements apply and why? Please describe
how these requirements would apply differently if classified as
transaction-level requirements instead of as entity-level requirements.
Please also describe any practical challenges that would be presented
by classifying them differently from the CFTC.
III. Availability of Substituted Compliance for Rules 15Fi-3 Through
15Fi-5
A. Existing Substituted Compliance Rule
In 2016, the Commission adopted Rule 3a71-6 under the Exchange Act
to provide that non-U.S. SBS Entities could satisfy applicable business
conduct requirements under Section 15F by complying with comparable
regulatory requirements of a foreign jurisdiction, subject to certain
conditions. The rule in part provides that the Commission shall not
make a determination providing for substituted compliance unless the
Commission determines, among other things, that the foreign regulatory
requirements are comparable to otherwise applicable requirements.\143\
In adopting that substituted compliance rule, the Commission addressed
a range of issues and concerns that commenters had raised in response
to the substituted compliance proposal that was set forth in the Cross-
Border Proposing Release.
---------------------------------------------------------------------------
\143\ See Business Conduct Standards Adopting Release, 81 FR at
30074.
---------------------------------------------------------------------------
When the Commission adopted this substituted compliance rule that
solely addressed the business conduct rules, it stated that it expected
to assess the potential availability of substituted compliance in
connection with other requirements when the Commission considers final
rules to implement those requirements.\144\ Consistent with that
statement, the Commission subsequently amended Rule 3a71-6 in the Trade
Acknowledgment and Verification Adopting Release to provide SBS
Entities with the potential to avail themselves of substituted
compliance to satisfy the Title VII trade acknowledgment and
verification requirements.\145\
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\144\ The Commission first addressed the potential for allowing
market participants to satisfy certain Title VII requirements by
complying with comparable foreign rules as a substitute in 2013 as
part of the Cross-Border Proposing Release. Pursuant to that
release, the Commission proposed making substituted compliance
potentially available in connection with the requirements applicable
to SBS dealers pursuant to Section 15F of the Exchange Act, other
than the registration requirements applicable to dealers. See Cross-
Border Proposing Release, 78 FR at 31088, 31207-08 (proposed Rule
3a71-5).
\145\ See Trade Acknowledgment and Verification Adopting
Release, 81 FR at 39827-28.
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B. Proposed Amendment to Rule 3a71-6
The Commission is proposing to further amend Rule 3a71-6 to provide
SBS Entities that are not U.S. persons (as defined in Rule 3a71-3(a)(4)
of the Exchange Act) with the potential to avail themselves of
substituted compliance to satisfy the Title VII portfolio compression,
portfolio reconciliation, and trading relationship documentation
requirements. In proposing to amend the rule, the Commission has
preliminarily concluded that the principles associated with substituted
compliance, as previously adopted in connection with both the business
conduct requirements and the trade acknowledgement and verification
requirements, in large part should similarly apply to the portfolio
compression, portfolio reconciliation, and trading relationship
documentation requirements we are proposing today. Accordingly, except
as discussed below, the proposed substituted compliance rule would
apply to the portfolio compression, portfolio reconciliation, and
trading relationship documentation requirements in the same manner as
it already applies to the business conduct requirements and the trade
acknowledgement and verification requirements.\146\
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\146\ The discussions in the Business Conduct Standards Adopting
Release, including those regarding consideration of supervisory and
enforcement practices (see id. at 30079), regarding certain multi-
jurisdictional issues (see id. at 30079-80), and regarding
application procedures (see id. at 30080-81) are applicable to the
proposed portfolio compression, portfolio reconciliation, and
trading relationship documentation requirements.
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1. Basis for Substituted Compliance in Connection With the Portfolio
Reconciliation, Portfolio Compression, and Trading Relationship
Documentation Requirements
In light of the global nature of the security-based swap market and
the prevalence of cross-border transactions within that market, there
is the potential that the application of the Title VII portfolio
compression, portfolio reconciliation, and trading relationship
documentation requirements may lead to requirements that are
duplicative of, or in conflict with, applicable foreign requirements,
even when the two sets of requirements implement similar goals and lead
to similar results. Those results have the potential to disrupt
existing business relationships and, more generally, to reduce
competition and market efficiency.\147\
---------------------------------------------------------------------------
\147\ See generally Business Conduct Standards Adopting Release,
81 FR at 30073-74 (addressing the basis for making substituted
compliance available in the context of the business conduct
requirements).
---------------------------------------------------------------------------
To address those effects, the Commission preliminarily believes
that under certain circumstances it may be appropriate to allow the
possibility of substituted compliance, whereby market participants may
satisfy the proposed portfolio compression, portfolio reconciliation,
and trading relationship documentation requirements by complying with
comparable foreign requirements. Allowing for the possibility of
substituted compliance in this manner may be expected to help achieve
the benefits of those particular risk mitigation requirements--helping
to curb legal uncertainty and reduce credit and operational risk for
participants in security-based swap transactions and in the broader
market--in a way that helps avoid regulatory conflict and minimizes
duplication, thereby promoting market efficiency, enhancing
competition, and contributing to the overall functioning of the global
security-based swap market. Accordingly, the Commission is proposing to
amend paragraph (d) of Rule 3a71-6 to identify the portfolio
compression, portfolio reconciliation, and trading relationship
documentation requirements of Title VII as being potentially eligible
for substituted compliance.\148\
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\148\ Paragraph (a)(1) of the rule provides that the Commission
may, conditionally or unconditionally, by order, make a
determination with respect to a foreign financial regulatory system
that compliance with specified requirements under the foreign
financial system by an SBS dealer and/or by a registered major SBS
swap participant, or class thereof, may satisfy the corresponding
requirements identified in paragraph (d) of the rule that would
otherwise apply.
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2. Comparability Criteria, and Consideration of Related Requirements
As discussed when we first adopted Rule 3a71-6--and reiterated when
we amended the rule pursuant to the Trade Acknowledgement and
Verification Adopting Release--the Commission will endeavor to take a
holistic approach in determining the comparability of foreign
requirements for substituted compliance purposes, focusing on
regulatory outcomes as a whole, rather than on a requirement-by-
requirement comparison.\149\ Under the proposed rule, the Commission's
comparability assessments associated with the
[[Page 4639]]
portfolio compression, portfolio reconciliation, and trading
relationship documentation rules accordingly will consider whether, in
the Commission's view, the foreign regulatory system achieves
regulatory outcomes that are comparable to the regulatory outcomes
associated with those Exchange Act requirements.
---------------------------------------------------------------------------
\149\ See Business Conduct Standards Adopting Release, 81 FR at
30078-79. See also Trade Acknowledgment and Verification Adopting
Release, 81 FR at 39828.
---------------------------------------------------------------------------
Proposed new paragraph (d)(4) of Rule 3a71-6 would also provide
that prior to making a substituted compliance determination in
connection with the portfolio reconciliation, portfolio compression,
and trading relationship documentation requirements, the Commission
intends to consider whether the requirements of the foreign financial
regulatory system, the duties imposed by the foreign financial
regulatory system, and the information that is required to be provided
to counterparties pursuant to the requirements of the foreign financial
regulatory system, are comparable to those required pursuant to the
applicable Exchange Act provisions.
In application, the Commission may determine to conduct its
comparability analyses regarding the portfolio reconciliation,
portfolio compression, and trading relationship documentation
requirements in conjunction with comparability analyses regarding other
Exchange Act requirements that, like the requirements we are proposing
today, promote risk mitigation in connection with SBS Entities.
Accordingly, depending on the applicable facts and circumstances, the
comparability assessment associated with the portfolio reconciliation,
portfolio compression, and trading relationship documentation
requirements may constitute part of a broader assessment of Exchange
Act risk mitigation requirements, and the applicable comparability
decisions may be made at the level of those risk mitigation
requirements as a whole.\150\
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\150\ We have not proposed rules making substituted compliance
available specifically with respect to the amendments we are
proposing to proposed Rules 18a-5 and 18a-6, which specify the
recordkeeping, reporting, and notification requirements applicable
to SBS Entities. Rather, to the extent that substituted compliance
is made available with respect to those rules, we would anticipate
that any determination made with respect to the comparability of the
foreign financial regulatory system would address all aspects of the
Commission recordkeeping, reporting, and notification requirements
for SBS Entities including any amendments that we ultimately adopt
with respect to the portfolio reconciliation, portfolio compression,
and trading relationship document requirements.
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3. Comments Requested
The Commission generally requests comments on all aspects of the
proposed amendment to Rule 3a71-6. In addition, the Commission requests
comments on the following specific issues:
Should the Commission provide SBS Entities with the
potential to avail themselves of substituted compliance to satisfy the
Title VII portfolio reconciliation, portfolio compression, and trading
relationship requirements? Why or why not? If you believe that
substituted compliance should not be available with respect to these
requirements, how would you distinguish this policy decision from the
Commission's previous determination to make substituted compliance
potentially available with respect to other Title VII requirements
(i.e., the business conduct rules and the trade acknowledgment and
verification rules)?
Do commenters agree with the scope and language of the
proposed amendment to Rule 3a71-6? Why or why not? Are there aspects of
the scope of the proposed rule for which the Commission should consider
providing additional guidance? If so, what additional guidance should
be provided and why?
Are the items identified in the proposed amendment to Rule
3a71-6 as factors the Commission will consider prior to making a
substituted compliance determination in connection with the portfolio
reconciliation, portfolio compression, and trading relationship
documentation requirements appropriate? Why or why not? Should any of
those items be modified or deleted? Should additional considerations be
added? If so, please explain.
IV. General Request for Comment
We request and encourage any interested person to submit comments
regarding the proposed rules, specific issues discussed in this
release, and other matters that may have an effect on the proposed
rules. With regard to any comments, we note that such comments are of
particular assistance to our rulemaking initiative if accompanied by
supporting data and analysis of the issues addressed in those comments.
In addition, we would appreciate any comments related to the
comparability of the rules we are proposing today and the corresponding
CFTC rules already in effect, including whether certain aspects of the
proposed rules should be modified to more fully conform to the CFTC's
rules. In comparing the two sets of rules, commenters are encouraged to
identify any areas where the proposed rules may not be sufficiently
aligned with the corresponding CFTC rules, such that they could impose
unnecessary burdens (with respect to documentation or otherwise) on
persons likely to register with the Commission as SBS Entities who are
also registered with the CFTC as Swap Entities.
V. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (``PRA'') \151\ imposes certain
requirements on federal agencies in connection with the conducting or
sponsoring of any ``collection of information.'' \152\ For example, 44
U.S.C. 3507(a)(1)(D) provides that before adopting (or revising) a
collection of information requirement, an agency must, among other
things, publish a notice in the Federal Register stating that the
agency has submitted the proposed collection of information to the
Office of Management and Budget (``OMB'') and setting forth certain
required information, including: (1) A title for the collection
information; (2) a summary of the collected information; (3) a brief
description of the need for the information and the proposed use of the
information; (4) a description of the likely respondents and proposed
frequency of response to the collection of information; (5) an estimate
of the paperwork burden that shall result from the collection of
information; and (6) notice that comments may be submitted to the
agency and director of OMB.\153\
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\151\ 44 U.S.C. 3501 et seq.
\152\ See 44 U.S.C. 3502(3).
\153\ See 44 U.S.C. 3507(a)(1)(D); see also 5 CFR
1320.5(a)(1)(iv).
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Certain provisions of the proposed rules contain ``collection of
information'' requirements within the meaning of the PRA. The
Commission is submitting these collections of information to OMB for
review in accordance with 44 U.S.C. 3507 and 5 CFR 1320.11. An agency
may not conduct or sponsor, and a person is not required to respond to,
a collection of information unless it displays a currently valid
control number.
Specifically, proposed Rules 15Fi-3, 15Fi-4, and 15Fi-5 would
impose new collection of information requirements. The title of these
new collections of information is, collectively, ``Rules 15Fi-3--15Fi-
5--Risk Mitigation Techniques for Uncleared Security-Based Swaps.'' OMB
has not yet assigned a control number to these new collections of
information. In addition, the proposals to amend Rules 3a71-6, 17a-3
and 17a-4 would amend already-existing collection of information
requirements. Finally, the proposals to amend proposed Rules 18a-5 and
18a-6 would amend proposed collection of information requirements that
were previously submitted to OMB for review
[[Page 4640]]
in connection with the SBS Books and Records Proposing Release. The
titles and control numbers for these collections of information are as
follows:
(1) Rule 17a-3--Records to be made by certain brokers and dealers
(OMB control number 3235-0033);
(2) Rule 17a-4--Records to be preserved by certain brokers and
dealers (OMB control number 3235-0279);
(3) Rule 18a-5--Records to be made by certain security-based swap
dealers and major security-based swap participants (OMB control number
3235-0745);
(4) Rule 18a-6--Records to be preserved by certain security-based
swap dealers and major security-based swap participants (OMB control
number 3235-0751); and
(5) Rule 3a71-6--Substituted Compliance for Foreign Security-Based
Swap Dealers (OMB control number 3235-0715).
A. Summary of Collections of Information
1. Proposed Rule 15Fi-3: Portfolio Reconciliation
Proposed Rule 15Fi-3 generally would require SBS Entities to (1)
engage in periodic portfolio reconciliation activities with
counterparties who are also SBS Entities, and (2) establish, maintain,
and follow written policies and procedures reasonably designed to
ensure that they engage in periodic portfolio reconciliation with
counterparties who are not SBS Entities.\154\ Among other things,
proposed Rule 15Fi-3 would specify the requirements applicable to an
SBS Entity for purposes of engaging in portfolio reconciliation with
either type of counterparty (as well as the applicable definitions),
with regard to (1) the information that the two sides would be required
to exchange as part of the reconciliation process,\155\ (2) the
frequency by which an SBS Entity would be required to reconcile its
security-based swap portfolios with its counterparties,\156\ (3) the
required policies and procedures specifying the means and timeframes by
which an SBS Entity would be required to resolve discrepancies with
respect to either the valuation or a material term of a security-based
swap,\157\ and (4) the requirement that an SBS Entity agree in writing
with each of its counterparties on the terms of the portfolio
reconciliation, including agreement of the selection of any third-party
service provider.\158\ Finally, proposed Rule 15Fi-3(c) would require
an SBS Entity to promptly notify the Commission of any security-based
swap valuation dispute in excess of $20,000,000 (or its equivalent in
any other currency) if not resolved within: (1) Three business days, if
the dispute is with a counterparty that is an SBS Entity; or (2) five
business days, if the dispute is with a counterparty that is not an SBS
Entity.\159\
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\154\ Proposed Rule 15Fi-3 would not apply to any security-based
swap that has a clearing agency as a direct counterparty.
\155\ See supra Section I.B.2.
\156\ See supra Sections I.B.3 and I.B.5.
\157\ See supra Sections I.B.4 and I.B.5.
\158\ See supra Sections I.B.3 and I.B.5.
\159\ See supra Section I.B.6.
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2. Proposed Rule 15Fi-4: Portfolio Compression
Proposed Rule 15Fi-4 would require SBS Entities to establish,
maintain, and follow written policies and procedures related to
bilateral offsetting of security-based swaps, and periodic bilateral
and multilateral compression exercises. Specifically, proposed Rules
15Fi-4(a)(2) and (3) would require each SBS Entity to establish,
maintain, and follow written policies and procedures for periodically
engaging in both bilateral portfolio compression exercises and
multilateral portfolio compression exercises, in each case when
appropriate, with each counterparty that is an SBS Entity.\160\
Similarly, proposed Rule 15Fi-4(a)(1) would require each SBS Entity to
establish, maintain, and follow written policies and procedures for
terminating each ``fully offsetting security-based swap'' that it
maintains with another SBS Entity in a timely fashion, when
appropriate.\161\ To the extent that an SBS Entity transacts with a
counterparty that is not an SBS Entity, proposed Rule 15Fi-4(b)
provides that such policies and procedures would only need to address
terminating each ``fully offsetting security-based swap'' or engaging
in a bilateral or multilateral portfolio compression exercise, when
appropriate and to the extent requested by any such counterparty.\162\
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\160\ See supra Section I.C.2.
\161\ See supra Section I.C.3.
\162\ See supra Section I.C.2 and I.C.3.
---------------------------------------------------------------------------
3. Proposed Rule 15Fi-5: Written Trading Relationship Documentation
Proposed Rule 15Fi-5 would require that each SBS Entity enter into
written trading relationship documentation with each of its
counterparties, subject to certain exceptions, prior to, or
contemporaneously with, executing a security-based swap transaction, in
each case in the manner as provided for in the rule.\163\ The proposed
rule also requires that the trading relationship documentation include
(1) credit support arrangements addressing certain specified items
related to, among other things, margin haircuts, and custody of margin
assets \164\ and (2) agreements regarding the means by which the
counterparties would determine the value of each security-based
swap.\165\ The proposal also contains requirements for SBS Entities and
their counterparties to disclose to each other certain information
regarding their legal and bankruptcy status, and to include a statement
regarding the status of a security-based swap if accepted for clearing
by a CCP.\166\ Finally, the proposal would require each SBS Entity to
have an independent auditor conduct periodic audits sufficient to
identify any material weakness in its documentation policies and
procedures required by the rule.\167\
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\163\ See supra Section I.D.2. The proposed rule would require
that the security-based swap trading relationship documentation
address, among other things, terms addressing payment obligations,
netting of payments, events of default or other termination events,
calculation and netting of obligations upon termination, transfer of
rights and obligations, allocation of any applicable regulatory
reporting obligations, governing law, valuation and dispute
resolution.
\164\ See id.
\165\ See supra Section I.D.3.
\166\ See supra Section I.D.4.
\167\ See supra Section I.D.5.
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4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books
and Records Requirements
Rule 17a-3 requires a broker-dealer to make and keep current
certain records, and Rule 17a-4 requires a broker-dealer to preserve
certain records if it makes or receives them.\168\ The Commission is
proposing to amend these existing rules to account for the security-
based swap risk mitigation activities of broker-dealers, including
broker-dealer SBS Entities, by requiring the making and preserving of
any required records regarding portfolio reconciliation, bilateral
offsets, bilateral or multilateral portfolio compression, valuation
disputes, and written trading relationship documentation. With respect
to stand-alone SBS Entities, the Commission is proposing to amend
proposed Rules 18a-5 and 18a-6--which were first proposed in 2014 and
are themselves modeled on Rule 17a-3 and 17a-4--to account for these
same risk mitigation requirements.\169\
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\168\ 17 CFR 240.17a-3; 17 CFR 240.17a-4.
\169\ See supra Section I.F.1.
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[[Page 4641]]
5. Proposed Amendment to Rule 3a71-6: Substituted Compliance
The proposed amendment to Rule 3a71-6 would permit non-U.S. SBS
Entities to comply with the proposed portfolio reconciliation,
portfolio compression, and written trading relationship documentation
requirements by following the comparable regulatory requirements of a
foreign financial regulatory system. Specifically, the proposal would
add proposed Rules 15Fi-3 through 15Fi-5 to the list of Commission
requirements eligible for a substituted compliance determination and
would set forth the standard by which the Commission would make such
determination.\170\
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\170\ See supra Sections III.B.1 and III.B.2.
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B. Proposed Use of Information
1. Proposed Rule 15Fi-3: Portfolio Reconciliation
As previously noted, the Commission preliminarily believes that the
information shared by counterparties to a security-based swap
transaction periodically during the portfolio reconciliation process,
as contemplated by proposed Rule 15Fi-3, will play an important role in
assisting those counterparties in identifying and resolving
discrepancies involving key terms of their transactions on an ongoing
basis. This information also should allow those counterparties to
improve their management of internal risks related to the enforcement
of their rights and the performance of their obligations under a
security-based swap. For example, the information obtained and provided
in the course of portfolio reconciliation should help ensure that the
counterparties to a security-based swap are and remain in agreement
with respect to all material terms throughout the life of the
transaction, thereby mitigating the possibility that a discrepancy
could unexpectedly affect either side's ability to perform any or all
of its obligations under the contract, including those obligations
related to the posting of collateral. Moreover, requiring SBS Entities
to agree in writing with each of their counterparties on the terms of
the portfolio reconciliation (including, if applicable, agreement on
the selection of any third party service provider who may be performing
the reconciliation) should help to minimize any discrepancies regarding
the portfolio reconciliation process itself, thereby ensuring that it
operates in as efficient and cost-effective means possible. Finally,
the requirement to report certain unresolved valuation disputes to the
Commission should assist the Commission in identifying potential issues
with respect to an SBS Entity's internal valuation methodology and also
could serve as an indication of a widespread market disruption in cases
where the Commission receives a large number of such notices from
multiple firms.
2. Proposed Rule 15Fi-4: Portfolio Compression
As previously discussed, the Commission preliminarily believes that
proposed Rule 15Fi-4 would help market participants by eliminating
redundant uncleared derivatives contracts, thereby potentially reducing
a market participant's credit risk to its direct counterparties,
including by eliminating all outstanding contracts with some
counterparties, without affecting the market participant's overall
economic position. In addition, we preliminarily believe that the
proposed collection of information is expected to lead to processing
improvements for market participants, as envisioned by Section 15F(i)
of the Exchange Act, by virtue of the fact that both SBS Entities and
their counterparties should ultimately have fewer trades to manage,
maintain, and settle, resulting in fewer opportunities for processing
errors, failures, or other problems that could develop throughout the
lifecycle of a transaction.
3. Proposed Rule 15Fi-5: Written Trading Relationship Documentation
The Commission preliminarily believes that the information required
to be contained in the written trading relationship documentation
pursuant to proposed Rule 15Fi-5 should help ensure that each SBS
Entity mitigates risk with respect to its security-based swap portfolio
by, among other things, enhancing clarity and legal certainty from the
outset of a transaction regarding each party's rights and obligations.
This outcome should help to reduce exposure to, among other things,
counterparty credit risk and promote agreement regarding the proper
valuation and other material terms of a security-based swap.
4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books
and Records Requirements
The Commission preliminarily expects that the information contained
in the records required to be made and kept pursuant to the proposed
amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6 would be used to
assist the Commission in conducting effective examinations and
oversight of SBS Entities. In addition, records regarding portfolio
reconciliation, bilateral offsets, bilateral or multilateral portfolio
compression, valuation disputes, and written trading relationship
documentation should help to provide SBS Entities and their
counterparties to security-based swaps with an ability to identify and
resolve discrepancies involving key terms of their transactions on an
ongoing basis, allowing for better management of internal risks related
to performance of obligations, valuation, margin obligations, internal
valuation systems and models, or internal controls.
5. Proposed Amendment to Rule 3a71-6: Substituted Compliance
Under the proposed amendment to Rule 3a71-6 under the Exchange Act,
the Commission would use the information collected to evaluate requests
for substituted compliance with respect to the portfolio
reconciliation, portfolio compression, and written trading relationship
documentation requirements applicable to SBS Entities.
C. Respondents
Proposed Rules 15Fi-3 through 15Fi-5 and Rules 17a-3, 17a-4, 18a-5,
and 18a-6 would apply only to SBS Entities, each of which will be
registered with the Commission. In a number of prior releases,
including the release adopting the rules by which SBS Entities can
register (and withdraw from registration) with the Commission, we
estimated that approximately 50 entities may meet the definition of SBS
dealer, and up to five entities may meet the definition of major SBS
participant.\171\ The Commission continues to believe that these
estimates are appropriate. Thus, the Commission preliminarily believes
that approximately 55 entities will be required to register with the
Commission under either category, and will therefore be subject to
Rules 15Fi-3 through 15Fi-5.
---------------------------------------------------------------------------
\171\ See SBS Entity Registration Adopting Release, 80 FR at
48990. See also Trade Acknowledgement and Verification Adopting
Release, 81 FR at 39830.
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With regard to the requirements under Rule 3a71-6, as proposed to
be amended, requests for a substituted compliance determination with
respect to the portfolio reconciliation, portfolio compression, and
written trading relationship documentation requirements may be filed by
foreign financial authorities, or by non-U.S. SBS Entities. Consistent
with prior estimates, the Commission expects that there may be
approximately 22 non-U.S. entities that may potentially register as SBS
dealers, out of approximately 50 total
[[Page 4642]]
entities that may register as SBS dealers.\172\
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\172\ See Application of the Title VII Security-Based Swap
Dealer De Minimis Counting Requirements to Activity in the United
States,'' Exchange Act Release No. 77104 (Feb. 10, 2016), 81 FR
8598, 8605 (Feb. 19, 2016) (``U.S. Activity Adopting Release''); see
also Business Conduct Standards Adopting Release, 81 FR at 30090.
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Potentially, all such non-U.S. SBS dealers, or some subset thereof,
may seek to rely on a substituted compliance determination in
connection with these portfolio reconciliation, portfolio compression,
and written trading relationship documentation requirements.\173\ In
practice, however, the Commission expects that the greater portion of
any such requests will be submitted by foreign financial authorities,
given their expertise in connection with the relevant substantive
requirements, and in connection with their supervisory and enforcement
oversight with regard to SBS dealers and their activities.
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\173\ Consistent with prior estimates, the Commission further
believes that there may up to five major SBS participants. See SBS
Entity Registration Adopting Release, 80 FR at 49000; see also
Business Conduct Standards Adopting Release, 81 FR at 30089. It is
possible that some subset of those entities will be non-U.S. major
SBS participants that will seek to rely on substituted compliance in
connection with the applicable portfolio reconciliation, portfolio
compression, and written trading relationship documentation
requirements.
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D. Total Annual Recordkeeping Burden
1. Portfolio Reconciliation Activities Generally
Under proposed Rule 15Fi-3(a), the approximately 55 respondent SBS
Entities would be required to reconcile security-based swap portfolios
with other SBS Entities on a daily, weekly, or quarterly basis,
depending upon the size of the portfolio. For purposes of this
requirement, the Commission preliminarily estimates that each SBS
Entity will engage in security-based swap transactions with
approximately one-third of the other 54 SBS Entities, meaning that an
SBS Entity will maintain security-based swap portfolios with
approximately 18 SBS Entities. Of this total, we preliminarily believe
that, on average, two SBS Entity counterparty portfolios will require
daily reconciliation (i.e., a portfolio consisting of 500 or more
uncleared security-based swaps), four SBS Entity counterparty
portfolios will require weekly reconciliation (i.e., a portfolio of
more than 50 but fewer than 500 uncleared security-based swaps), and
the remaining 12 SBS Entity counterparty portfolios will require
quarterly reconciliation (i.e. a portfolio of no more than 50 uncleared
security-based swaps).\174\ The Commission therefore estimates that
each SBS Entity will engage in an average of 760 portfolio
reconciliations with other SBS Entities per year.\175\
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\174\ These estimates are consistent with those used by the CFTC
in connection with its portfolio reconciliation rule. See
Confirmation, Portfolio Reconciliation, and Portfolio Compression
Requirements for Swap Dealers and Major Swap Participants, 75 FR
81519, 81528 (Dec. 28, 2010).
\175\ This estimate uses 252 business days for purposes of the
daily portfolio reconciliation requirement, which is consistent with
the definition of ``business day'' in proposed Rule 15Fi-1(b).
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The Commission preliminarily believes that each portfolio
reconciliation is likely to be conducted through an automated
process.\176\ As a result, we preliminarily believe that each
reconciliation will require an average of 30 minutes to complete in
total (which is the combined estimate for both counterparties),
regardless of the size of the security-based swap portfolio with the
applicable counterparty.\177\ Using these figures, the Commission
preliminarily estimates that compliance with proposed Rule 15Fi-3(a),
as it relates to engaging in portfolio reconciliation with other SBS
Entities, will impose an average annual burden of approximately 190
hours per year on each of the respondent 55 SBS Entities, for an
estimated average annual burden of 10,450 hours in the aggregate. These
calculations are summarized in PRA Table 1, below.
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\176\ The Commission recognizes that some respondents may choose
to engage a third-party vendor to conduct portfolio reconciliations.
For simplicity, however, the Commission's burden estimate is based
upon SBS Entities conducting these activities internally, without
the use of third-party vendors. The Commission welcomes comments on
this approach, including regarding the likelihood and cost of using
third-party providers.
\177\ Because the 30 minute estimate is for the entire
reconciliation process, without respect to how that time is
allocated between the two parties, to avoid double-counting we have
divided it by one-half in the context of security-based swap
portfolios between two SBS Entities, resulting in an estimate of 15
minutes per reconciliation per counterparty for those portfolios.
PRA Table 1--Proposed Rule 15i-3(a): Portfolio Reconciliations With Other SBS Entities
----------------------------------------------------------------------------------------------------------------
Hourly burden
per Total annual
Number of counterparties per respondent Number of annual reconciliations reconciliation burden (hours)
(hours)
----------------------------------------------------------------------------------------------------------------
2 (>=500 transactions)........................ 252 (daily)..................... .25 126
4 (>50<500 transactions)...................... 52 (weekly)..................... .25 52
12 (<=50 transactions)........................ 4 (quarterly)................... .25 12
-------------------------------
Total per respondent...................... ................................ .............. 190
-------------------------------
Total Aggregate Annual Burden for all 55 ................................ .............. 10,450
respondents.
----------------------------------------------------------------------------------------------------------------
In addition, proposed Rule 15Fi-3(b) would require each SBS Entity
to establish, maintain, and follow written policies and procedures
reasonably designed to ensure that it engages in portfolio
reconciliation for all security-based swaps (other than security-based
swaps that will be cleared by a clearing agency) in which its
counterparty is not an SBS Entity.\178\ In calculating the burden of
performing the portfolio reconciliations required by these policies and
procedures, the Commission preliminarily estimates that (1) there are
currently 13,082 market participants in security-based swaps who will
not be required to register as SBS Entities,\179\ and (2) each SBS
Entity will have an average of approximately 350 of these non-SBS
Entity market participants as counterparties.\180\ Further, the
Commission preliminarily believes that reconciliations with these
parties will
[[Page 4643]]
be conducted on a quarterly basis for 10% of these portfolios (i.e.,
portfolios with more than 100 uncleared security-based swaps), and on
an annual basis for the remaining 90% of these portfolios (i.e.,
portfolios that do not involve 100 or more uncleared security-based
swaps).\181\
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\178\ The Commission's estimate for the hourly burden for
preparing these policies and procedures is discussed below.
\179\ In the Economic Analysis, the Commission estimates that
there are approximately 13,137 market participants in the security-
based swap market. See infra Section VI.B.1.c (Table 2). Subtracting
the estimated 55 SBS Entities from this figure results in an
estimated 13,082 non-SBS Entities.
\180\ This estimate is based upon the assumption that each non-
SBS Entity market participant will do business with, on average,
between one or two SBS Entities and is calculated as follows:
((13,082 non-SBS Entity market participants/55 SBS Entities) x 1.5
SBS Entities per non-SBS market participants) = approximately 350
non-SBS Entity counterparties per SBS Entity.
\181\ Accordingly, of the estimated 350 security-based swap
portfolios that an SBS Entity maintains with non-SBS Entities, 90%
(or 315) will require only one portfolio reconciliation each year,
and 10% (or 35) will require quarterly portfolio reconciliations,
resulting in a total of 455 portfolio reconciliations per SBS Entity
per year.
---------------------------------------------------------------------------
The Commission further estimates that each portfolio reconciliation
between an SBS Entity and a non-SBS Entity will require an average of
30 minutes to complete (which is the combined estimate for both
counterparties).\182\ Using these figures, the Commission preliminarily
estimates that compliance with proposed Rule 15Fi-3(b), as it relates
to conducting portfolio reconciliations with non-SBS Entities, will
impose an annual hourly burden of approximately 227.5 hours per SBS
Entity, for an estimated average annual burden of approximately
12,512.5 hours in the aggregate for all 55 SBS Entity respondents.
These calculations are summarized in PRA Table 2, below.
---------------------------------------------------------------------------
\182\ This figure is identical to the estimate used for
reconciliations between two SBS Entities (before dividing by one-
half to avoid double-counting) and is consistent with the estimate
used by the CFTC, which used an estimate of six minutes (or .10
hours) in connection with its portfolio reconciliation requirements.
See supra notes 174 and 177 and accompanying text.
PRA Table 2--Proposed Rule 15i-3(b): Portfolio Reconciliations With Non-SBS Entities
----------------------------------------------------------------------------------------------------------------
Hourly burden
Number of counterparties per respondent Number of annual reconciliations per Total annual
reconciliation burden (hours)
----------------------------------------------------------------------------------------------------------------
35 (>100 transactions)........................ 4 (quarterly)................... .5 70
315 (<=100 transactions)...................... 1 (annual)...................... .5 157.5
-------------------------------
Total per respondent...................... ................................ .............. 227.5
-------------------------------
Total Aggregate Annual Burden for all 55 ................................ .............. 12,512.5
respondents.
----------------------------------------------------------------------------------------------------------------
2. Establishing, Maintaining, and Enforcing Written Policies and
Procedures
Proposed Rule 15Fi-3 also contains policies and procedures
requirements applicable to SBS Entities in connection with engaging in
portfolio reconciliation with both SBS Entities and other
counterparties. As the Commission explained in the Business Conduct
Standards Adopting Release, the Commission estimates that of the
estimated 55 persons that may register with the Commission as SBS
Entities, approximately 35 will be dually-registered with the CFTC as
Swap Entities.\183\ In addition, other than as expressly noted above in
Section I.B, the CFTC's adopted final rules on portfolio reconciliation
written policies and procedures are substantively identical to those
proposed by Rule 15Fi-3. Accordingly, these 35 dually-registered
entities are already required to establish, maintain, and follow
written policies and procedures as they relate to the reconciliation of
their swap portfolios, and these policies and procedures would be
expected to be largely consistent with those that would be required
with respect to their security-based swap portfolios. Assuming that
these existing policies and procedures would simply need to be amended
to apply to security-based swap transactions upon adoption of proposed
Rule 15Fi-3, we preliminarily estimate that the initial burden of
revising these policies and procedures would be one hour per
respondent, for an estimated one-time initial burden of 35 hours in the
aggregate. With respect to the remaining 20 SBS Entities that will not
be dually-registered with the CFTC, the Commission preliminarily
estimates, based on prior estimates in earlier Dodd-Frank rulemakings,
that these policies and procedures would require an average of 80 hours
per non-dually-registered respondent to initially prepare and
implement, for an estimated one-time initial burden of 1,600 hours in
the aggregate.\184\ Once these policies and procedures are established,
the Commission estimates that it will take an average of 40 hours
annually to revise and maintain these policies and procedures per
respondent (including both dually-registered and non-dually-registered
SBS Entities),\185\ for an estimated average annual burden of 2,200
hours in the aggregate for all 55 respondents.\186\
---------------------------------------------------------------------------
\183\ See Business Conduct Standards Adopting Release, 81 FR at
30098.
\184\ This estimate is based on Commission staff discussions
with market participants and is calculated as follows: [((Compliance
Attorney at 40 hours) + (Director of Compliance at 20 hours) +
(Deputy General Counsel at 20 hours))] = 80 hours per SBS Entity.
See Trade Acknowledgment and Verification Adopting Release, 81 FR at
39831 n. 242.
\185\ Although dually-registered SBS Entities would technically
need to revise and maintain their policies and procedures to ensure
compliance with both the Commission's and CFTC's rules, we have
preliminarily decided to conservatively assume that all of the
estimated hours would be incurred in connection with compliance with
the collection of information associated with proposed Rule 15Fi-3.
\186\ This estimate is based on Commission staff discussions
with market participants and is calculated as follows: [((Compliance
Attorney at 20 hours) + (Director of Compliance at 10 hours) +
(General Counsel at 10 hours))] = 40 hours per SBS Entity. See Trade
Acknowledgment and Verification Adopting Release, 81 FR at 39831 n.
243.
---------------------------------------------------------------------------
3. Reporting of Certain Valuation Disputes
Proposed Rule 15Fi-3(c) would require each SBS Entity to promptly
notify the Commission (and any applicable prudential regulator for an
SBS Entity that is also a bank), in a form and manner acceptable to the
Commission, of any security-based swap valuation dispute in excess of
$20,000,000 (or its equivalent in any other currency) if not resolved
within a prescribed time period. As previously noted, we crafted the
rule in this way to provide SBS Entities with flexibility to determine
the most efficient and cost-effective form and manner of making such
submissions, so long as it is deemed to be acceptable by the
Commission.\187\ Accordingly, we preliminarily do not expect there to
be any initial burden of designing a system for submitting these
notices.\188\ We also preliminarily believe that the associated ongoing
hourly burden of preparing and submitting such notices would be
minimal. In addition, until SBS Entities
[[Page 4644]]
are registered with the Commission, it is difficult for us to determine
the typical number of valuation disputes meeting the applicable
thresholds that SBS Entities would be required to submit on an annual
basis. As such, and consistent with the estimate the CFTC provided when
it first proposed a similar requirement, we preliminarily estimate that
each SBS Entities will spend on average of 24 hours each year complying
with this requirement, for an estimated average annual burden of 1,320
hours in the aggregate for all 55 respondents.\189\ We also recognize,
however, that there are differences between the markets for swaps and
security-based swaps and welcomes comment from the public on this
estimate.
---------------------------------------------------------------------------
\187\ See supra note 47.
\188\ In the request for comments, we asked whether we should
require such notices to be submitted in a particular manner, such as
having them sent to a dedicated email box or using the EDGAR system
(or any successor system thereto, as designated by the Commission).
As SBS Entities will already have access to EDGAR (and a Form ID) by
virtue of having used the system to register with the Commission, we
would not expect there to be any initial burden associated with
either approach.
\189\ See Swap Trading Relationship Documentation Requirements
for Swap Dealers and Major Swap Participants, 76 FR 6715, 6723 (Feb.
8, 2011).
---------------------------------------------------------------------------
Combining all of the estimated burdens described above, the
Commission preliminarily estimates that proposed Rule 15Fi-3 would
impose an estimated one-time initial burden of 1,635 hours in the
aggregate for all SBS Entities to prepare new written policies and
procedures or to bring existing ones into compliance. The Commission
also preliminarily estimates that proposed Rule 15Fi-3 would impose an
estimated ongoing burden of 26,482.5 hours each year in the aggregate
for all SBS Entities, which is composed of (1) an estimated annual
burden of 10,450 hours in the aggregate for all SBS Entities to engage
in portfolio reconciliation with SBS Entities; (2) an estimated annual
burden of 12,512.5 hours in the aggregate for all SBS Entities to
engage in portfolio reconciliation with non-SBS Entities; (3) an
estimated annual burden of 2,200 hours in the aggregate for all SBS
Entities to revise and maintain the written policies and procedures
required pursuant to the rule; and (4) 1,320 hours for all SBS Entities
to report certain large valuation disputes to the Commission and any
applicable prudential regulator.\190\ These calculations are summarized
in PRA Tables 3 and 4, below.
---------------------------------------------------------------------------
\190\ Rule 15Fi-3(a)(1) and 15Fi-3(b)(1) also require an SBS
Entity to agree in writing with each of its counterparties on the
terms of the portfolio reconciliation including, if applicable,
agreement on the selection of any third party service provider who
may be performing the reconciliation. The Commission expects SBS
Entities to undertake this agreement as part of the written trading
relationship documentation each is required to enter into with its
counterparties as a result of proposed Rule 15Fi-5. Thus, the
estimate here does not account for this burden, which is instead
assumed to form part of the burden of complying with Rule 15Fi-5.
PRA Table 3--Proposed Rule 15Fi-3: Total Estimated Initial Burdens
------------------------------------------------------------------------
Total one-time
Requirement Hourly burden burden (hours)
------------------------------------------------------------------------
Preparation of New Written Policies and 1 35
Procedures (35 dual SEC-CFTC
registrants)...........................
Preparation of New Written Policies and 80 1,600
Procedures (20 SEC-only registrants)...
-------------------------------
Total Aggregate One-Time Burden for .............. 1,635
all 55 respondents.................
------------------------------------------------------------------------
PRA Table 4--Proposed Rule 15Fi-3: Summary of Annual Burdens
----------------------------------------------------------------------------------------------------------------
Requirement Aggregate hourly burden (all 55 respondents)
----------------------------------------------------------------------------------------------------------------
Portfolio Reconciliations with Other SBS Entities....... 10,450
Portfolio Reconciliations with Non-SBS Entities......... 12,512.5
Revise and Maintain Written Policies and Procedures..... 2,200
Prepare and Submit Notices of Valuation Disputes >$20 1,320
million.
-------------------------------------------------------
Total Aggregate Annual Burden for all 55 respondents 26,482.5
----------------------------------------------------------------------------------------------------------------
4. Proposed Rule 15Fi-4: Portfolio Compression
With regard to the written policies and procedures, the Commission
continues to believe that of the estimated 55 persons that may register
with the Commission as SBS Entities, approximately 35 will be dually-
registered with the CFTC as Swap Entities. In addition, and as we
previously noted, the CFTC's adopted final rules requiring Swap
Entities to establish, maintain, and follow written policies and
procedures on bilateral offsets and portfolio compression exercises
are, other than as expressly noted above in Section I.C, substantively
identical to those proposed by Rule 15Fi-4. Accordingly, these 35
entities are already required to establish, maintain, and follow
relevant written policies and procedures related to bilateral offsets
and portfolio compression exercises involving their swap portfolios,
and these policies and procedures would be expected to be largely
consistent with those that would be required with respect to their
security-based swap portfolios. Assuming that these existing policies
and procedures would simply need to be amended to apply to security-
based swap transactions upon adoption of proposed Rule 15Fi-4, we
preliminarily estimate that the initial burden of revising these
policies and procedures would be one hour per respondent, for an
estimated one-time initial burden of 35 hours in the aggregate.
With respect to the remaining 20 SBS Entities that are not dually-
registered with the CFTC, the Commission preliminarily estimates, based
on prior estimates in earlier Dodd-Frank rulemakings, that these
policies and procedures would require an average of 80 hours per non-
dually-registered respondent to initially prepare and implement, for an
estimated average annual burden of 1,600 hours in the aggregate.\191\
Once these policies and procedures are established, the Commission
estimates that it will take an average of 40 hours annually to revise
and maintain these policies and procedures per respondent (including
both dually-registered and non-dually-registered SBS Entities), for an
estimated average annual burden of 2,200 hours in the aggregate for all
55 respondents.
---------------------------------------------------------------------------
\191\ See supra note 184.
---------------------------------------------------------------------------
In addition, the respondents will incur additional hourly burdens
as they undertake bilateral offsets and portfolio compression exercises
consistent with these written policies and procedures. As noted above
the Commission estimates that each of the 55 estimated
[[Page 4645]]
SBS Entities will be counterparty to an average of 18 other SBS
Entities and 350 non-SBS Entities, for a total of 368 counterparties.
For purposes of conducting bilateral offsets and portfolio compression
exercises, the Commission preliminarily estimates that (1) each SBS
Entity will have an average of one set of security-based swaps that are
eligible for annual bilateral offset with each of these 368
counterparties, (2) each SBS Entity will conduct an annual bilateral
compression exercise with one-third, or six of its 18 SBS Entity
counterparties, (3) each SBS Entity will conduct an annual bilateral
compression exercise with each of its 350 non-SBS Entity
counterparties, and (4) each SBS Entity will engage in multilateral
compression exercises at an average rate of 12 exercises per year.
The Commission preliminarily believes that each bilateral offset
and portfolio compression exercise is likely to be conducted through an
automated process. As a result, we preliminarily believe that (1) each
bilateral offset will require on average five minutes of respondent
time to complete with each of the 350 non-SBS Entity counterparties,
(2) each bilateral offset will require on average 2.5 minutes of
respondent time to complete with each of the 18 SBS Entity
counterparties,\192\ (3) each bilateral compression will require an
average of 15 minutes of respondent time to complete with each of the
350 non-SBS Entity counterparties, (4) each bilateral compression will
require an average of 7.5 minutes with each of the six SBS Entity
counterparties,\193\ and (5) each multilateral compression exercise
will require an average of 30 minutes of respondent time to complete 12
times annually. In each of those hourly burdens, the figure used is the
combined estimate for both counterparties. Based on these estimates,
the Commission estimates the average annual hourly burden for these
activities at 124.16 hours per respondent, an estimated average annual
burden of 6,828.8 hours in the aggregate. These calculations are
summarized in PRA Table 5, below.
---------------------------------------------------------------------------
\192\ Similar to our estimates in the context of the portfolio
reconciliation requirements, because the five minute estimate is for
the entire bilateral offset process, without respect to how that
time is allocated between the two parties, to avoid double-counting
we have divided it by one-half in the context of security-based swap
portfolios between two SBS Entities, resulting in an estimate of 2.5
minutes per bilateral offset for those portfolios.
\193\ Again, we have divided the 15 minute estimate to complete
the bilateral compression exercise by one-half in the context of
security-based swap portfolios between two SBS Entities, resulting
in an estimate of 7.5 minutes per bilateral compression for those
portfolios.
PRA Table 5--Portfolio Compression With All Entities
----------------------------------------------------------------------------------------------------------------
Number of Hourly burden
Type of exercise Number of annual per exercise Total annual
counterparties exercises (hours) burden (hours)
----------------------------------------------------------------------------------------------------------------
Bilateral Offset (w/non-SBS Entities)........... 350 1 .0833 29.16
Bilateral Offset (w/SBS Entities)............... 18 1 .0417 .75
Bilateral Compression (w/non SBS-Entities)...... 350 1 .25 87.5
Bilateral Compression (w/SBS Entities).......... 6 1 .125 .75
Multilateral Compression........................ N/A 12 .5 6
---------------------------------------------------------------
Total per respondent........................ .............. .............. .............. 124.16
---------------------------------------------------------------
Total Aggregate Annual Burden for all 55 .............. .............. .............. 6,828.8
respondents................................
----------------------------------------------------------------------------------------------------------------
Combining all of the estimated burdens described above, the
Commission preliminarily estimates that proposed Rule 15Fi-4 would
impose an estimated one-time initial burden of 1,635 hours in the
aggregate for all SBS Entities to prepare new written policies and
procedures or to bring existing ones into compliance. The Commission
also preliminarily estimates that proposed Rule 15Fi-4 would impose an
estimated ongoing burden of 9,028.8 hours each year in the aggregate
for all SBS Entities, which is composed of (1) an estimated annual
burden of 1,603.8 hours in the aggregate to conduct bilateral offsets
with non-SBS Entities; (2) an estimated annual burden of 41.25 hours in
the aggregate to conduct bilateral offsets with SBS Entities; (3) an
estimated annual burden of 4,812.5 hours in the aggregate to
participate in bilateral compression exercises with non-SBS Entities;
(4) an estimated annual burden of 41.25 hours in the aggregate to
participate in bilateral compression exercises with SBS Entities; (5)
an estimated annual burden of 330 hours in the aggregate to participate
in multilateral compression exercises; and (6) an estimated annual
burden of 2,200 hours in the aggregate for all SBS Entities to revise
and maintain written policies and procedures. These calculations are
summarized in PRA Tables 6 and 7, below.
PRA Table 6--Proposed Rule 15Fi-4: Total Estimated Initial Burden
------------------------------------------------------------------------
Hourly burden Total one-time
Activity (hours) burden (hours)
------------------------------------------------------------------------
Preparation of New Written Policies and 1 35
Procedures (35 dual SEC-CFTC
registrants)...........................
Preparation of New Written Policies and 80 1,600
Procedures (20 SEC-only registrants)...
-------------------------------
Total Aggregate One-Time Burden for .............. 1,635
all 55 respondents.................
------------------------------------------------------------------------
[[Page 4646]]
PRA Table 7--Proposed Rule 15Fi-3: Summary of Annual Burdens
------------------------------------------------------------------------
Aggregate
hourly burden
Requirement (hours) (all
55
respondents)
------------------------------------------------------------------------
Bilateral Offsets with non-SBS Entities................. 1,603.8
Bilateral Offsets with SBS Entities..................... 41.25
Bilateral Compression with non-SBS Entities............. 4,812.5
Bilateral Compression with SBS Entities................. 41.25
Multilateral Compression................................ 330
Revise and Maintain Written Policies and Procedures..... 2,200
---------------
Total Aggregate Annual Burden for all 55 respondents 9,028.8
------------------------------------------------------------------------
5. Proposed Rule 15Fi-5: Written Trading Relationship Documentation
As previously noted, the Commission estimates that each SBS Entity
will have 18 SBS Entity counterparties and 350 non-SBS Entity
counterparties, for a total of 368 counterparties per SBS Entity. For
the purposes of the underlying documentation requirements, and based on
staff discussions with market participants, the Commission understands
that many SBS Entities already have in place industry-standard written
trading relationship documentation that is likely to contain many of
the elements required by this proposed rule. With this in mind, the
Commission preliminarily estimates that (1) the initial burden per
respondent to negotiate and draft written trading relationship
documentation with non-SBS Entities that is compliant with proposed
Rule 15Fi-5 will be approximately 30 hours (which is the combined
estimate for both counterparties), and (2) the initial burden per
respondent to negotiate and draft written trading relationship
documentation with SBS Entities that is compliant with proposed Rule
15Fi-5 will be approximately 15 hours.\194\ These estimates are
averages, and both account for the fact that some SBS Entities may lack
appropriate documentation in certain respects and will need to enter
into new documentation with counterparties, while in other cases
existing documentation will need only to be modified to be brought into
compliance. The Commission's estimates are further based on an
assumption that, in each case, the written documentation will always
include the valuation agreements set forth in proposed Rule 15Fi-
5(b)(4), notwithstanding the fact that the rule only requires this
information in certain circumstances.
---------------------------------------------------------------------------
\194\ As was the case in calculating the PRA estimates for the
portfolio reconciliation and portfolio compression requirements,
because the 30 hours estimate is for the entire process of
negotiating and executing written trading relationship
documentation, without respect to how that time is allocated between
the two parties, to avoid double-counting we have divided it by one-
half in the context of counterparties that are also SBS Entities,
resulting in an estimate of 15 hours to negotiate and execute such
documentation.
---------------------------------------------------------------------------
Based on these estimates and assumptions, the Commission
preliminarily believes that the requirement to prepare written
relationship documentation in accordance with proposed Rule 15Fi-5 will
result in an estimated one-time initial burden of 9,540 hours for each
of the 55 SBS Entity respondents, for an estimated average one-time
burden of 524,700 hours in the aggregate. The Commission also
preliminarily believes that there will be little need to modify the
written trading relationship documentation on an ongoing basis once it
is in place, and therefore is not estimating any additional annual
hourly burden for ongoing modifications.
With regard to the written policies and procedures required
pursuant to proposed Rule 15Fi-5, the Commission continues to believe
that of the estimated 55 persons that may register with the Commission
as SBS Entities, approximately 35 will be dually-registered with the
CFTC as Swap Entities. In addition, and as we previously noted, the
CFTC's adopted final rules requiring Swap Entities to establish,
maintain, and follow written policies and procedures requiring the
execution of written trading relationship documentation are, other than
as expressly noted above in Section I.D, substantively identical to
those proposed by Rule 15Fi-5. Accordingly, these 35 entities are
already required to establish, maintain, and follow relevant written
policies as they relate to the execution of written trading
relationship documentation involving their swap portfolios, and these
policies and procedures would be expected to be largely consistent with
those that would be required with respect to their security-based swap
portfolios. Assuming that these existing policies and procedures would
simply need to be amended to apply to security-based swap transactions
upon adoption of proposed Rule 15Fi-5, we preliminarily estimate that
the average initial burden of revising these policies and procedures
would be one hour per respondent, for an estimated one-time burden of
35 hours in the aggregate.
With respect to the remaining 20 SBS Entities that are not dually-
registered with the CFTC, the Commission preliminarily estimates, based
on prior estimates in earlier Dodd-Frank rulemakings, that these
policies and procedures would require an average of 80 hours per non-
dually-registered respondent to initially prepare and implement, for an
estimated average annual burden of 1,600 hours in the aggregate.\195\
Once these policies and procedures are established, the Commission
estimates that it will take an average of 40 hours annually to revise
and maintain these policies and procedures per respondent (including
both dually-registered and non-dually-registered SBS Entities), for an
estimated average annual burden of 2,200 hours in the aggregate for all
55 respondents.
---------------------------------------------------------------------------
\195\ See supra note 184.
---------------------------------------------------------------------------
With regard to having an independent auditor conduct the required
periodic audit of written trading relationship documentation and the
requirement to retain a record of each such audit, the Commission
estimates that it will take an average of 10 hours to audit an SBS
Entity's documentation with each of its 368 counterparties, for a total
of 3,680 hours per SBS Entity, or 202,400 hours for all 55 SBS Entity
respondents.
Combining all of the estimated burdens described above, the
Commission preliminarily estimates that proposed Rule 15Fi-5 would
impose an estimated one-time initial burden of 593,985 hours in the
aggregate for all SBS Entities, which consists of (1) 1,635 hours in
the aggregate for all SBS Entities to prepare new written policies and
procedures or to bring
[[Page 4647]]
existing ones into compliance, (2) 577,500 hours in the aggregate for
SBS Entities to negotiate and execute trading relationship
documentation with 350 non-SBS Entity counterparties, and (3) 14,850
hours in the aggregate for SBS Entities to negotiate and execute
trading relationship documentation with 18 SBS Entity counterparties.
The Commission also preliminarily estimates that proposed Rule 15Fi-5
would impose an estimated ongoing burden of 204,600 hours each year in
the aggregate for all SBS Entities, which is composed of: (1) An
estimated annual burden of 2,200 hours in the aggregate for all SBS
Entities to revise and maintain written policies and procedures and (2)
an estimated annual burden of 202,400 hours in the aggregate for all
SBS Entities to conduct the required periodic audits. These
calculations are summarized in PRA Tables 8 and 9, below.
PRA Table 8--Proposed Rule 15Fi-5: Total Estimated Initial Burdens
------------------------------------------------------------------------
Hourly burden Total one-time
Activity (hours) burden (hours)
------------------------------------------------------------------------
Preparation of New Written Policies and 1 35
Procedures (35 dual SEC-CFTC
registrants)...........................
Preparation of New Written Policies and 80 1,600
Procedures (20 SEC-only registrants)...
Negotiate and Execute Trading 30 577,500
Relationship Documentation with 350 non-
SBS Entities (all 55 respondents)......
Negotiate and Execute Trading 15 14,850
Relationship Documentation with 18 SBS
Entities (all 55 respondents)..........
-------------------------------
Total Aggregate One-Time Burden for .............. 593,985
all 55 respondents.................
------------------------------------------------------------------------
PRA Table 9--Proposed Rule 15Fi-3: Summary of Annual Burdens
------------------------------------------------------------------------
Aggregate
hourly burden
Requirement (hours) (all
55
respondents)
------------------------------------------------------------------------
Audit of Written Trading Relationship Documentation..... 202,400
Revise and Maintain Written Policies and Procedures..... 2,200
---------------
Total Aggregate Annual Burden for all 55 respondents 204,600
------------------------------------------------------------------------
6. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books
and Records Requirements
The proposed amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6
would impose collection of information requirements that result in
initial and annual time burdens for SBS Entities. The proposed
amendments to Rules 17a-3 and 18a-5 would require three additional
types of records to be made and kept current by SBS Entities--records
regarding portfolio reconciliations, valuation disputes, and portfolio
compressions. Because the burden to make these records is accounted for
in the PRA estimates for proposed Rules 15Fi-3 and 15Fi-4, the burden
imposed by these proposed new requirements is the requirement in Rules
17a-4 and 18a-6 to maintain and preserve a written record of these
tasks, as well as the additional requirements in those provisions to
maintain and preserve records of policies and procedures required by
Rules 15Fi-3 through 15Fi-5 and written agreements with counterparties
regarding the terms of portfolio reconciliation. The Commission
estimates that these recordkeeping requirements, as proposed to be
amended, would impose an initial burden of 60 hours per firm for
updating the applicable policies and systems required to account for
capturing the additional records made pursuant to proposed Rule 15Fi-3
through 15Fi-5, and an ongoing annual burden of 75 hours per firm for
maintaining such records as well as to make additional updates to the
applicable recordkeeping policies and systems to account for the
proposed rules. As noted previously, the Commission estimates that
there are 55 SBS Entity respondents, for a total average initial annual
burden for all respondents of 3,300 hours and a total ongoing average
annual burden of 4,125 hours.
7. Proposed Amendment to Rule 3a71-6: Substituted Compliance
Proposed amended Rule 3a71-6 would require submission of certain
information to the Commission to the extent SBS Entities elect to
request a substituted compliance determination with respect to the
proposed portfolio reconciliation, portfolio compression, and written
trading relationship documentation requirements. The Commission expects
that registered SBS Entities will seek to rely on substituted
compliance upon registration, and that it is likely that the majority
of such requests will be made during the first year following the
effective date. Requests would not be necessary with regard to
applicable rules and regulations of a foreign financial regulatory
system that have previously been the subject of a substituted
compliance determination in connection with the applicable rules.
The Commission expects that the great majority of substituted
compliance applications will be submitted by foreign authorities, and
that very few substituted compliance requests will come from SBS
Entities. For purposes of this assessment, the Commission estimates
that three such SBS Entities will submit such an application.\196\
---------------------------------------------------------------------------
\196\ See Business Conduct Standards Adopting Release, 81 FR at
30097 n. 1582.
---------------------------------------------------------------------------
The Commission has previously estimated that the paperwork burden
associated with making each such substituted compliance request would
be approximately 80 hours of in-house counsel time, plus $80,000 for
the services of outside professionals (based on 200 hours of outside
time x $400 per hour).\197\ The Commission is currently of the belief
that this prior estimate is sufficient to cover a combined substituted
compliance request that also seeks a determination for the portfolio
reconciliation, portfolio compression, and written trading relationship
documentation rules proposed in this release. This estimate results in
an aggregate total of 240 internal hours, plus $240,000 for outside
services. Therefore, the Commission estimates that the total paperwork
burden incurred by such entities associated
[[Page 4648]]
with preparing and submitting a request for a substituted compliance
determination in connection with the portfolio reconciliation,
portfolio compression, and written trading relationship documentation
requirements will be approximately 240 hours per applicant, plus
$240,000 for the services of outside professionals for all three
requests.
---------------------------------------------------------------------------
\197\ See Business Conduct Standards Adopting Release, 81 FR at
30097 n. 1583.
---------------------------------------------------------------------------
E. Collection of Information Is Mandatory
Each collection of information for proposed Rules 15Fi-3 through
15Fi-5 and for the proposed amendments to Rules 17a-3, 17a-4, 18a-5,
and 18a-6 is a mandatory collection of information. With respect to the
proposed amendment to Rule 3a71-6, the application for substituted
compliance is mandatory for all foreign financial authorities or SBS
Entities that seek a substituted compliance determination.
F. Confidentiality
Proposed Rule 15Fi-3(c) would require an SBS Entity to promptly
notify the Commission of any security-based swap valuation dispute in
excess of $20,000,000 (or its equivalent in any other currency) if not
resolved within: (1) Three business days, if the dispute is with a
counterparty that is an SBS Entity; or (2) five business days, if the
dispute is with a counterparty that is not an SBS Entity. We have
requested comment as to whether these notices should be submitted to
the Commission on a confidential basis. No other information would be
submitted directly to the Commission under proposed Rules 15Fi-3
through 15Fi-5 or under the proposed amendments to Rules 17a-3, 17a-4,
18a-5, and 18a-6. To the extent that the Commission receives
confidential information pursuant to this collection of information
that is otherwise not publicly available, including in connection with
examinations or investigations, that information will be kept
confidential, subject to applicable law.
With regard to the proposed amendment to Rule 3a71-6, the
Commission generally will make requests for a substituted compliance
determination public, subject to requests for confidential treatment
being submitted pursuant to any applicable provisions governing
confidentiality under the Exchange Act.
G. Request for Comment
We request comment on whether our estimates for burden hours and
any external costs as described above are reasonable. Pursuant to 44
U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (1)
Evaluate whether the proposed collections of information are necessary
for the proper performance of the functions of the Commission,
including whether the information will have practical utility; (2)
evaluate the accuracy of the Commission's estimate of the burden of the
proposed collections of information; (3) determine whether there are
ways to enhance the quality, utility, and clarity of the information to
be collected; and (4) determine whether there are ways to minimize the
burden of the collections of information on those who are to respond,
including through the use of automated collection techniques or other
forms of information technology.
In addition, would we would appreciate any comments related to our
Paperwork Reduction Act estimates with respect to the following:
The number of counterparties with whom an SBS Entity would
maintain a security-based swap portfolio.
The number and proportion of security-based swap
portfolios that would fall under each of the proposed thresholds for
determining the frequency of the required portfolio reconciliations,
with respect to both SBS Entity and non-SBS Entity counterparties.
The hourly burden of conducting each portfolio
reconciliation and the use of automated systems to perform this
function, including those offered by third parties.
The use of third parties to perform portfolio
reconciliation and portfolio compression exercises, any upfront burdens
associated with engaging a third party to perform these services, and
the ongoing burdens associated with each exercise.
The burdens associated with establishing and routinely
updating all required policies and procedures.
The agency has submitted the proposed collections of information to
OMB for approval.Persons wishing to submit comments on the collection
of information requirements should direct the comments to the Office of
Management and Budget, Attention: Desk Officer for the Securities and
Exchange Commission, Office of Information and Regulatory Affairs,
Washington, DC 20503, and send a copy to Brent J. Fields, Secretary,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-1090, with reference to File No. S7-28-18. OMB is required to
make a decision concerning the collection of information between 30 and
60 days after publication of this release. Consequently, a comment to
OMB is best assured of having its full effect if OMB receives it within
30 days of publication. Requests for materials submitted to OMB by the
Commission with regard to these collections of information should be in
writing, refer to File No. S7-28-18, and be submitted to the Securities
and Exchange Commission, Office of FOIA Services, 100 F Street NE,
Washington, DC 20549-2736.
VI. Economic Analysis
The Commission is sensitive to the economic effects of its rules,
including the costs and benefits and the effects of its rules on
efficiency, competition, and capital formation. Section 3(f) \198\ of
the Exchange Act requires the Commission, whenever it engages in
rulemaking pursuant to the Exchange Act and is required to consider or
determine whether an action is necessary or appropriate in the public
interest, also to consider, in addition to the protection of investors,
whether the action would promote efficiency, competition, and capital
formation. In addition, Section 23(a)(2) \199\ of the Exchange Act
requires the Commission, when promulgating rules under the Exchange
Act, to consider the impact such rules would have on competition.
Section 23(a)(2) also provides that the Commission shall not adopt any
rule which would impose a burden on competition that is not necessary
or appropriate in furtherance of the purposes of the Exchange Act.\200\
---------------------------------------------------------------------------
\198\ 15 U.S.C. 78c(f).
\199\ 15 U.S.C. 78w(a)(2).
\200\ See id.
---------------------------------------------------------------------------
A. Broad Economic Considerations
Unlike some other types of securities transactions, a security-
based swap typically gives rise to ongoing obligations between
transaction counterparties during the life of the transaction,
including payments contingent on specific events, such as a corporate
default or a change in the price of an underlying reference asset
(e.g., changes in price to the floating leg of a total return swap).
Consequently, certain risk mitigation techniques, such as engaging in
portfolio reconciliation at periodic intervals, exercising
opportunities for portfolio compression, and ensuring that the terms of
a transaction are fully documented, are important practices for
assisting SBS Entities in effectively measuring and managing market and
credit risk.
Credit risk refers to the probability of a financial loss due to a
counterparty to a transaction failing to fulfill its financial
obligations. In order to manage credit risk in the security-based swap
context properly, a market participant
[[Page 4649]]
should know the identity of each of its counterparties, the details of
the obligations of each counterparty in each transaction into which the
two have entered, and the value of those obligations (including for
purposes of calculating margin or measuring outstanding exposure for
risk management). The greater the number of counterparties and
transactions, the complexity of those transactions, and the value of
the outstanding obligations, the more important it becomes for each
counterparty to have well-documented credit risk management policies.
The risks of the counterparties' failure to manage credit risk
adequately may not become apparent until the onset of a financial
crisis. Such a crisis occurred in the fall of 2008, when certain events
threatened to freeze U.S. and global credit markets. The severity of
that crisis has been partially attributed to poor risk management
practices of financial firms and flawed supervisory oversight for
certain financial institutions.\201\
---------------------------------------------------------------------------
\201\ See Lessons of the Financial Crisis for Future Regulation
of Financial Institutions, at 3-4, IMF Policy Paper (Feb. 4, 2009),
available at: http://www.imf.org/external/np/pp/eng/2009/020409.pdf;
see also Sewall Chan, Financial Crisis Was Avoidable, Inquiry Finds,
N.Y. Times (Jan. 25, 2011), available at: http://www.nytimes.com/2011/01/26/business/economy/26inquiry.html?_r=1;.
---------------------------------------------------------------------------
Shortcomings in credit risk management and documentation may be
unobservable to counterparties and other market participants until a
crisis occurs as it did in 2008; thus some benefits of compliance will
accrue to the financial system as a whole while the ongoing direct
costs are borne by the institution. If firms do not fully internalize
the benefits of risk management, then they may underinvest. For
example, shortcomings in documentation were reported to have created
significant problems during the financial crisis that immediately
preceded passage of the Dodd-Frank Act in connection with efforts by
Barclays PLC to take over a portion of Lehman Brothers Holdings Inc.'s
derivatives trades.\202\ Shortcomings in the documentation of portfolio
valuation methods and reconciliation of portfolio values were also
exposed when, during bankruptcy proceedings, counterparties' valuations
differed by hundreds of millions of dollars from the value of those
same positions on the bankrupt entity's books.\203\
---------------------------------------------------------------------------
\202\ See Linda Sandler, Lehman Derivatives Records a `Mess,'
Barclays Executive Says, Bloomberg (Aug. 30, 2010), available at:
http://www.bloomberg.com/news/articles/2010-08-30/lehman-derivatives-records-a-mess-barclays-executive-says.
\203\ See Satyajit Das, In the Matter of Lehman Brothers, 59
Wilmott 20-29 (May 2012). Disagreement over CDO valuation between
AIG and its counterparties was also an issue around the same time.
See supra note 15 and accompanying text.
---------------------------------------------------------------------------
Among other things, effective risk management requires the
existence of sound documentation, periodic reconciliation of
portfolios, rigorously tested valuation methodologies, and sound
collateralization practices.\204\ More broadly, the President's Working
Group on Financial Policy (``PWG'') noted shortcomings in the OTC
derivatives market as a whole during the financial crisis that
immediately preceded passage of the Dodd-Frank Act. The PWG identified
the need for an improved integrated operational structure supporting
OTC derivatives, specifically highlighting the need for an enhanced
ability to manage counterparty risk through ``netting and collateral
agreements by promoting portfolio reconciliation and accurate valuation
of trades.'' \205\
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\204\ See PriceWaterhouseCoopers, Lehman Brothers' Bankruptcy:
Lessons learned for the survivors, Informational presentation for
clients, (Aug. 2009), at 12-24, available at: http://www.pwc.com/en_JG/jg/events/Lessons-learned-for-thesurvivors.pdf.2009), at 12-
24, available at http://www.pwc.com/en_JG/jg/events/Lessons-learned-for-thesurvivors.pdf.
\205\ See The President's Working Group on Financial Markets,
Policy Statements on Financial Market Developments, (Mar. 2008)
(``PWG Report''), available at: http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.2008) (``PWG Report''),
available at http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.
---------------------------------------------------------------------------
The rules we are proposing today are designed to ensure that SBS
Entities implement certain risk mitigation techniques by engaging in
periodic portfolio reconciliation, maintaining policies and procedures
for engaging in certain forms of portfolio compression exercises with
each of their counterparties, and maintaining policies and procedures
reasonably designed to ensure that they execute written trading
relationship documentation with each of their counterparties prior to
executing a security-based swap transaction. The proposed rules also
would set minimum standards with respect to identifying the matters
that must be addressed in the security-based swap trading
documentation, and outline certain requirements related to the
resolution of discrepancies, particularly those involving differences
in the valuation of security-based swaps.\206\ In proposing these
rules, the Commission preliminarily believes that they will promote
effective risk management practiced by security-based swap market
participants in a number of important ways, which we discuss in greater
detail below.
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\206\ The proposed rules also would (1) address the potential
availability of substituted compliance in connection with those
portfolio reconciliation, portfolio compression, and trading
relationship documentation requirements and (2) add corresponding
requirements to the Commission's recordkeeping rules that would
require SBS Entities to make and keep records demonstrating
compliance with the new risk mitigation requirements.
---------------------------------------------------------------------------
The Commission notes that, where possible, it has attempted to
quantify the costs, benefits, and effects on efficiency, competition,
and capital formation expected to result from adopting these rules. In
certain cases, however, the Commission is unable to quantify the
economic effects. Crucially, many of the relevant economic effects,
such as improved risk management and the value of Commission
enforcement and oversight, are inherently difficult to quantify. In
other cases, we lack the information necessary to provide reasonable
estimates. For example, we lack data on prices charged by certain
third-party service providers, current trading relationship
documentation practices for entities and transactions not already
subject to similar rules from other regulators, the fraction of
outstanding positions that when reconciled will result in a dispute and
the costs incurred by the participants in resolving the dispute. To the
best of our knowledge, no such data is publicly available. Where the
Commission is unable to quantify the economic effects, the discussion
is qualitative in nature and includes, where possible, descriptions of
the direction of these effects. The Commission requests data from
commenters to help quantify these effects.
B. Economic Baseline
To assess the economic impact of the proposed risk mitigation
rules, the Commission is using as a baseline the security-based swap
market as it exists today, including applicable rules that have already
been adopted, and excluding rules that have been proposed but not yet
finalized. The analysis includes the statutory and regulatory
provisions that currently govern the security-based swap market
pursuant to the Dodd-Frank Act, as well as rules adopted in, among
others, the Business Conduct Standards Adopting Release \207\ and the
Trade Acknowledgment and Verification Adopting Release.\208\ Moreover,
because participants in the security-based swap market may also operate
in other markets, particularly the swaps market, we have considered
both the direct and indirect impact of
[[Page 4650]]
rules that have been adopted by other regulators (e.g., the CFTC as
well as foreign regulatory bodies) in formulating the baseline. Our
understanding of the market is informed by available data on security-
based swap transactions, though we acknowledge the data available to us
limits the extent to which we can quantitatively characterize the
market. Because this data does not cover the entire market, we have
developed an understanding of market activity using a sample that
includes only certain portions of the market.
---------------------------------------------------------------------------
\207\ See supra note 138.
\208\ See supra note 6.
---------------------------------------------------------------------------
Furthermore, the overall Title VII regulatory framework will have
consequences for the ways in which security-based swaps are transacted
which, in turn, will affect the activities addressed by these proposed
rules. For example, the proposed rules generally do not apply to
security-based swaps cleared through a registered clearing agency.
Therefore, the scope of future mandatory clearing requirements may
affect the overall level of security-based swap activity subject to the
final rules ultimately adopted under the proposal, as well as the
overall costs borne by SBS Entities.
1. Security-Based Swap Market Activity and Participants
a. Available Data From the Security-Based Swap Market
The Commission's understanding of the market is informed, in part,
by available data on security-based swap transactions, though the
Commission acknowledges that limitations in the data limit the extent
to which it is possible to quantitatively characterize the market.
Since this data does not cover the entire market, the Commission has
analyzed market activity using a sample of transactions that includes
only certain segments of the market. The Commission believes, however,
that the data underlying this analysis provides reasonably
comprehensive information regarding single-name CDS transactions and
the composition of the participants in the single-name CDS market.
Specifically, the analysis of the state of the current security-
based swap market is based on data obtained from the Depository Trust
and Clearing Corporation (``DTCC'') Derivatives Repository Limited
Trade Information Warehouse (``DTCC-TIW''), especially data regarding
the activity of market participants in the single-name CDS market
during the period from 2006 to 2017.\209\ Although the definition of
``security-based swap'' is not limited to single-name CDS,\210\ single-
name CDS contracts make up a majority of security-based swaps, and we
believe that the single-name CDS data is sufficiently representative of
the market to inform our analysis of the current security-based swap
market. According to data published by the Bank for International
Settlements (``BIS''), the global notional amount outstanding in
single-name CDS was approximately $4.6 trillion,\211\ in multi-name
index CDS was approximately $4.4 trillion, and in multi-name, non-index
CDS was approximately $343 billion.\212\ The total gross market value
outstanding in single-name CDS was approximately $130 billion, and in
multi-name CDS instruments was approximately $174 billion.\213\ The
global notional amount outstanding in equity forwards and swaps as of
December 2017 was $3.21 trillion, with total gross market value of $197
billion.\214\
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\209\ In prior releases, the Commission has examined data for
other time periods. For example, in the Business Conduct Standards
Adopting Release, the Commission presented an analysis of TIW data
for November 2006 through December 2014. While the exact numbers of
various groups of transacting agents and account holders in that
analysis differ from the figures reported in this section (for a
longer time period), we do not observe significant structural
differences in market participation. Compare 81 FR at 30102 (Tables
1 and 2) with Tables 1 and 2 below.
\210\ While other repositories may collect data on transactions
in total return swaps on equity and debt, we do not currently have
access to such data for these products (or other products that are
security-based swaps). Additionally, the Commission explains below
that data related to single-name CDS provides reasonably
comprehensive information for the purpose of this analysis.
\211\ The global notional amount outstanding represents the
total face amount used to calculate payments under outstanding
contracts. The gross market value is the cost of replacing all open
contracts at current market prices.
\212\ See BIS, Semi-annual OTC derivatives statistics at
December 2017, Table 10.1, available at: https://www.bis.org/statistics/d10_1.pdf (last accessed May 18, 2018).
\213\ See id.
\214\ These totals include swaps and security-based swaps, as
well as products that are excluded from the definition of ``swap,''
such as certain equity forwards. See OTC, Equity-Linked Derivatives
Statistics, Table D8, available at: https://www.bis.org/statistics/d8.pdf (last accessed May 18, 2018). For the purposes of this
analysis, the Commission assumes that multi-name index CDS are not
narrow-based index CDS and therefore, do not fall within the
security-based swap definition. See 15 U.S.C. 78c(a)(68)(A). See
also Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping, 77 FR 48208. The Commission also assumes
that all instruments reported as equity forwards and swaps are
security-based swaps, potentially resulting in underestimation of
the proportion of the security-based swap market represented by
single-name CDS. Therefore, when measured on the basis of gross
notional outstanding single-name CDS contracts appear to constitute
roughly 59% of the security-based swap market. Although the BIS data
reflects the global OTC derivatives market, and not just the U.S.
market, the Commission has no reason to believe that these ratios
differ significantly in the U.S. market.
---------------------------------------------------------------------------
The Commission further notes that the data available from TIW does
not encompass those CDS transactions that both: (i) Do not involve U.S.
counterparties; \215\ and (ii) are based on non-U.S. reference
entities. Notwithstanding this limitation, the TIW single-name CDS data
should provide sufficient information to permit the Commission to
identify the types of market participants active in the security-based
swap market and the general pattern of dealing within that market.\216\
---------------------------------------------------------------------------
\215\ Following publication of the Warehouse Trust Guidance on
CDS data access, TIW surveyed market participants, asking for the
physical address associated with each of their accounts (i.e., where
the account is organized as a legal entity). This physical address
is designated the registered office location by TIW. When an account
reports a registered office location, we have assumed that the
registered office location reflects the place of domicile for the
fund or account. When an account does not report a registered office
location, we have assumed that the settlement country reported by
the investment adviser or parent entity to the fund or account is
the place of domicile. Thus, for purposes of this analysis, the
Commission has classified accounts as ``U.S. counterparties'' when
they have reported a registered office location in the United
States. The Commission notes, however, that this classification is
not necessarily identical in all cases to the definition of U.S.
person under Rule 3a71-3(a)(4).
\216\ The challenges the Commission faces in estimating measures
of current market activity stem, in part, from the absence of
comprehensive reporting requirements for security-based swap market
participants. The Commission has adopted rules regarding trade
reporting, data elements, and public reporting for security-based
swaps that are designed to, when fully implemented, provide the
Commission with additional measures of market activity that will
allow us to better understand and monitor activity in the security-
based swap market. See Regulation SBSR Adopting Release, 81 FR at
53545.
---------------------------------------------------------------------------
b. Affected SBS Entities
Final SBS Entity registration rules have been adopted, but
compliance is not yet required. Therefore, we do not have data on the
actual number of SBS Entities that will register with the Commission,
or the number of persons associated with registered SBS Entities. The
Commission has elsewhere estimated that up to 50 entities may register
with the Commission as security-based swap dealers, and up to five
additional entities may register as major security-based swap
participants,\217\ and these estimates remain unchanged.
---------------------------------------------------------------------------
\217\ See, e.g., Registration Adopting Release, 80 FR at 49000.
---------------------------------------------------------------------------
Firms that act as dealers play a central role in the security-based
swap market. Based on an analysis of 2017 single-name CDS data in TIW,
accounts of those firms that are likely to exceed the
[[Page 4651]]
security-based swap dealer de minimis thresholds and trigger
registration requirements for intermediated transactions with a gross
notional amount of approximately $2.9 trillion, approximately 55% of
the gross notional intermediated by the top five dealer accounts.\218\
---------------------------------------------------------------------------
\218\ The Commission staff analysis of DTCC Derivatives
Repository Limited Trade Information Warehouse transaction records
indicates that approximately 99% of single-name CDS price-forming
transactions in 2017 involved an ISDA-recognized dealer.
---------------------------------------------------------------------------
These dealers transact with hundreds or thousands of
counterparties. Approximately 21% of accounts of firms expected to
register as security-based dealers and observable in TIW have entered
into security-based swaps with over 1,000 unique counterparty accounts
as of year-end 2017.\219\ Another 25% of these accounts transacted with
500 to 1,000 unique counterparty accounts; 29% transacted with 100 to
500 unique accounts; and 25% of these accounts intermediated security-
based swaps with fewer than 100 unique counterparties in 2017. The
median dealer account transacted with 495 unique accounts (with an
average of approximately 570 unique accounts). Non-dealer
counterparties transacted almost exclusively with these dealers. The
median non-dealer counterparty transacted with two dealer accounts
(with an average of approximately three dealer accounts) in 2017.
---------------------------------------------------------------------------
\219\ Many dealer entities and financial groups transact through
numerous accounts. Given that individual accounts may transact with
hundreds of counterparties, the Commission may infer that entities
and financial groups may transact with at least as many
counterparties as the largest of their accounts.
---------------------------------------------------------------------------
c. Other Market Participants
In addition to dealers, thousands of other participants appear as
counterparties to security-based swap contracts in our sample, and
include, but are not limited to, investment companies, pension funds,
private funds, sovereign entities, and industrial companies. We observe
that most non-dealer users of security-based swaps do not engage
directly in the trading of swaps, but trade through banks, investment
advisers, or other types of firms acting as dealers or agents. Based on
an analysis of the counterparties to trades reported to the TIW, there
are 2,110 entities that engaged directly in trading between November
2006 and December 2017.\220\
---------------------------------------------------------------------------
\220\ These 2,110 entities, which are presented in more detail
in Table 1, infra, include all DTCC-defined ``firms'' shown in TIW
as transaction counterparties that report at least one transaction
to TIW as of December 2017. The staff in the Division of Economic
and Risk Analysis classified these firms, which are shown as
transaction counterparties, by machine matching names to known
third-party databases and by manual classification. See, e.g.,
Dealing Activity Adopting Release, 81 FR 8602, fn.43. Manual
classification was based in part on searches of the EDGAR and
Bloomberg databases, the SEC's Investment Adviser Public Disclosure
database, and a firm's public website or the public website of the
account represented by a firm. The staff also referred to ISDA
protocol adherence letters available on the ISDA website.
---------------------------------------------------------------------------
As shown in Table 1 below, close to three-quarters of these
entities (DTCC-defined ``firms'' shown in TIW, which we refer to here
as ``transacting agents'') were identified as investment advisers, of
which approximately 40% (about 30% of all transacting agents) were
registered as investment advisers under the Advisers Act.\221\ Although
investment advisers are the vast majority of transacting agents, the
transactions they executed account for only 12.8% of all single-name
CDS trading activity reported to the TIW, measured by number of
transaction-sides (each transaction has two transaction sides, i.e.,
two transaction counterparties). The vast majority of transactions
(83.3%) measured by number of transaction-sides were executed by ISDA-
recognized dealers.
---------------------------------------------------------------------------
\221\ See 15 U.S.C. 80b1-80b21. Transacting agents participate
directly in the security-based swap market, without relying on an
intermediary, on behalf of principals. For example, a university
endowment may hold a position in a security-based swap that is
established by an investment adviser that transacts on the
endowment's behalf. In this case, the university endowment is a
principal that uses the investment adviser as its transacting agent.
Table 1--The number of Transacting Agents by Counterparty Type and the Fraction of Total Trading Activity, From
November 2006 Through December 2017, Represented by Each Counterparty Type
----------------------------------------------------------------------------------------------------------------
Transaction
Transacting agents Number Percent share
(percent)
----------------------------------------------------------------------------------------------------------------
Investment Advisers............................................. 1635 77.5 12.8
- SEC registered............................................ 658 31.2 8.6
Banks........................................................... 262 12.4 3.4
Pension Funds................................................... 29 1.4 0.1
Insurance Companies............................................. 42 2.0 0.2
ISDA-Recognized Dealers \222\................................... 17 0.8 83.3
Other........................................................... 125 5.9 0.2
-----------------------------------------------
Total................................................... 2,110 100.0 100
----------------------------------------------------------------------------------------------------------------
Principal holders of CDS risk exposure are represented by
``accounts'' in the TIW.\223\ The staff's analysis of these accounts in
TIW shows that the 2,110 transacting agents classified in Table 1
represent 13,137 principal risk holders. Table 2, below, classifies
these principal risk holders by their counterparty type and whether
they are represented by a registered or unregistered investment
adviser.\224\ For instance, banks in Table 1 allocated transactions
across 349 accounts, of which 20 were represented by investment
advisers. In the remaining instances, banks traded for their own
accounts. Meanwhile, ISDA-recognized dealers in Table 1 allocated
transactions across 91 accounts. Private funds are the largest type of
account holders that we were able to classify, and although not
verified through a recognized database, most of the funds
[[Page 4652]]
we were not able to classify appear to be private funds.\225\
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\222\ For the purpose of this analysis, the ISDA-recognized
dealers are those identified by ISDA as belonging to the G14 or G16
dealer group during the period: JP Morgan Chase NA (and Bear
Stearns), Morgan Stanley, Bank of America NA (and Merrill Lynch),
Goldman Sachs, Deutsche Bank AG, Barclays Capital, Citigroup, UBS,
Credit Suisse AG, RBS Group, BNP Paribas, HSBC Bank, Lehman
Brothers, Soci[eacute]t[eacute] G[eacute]n[eacute]rale, Credit
Agricole, Wells Fargo and Nomura. See, e.g., https://www.isda.org/a/5eiDE/isda-operations-survey-2010.pdf.
\223\ ``Accounts'' as defined in the TIW context are not
equivalent to ``accounts'' in the definition of ``U.S. person''
provided by Exchange Act rule 3a71-3(a)(4)(i)(C). They also do not
necessarily represent separate legal persons. One entity or legal
person may have multiple accounts. For example, a bank may have one
DTCC account for its U.S. headquarters and one DTCC account for one
of its foreign branches.
\224\ Unregistered investment advisers include all investment
advisers not registered under the Investment Advisers Act and may
include investment advisers registered with a state or a foreign
authority as well as investment advisers that are exempt reporting
advisers under Section 203(l) or 203(m) of the Investment Advisers
Act.
\225\ For the purposes of this discussion, ``private fund''
encompasses various unregistered pooled investment vehicles,
including hedge funds, private equity funds, and venture capital
funds. There remain over 5,800 DTCC accounts unclassified by type.
Although unclassified, each account was manually reviewed to verify
that it was not likely to be a special entity within the meaning of
the Dodd-Frank Act and instead was likely to be an entity such as a
corporation, an insurance company, or a bank.
\226\ This column reflects the number of participants who are
also trading for their own accounts.
Table 2--The Number and Percentage of Account Holders--by Type--Who Participate in the Security-Based Swap Market Through a Registered Investment
Adviser, an Unregistered Investment Adviser, or Directly as a Transacting Agent, from November 2006 Through December 2017
--------------------------------------------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------------------------------------------------
Account holders by type Number Represented by a
registered investment
adviser
Represented by an
unregistered investment
dviser
Participant is
transacting agent \226\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Private Funds............................................. 3,857 1,973 51% 1,859 48% 25 1%
DFA Special Entities...................................... 1,319 1,262 96% 37 3% 20 2%
Registered Investment Companies........................... 1,159 1,082 93% 73 6% 4 0%
Banks (non-ISDA-recognized dealers)....................... 349 20 6% 8 2% 321 92%
Insurance Companies....................................... 301 196 65% 34 11% 71 24%
ISDA-Recognized Dealers................................... 91 0 0% 0 0% 91 100%
Foreign Sovereigns........................................ 83 63 76% 3 4% 17 20%
Non-Financial Corporations................................ 75 52 69% 4 5% 19 25%
Finance Companies......................................... 20 11 55% 0 0% 9 45%
Other/Unclassified........................................ 5,883 3,745 64% 1,887 32% 251 4%
---------------------------------------------------------------------------------------------
All................................................... 13,137 8,404 64% 3,905 30% 828 6%
--------------------------------------------------------------------------------------------------------------------------------------------------------
d. Outstanding Positions
Our analysis here focuses on outstanding positions in single-name
CDS. As we have previously noted, although the definition of a
security-based swap is not limited to single-name CDS, we believe that
the single-name CDS data is sufficiently representative of the market
and therefore can directly inform the analysis of the state of the
current security-based swap market.\227\ In 2017, there were 1,534,753
single-name CDS transactions reported to DTCC-TIW, of which 1,036,155
were transactions with a clearing agency as a counterparty.\228\
Currently, security-based swap transactions are generally negotiated
and executed bilaterally, typically with a dealer as one of the
counterparties. Indeed, based on our analysis of DTCC-TIW data for
2017, more than 99% of single-name CDS transactions have an ISDA-
recognized dealer as a counterparty, and 31% of transactions are
between two ISDA-recognized dealers.\229\
---------------------------------------------------------------------------
\227\ While other repositories may collect data on transactions
in total return swaps on equity and debt, we do not currently have
access to such data for these products (or other products that are
security-based swaps). In the Cross-Border Proposing Release, we
explained that we believed that data related to single-name CDS was
reasonable for purposes of this analysis; such transactions appear
to constitute roughly 82% of the security-based swap market as
measured on a notional basis. See Cross-Border Proposing Release, 78
FR at 31120 n. 1301. None of the commenters to that release disputed
these assumptions, and we therefore continue to believe that,
although the BIS data reflect the global OTC derivatives market, and
not just the U.S. market, these ratios are an adequate
representation of the U.S. market.
Also consistent with our approach in that release, with the
exception of the analysis regarding the degree of overlap between
participation in the single-name CDS market and the index CDS market
(cross-market activity), our analysis below does not include data
regarding index CDS (including CDS based on narrow-based security
indices) as we do not currently have sufficient information to
identify the relative volumes of index CDS that are either swaps or
security-based swaps.
\228\ For the purposes of this analysis, we estimate there were
approximately 1.53 million single-name CDS transactions in 2017, of
which approximately 1.04 million were transactions with a clearing
agency as a counterparty. In addition to CDS, security-based swap
products include equity swaps, such as total return swaps on single
names and swaps based on narrow-based security indices. The
Commission currently lacks comprehensive data on equity swaps,
including data on transaction volumes and notional amounts. While
there were more than 1.53 million security-based swap transactions
in 2017, we do not currently have sufficient information to
precisely identify the number of transactions beyond those that were
single-name CDS. However, while recognizing that average notional
transaction amounts for equity and multi-name CDS may differ from
average notional transaction amounts for CDS, our estimate (using
data from 2015) that single-name CDS constitute roughly 82% of the
security-based swap market implies that there were approximately
337,000 security-based swap transactions in 2017 in addition to the
approximately 1.53 million single-name CDS transactions we identify
in the DTCC-TIW data, or 1.87 million total security-based swap
transactions. Note that our estimate that single-name CDS
constitutes roughly 82% of the security-based swap market is based
on notional transaction amounts rather than transaction counts; in
using this figure to estimate the total number of security-based
swap transactions, we have assumed that the average notional amount
is the same across single-name CDS, multi-name CDS, and equity
swaps.
\229\ For the purpose of this analysis, the reference to ``ISDA-
recognized dealers'' means those dealers identified by ISDA as
belonging to the G14 or G16 dealer group during the period. This
group includes: JP Morgan Chase NA (and Bear Stearns), Morgan
Stanley, Bank of America NA (and Merrill Lynch), Goldman Sachs,
Deutsche Bank AG, Barclays Capital, Citigroup, UBS, Credit Suisse
AG, RBS Group, BNP Paribas, HSBC Bank, Lehman Brothers,
Soci[eacute]t[eacute] G[eacute]n[eacute]rale, Credit Agricole, Wells
Fargo and Nomura. See, e.g., https://www.isda.org/a/5eiDE/isda-operations-survey-2010.pdf. See also Aldasoro, Inaki, and Torsten
Ehlers, 2018, The Credit Default Swap Market: What a Difference a
Decade Makes, BIS Quarterly Review June 2018, Graph 2, available at:
https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf. https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf. https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf, Graph 2.
---------------------------------------------------------------------------
As of December 30, 2017 there were 360,473 outstanding positions
(with a gross notional value of $4.196 trillion) in single-name
corporate CDS of which 252,108 positions ($2.095 trillion) did not
include a central counterparty (``CCP'') as one of the counterparties.
Of the 252,108 positions, 158,674 positions ($1.383 trillion) were
between two market participants the Commission expects will register as
SBS Entities, based on an analysis of DTCC-TIW data.\230\ In addition,
90,559 positions ($0.684 trillion) were between an expected SBS Entity
and a market participant not expected to register as an SBS Entity and
2,875 ($0.028 trillion) were between two participants not expected to
register as SBS Entities.
---------------------------------------------------------------------------
\230\ See supra Section VI.B.1.b for current estimates of the
number of SBS Entities.
---------------------------------------------------------------------------
If transactions are examined instead, there were 383,212 price-
forming transactions in calendar-year 2017 (with an aggregate gross
trade size of $5.304 trillion) in single-name corporate CDS of which
175,600 transactions ($4.321 trillion) did not include a CCP as one of
the counterparties. Of those 175,660
[[Page 4653]]
transactions, 75,119 transactions ($1.695 trillion) were between two
expected SBS Entities, 99,370 transactions ($2.245 trillion) were
between an expected SBS Entity and a participant not expected to
register, and 1,171 transactions ($0.382 trillion) were between two
participants not expected to register as SBS Entities.
Further analysis of the data reveals that of the 24 expected SBS
Entities with outstanding positions as of December 30, 2017, 10 are not
U.S. persons and may be subject to similar requirements as those being
proposed here by foreign regulators. We note that the data available to
us from DTCC-TIW does not encompass those CDS positions that both: (i)
Do not involve U.S. counterparties; \231\ and (ii) are based on non-
U.S. reference entities. Notwithstanding this limitation, we believe
that the DTCC-TIW data provides sufficient information to identify the
types of market participants active in the security-based swap market
and the general pattern of transactions within that market.\232\ We
find that of the outstanding positions on December 30, 2017, 317,854
positions ($1.661 trillion) include at least one expected SBS Entity,
3,037 ($0.018 trillion) are between non-U.S. domiciled expected SBS
Entities and 60,948 ($0.489 trillion) are between a non-U.S, domiciled
expected SBS Entity and a participant not expected to register as an
SBS Entity.
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\231\ We note that DTCC-TIW's determinations as to the domicile
of a counterparty or reference entity may not reflect our definition
of ``U.S. person'' in all cases. Our definition of ``U.S. person''
follows the definition used in the Commission's June 2014 release
where it, among other things, adopted rules and guidance regarding
the application of the certain Title VII definitions in the cross-
border context. See Application of ``Security-Based Swap Dealer''
and ``Major-Security-Based Swap Participant'' Definitions to Cross-
Border Security- Based Swap Activities, Exchange Act Release No.
72472 (June 25, 2014), 79 FR 47277, 47303 (Aug. 12, 2014
(republication)) (``Cross-Border Adopting Release'').
\232\ The challenges we face in estimating measures of current
market activity stems, in part, from the absence of comprehensive
reporting requirements for security-based swap market participants.
The Commission has adopted rules regarding trade reporting, data
elements, and public reporting for security-based swaps that are
designed to, when fully implemented, provide us with appropriate
measures of market activity. See Regulation SBSR Adopting Release,
80 FR at 14699-700.
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2. Current Portfolio Reconciliation Practices
While the Commission does not have data on current portfolio
reconciliation practices of security-based swap market
participants,\233\ certain market participants we expect will register
as SBS Entities are already subject to similar requirements from other
regulators. In particular, those entities that are also registered with
the CFTC as Swap Entities are subject to CFTC rules on portfolio
reconciliation. These rules require Swap Entities to reconcile their
swap portfolios with one another and to provide counterparties who are
not registered as Swap Entities with regular opportunities for
portfolio reconciliation.\234\ The Commission has reviewed these rules
and preliminarily believes that, other than as expressly noted above in
Section I.B, they are substantively identical to the rules we are
proposing today.\235\
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\233\ Although the Commission does not have information on the
number of valuation discrepancies between counterparties in SBS
markets, a June 2017 survey on dealer financing noted that two-
fifths of survey respondents reported that the volume of valuation
disputes increased somewhat over the September 2016 to June 2017
period. Small net fractions of dealers responded that the volume,
duration, and persistence of mark and collateral disputes had
increased in OTC derivatives, especially in foreign exchange and
interest rate contracts. Three-fifths of dealers responded that, on
average, it takes more than two days but less than a week to resolve
a mark and collateral dispute on VM. One-third indicated two days or
fewer. See Yesol Huh, Division of Research and Statistics, Federal
Reserve Board, The June 2017 Senior Credit Officer Opinion Survey on
Dealer Financing Terms, available at: https://www.federalreserve.gov/data/scoos/files/scoos_201706.pdf.
\234\ See 17 CFR 23.502 (Portfolio reconciliation).
\235\ See, e.g., supra Section I.B.2 for a discussion of
similarities and differences in approach to the definition of
material terms that must be reconciled.
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Further, SBS Entities that are domiciled outside of the U.S. may be
subject to similar requirements of regulators from their home
jurisdiction. For example, entities subject to Chapter VII, Article 13
of EU Regulation No 149/2013 already must comply with portfolio
reconciliation requirements similar to those under the proposed rules.
The EU regulations require all counterparties to agree on arrangements
under which portfolios shall be reconciled before entering into an OTC
derivative contract. Furthermore, the frequency of portfolio
reconciliation under those regulations depends on both whether either
counterparty is a ``financial counterparty'' or a ``non-financial
counterparty'' (each as defined in European regulations), and the
number of outstanding contracts between the counterparties.
In addition to regulations that may apply to certain SBS Entities
that are either dually registered with the CFTC as Swap Entities or
subject to similar portfolio reconciliation rules in other
jurisdictions, portfolio reconciliation forms a part of current market
practices. In particular, ISDA publishes a set of `best practices' for
its members for the OTC derivatives collateral process that addresses,
among other things, portfolio reconciliation of non-cleared OTC
derivatives.\236\ These `best practices' include written agreement
between counterparties as to the terms of the reconciliation and
reconciliation tolerances, and also recognize both the CFTC and EU
rules pertaining to portfolio reconciliation.
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\236\ See ISDA, 2013 Interim Updated Best Practices for the OTC
Derivatives Collateral Process, Best Practices 10.1--10.6 (Oct. 23,
2013), available at: https://www2.isda.org/attachment/NjA3NQ==/2013%20ISDA%20Best%20Practices%20for%20the%20OTC%20Derivatives%20Collateral%20Process%20-%20FINAL.pdf (``ISDA Collateral Best
Practices'').
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3. Current Portfolio Compression Practices
While the Commission does not have data on current portfolio
compression practices of security-based swap market participants,
certain SBS Entities are already subject to similar compression
requirements in other contexts similar to the situation involving
portfolio reconciliation. Specifically, SBS Entities that are also
registered with the CFTC as Swap Entities are subject to CFTC rules on
portfolio compression. As discussed above, the Commission has reviewed
those rules and preliminarily believes that they are, other than as
expressly noted above in Section I.C, substantively identical to the
rules we are proposing today.
Further, SBS Entities that are domiciled outside of the U.S. may be
subject to similar requirements from regulators in their home
jurisdiction. For example, entities subject to Chapter VII, Article 14
of EU Regulation No 149/2013 already must comply with portfolio
compression requirements. Under these requirements any entity that has
500 or more non-cleared OTC derivative contracts with any one
counterparty must have procedures in place to regularly (at least twice
a year) analyze the possibility of conducting a portfolio compression
exercise in order to reduce their counterparty credit risk and engage
in such a portfolio compression exercise. The EU regulations differ
from these proposed rules in a few important ways, including their
application to all OTC derivative positions, not just security-based
swaps, as well as the minimum frequency of compression exercises.
Moreover, both financial and non-financial counterparties are required
under the EU regulations to ensure that they are able to provide ``a
reasonable and valid explanation to the relevant competent authority
for concluding that a portfolio compression exercise is not
appropriate.''
[[Page 4654]]
In addition to regulations that may apply to certain SBS Entities
that are either dually registered with the CFTC as Swap Entities or
subject to similar portfolio compression rules in other jurisdictions,
portfolio compression forms a part of current market practices. The
ISDA Collateral Best Practices also includes a best practice that
addresses portfolio compression, explaining that trades that are
subject to industry-wide trade-reducing events should be removed from
the portfolio on the day the trade-reducing event occurs and that this
should be in agreement with governing documentation for the applicable
risk reducing process.\237\
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\237\ See ISDA Collateral Best Practices, supra note 236, Best
Practice 8.4.
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Although we lack data on current portfolio compression practices of
individual SBS market participants, the importance of portfolio
compression is illustrated by the scope of its use among security-based
swap market participants.\238\ In March 2010, DTCC explicitly
attributed the reduction in the gross notional value of the credit
derivatives in its warehouse to industry supported portfolio
compression.\239\ Using data from TriOptima, the BIS reports CDS
portfolio compression rates as high as 25% of notional outstanding in
the first half of 2008.\240\ Compression volumes fell steadily over the
following years due, in part, to falling transaction volumes and the
rise of central clearing.\241\ TriOptima, as well as other firms,
continue to offer compression services, and the Commission
preliminarily believes that the fact that market participants continue
to find it worthwhile to pay for such services lends support to the
argument that market participants view portfolio compression as a
valuable tool.
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\238\ The data available to the Commission with respect to
portfolio compression does not allow for enumeration of the actual
participants which participate in such practices; however,
inferences regarding the scope can be drawn from the magnitude of
the reduction in the gross notional value of the credit derivatives.
\239\ See DTCC Press Release, DTCC Trade Information Warehouse
Completes Record Year Processing OTC Credit Derivatives, (Mar. 11,
2010). Notably, beginning in August 2008, ISDA encouraged
compression exercises for CDS by selecting the service provider and
defining the terms of service.
\240\ See Aldasoro, Inaki, and Torsten Ehlers, 2018, The Credit
Default Swap Market: What a Difference a Decade Makes, BIS Quarterly
Review June 2018, Graph 1 panel 2 and accompanying text, available
at: https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf. In March of 2010,
the staff of the FRBNY estimated that since 2008 nearly $50 trillion
gross notional of CDS positions has been eliminated through
portfolio compression. See FRBNY OTC Derivatives Report, supra note
62.
\241\ Id.
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The chart below illustrates the opportunities for portfolio
compression between 2010 and 2017 for single-name security-based
swaps.\242\ As the gap between gross and net notional values widens,
the opportunities for portfolio compression increase. Over our
reference period, however, the difference between gross and net
notional values has declined. For instance, in 2010, the percentage,
which captures the ratio of net to gross notional value, was 11.0%, but
this number has been gradually increasing through December 30, 2018
when it was 15.2%. Smaller ratios indicate greater opportunities for
portfolio compression; however, as shown in the chart below, based on
changes in gross and net notional value over time, unexploited
opportunities for compression are diminishing.\243\
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\242\ The chart below includes only gross and net notional of
single-name security-based swaps. The inclusion of index security-
based swaps could expand potential compression opportunities
available to SBS Entities.
\243\ The result is likely driven by banks and securities firms.
See Aldasoro, Inaki, and Torsten Ehlers, 2018, supra note 240, Graph
5.
[GRAPHIC] [TIFF OMITTED] TP15FE19.000
[[Page 4655]]
It is possible that market participants may already be taking
advantage of portfolio compression opportunities. However, the
Commission does not infer that the entirety of the reduction in the gap
between gross and net notional values is due to portfolio compression
exercises. Other plausible explanations for the reduction in the gross
notional value of security-based swaps include both fewer and/or
smaller new transactions, expiration of existing positions without
rollover into new positions, and loss or consolidation of market
participants throughout time. Due to limitations of the data available
to the Commission, it is infeasible to distinguish the overall effect
of portfolio compression exercises on the reduction in the gross
notional value of the security-based swap market from the alternative
explanations presented above.
4. Current Trading Relationship Documentation Practices
Memorializing the specific terms of the security-based swap trading
relationship and security-based swap transactions between
counterparties is prudent business practice and, in fact, many market
participants already use standardized documentation. Examination of the
use of ISDA Master Agreements (the measure of trading relationship
documentation available to the Commission in the data provided by DTCC-
TIW) shows that the percentage of transactions with these agreements
declines from 78.2% in 2008 to 34.1% in 2017, with the peak occurring
in 2010 (96.1%). However, as trading relationship documentation may be
different when the counterparty is a CCP, an analysis of documentation
on aggregate security-based swap transactions (both cleared and
uncleared) may be misleading. With the introduction of ICE Clear Credit
in 2009, the percentage of cleared transactions has increased over
time, thus a seemingly more relevant measure to look at is the
frequency of use of ISDA Master Agreements for uncleared transactions.
Approximately 99% of all uncleared transactions are reported (by DTCC-
TIW) as using trading relationship documentation (in the form of ISDA
Master Agreements) in 2017 compared to 78.2% in 2008. Accordingly, the
Commission generally believes that many, if not most, market
participants currently execute and maintain trading relationship
documentation of the type required by the proposed rules in the
ordinary course of their businesses, including documentation that
contains several of the terms that would be required by the proposed
rules.
Finally, and similar to the discussion regarding the reconciliation
and compression, SBS Entities that are also registered with the CFTC as
Swap Entities are subject to CFTC rules requiring the use of trading
relationship documentation. As discussed above, the Commission has
reviewed those rules and preliminarily believes that they are, other
than as expressly noted above in Section I.D, substantively identical
to the rules we are proposing today.
C. Economic Costs and Benefits, Including Impact on Efficiency,
Competition, and Capital Formation
In this section we first discuss the expected effects of the
proposed rules on efficiency, competition, and capital formation,
focusing particularly on the risk-mitigation benefits that stem from
the use of portfolio reconciliation, expanding opportunities for
portfolio compression, and improvements in documentation. We then turn
our discussion to additional costs and benefits, including compliance
costs and alternatives considered of the proposed rules.
1. Effects on Efficiency, Competition, and Capital Formation
Risk mitigation rules have the potential to affect efficiency,
competition, and capital formation in the security-based swap market,
primarily through a reduction in operational, market, and credit risks
that accompany outstanding security-based swap positions. In addition,
the substituted compliance framework may provide additional effects
that are distinct from the broader market impacts that are described
below. As with the benefits and costs, we believe that several of the
effects described below only occur to the extent that current market
practices do not already conform to our proposed rules.
a. Broad Market Effects
In the release adopting final rules requiring SBS Entities to
provide trade acknowledgments and to verify those trade acknowledgments
with their counterparties to security-based swap transactions, the
Commission explained the importance of confirming trades in a timely
manner, noting that confirmation of the terms of a transaction is
essential for SBS Entities ``to effectively measure and manage market
and credit risk.'' 244 245 In this regard, portfolio
reconciliation addresses many of these same issues, but unlike the
confirmation process, which occurs at the outset of a transaction,
reconciliation operates throughout the life of the transaction.\246\
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\244\ See Trade Acknowledgment and Verification Adopting
Release, 81 FR at 39833.
\245\ See supra Section I.B.1.
\246\ See id.
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Failure to periodically conduct portfolio reconciliation may cause
errors and disputes over the terms of a transaction that may exist to
go undetected, leading to errors in measurement and management of
market and credit risks associated with particular transactions. More
generally, timely portfolio reconciliation will provide counterparties
with accurate information that will enable them to evaluate their own
risk exposure in a timely manner. Efficient and cost-effective risk
management may conserve resources and free up capital that can be
deployed in other asset classes, promoting risk-sharing and efficient
capital allocation. In addition, cost-effective risk management may
reduce the overall costs of financial intermediation, allowing market
participants to increase lending and other capital formation
activities.
Similarly, periodic portfolio reconciliation and improved standards
for transaction documentation may contribute to broader market
stability, particularly during periods of distress. Disagreement as to
one or more material terms of a transaction or inadequate documentation
could hinder timely and efficient settlement of security-based swap
transactions, particularly in the case of a credit event on a reference
entity on which many different counterparties have, in the aggregate, a
large notional outstanding exposure. During periods of financial
distress, uncertainty about terms, value, and documentation of
outstanding transactions could contribute to liquidity and cash
shortfalls that threaten the stability of the financial system. Thus,
to the extent that the proposed rules reduce uncertainty about
outstanding transactions, we expect reduced risk of uncertainty about
the credit risk of potential counterparties, particularly during a
financial crisis.
Finally, to the extent that portfolio reconciliation requirements
differ from current market practices, the proposed rules have the
potential to affect competition across multiple dimensions. If the
costs of portfolio reconciliation, portfolio compression, and complying
with transaction documentation rules for security-based swap
transactions are largely fixed (i.e., the costs come from establishing
infrastructure and systems necessary to
[[Page 4656]]
perform portfolio reconciliation and portfolio compression and comply
with documentation requirements) rather than varying with the number of
transactions or positions outstanding, smaller dealers intermediating a
smaller number of trades may have a larger burden placed on them;
larger dealers, on the other hand, may be able to spread the costs over
a greater number of trades or positions, with a lower average cost of
complying with these rules. Similarly, the costs of establishing an
infrastructure to comply with these requirements may create a barrier
to entry for market participants wishing to establish a SBS dealer
business.\247\
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\247\ The Commission does not expect that this effect would
extend to major SBS participants, which are by definition the
largest non-dealer participants in the security-based swap market.
As described in the economic baseline, out of more than 4,000
security-based swap market participants, we expect at most five to
register as major SBS participants. These entities maintain
substantial positions in security-based swaps, as defined in the
Intermediary Definitions Adopting Release, and the Commission
expects these entities have sufficient resources and infrastructure
to comply with portfolio reconciliation and documentation
requirements.
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b. Substituted Compliance
As discussed above, if the Commission has made a positive
substituted compliance determination with respect to a particular
foreign regulatory regime, SBS Entities operating in that jurisdiction
may be able to satisfy their Title VII risk mitigation requirements by
complying with similar requirements of the foreign financial regulatory
system. Substituted compliance would be available only for SBS Entities
who are not U.S. persons.
The Commission is proposing to amend its rules to make substituted
compliance potentially available to the portfolio reconciliation,
portfolio compression, and trading relationship documentation
requirements in order to minimize the likelihood that SBS dealers are
subjected to potentially duplicative or conflicting regulation. The
Commission preliminarily believes that duplicative regulations that
achieve comparable regulatory outcomes increase the compliance burdens
on market participants without corresponding increases in benefits. By
decreasing the compliance burden for foreign SBS dealers active in the
U.S. market, the availability of substituted compliance could encourage
foreign firms' participation in the U.S. market, increasing the ability
of U.S. firms to access global liquidity, and reducing the likelihood
that liquidity would fragment along jurisdictional lines. Such
participation and access to liquidity might result in increased
competition between both U.S. and foreign intermediaries without
compromising the regulatory benefits intended by the applicable risk
mitigation rules.
2. Portfolio Reconciliation
Disputes related to confirming the terms of a swap, as well as swap
valuation disputes, have long been recognized as a significant problem
in the OTC derivatives market. The Commission preliminarily believes
that the ability to determine definitively the value of a security-
based swap at any given time is an important component of many of the
OTC derivatives market reforms contained in the Dodd-Frank Act and is a
component of sound risk management practices.\248\ Security-based swap
valuation is also crucial for determining capital and margin
requirements applicable to SBS Entities and therefore plays a primary
role in risk mitigation for uncleared security-based swaps. Portfolio
reconciliation is considered an effective means of identifying and
resolving these disputes at a time and in a manner that will be least
disruptive to the counterparties and the broader financial system.
---------------------------------------------------------------------------
\248\ See ISDA Collateral Best Practices, supra note 236,
Section 10.
---------------------------------------------------------------------------
Parties may dispute valuations of thinly traded security-based
swaps where there is not agreement on valuation methodologies or the
source for formula inputs. Many of these security-based swaps are
thinly traded either because of their limited liquidity or because they
are simply too customized to have comparable counterparts in the
market. As many of these security-based swaps are valued by dealers
internally by ``marking-to-model,'' their counterparties may dispute
the inputs and methodologies used in the model. As uncleared security-
based swaps are bilateral, privately negotiated contracts, on-going
security-based swap valuation for purposes of initial and variation
margin calculation and security-based swap terminations or novations,
also has been largely a process of on-going negotiation between the
parties. The inability to agree on the value of a security-based swap
became especially acute during the financial crisis that immediately
preceded passage of the Dodd-Frank Act when there was widespread
failure of the market inputs needed to value many security-based
swaps.\249\
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\249\ The lack of liquidity in markets for mortgage-backed
securities led to wide disparities in the valuation of CDS
referencing mortgage-backed securities (especially collateralized
debt obligations). Such wide disparities led to large collateral
calls from dealers on AIG, hastening its downfall. See CBS News,
``Calling AIG? Internal Docs Reveal Company Silent About Dozens of
Collateral Calls,'' June 23, 2009, available at: http://www.cbsnews.com/stories/2009/06/23/cbsnews_investigates/main5106672.shtml; See also Financial Crisis Inquiry Commission, The
Financial Crisis Inquiry Report: Final Report of the National
Commission on the Causes of the Financial and Economic Crisis in the
United States, Chapter 8, available at: https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
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a. Requirements
The Commission is proposing rules and interpretations that
generally would require each SBS Entity (1) to engage in portfolio
reconciliation with counterparties who are also SBS Entities at
periodic intervals based on the number of outstanding transactions with
the counterparty and (2) to establish, maintain, and follow written
policies and procedures reasonably designed to ensure that it engages
in portfolio reconciliation with counterparties who are not SBS
Entities, also at periodic intervals based on the number of outstanding
transactions with the counterparty.\250\
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\250\ Pursuant to proposed Rule 15Fi-3(d), the new requirements
regarding portfolio reconciliation would not apply to a clearing
transaction (i.e., a security-based swap that has a clearing agency
as a direct counterparty). See supra note 58 and accompanying text.
---------------------------------------------------------------------------
The Commission is proposing to vary the proposed portfolio
reconciliation requirement based on the particular type of counterparty
with which the SBS Entity transacts. For transactions between two SBS
Entities, the proposed rules would require the two sides to engage in
portfolio reconciliation at frequencies that are based on the size of
the security-based swap portfolio between the two parties.\251\ In
addition to the requirements regarding the frequency of the
reconciliation, proposed Rule 15Fi-3(a)(1) would require the two SBS
Entities to agree in writing with each of their counterparties on the
terms of the portfolio reconciliation including, if applicable,
agreement on the selection of any third party service provider who may
be performing the reconciliation.
---------------------------------------------------------------------------
\251\ See proposed Rule 15Fi-3(a).
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To the extent that the two SBS Entities identify a discrepancy, the
proposed rule would require the parties to take certain steps. First,
proposed Rule 15Fi-3(a)(4) would require the two sides to resolve
immediately any discrepancy in a material term, whether identified
directly as part of the portfolio reconciliation or otherwise. Second,
proposed Rule 15Fi-3(a)(5) would require each SBS Entity to establish,
maintain, and follow written policies and procedures reasonably
designed to resolve any discrepancy in a valuation identified as part
of a
[[Page 4657]]
portfolio reconciliation or otherwise as soon as possible, but in any
event within five business days after the date on which the discrepancy
is first identified. As a condition to this requirement, however,
proposed Rule 15Fi-3(a)(5) would require each SBS Entity to establish,
maintain, and follow written policies and procedures reasonably
designed to identify how the SBS Entity will comply with any variation
margin requirements under Section 15F(e) of the Exchange Act \252\ and
any related regulations pending resolution of the valuation
discrepancy. Finally, proposed Rule 15Fi-3(a)(5) would clarify that for
purposes of the requirement to resolve valuation discrepancies within
five business days of being identified, a difference between the lower
valuation and the higher valuation of less than 10% of the higher
valuation need not be deemed a discrepancy.\253\
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\252\ 15 U.S.C. 78o-10(e).
\253\ This 10% threshold would apply on a transaction-by-
transaction basis, and not on a portfolio level.
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Separately, with respect to transactions between an SBS Entity and
a counterparty that is not an SBS Entity, proposed Rule 15Fi-3(b) would
require each SBS Entity to establish, maintain, and follow written
policies and procedures reasonably designed to ensure that it engages
in portfolio reconciliation as set forth in the rule.\254\ This is in
contrast to proposed Rule 15Fi-3(a), which expressly requires portfolio
reconciliation with respect to transactions where both counterparties
are SBS Entities.
---------------------------------------------------------------------------
\254\ See proposed Rule 15Fi-3(b).
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Proposed Rule 15Fi-3(b) contains a number of requirements regarding
the contents of the policies and procedures required therein, as they
relate to reconciliation with non-SBS Entities, which are largely
consistent with the requirements imposed directly on the parties under
proposed Rule 15Fi-3(a). Specifically, proposed Rule 15Fi-3(b)(3)
provides that such policies and procedures must require that the
portfolio reconciliation be performed no less frequently than: (1) Once
each calendar quarter for each security-based swap portfolio that
includes more than 100 security-based swaps at any time during the
calendar quarter and (2) once annually for each security-based swap
portfolio that includes no more than 100 security-based swaps at any
time during the calendar year.
In addition, proposed Rule 15Fi-3(b)(4) requires each SBS Entity to
establish, maintain, and follow written procedures reasonably designed
to resolve any discrepancies in the valuation or a material term of
each security-based swap identified as part of a portfolio
reconciliation or otherwise with a counterparty that is not an SBS
Entity within five days.\255\
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\255\ Similar to the requirement in paragraph (a) of the
proposed rule for portfolio reconciliation with counterparties that
are either SBS dealers or major SBS participants, proposed Rule
15Fi-3(b)(4) provides that a difference between the lower valuation
and the higher valuation of less than 10% of the higher valuation
need not be deemed a discrepancy for purposes of that paragraph. See
supra note 39 and accompanying text (discussing the 10% threshold in
the context of Rule 15Fi-3(a)(5)).
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Finally, proposed Rule 15Fi-3(c) would require each SBS Entity to
promptly notify the Commission of any security-based swap valuation
dispute in excess of $20,000,000 (or its equivalent in any other
currency) if not resolved within:
three business days, if the dispute is with a counterparty
that is an SBS Entity, or
five business days, if the dispute is with a counterparty
that is not an SBS Entity.
Such notification would be required to be in a form and manner
acceptable to the Commission, and would also be required to be sent to
any applicable prudential regulator (i.e., for any SBS Entity that is
also a bank, to its bank regulator).\256\
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\256\ See supra Section I.B.6.
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For the security-based swap market to operate efficiently and to
reduce credit and operational risk between counterparties, the
Commission preliminarily believes that, although the frequency of
portfolio reconciliation depends on the number of positions with a
counterparty, reconciliation should occur by position because terms may
vary across positions with the same counterparty. By identifying and
managing mismatches in key economic terms and valuation for individual
transactions across an entire portfolio, these rules are intended to
require a process in which risk between counterparties can be
identified and reduced.
b. Benefits
Reconciliation is beneficial not only to the parties involved but
also to the markets as a whole. By identifying and managing disputed
key economic terms or valuation for each transaction across a
portfolio, an entity's counterparty credit risk and operational risk
can be diminished. By requiring a systematic reconciliation process, as
well as policies and procedures related to portfolio reconciliation
between counterparties, SBS Entities will be able to better identify
and correct problems in a timely manner in their post-execution
processes (including confirmation) in order to reduce the number of
disputes and improve the integrity and efficiency of their internal
processes. Accordingly, expanding the universe of participants subject
to the reconciliation requirements can help to reduce the risk
bilateral markets may pose to the broader financial system.
As discussed above, because shortcomings in credit risk management
and documentation may only become evident during a crisis, some
benefits of portfolio reconciliation will accrue to the financial
system as a whole while the ongoing direct costs are borne by the
individual market participant. Therefore, in the absence of these
rules, the level and frequency of portfolio reconciliation chosen by
individual market participants may be less than what would be desired
by all market participants in order to properly manage risks to the
financial system.
In addition, the Commission preliminarily believes that the
proposed tiering of obligations, whereby the frequency of the portfolio
reconciliation would be based on the number of outstanding transactions
with the applicable counterparty, represents a reasonable attempt to
calibrate the costs to the benefits expected from reconciling a
person's security-based swap portfolio at regular intervals. In this
respect, those benefits would be expected to rise for larger--and often
more complex--portfolios that may represent a greater potential for
loss than a smaller, less complex portfolio.
The Commission preliminarily believes that, given the expected
benefits of making the frequency of portfolio reconciliation a function
of the size of a portfolio with a particular counterparty, setting the
frequency of reconciliation identical to that adopted by the CFTC will
provide additional benefit for SBS Entities that are also registered
with the CFTC as Swap Entities. In particular, harmonizing the
frequency of reconciliation for swaps and SBS should reduce
implementation cost and reduce operational complexity.
Similarly, the Commission notes that the EC has adopted portfolio
reconciliation requirements for the EU that are similar to those
proposed by the Commission in this release. The Commission
preliminarily believes that aligning its portfolio reconciliation
requirements with those in other major security-based swap markets will
benefit SBS Entities by avoiding the imposition of disparate compliance
and operational policies and procedures.
[[Page 4658]]
Moreover, proposed Rule 15Fi-3(a)(2) provides that portfolio
reconciliation may be performed either on a bilateral basis by the
counterparties or by a third party selected by the counterparties in
accordance with paragraph (a)(1) of the proposed rule. Under this
approach, the process for selecting a third-party service provider--or
the actual identity of the service provider--should be included in the
written agreement between the two sides setting forth the terms of the
portfolio reconciliation process.
In the absence of periodic portfolio reconciliation, if the
counterparties to a security-based swap transaction are not in
agreement with respect to each of the terms of the transaction that may
affect each party's rights and obligations, any such difference could
lead to complications at various points throughout the trade.\257\
These discrepancies could be exacerbated if they remain undetected
until such times as the parties become obligated to perform on their
requirements under the contract. Such discrepancies could be
particularly problematic if they are discovered during a period of
financial stress for the market participant.\258\ Thus, portfolio
reconciliation may help to mitigate the possibility of a discrepancy
unexpectedly affecting performance by ensuring that the parties are and
remain in agreement with respect to all of the material terms of the
security-based swap transaction.
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\257\ See supra note 14.
\258\ See supra note 203.
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Regular reconciliation of all portfolios is a process to reduce
counterparty credit exposure and operational risk and help prevent
disputes from arising. The rule should promote market integrity and
reduce risk by establishing procedures that will promote legal
certainty concerning security-based swap transactions, assist with the
early resolution of valuation disputes, reduce operational risk, and
increase operational efficiency.
The proposed rules may have differential benefits for smaller
market participants. Smaller market participants may not have the
bargaining power necessary to compel larger counterparties to
coordinate on portfolio reconciliation. Since SBS Entities, absent a
mandate, are likely to focus risk management resources on larger
counterparties, the ability of smaller counterparties to require the
necessary cooperation from their counterparties who are SBS Entities
will be improved. Reduced uncertainty concerning material terms and
valuation methodologies could reduce the risks to these smaller
participants for using SBS for hedging market risk to which they may be
exposed.
Portfolio reconciliation is particularly relevant with respect to
terms related to the valuation of the instrument. Unresolved
discrepancies regarding the value of a security-based swap can lead to,
among other things, active disputes between counterparties with respect
to the amount of margin that must be posted or collected, as well as
errors and other complications that may result in significant
uncollateralized exposure in the uncleared security-based swap markets
(or alternately, potentially inefficient overcollateralization).
Accordingly, we preliminarily believe that requiring counterparties to
clearly document the applicable processes and requirements for
calculating and exchanging margin in connection with a security-based
swap transaction is an important step in achieving this broader
regulatory objective.
The notification requirement of proposed Rule 15Fi-3(c) would
provide the Commission with information about disagreements over
position values between counterparties. Valuation is one of the most
fundamental elements for determining the economic rights and
obligations of each of the counterparties to a security-based swap
transaction. For example, market participants manage credit risks to
their counterparties by exchanging margin with each other in an amount
determined using the value of the underlying security-based swap. If
those valuations are not accurate for any reason, such as human or
system errors, problems with the valuation methodology, or an issue
affecting the timeliness of the calculation, that error could result in
one of the counterparties having an uncollateralized credit exposure
and a potential for loss in the event of a default. We therefore expect
that the notification requirement could assist the Commission in
anticipating potential valuation problems that could ultimately lead to
market disruption, and in identifying potential issues with respect to
an SBS Entity's internal valuation methodology. As noted above, the
CFTC has adopted a nearly identical requirement with the same
$20,000,000 threshold, and the Commission believes that divergence from
that requirement could lead to additional costs for SBS Entities that
are also registered with the CFTC as Swap Entities.\259\ Finally, as
discussed above, the Commission preliminarily believes reconciliation
may provide indirect benefits by improving the accuracy of SDR
data.\260\ As described above in Section I.B.2, the information that
SBS Entities would initially be required to reconcile with their
counterparties would include each term that is required to be reported
to a registered SDR under Rule 901 under the Exchange Act.\261\
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\259\ See supra Section I.B.6.
\260\ See SDR Adopting Release, 80 FR at 14528-48, for a
discussion of the expected economic benefits accurate SBS data held
at SDRs.
\261\ See proposed Rule 15Fi-1(i)(1) (referencing 17 CFR
242.901).
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c. Costs
The portfolio reconciliation rules the Commission is proposing
today are similar to the corresponding CFTC rules for Swap Entities. As
a result, the one-time costs to develop, test, and implement new
procedures and technology that may be required in order to be compliant
with the proposed rules are mitigated by the fact that many SBS
Entities also are likely to be Swap Entities. These dually registered
entities are likely to be familiar with these general requirements and
have the infrastructure in place to comply with similar rules that
apply to their swap business.
SBS Entities that are not also CFTC-regulated Swap Entities and
that do not currently use an electronic platform or vendor service to
conduct portfolio reconciliation will need to expend significant time
and resources to modify the necessary systems to comply with proposed
Rule 15Fi-3. Even those SBS Entities that do use electronic platforms
or vendors services may find it necessary to make significant
adjustments to comply with the rules. The Commission estimates a one-
time upfront cost of approximately $5-10 million for an SBS Entity that
is not also a Swap Entity.\262\ Although the Commission does not
currently have cost data for either reconciliation performed in-house
or by third-party service providers, and therefore cannot quantify
these costs, the Commission preliminarily believes that the ongoing
portfolio reconciliation cost would likely be a function of portfolio
size and the availability of third party service providers.
---------------------------------------------------------------------------
\262\ This estimate is based on an estimate supplied by ISDA to
the CFTC in response to their proposed portfolio reconciliation
rule. See CFTC Risk Mitigation Adopting Release 77 FR at 55952-3.
---------------------------------------------------------------------------
In contrast, when commenting on the CFTC's then-proposed portfolio
reconciliation rule, a third party provider of multilateral compression
services stated that a large number of Swap Entities already regularly
reconcile their portfolios with each other and with other entities and
that
[[Page 4659]]
the increased frequency and inclusion of smaller portfolios as proposed
should prove no obstacle to such entities.\263\ If SBS Entities have
similar business practices, then this comment suggests start-up and on-
going portfolio reconciliation costs could be small.
---------------------------------------------------------------------------
\263\ See Letter from Per Sj[ouml]berg, Executive Vice TriOptima
AB to the CFTC, dated Feb. 28, 2011 at 2, available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=30562&SearchText.28, 2011 at 2, available at
http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=30562&SearchText.
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The Commission preliminarily believes that certain costs will arise
despite the fact that an SBS Entity also may be registered with the
CFTC as a Swap Entity, and therefore subject to similar rules already
adopted by the CFTC. Such costs may include (i) increased costs to
account for possible differences between the SEC and CFTC related to
the terms considered to be material for purposes of the reconciliation
requirement; (ii) the additional resources necessary to design,
compose, and implement the required policies and procedures; (iii) the
additional resources needed to comply with the dispute resolution
timeframes; and (iv) the compilation and maintenance of applicable
records. These costs, however, are by nature specific to each entity's
internal operations; absent specific information from commenters, the
Commission cannot provide reasonable estimations regarding the
resources needed to comply.
The proposed rule also requires SBS Entities to agree in writing
with each of their counterparties on the terms of the portfolio
reconciliation including, if applicable, agreement on the selection of
any third party service provider who may be performing the
reconciliation. Accordingly, each counterparty to a SBS Entity subject
to these rules would incur an upfront cost in implementing this
requirement, particularly since the Commission would expect that such
terms be agreed to in writing prior to, or contemporaneously with, the
two parties executing any new security-based swap transaction. These
costs would be mitigated if, once the parties have agreed in writing on
the terms of the portfolio reconciliation for the first time, the two
sides comply with this requirement for subsequent transactions by
merely agreeing in writing to abide by the existing agreement regarding
the reconciliation process. This practice could help to ensure that
portfolio reconciliation begins without delay after execution of the
transaction and is designed to minimize the number of disagreements
regarding the portfolio reconciliation process itself.
The Commission estimates that of the 55 market participants we
expect to register as SBS Entities, approximately 35 will be dually-
registered with the CFTC and may already have automated portfolio
reconciliation systems in place. Thus, for these entities, the costs
associated with modifying these existing systems to account for
security-based swap reconciliations is expected to be minimal. For the
remaining 20 SBS Entities which are not expected be dually-registered
with the CFTC, the anticipated personnel costs associated with setting
up an automated portfolio reconciliation system per SBS Entity is
$58,795, or $1,175,900 in aggregate.264 265 The Commission
preliminarily believes that these costs would be a component of the
upfront cost estimate of $5-10 million discussed above.\266\ For each
SBS Entity, we anticipate that approximately 190 hours per year will be
required for reconciliation or a total of 10,450 hours across the 55
SBS Entities.\267\ With respect to reconciliations with non-SBS
counterparties, the Commission estimates that an additional 227.5 hours
per SBS Entity, or 12,512.5 hours in aggregate would be needed for
automated portfolio reconciliation with these counterparties.\268\
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\264\ This estimate is based on the following: [(Sr. Programmer
(80 hours) x $314 per hour) + (Sr. Systems Analyst (80 hours) x $269
per hour) + (Compliance Manager (10 hours) x $293 per hour) +
(Director of Compliance (5 hours) x $461 per hour) + (Compliance
Attorney (20 hours) x $346 per hour)] = $58,795 per SBS Entity, or
($58,795 x 20 SBS Entities) = $1,175,900 in aggregate.
\265\ The hourly rates for internal professionals used
throughout Sections VII.C.2.c, VII.C.3.c, and VII.C.4.c of the
release are taken from SIFMA's Management & Professional Earnings in
the Securities Industry 2013, modified to account for an 1800-hour
work-year and inflation, and multiplied by 5.35 to account for
bonuses, firm size, employee benefits, and overhead.
\266\ See supra note 262 and associated text.
\267\ Each SBS Entity is anticipated to have counterparty
relationships with approximately one-third of the other SBS market
participants (\1/3\ x 55 = 18.333), which is rounded to 18
participants. Of those counterparty relationships, two are expected
to have portfolios in excess of 500 positions, which would need to
be reconciled daily (252 trading days per year), four would have
between 50 and 500 positions, which would need to be reconciled
weekly (52 weeks per year), and the remaining 12 would have less
than 50 positions, which would need to be reconciled quarterly (four
times per year). The Commission estimates that each portfolio
reconciliation would require 30 minutes, 15 minutes per
counterparty, through an automated system, thus the total
anticipated reconciliation time would be [(2 counterparties x 252
trading days x 0.25 hours) + (4 counterparties x 52 weeks x 0.25
hours) + (12 counterparties x 4 quarters x 0.25 hours)] = 190 hours
per SBS Entity, or (190 x 55 SBS Entities) = 10,450 hours in
aggregate.
\268\ There are anticipated to be 13,137 total SBS
counterparties, of which 55 are registered SBS Entities, leaving
13,082 non-SBS market participants. See supra note 179. The
Commission estimates that each SBS Entity will transact with
approximately 350 of these non-registered participants. Of those 350
counterparties, 35 are expected to have portfolio positions in
excess of 100 positions, which would require quarterly
reconciliations, while the remaining 315 are expected to have
positions of less than 100 security-based swaps, and therefore,
would require annual reconciliation. The Commission estimates that
each portfolio reconciliation would require 30 minutes through an
automated system, thus the total anticipated reconciliation time
would be [(35 counterparties x 4 quarters x 0.5 hours) + (315
counterparties x 1 time per year x 0.5 hours)] = 227.5 hours per SBS
Entity, or (227.5 x 55 SBS Entities) = 12,512.5 hours in aggregate.
---------------------------------------------------------------------------
The Commission further estimates that the development and
implementation of written policies and procedures as required under
proposed Rule 15Fi-3 would impose an initial cost of $702,232.50. Of
the total 55 SBS Entities that would be subject to Rule 15Fi-3, 35 are
estimated to be dually-registered with the CFTC, and are anticipated to
already have policies and procedures in place with respect to
reconciliation. The expected additional time to revise the existing
policies and procedures for these SBS Entities is expected to be one
hour per SBS Entity, for a cumulative 35 hours, costing $429.50 per SBS
Entity or $15,032.50 in aggregate.\269\ For the remaining 20 SBS
Entities, the Commission estimates that it will take approximately 80
hours per entity to establish the written policies and procedures. The
costs for these SBS Entities will be $687,200, or $34,360 per SBS
Entity.\270\ Once established, the Commission estimates that it would
cost SBS Entities approximately $944,900 or $17,180 per SBS Entity to
revise and maintain these policies and procedures.\271\ Resolution of
valuation discrepancies can be labor intensive. One objective of the
proposed rule is to reduce the incidence of valuation discrepancies
through the periodic reconciliations between security-based swap
counterparties. It is unlikely, however, that the proposed rule will
completely eliminate disputes related to
[[Page 4660]]
valuation. The Commission lacks data on the fraction of positions that,
when reconciled, will result in a dispute as well as the costs likely
to be incurred resolving those disputes, and is therefore unable to
quantify these costs. However, the Commission recognizes that the costs
associated with resolution of these disputes is likely to be higher
than costs for reconciliations in which disputes do not arise.
---------------------------------------------------------------------------
\269\ The estimate is based on the following: [((Compliance
Attorney (30 minutes) at $346 per hour) + ((Director of Compliance
(15 minutes) at $461 per hour) + ((Deputy General Counsel (15
minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or
($429.50 per hour x 35 SBS dually-registered Entities) = $15,032.50.
\270\ The estimate is based on the following: [((Compliance
Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20
hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at
$565 per hour)] = $34,360 per SBS Entity or ($34,360 x 20 SBS
Entities that are not dually-registered) = $687,200 in aggregate.
\271\ The estimate is based on the following: [((Compliance
Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10
hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at
$565 per hour)] = $17,180 per SBS Entity or ($17,180 x 55 SBS
Entities) = $944,900 in aggregate.
---------------------------------------------------------------------------
However, the Commission preliminarily believes that these costs may
be mitigated by only requiring counterparties to address differences in
valuation greater than 10%. These costs of reconciliation may be
further mitigated by agreement between the counterparties to use a
third party service provider to assist in resolving valuation
discrepancies. Reconciliation of other terms is likely to be less
costly as the terms of the agreement are unlikely to change over the
life of the contract.
The 10% threshold was designed to both identify large deviations in
valuations between SBS Entities, while not requiring those entities to
devote significant effort to resolving minor valuation disputes.
Further, this threshold is identical to that already adopted by the
CFTC.\272\ The Commission notes, however, that this 10% threshold is at
the transaction level, rather than the entity level. While
discrepancies could be random in nature, the risk exists that one
counterparty could have systemic issues in valuation across its entire
portfolio, thereby leading to discrepancies in valuation with one or
several counterparties and throughout the portfolio. For example, if an
entity's valuation model consistently undervalued each of its security-
based swap positions by 9%, in aggregate, the overall level of risk
could be substantial, even though it would not trigger a discrepancy
event as currently defined by the 10% transaction level threshold.
Further, since the Commission estimates that approximately 35 of the
expected 55 SBS Entities are likely to be dually-registered with the
CFTC and active in swap and security-based swap markets, these
participants are likely to face higher costs when regulations differ.
---------------------------------------------------------------------------
\272\ See 17 CFR 23.502 (portfolio reconciliation).
---------------------------------------------------------------------------
The costs of resolving valuation disputes are expected to be
mitigated, because the reconciliation requirements are expected to
prevent disputes from arising in the first instance through the regular
comparison of material terms and valuations. The Commission
preliminarily believes that by requiring SBS Entities to reach
agreement with certain counterparties on the methods and inputs for
valuation of each security-based swap, as required in connection with
the trading relationship documentation requirements in proposed Rule
15Fi-5, the overall framework of these rules should assist SBS Entities
in resolving valuation disputes within five business days. In addition,
the Commission estimates that SBS Entities will spend an average of 24
hours per year to comply with the notification requirement of proposed
Rule 15Fi-3(c) costing $8,304 per SBS Entity or $456,720 in
aggregate.\273\
---------------------------------------------------------------------------
\273\ The estimate is based on the following: [Compliance
Attorney (24 hours) at $346 per hour] = $8,304 per entity x 55 SBS
entities = $456,720.
---------------------------------------------------------------------------
Lastly, portfolio reconciliation costs are also mitigated by virtue
of the fact that cleared security-based swaps are not within the scope
of the requirements of these rules. The Commission preliminarily
believes that CCPs establish settlement prices for each cleared
security-based swap every business day for margining purposes and this
process is more appropriately addressed by rules governing a clearing
agency's risk management practices.\274\ Because a large part of the
security-based swap portfolios of SBS Entities may consist of cleared
security-based swaps to which the reconciliation requirements will not
apply, the sizes of the bilateral, uncleared portfolios (to which the
requirement would apply) may be limited.\275\
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\274\ See supra Section I.B.7.
\275\ Currently, there is no regulatory requirement in the
United States to clear security-based swaps. As of December 2015,
approximately 56% of the total volume of new trade activity in
single-name security-based swap products had been cleared through
ICE Clear Credit. Further, approximately 79% of index CDS
transactions were centrally cleared as of December 2015 (see https://www.isda.org/a/kVDDE/swapsinfo-q4-2015-review-final.pdf);
therefore, single-name security-based swaps potentially could be
cleared at a similar rate.
---------------------------------------------------------------------------
d. Alternatives
The proposed rule creates a specific definition of ``material
terms'' for purposes of determining what discrepancies must be resolved
in connection with the portfolio reconciliation which includes each
term required to be reported to an SDR, but then permits SBS Entities
to exclude any term that is not relevant to the ongoing rights and
obligations of the parties and the valuation of the security-based swap
during subsequent reconciliations. The Commission considered not
providing a specific definition of ``material terms'' and allowing SBS
Entities discretion in determining those terms that are relevant to the
ongoing rights or obligations of the parties or affect the valuation of
the security-based swap.
The Commission has preliminarily concluded that the data required
to be submitted to an SDR in connection with regulatory reporting
requirements is an appropriate measure for determining which terms
should be reconciled pursuant to proposed Rule 15Fi-3. The Commission
also preliminarily believes that tying the definition of ``material
terms'' to reporting requirements to an SDR could reduce the burdens on
some SBS Entities by potentially allowing them to leverage the same
electronic systems used for SDR reporting for purposes of the portfolio
reconciliation requirements.
The portfolio size breakpoints and frequencies are consistent with
those adopted by the CFTC for Swap Entities and are therefore likely to
be familiar to those entities that are registered as both an SBS Entity
and a Swap Entity. These are also the breakpoints adopted by the EC.
Further, the Commission believes that alternative breakpoints based on
the number of transactions which deviate from those adopted by the CFTC
and the EC would likely impose additional costs on SBS Entities without
any corresponding increases in material benefits to those participants.
Although the notion of breakpoints based on number of transactions
previously has been accepted by the CFTC and other regulatory agencies,
the Commission notes that breakpoints based on alternative measures
could be considered. In particular, breakpoints for reconciliation
could be categorized by either gross (or net) notional amounts of
positions or the current market value of positions, and identified as
levels or scaled by some measure such as the aggregate notional value
of the market (for gross or net notional values) or the assets of the
SBS Entity (if market values are used instead). Although the number of
security-based swaps between counterparties is easy to capture, it may
actually be misleading with respect to the complexity or magnitude of
the risk between counterparties.
For instance, say two counterparties have over 500 transactions
between them, but the average value of each transaction is only $5
million notional value. The total exposure between the two
counterparties would only be $2.5 billion, but this portfolio would
need to be reconciled daily due to the number of transactions. If, on
the other hand, two counterparties have only 40 transactions, but the
average value of each transaction is $1 billion notional value, the
overall exposure would be $40 billion (16 times greater exposure
[[Page 4661]]
than the 500 transaction counterparties), but this portfolio would only
be reconciled quarterly. Basing breakpoints on some measure other than
the number of transactions may enable SBS Entities to better assess the
overall level of counterparty credit risk as well as operational risk
associated with their security-based swap portfolios. Setting aside
these concerns, the Commission believes that breakpoints based on the
number of transactions is likely to capture the complexity of SBS
Entities' portfolios, and that reconciliations based on this dimension
are likely to identify discrepancies in a timely manner. Further, given
that the Commission estimates that approximately 35 of the expected 55
SBS Entities are likely to be dually-registered with the CFTC and
active in both swap and security-based swap markets, this alternative
could potentially impose additional costs due to differences in
regulatory requirements.
The Commission has also considered alternatives to the requirement
that valuation discrepancies exceeding 10% must be resolved within five
days. The 10% threshold is consistent with the rule adopted by the CFTC
for Swap Entities and, as a result, is likely to be familiar to those
entities that are registered as both an SBS Entity and a Swap Entity.
The Commission preliminarily believes that the proposed 10% threshold
is high enough to prevent market participants from incurring costs to
resolve small valuation differences that would have only a small effect
on margin or other risk management practices, yet low enough to prevent
difference in valuation from resulting in significant miscalculations
in risk management.
As noted above, there are potential economic costs that could
accrue to counterparties related to both the 10% threshold and the five
business day resolution window. An alternative (albeit supplementary)
approach would be an additional requirement of a valuation threshold
related to the overall portfolio discrepancies, in aggregate and/or
with individual counterparties. For instance, if the aggregate
portfolio has valuation discrepancies of 5% or 10%, this could trigger
a discrepancy event, even if the individual transaction-level
discrepancies fall below the prescribed threshold as documented
currently in the proposed rule. Relatedly, while the five business day
window is narrow enough to potentially stem valuations from deviating
for extended periods of time while still providing a horizon in which
parties can work through their valuation disputes, entities can face
significant counterparty risk over seemingly short-term horizons. For
relatively stable valuation disputes in which the value does not
continue to deviate further from the agreed-upon level, then a five
business day window is likely to be sufficient; however, a more
compressed alternative horizon could be invoked when the discrepancies
in value continue to widen between counterparties. The Commission
preliminarily believes that the proposed five business day horizon is
sufficient and serves as an upper-bound for which market participants
to address and correct any material discrepancies that arise during
reconciliation. Moreover, this approach is consistent with requirements
from other regulators, and given the Commission's estimates on SBS
Entities that are likely to be dually-registered with the CFTC, any
differences in regulation would likely impose additional costs to those
entities.
Finally, proposed Rule 15Fi-3(c) would require each SBS Entity to
promptly notify the Commission of any security-based swap valuation
dispute in excess of $20,000,000 (or its equivalent in any other
currency) if not resolved within:
Three business days, if the dispute is with a counterparty
that is an SBS Entity, or
five business days, if the dispute is with a counterparty
that is not an SBS Entity.
Such notification would be required to be in a form and manner
acceptable to the Commission, and would also be required to be sent to
any applicable prudential regulator (i.e., for any SBS Entity that is
also a bank, to its bank regulator).\276\
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\276\ See supra Section I.B.6.
---------------------------------------------------------------------------
The Commission has considered as an alternative, requiring SBS
Entities to make and keep records of valuation discrepancies that
exceed $20,000,000 rather than requiring that they be reported to the
Commission. The Commission preliminarily concluded that the benefit of
receiving an early warning of potential problems before they surfaced
though an ordinary course of review of books and records justifies any
additional cost imposed on SBS entities.
Proposed Rule 15Fi-3(d), the new requirements regarding portfolio
reconciliation would not apply to a ``clearing transaction'' which is
defined as a security-based swap that has a clearing agency as a direct
counterparty.\277\ A clearing agency means a clearing agency that is
registered with the Commission pursuant to Section 17A of the Exchange
Act and that provides central counterparty services for security-based
swap transactions. The Commission considered as an alternative
including transactions cleared at a foreign clearing agency that is not
registered with the Commission within its definition of ``clearing
transaction'' for the purposes of the proposed rule. The Commission
preliminarily concluded that an approach that is similar to that taken
by the Commission in other rules,\278\ as well as the approach taken by
the CFTC,\279\ would reduce implementation and compliance costs.
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\277\ See supra Section I.B.7.
\278\ See, e.g., Trade Acknowledgement and Verification Adopting
Release, 81 FR at 39839.
\279\ Specifically, CFTC Rule 23.502(c) provides that
``[n]othing in this section shall apply to a swap that is cleared by
a derivatives clearing organization.'' 17 CFR 23.502(c).
---------------------------------------------------------------------------
The Commission has considered as an alternative, an alternative
compliance mechanism that would allow a SBS Entity to be deemed in
compliance with certain proposed rules regarding portfolio
reconciliation if the SBS Entity is also registered as a swap dealer or
major swap participant with the CFTC and is in compliance with the
corresponding CFTC portfolio reconciliation rules. The Commission
preliminarily concludes that differences between its proposed rules and
rules adopted by the CFTC may provide certain benefits to SBS Entities
and other market participants that would not be available under a rule
that was identical to the corresponding CFTC rule. For example, the
requirement in the proposed rule that each term required to be reported
to a registered SDR under Rule 901 must be reconciled may facilitate
the verification of transaction data by SDRs, which could address
concerns raised by market participants and data repositories. Such
benefits could be unavailable under an alternative compliance mechanism
given that CFTC portfolio reconciliation rules do not require all of
this information to be reconciled.\280\
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\280\ See supra Section I.E for a discussion of the proposed
reconciliation rules and the verification of transaction data by
SDRs. See also supra note 32 for a discussion of differences between
CFTC and proposed Commission requirements concerning third party
reconciliation.
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3. Portfolio Compression
Portfolio compression is an important post-trade processing
mechanism that can be an effective and efficient tool for the
management of risk by security-based swap market participants.
Portfolio compression is a mechanism whereby directionally opposite
[[Page 4662]]
transactions with substantially similar terms among two or more
counterparties are terminated and, if any exposure remains, replaced
with a smaller number of transactions of decreased notional value in an
effort to reduce the risk, cost, and inefficiency of maintaining
offsetting transactions on the counterparties' books. Because portfolio
compression participants are permitted to establish their own credit,
market, and cash payment risk tolerances and to establish their own
mark-to-market values for the transactions to be compressed, the
process does not alter the risk profiles of the individual participants
beyond a level acceptable to the participant. Portfolio compression is
commonly acknowledged as useful risk management tool.\281\
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\281\ See http://www2.isda.org/news/isda-publishes-paper-highlighting-achievements-in-portfolio-compression.
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a. Requirements
The Commission is proposing rules and interpretations that
generally would require each SBS Entity to establish, maintain, and
follow written policies and procedures for engaging in certain forms of
portfolio compression exercises with each of its counterparties.
Depending on the number of counterparties, the portfolio compression
exercise would be defined as either a ``bilateral portfolio compression
exercise'' or as a ``multilateral portfolio compression exercise.''
Under proposed Rule 15Fi-4(a), SBS Entities would be required to
establish, maintain, and follow written policies and procedures for
periodically engaging in both bilateral portfolio compression exercises
and multilateral portfolio compression exercises, when appropriate,
with each counterparty that is also an SBS Entity.\282\ For
transactions with non-SBS Entities, the policies and procedures
required under the proposed rule would require only that portfolio
compression exercise would have to occur when appropriate and only if
requested by any such counterparty.\283\
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\282\ See proposed Rules 15Fi-4(a)(2) and (3).
\283\ See proposed Rule 15Fi-4(b). See also supra notes 70 and
71 and associated text.
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b. Benefits
As a mechanism for post-trade management of risk in security-based
swaps, portfolio compression provides benefits not only to the
counterparties in each transaction but also to the markets as a whole.
A portfolio compression exercise permits firms to identify instances in
which directionally opposite transactions with similar terms can be
terminated or replaced, with a smaller number of transactions with
decreased notional value, reducing the overall risk, cost, and
inefficiencies associated with maintaining offsetting transactions. As
such, portfolio compression is recognized as an important risk
management tool.\284\ By expanding the universe of participants
required to maintain portfolio compression policies and procedures,
credit risk in the uncleared security-based swaps market can be reduced
and may provide benefits to the entire financial system.
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\284\ For example, in 2008, the PWG identified frequent
portfolio compression of outstanding trades as a key policy
objective in the effort to strengthen the OTC derivatives market
infrastructure. See PWG Report, supra note 205. Similarly, the 2010
staff report issued by the FRBNY outlined policy perspectives on OTC
derivatives infrastructure and identified trade compression as an
element of strong risk management and recommended that market
participants engage in regular, market-wide portfolio compression
exercises. See FRBNY OTC Derivatives Report, supra note 62. Since
the years immediately following the 2008 financial crisis,
compression outside of CCPs has been somewhat less common and has
declined substantially from its 2008 peak. See supra note 240.
---------------------------------------------------------------------------
Further, the termination of redundant security-based swap
transactions through the portfolio compression process is likely to
result in the potential reduction of both counterparty and operational
risk at the SBS Entity level. The use of portfolio compression also
could reduce the overall level of bilateral risk exposures, while
leaving the net positions of market participants unaltered, thereby
improving operational efficiency. Improvements in operational
efficiency may arise due to fewer overall positions for each entity, a
reduction in carried margin and variation margin calculations, and
fewer (and potentially less frequent) portfolio reconciliations. This
would also reduce the number of bilateral positions that would have to
be resolved in the event of insolvency of a market participant. These
reductions in risk and improvements in operational efficiency of SBS
Entities could benefit the financial system as a whole, thereby
potentially increasing the number of market participants as well as
improving liquidity.
Although the costs of participating in portfolio reconciliation are
fully internalized by each counterparty, the potential benefits,
particularly for multilateral compression exercises, increase with the
number of counterparties that participate. Under proposed Rule 15Fi-
4(a), SBS Entities would be required to establish, maintain, and follow
written policies and procedures for periodically engaging in both
bilateral portfolio compression exercises and multilateral portfolio
compression exercises, in each case when appropriate, with
counterparties that also are an SBS Entities.\285\ To the extent that
an SBS Entity transacts with a counterparties that are not SBS
Entities, the policies and procedures required under the proposed rule
would require only that portfolio compression exercises occur when
appropriate and only if requested by any such counterparty. In the
absence of the proposed rules, some counterparties may not participate
in compression activities reducing the potential benefits available to
other counterparties and the financial system generally.
---------------------------------------------------------------------------
\285\ See supra Section I.C.
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As noted in the economic baseline, the emergence of third-party
vendors has provided portfolio compression services for security-based
swaps. SBS Entities may be able to continue to benefit from the
services of these third-party vendors to provide additional portfolio
compression opportunities for these firms.
The proposed rule provides flexibility to security-based swap
market participants with respect to portfolio compression. The
Commission preliminarily believes that by not proposing prescriptive
requirements, an SBS Entity would allow the counterparties flexibility
in the manner in which they reduce the size of their security-based
swap portfolios in light of each counterparty's unique risks and
operations. Moreover, the proposed rules regarding bilateral offset
have been designed to reflect the understanding by the Commission that
firms may have legitimate economic and business reasons for maintaining
fully offsetting security-based swap transactions. Certain portfolio
compression exercises could result in adverse credit exposures to
certain counterparties. For example, the results of a particular
multilateral compression exercise may result in a credit exposure to a
particular counterparty that exceeds credit exposure limits for that
counterparty.
Thus, the Commission preliminarily believes that the policies and
procedures should be flexible enough to allow an SBS Entity to take the
most appropriate course of action with respect to managing its risks,
while at the same time, encouraging SBS Entities to consider the risk
mitigation possibilities of portfolio compression in a non-arbitrary
manner and consistent with the purposes of Section 15F(i) of the
Exchange Act. As such, proposed
[[Page 4663]]
Rules 15Fi-4(a)(1) and (b) would require a firm's policies and
procedures to address the termination of fully offsetting security-
based swaps only ``when appropriate.''
Finally, the Commission notes that both the CFTC and the EC have
adopted portfolio compression requirements that are substantially
similar to those being proposed by the Commission in this release.\286\
By closely aligning portfolio compression requirements through
consultation with the CFTC and with ESMA, the Commission preliminarily
believes that SBS Entities will benefit from a largely unitary
regulatory regime that does not require separate compliance and
operational policies and procedures.
---------------------------------------------------------------------------
\286\ See supra note 7 and accompanying text.
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c. Costs
SBS Entities will necessarily have to design, compose, and
implement policies and procedures to regularly evaluate compression
opportunities with their counterparties as well as those opportunities
offered by third parties. However, the Commission preliminarily
believes that given the large risk management benefits available from
the regular compression of offsetting trades--benefits including
reduced risk and enhanced operational efficiency--SBS Entities already
undertake regular portfolio compression exercises. For this reason and
those discussed below, the Commission preliminarily believes that the
relevant costs will primarily be the creation of policies and
procedures.
The greater the level of standardization in security-based swaps,
the less costly it becomes to identify compression opportunities. In
April 2009, ISDA announced the implementation of the 2009 ISDA Credit
Derivatives Determinations Committees and Auction Settlement CDS
Protocol, known colloquially in the industry as the ``Big Bang
Protocol,'' which introduced a number of documentation changes to help
standardize single-name CDS contracts.\287\ Among these changes were
the introduction of standard coupon rates and standard effective dates.
Following the standardization of single-name CDS, compression in this
market segment increased.\288\ As that standardization continues, we
would expect that the cost of identifying appropriate compression
opportunities should continue to fall. Using single-name corporate CDS
data from DTCC-TIW discussed above, we find the percentage of new
trades in North American Single-Name Corporate that have standardized
coupons has risen from 95.2% in 2012 to 99.8% in 2017. The reduction in
the number of roll-dates from four to two in order to both improve
liquidity as well as to align with updates to CDS indices \289\ also
may result in increased standardization and therefore may reduce the
costs of identifying compression opportunities.
---------------------------------------------------------------------------
\287\ See Press Release, ISDA Announces Successful
Implementation of `Big Bang' CDS Protocol; Determinations Committees
and Auction Settlement Changes Take Effect (Apr. 8, 2009), available
at: https://www.isda.org/a/XS6EE/ISDA-Announces-Successful-Implementation-of-%E2%80%98Big-Bang%E2%80%99-CDS-Protocol-Determinations-Committees-and-Auction-Settlement-Changes-Take-Effect.docx.
\288\ See Nicholas Vause, Counterparty risk and contract volumes
in the credit default swap market, BIS Quarterly Review (Dec. 2010),
available at: http://www.bis.org/publ/qtrpdf/r_qt1012g.pdf
(``TriOptima became the first company to offer CDS portfolio
compression when it extended its TriReduce service from interest
rate swaps to the CDS market in 2005. In the CDS market, TriReduce
has compressed mainly portfolios of CDS indices and index tranches,
but single names have accounted for an increasing share of its
compression volumes since standardisation in 2009.'').
\289\ See http://www2.isda.org/asset-classes/credit-derivatives/single-name-cds-roll/.
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The Commission estimates that the development and implementation of
written policies and procedures as required under proposed Rule 15Fi-4
would impose an initial cost of $702,232.50 in aggregate. Of the 55
market participants the Commission expects will register as SBS
Entities and be subject to Rule 15Fi-4, the Commission estimates that
approximately 35 of these market participants are registered with the
CFTC, and are anticipated to already have policies and procedures in
place with respect to portfolio compression. The expected additional
time to revise the existing policies and procedures for these SBS
Entities is expected to be one hour per SBS Entity, for a cumulative 35
hours, costing $429.50 per SBS Entity or $15,032.50 in aggregate.\290\
For the remaining 20 SBS Entities, the Commission estimates that it
will take approximately 80 hours per entity to establish the written
policies and procedures. The costs for these SBS Entities will be
$687,200, or $34,360 per SBS Entity.\291\ Once established, the
Commission estimates that it would cost SBS Entities approximately
$944,900 or $17,180 per SBS Entity to revise and maintain these
policies and procedures.\292\
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\290\ The estimate is based on the following: [((Compliance
Attorney (30 minutes) at $346 per hour) + ((Director of Compliance
(15 minutes) at $461 per hour) + ((Deputy General Counsel (15
minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or
($429.50 per hour x 35 SBS dually-registered Entities) = $15,032.50.
\291\ The estimate is based on the following: [((Compliance
Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20
hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at
$565 per hour)] = $34,360 per SBS Entity or ($34,360 x 20 SBS
Entities that are not dually-registered) = $687,200 in aggregate.
\292\ The estimate is based on the following: [((Compliance
Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10
hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at
$565 per hour)] = $17,180 per SBS Entity or ($17,180 x 55 SBS
Entities) = $944,900 in aggregate.
---------------------------------------------------------------------------
The Commission further estimates that an SBS Entity will devote
approximately 124.17 hours per year for portfolio offsets and
compression exercises (6,829.35 aggregate hours), a substantial portion
of which will be automated, and some of which may be handled by third-
party vendors.\293\ Similar to our discussion for portfolio
reconciliation (Section VIII.C.2.c), the Commission expects that the
costs of implementing portfolio compression exercises through an
automated process will be minimal for those SBS Entities that are
dually-registered with the CFTC, as many of those systems will already
be in place. With respect to the remaining 20 SBS Entities that are not
dually-registered, the Commission anticipates that any cost associated
with implementing the portfolio reconciliation system may also account
for the portfolio compression exercises that may periodically take
place; therefore, the overall costs of portfolio compression systems
should be minimal.
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\293\ The Commission estimates that each SBS Entity will
transact with approximately 368 counterparties (18 SBS Entities and
350 non-SBS market participants). It is estimated that approximately
one offset per year will take place between counterparties and it is
expected to take five minutes to complete, for a total number of
hours of (2.5/60 x 18 + 5/60*350) or 29.92 hours per year per SBS
Entity. Further, each SBS Entity is expected to conduct six
bilateral compressions with SBS Entities and 350 bilateral
compressions with non-SBS counterparties, each taking 15 minutes for
total hours of [(7.5/60 x 6) + (15/60 x 350)] = 88.25 hours. Lastly,
each SBS Entity is anticipated to complete 12 multilateral
compressions each year, each taking 30 minutes for a total of 6
hours. Total time for each SBS Entity for portfolio compression
exercises is estimated to be (29.92 + 88.25 + 6) = 124.17 hours, or
6829.35 hours (124.17 hours x 55 SBS Entities).
---------------------------------------------------------------------------
In terms of quantification of the costs of compression, the
Commission also notes that that there are a number of third-party
vendors that provide compression services, and some of these providers
may charge fees based on results achieved (such as number of swaps or
security-based swaps compressed). Assuming that third-party vendors
charge a fee directly related to the outcome of the compression
exercise (as opposed to a fixed fee in whole or some portion thereof
for portfolio compression activities), the direct costs of portfolio
compression by third-party vendors would therefore likely be
[[Page 4664]]
directly related to the economic benefits of reduced counterparty and
operational risk realized through the compression exercises. The
Commission does not currently have pricing data for third-party service
providers that offer portfolio compression services and so is unable to
quantify the costs to market participants who make use of these
services.
Many non-SBS Entities typically trade only in small volumes and on
one side of a particular security-based swap, to create a synthetic
position in the underlying asset or to hedge another position, for
example. Such one-sided market positions reduce the opportunities to
engage in periodic compression cycles. For SBS Entities that do not
currently participate in compression cycles, there could be costs to
modify the participant's risk systems and connectivity enhancements
that would allow for sharing the necessary information required to
identify compression opportunities and for the booking and processing
of a large volume of security-based swaps in a short time period.
Multilateral compression cycles are typically managed with automated
tools to support tear-up and new trade creation that end-users usually
do not possess, and the costs of obtaining such tools cannot be
justified by the benefits. The rule does not require market
participants to engage in mandatory compression cycles, but only to
establish, maintain, and follow written policies and procedures for
engaging in certain forms of portfolio compression exercises.
d. Alternatives
The proposed rule requires that SBS Entities establish, maintain,
and follow written policies and procedures as they relate to certain
forms of portfolio compression exercises with each of its
counterparties. As such, the Commission is not proposing to mandate the
specific contents of the policies and procedures created to comply with
these rules.\294\ However, a number of more specific requirements for
portfolio compression could be included. For example, the current
proposal only requires policies and procedures that address compression
to the extent requested by the counterparty rather than a more
prescriptive requirement.\295\
---------------------------------------------------------------------------
\294\ There is one exception to this statement, see supra note
72.
\295\ See supra Section I.C.3.
---------------------------------------------------------------------------
Pursuant to the proposed Rule 15Fi-4, SBS Entities are required
``periodically'' to examine the possibility for whether portfolio
compression exercises can take place. While this provides flexibility
to the counterparties in terms of the frequency with which rebalancing
would have to be explored, it leaves open the possibility that market
participants will suboptimally select the frequency with which
portfolio compression exercises can occur, which could impose
externalities on SBS counterparties as well as the financial system as
a whole. As an alternative, the Commission has considered requiring a
minimum frequency of analysis of portfolio compression exercises. For
instance, at least twice a year, SBS Entities could conduct an analysis
of the possibility of a portfolio compression exercise in order to
reduce their counterparty credit risk and engage in such a portfolio
compression exercise, similar to those adopted by the EC.\296\ Given
that portfolio compression has been identified to be a valuable and
important tool for risk management, it is likely that many SBS Entities
already have in place policies and procedures for periodic evaluation
of compression possibilities, thus imposing a minimum standard could be
burdensome and costly for firms to implement.
---------------------------------------------------------------------------
\296\ See EU Regulation 149/2013, art. 14, 2013 O.J. 11, 22.
---------------------------------------------------------------------------
Relatedly, the frequency with which SBS Entities evaluate their
prospects for portfolio compression opportunities could be related to
the number of transactions between counterparties (as is required for
portfolio reconciliation in proposed rule 15Fi-3). For instance, if
counterparties have portfolios in excess of 500 transactions, an
analysis of portfolio compression could be conducted quarterly, while
SBS Entities with portfolios between 50 and 500 transactions, portfolio
compression exercises could be explored twice a year. For
counterparties with fewer than 50 transactions between them (or for
portfolios with non-SBS Entities), portfolio compression exercises
could be simply ``periodically.'' This would allow counterparties to
assess the counterparty credit risk at frequencies aligned with the
complexities of their portfolios without incurring substantive
additional costs of this increase in periodic evaluation of portfolio
compression opportunities. The Commission has considered the costs and
benefits to market participants of imposing policies and procedures
related to portfolio compression based on the number of transactions
between counterparties. However, it is likely that market participants
expected to register as SBS Entities already have policies and
procedures in place to evaluate portfolio compression opportunities
with counterparties, and requiring alterations to these policies could
be costly for these entities without corresponding benefits.
Proposed Rule 15Fi-4(c), the new requirements regarding portfolio
compression, would not apply to a ``clearing transaction'', which is
defined as a security-based swap that has a clearing agency as a direct
counterparty.\297\ A clearing agency means a clearing agency that is
registered with the Commission pursuant to Section 17A of the Exchange
Act and that provides central counterparty services for security-based
swap transactions. The Commission considered as an alternative
including transactions cleared at a foreign clearing agency that is not
registered with the Commission within its definition of ``clearing
transaction'' for the purposes of the proposed rule. The Commission
preliminarily concluded that an approach that is similar to that taken
by the Commission in other rules,\298\ as well as the approach taken by
the CFTC,\299\ would reduce implementation and compliance costs.
---------------------------------------------------------------------------
\297\ See supra Section I.C.4.
\298\ See supra note 278.
\299\ Specifically, CFTC Rule 23.503(c) provides that
``[n]othing in this section shall apply to a swap that is cleared by
a derivatives clearing organization.'' 17 CFR 23.503(c).
---------------------------------------------------------------------------
The Commission has considered as an alternative, an alternative
compliance mechanism that would allow a SBS Entity to be deemed in
compliance with certain proposed rules regarding portfolio compression
if the SBS Entity is also registered as a swap dealer or major swap
participant with the CFTC and is in compliance with the corresponding
CFTC portfolio compression rules. The Commission preliminarily
concludes that, as a practical matter, the rules are nearly equivalent,
suggesting that any additional compliance cost arising from differences
in these rules for an entity that is registered with both the CFTC and
the Commission should be small. The Commission preliminarily believes
that the differences that do exist (such as the proposed rule providing
that requested compression by an entity that is not a security-based
swap dealer or major security-based swap participant need only be
conducted if appropriate \300\) may provide marginal benefits to SBS
market participants (such as by preventing portfolio compression that
is not appropriate given the particular circumstances of
[[Page 4665]]
the trade and the counterparties to that trade).\301\
---------------------------------------------------------------------------
\300\ See supra note 70 and accompanying text.
\301\ The corresponding CFTC compression rule applicable to
transactions with counterparties that are not SBS Entities does not
contain the caveat that any form of compression or offset covered by
the applicable policies and procedures would only need to occur
``when appropriate.'' See supra note 70. We solicit comment on this
difference. See supra Section I.C.5.
---------------------------------------------------------------------------
4. Trading Relationship Documentation
OTC derivatives market participants typically have relied on the
use of industry standard legal documentation, including master netting
agreements, definitions, schedules, and confirmations, to document
their security-based swap trading relationships. This industry standard
documentation offers a framework for documenting the transactions
between counterparties for OTC derivatives products.\302\ The standard
documentation is designed to set forth the legal, trading, and credit
relationship between the parties and to facilitate netting of
transactions in the event that parties have to close-out their position
with one another or determine credit exposure for margin and collateral
management. Notwithstanding the standardization of such documentation,
some or all of the terms of the master agreement and other documents
are subject to negotiation and modification.
---------------------------------------------------------------------------
\302\ One commonly used form of the industry standard
documentation is the ISDA Master Agreement and related definitions,
schedules, and confirmations specific to particular asset classes.
As noted in Section VI.B.4, over 99% of uncleared security-based
swap transactions use an ISDA Master Agreement as reported in DTCC-
TIW.
---------------------------------------------------------------------------
a. Requirements
The Commission is proposing rules and interpretations that
generally would require each SBS Entity to establish, maintain, and
follow written policies and procedures reasonably designed to ensure
that it executes written trading relationship documentation with its
counterparties prior to, or contemporaneously with, executing a
security-based swap. The security-based swap trading relationship
documentation is required to be in writing and to include all material
terms governing the trading relationship between counterparties.
Further, the proposed rule would also require that the security-
based swap trading relationship documentation include credit support
arrangements.\303\ One of the key elements of Title VII reforms was to
ensure that uncleared OTC derivatives were appropriately
collateralized, thus the documentation of processes for calculating and
exchanging margin in connection with security-based swaps helps to
achieve the broader regulatory objective.\304\
---------------------------------------------------------------------------
\303\ See supra Section I.C.2
\304\ 15 U.S.C. 78c-5(f).
---------------------------------------------------------------------------
The proposed rules also would establish minimum standards with
respect to identifying the matters that must be addressed in the
security-based swap trading documentation, and outline certain
requirements related to the resolution of discrepancies, particularly
those involving differences in the valuation of security-based swaps.
In the event that discrepancies in valuation arise, the proposed rule
requires that counterparties must provide documentation for either an
alternative method for determining value of the security-based swap or
documentation on the resolution process for such disputes.
The proposed rule also requires that counterparties to the
security-based swap provide information on their legal status,
particularly in the event of liquidation, as well as to disclose
certain information of a security-based swap accepted for clearing by a
clearing agency, in order to reduce any potential confusion regarding
the status of the trade following its acceptance and novation at the
clearing agency. Lastly, proposed Rule 15Fi-5 requires a periodic
independent audit to identify any material deficiencies in the trading
relationship documentation policies and procedures.
b. Benefits
Inadequate or incomplete documentation of open security-based swap
transactions could, in some cases, result in collateral and legal
disputes between the two counterparties, thereby exposing both sides to
significant counterparty credit risk. By way of contrast, adequate
documentation between counterparties offers a framework for
establishing the trading relationship between the parties from the
outset of the transaction, which should minimize both the number and
magnitude of potential disputes.
Further, the proposed rule provides particular guidance with
respect to policies and procedures documenting the valuation of
security-based swaps. Although having policies and procedures regarding
trading relationship documentation in place is important for all
aspects of the transaction, the valuation of the transaction and how it
affects margin requirements on an on-going basis is critical for
managing both counterparty credit as well as operational risk. Pursuant
to proposed Rule 15Fi-5, counterparties are required to provide
information on the valuation methods, procedures, rules, and inputs
(within limits so as to not reveal private information regarding
proprietary valuation models), while further stipulating that either
alternative valuation methods or valuation discrepancy resolutions are
detailed in the trading relationship documentation. These benefits are
both complemented by, and accrue to, the portfolio reconciliation
process contemplated by proposed Rule 15Fi-3. That is, comprehensive
and accurate documentation of a transaction may contribute to a
smoother reconciliation process by reducing the possibility of
discrepancies; and any discrepancies that may still arise could
subsequently be identified and resolved through reconciliation.
As discussed above, because shortcomings in credit risk management
and documentation may only become evident during a crisis, some
benefits of complying with these rules will accrue to the financial
system as a whole while the ongoing direct costs are borne by the
individual market participant. Therefore, in the absence of these
rules, trading relationship documentation practices employed by
individual market participants may be less thorough than would be
desired by all market participants in order to properly manage risks to
the financial system. However, the widespread use of standard
documentation mitigates both the potential benefit and costs of the
proposed rule.
c. Costs
Market participants will likely incur ongoing costs associated with
the rules concerning trading relationship documentation. Market
participants will have to (1) negotiate and document all terms of each
trading relationship; (2) design, compose, and implement policies and
procedures reasonably designed to ensure the execution of security-
based swap trading relationship documentation, including valuation
documentation; (3) obtain documentation from counterparties who are
claiming the end user exception to clearing; and (4) periodically audit
documentation and keep records and/or make reports as required under
these rules.
The Commission estimates that the initial burden to negotiate and
draft trading relationship documentation will be $4,741,680 per SBS
Entity, or $260,792,400 in aggregate across the 55
[[Page 4666]]
SBS Entities.\305\ The Commission further estimates that the
development and implementation of written policies and procedures as
required under proposed Rule 15Fi-5 would impose an initial cost of
$702,232.50 in aggregate. Of the total 55 SBS Entities as expected by
the Commission that would be subject to Rule 15Fi-5, 35 are anticipated
to be registered concurrently with the CFTC, and are anticipated to
already have policies and procedures in place with respect to portfolio
compression. The expected additional time to revise the existing
policies and procedures for these Entities is expected to be one hour
per Entity, for a cumulative 35 hours, costing $429.50 per Entity or
$15,032.50 in aggregate.\306\ For the remaining 20 SBS Entities, the
Commission estimates that it will take approximately 80 hours per
entity to establish the written policies and procedures. The costs for
these SBS Entities will be $687,200, or $34,360 per SBS Entity.\307\
Once established, the Commission estimates that it would cost SBS
Entities approximately $944,900 or $17,180 per SBS Entity to revise and
maintain these policies and procedures.\308\ Lastly, proposed Rule
15Fi-5 requires periodic independent audits of the trading relationship
documentation. The Commission estimates that the costs associated with
these audits will be $794,880 per SBS Entity, or $43,718,400 in
aggregate.\309\
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\305\ Each SBS Entity is anticipated to be counterparty to 18
other SBS Entities and 350 non-SBS market participants, for a total
of 368 counterparties. The initial negotiation and draft in expected
to take 30 hours per counterparty. The estimation is as follows:
[((Compliance Manager (15 hours) x $346) + (Director of Compliance
(7.5 hours) x $461) + (Deputy General Counsel (7.5 hours) x $565)) x
368 counterparties] = $4,741,680 per SBS Entity, or ($4,741,680 x 55
SBS Entities) = $260,792,400 in aggregate.
\306\ The estimate is based on the following: [((Compliance
Attorney (30 minutes) at $346 per hour) + ((Director of Compliance
(15 minutes) at $461 per hour) + ((Deputy General Counsel (15
minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or
($429.50 per hour x 35 SBS dually-registered Entities) = $15,032.50.
\307\ The estimate is based on the following: [((Compliance
Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20
hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at
$565 per hour)] = $34,360 per SBS Entity or ($34,360 x 20 SBS
Entities that are not dually-registered) = $687,200 in aggregate.
\308\ The estimate is based on the following: [((Compliance
Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10
hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at
$565 per hour)] = $17,180 per SBS Entity or ($17,180 x 55 SBS
Entities) = $944,900 in aggregate.
\309\ The estimate is based on the following: [368
counterparties x 10 hours per Audit x Auditor ($216 per hour)] =
$794,880 per SBS Entity, or ($794,880 x 55 SBS Entities) =
$43,718,400 in aggregate.
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Memorializing the specific terms of the security-based swap trading
relationship and security-based swap transactions between
counterparties is prudent business practice and, in fact, many market
participants already use standardized documentation.\310\ Accordingly,
the Commission preliminarily believes that many, if not most, market
participants that are expected to register as SBS Entities currently
execute and maintain trading relationship documentation of the type
required by the proposed rules in the ordinary course of their
businesses, including documentation that contains several of the terms
that would be required by the proposed rules. Thus, the hour and dollar
burdens associated with the security-based swap trading relationship
documentation requirements may be limited to amending existing
documentation to expressly include any additional terms required by the
proposed rules. In addition the Commission anticipates that
standardized security-based swap trading relationship documentation
will eventually incorporate changes that may be necessary to comply
with many of the requirements of this rule reducing the cost to
individual security-based swap market participants.\311\
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\310\ As noted in Section VI.B.4, as of 2015, the DTCC-TIW data
shows that over 99% of SBS Entities use the ISDA Master Agreement.
\311\ In response to prior Dodd Frank Act related regulatory
requirements, ISDA in partnership with third party providers, has
created technology-based solutions enabling counterparties to modify
OTC derivatives related documentation quickly and efficiently. See
http://www2.isda.org/dodd-frank-documentation-initiative/.
---------------------------------------------------------------------------
Proposed Rule 15Fi-5 also includes certain exceptions that are
intended to mitigate costs incurred by market participants while
preserving the risk mitigating benefits of thorough trading
relationship documents. First, the proposed rule would provide an
exception for security-based swaps executed prior to the date on which
the SBS Entity is required to be in compliance with the trading
relationship documentation rule, as it may be costly and impractical to
require SBS Entities to bring existing transactions into compliance
with the proposed rules. The Commission notes that this exception may
increase the likelihood of disputes in valuation with respect to such
transactions, which will be subject to the portfolio reconciliation
requirement of proposed Rule 15Fi-3 even though they are not subject to
the documentation requirements of proposed Rule 15Fi-5. Such disputes
could be costly to resolve and may lead to greater uncertainty with
respect to counterparty credit risk.
The proposed rule further provides exceptions for any ``clearing
transaction'', which, pursuant to existing Rule 15Fi-1(c) under the
Exchange Act, is defined as a security-based swap that has a clearing
agency as a direct counterparty. Once a security is cleared, the
transaction is primarily governed by the terms of the agreement between
clearing member and the clearing agency. Lastly, the proposed rule
would provide an exception for security-based swaps executed
anonymously on a national securities exchange or an SBSEF, provided
that these security-based swaps are intended to be cleared and are
actually submitted for clearing to a clearing agency that provides CCP
services. This exception is intended to recognize that documentation
requirements may be nearly impossible to fulfill within the context of
cleared anonymous transactions.\312\
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\312\ The exception with respect to security-based swap
transactions on national exchanges or SBSEF is limited. See Section
I.D.6 for a complete discussion of those limitations.
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d. Alternatives
The Commission has evaluated reasonable alternatives to the
proposed rule on trading relationship documentation. One alternative
would be that all SBS Entities are required to adhere to an industry-
accepted standard form of trading documentation, instead of
establishing policies and procedures related to documentation. It is
unlikely that this alternative would materially alter the primary
benefits of the rule, namely that of reducing disputes over
documentation that could lead to increased counterparty risk, but could
increase overall compliance costs without analogous increases in
benefits, due to reduced operational flexibility.
Further, the proposed rule requires that SBS Entities undertake a
periodic, independent audit to identify material weaknesses in its
documentation policies and procedures. As proposed, there is
flexibility on behalf of the SBS Entity as to how and when those audits
occur. Alternatively, the Commission has considered limiting to only
external auditors and requiring a once per year audit of trading
relationship documentation. Although this alternative would not
materially amend the primary benefits related to the audit of SBS
Entities' policies and procedures related to trading relationship
documentation, the Commission anticipates that this alternative could
increase compliance costs by reducing operational flexibility.
[[Page 4667]]
Proposed Rule 15Fi-5(a)(1)(ii) would provide an exception to the
trading relationship documentations requirements for any ``clearing
transaction'' which is defined as a security-based swap that has a
clearing agency as a direct counterparty.\313\ A clearing agency means
a clearing agency that is registered with the Commission pursuant to
Section 17A of the Exchange Act and that provides central counterparty
services for security-based swap transactions. The Commission
considered as an alternative including transactions cleared at a
foreign clearing agency that is not registered with the Commission
within its definition of ``clearing transaction'' for the purposes of
the proposed rule. The Commission preliminarily concluded that an
approach that is similar to that taken by the Commission in other
rules,\314\ as well as the approach taken by the CFTC,\315\ would
reduce implementation and compliance costs.
---------------------------------------------------------------------------
\313\ See supra Section I.D.6.
\314\ See supra note 278.
\315\ Specifically, CFTC Rule 23.504(a)(1)(iii) excludes from
the written trading relationship documentation requirements ``swaps
cleared by a derivatives clearing organization.'' 17 CFR
23.504(a)(1)(iii).
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The Commission has considered as an alternative, an alternative
compliance mechanism that would allow a SBS Entity to be deemed in
compliance with certain proposed rules regarding trading relationship
documentation if the SBS Entity is also registered as a swap dealer or
major swap participant with the CFTC and is in compliance with the
corresponding CFTC trading relationship documentation rules. The
Commission preliminarily concludes that, as a practical matter, the
rules are nearly equivalent, suggesting that any additional compliance
cost arising from differences in these rules for an entity that is
registered with both the CFTC and the Commission should be small. The
Commission preliminarily believes that differences that do exist are
necessary and appropriate. For example, to the extent that a
transaction entered into on an anonymous basis on a national securities
exchange or SBSEF that is then rejected for clearing but continues to
exist, the Commission preliminarily believes that the counterparties to
the ongoing security-based swap should have in place a written
agreement on the terms of that transaction.\316\
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\316\ See supra Section I.D.6.
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5. Recordkeeping Requirements
The Commission is also proposing rules that would modify existing
Rules 17a-3 and 17a-4, as well as proposed Rules 18a-5 and 18a-6 for
the recordkeeping and reporting requirements applicable to SBS
Entities. The proposed amendments would involve requiring each SBS
Entity to make and keep current information relevant to portfolio
reconciliation and portfolio compression exercises and to retain all
security-based swap trading relationship documentation required to be
created under proposed Rule 15Fi-5, as well as each policy and
procedure created pursuant to proposed Rules 15Fi-3, 15Fi-4, and 15Fi-
5.
a. Requirements
The Commission is proposing to amend Rule 17a-3 (which applies to
SBS Entities that are also registered with the Commission as broker-
dealers) and proposed Rule 18a-5 (which applies to SBS Entities that
are not registered with the Commission as broker-dealers). Under these
amendments, each SBS Entity would be required to make and keep records
of each security-based swap portfolio reconciliation and portfolio
compression exercise, which is believed to promote compliance with
proposed Rules 15Fi-3 and 15Fi-4 as well as support SBS Entities in the
event that disputes arise in relation to previous reconciliations or
compressions. The proposed amendments would also require that SBS
Entities make and keep records of valuation disputes in excess of $20
million if not resolved within three (for SBS Entities) or five (for
non-SBS counterparties) days.
The Commission also is proposing to amend Rule 17a-4 (which applies
to SBS Entities that are also registered with the Commission as broker-
dealers) and proposed Rule 18a-6 (which applies to SBS Entities that
are not registered with the Commission as broker-dealers), which
address record retention. All records made and kept under the proposed
amendments to Rule 17a-3 and proposed Rule 18a-5 would need to be
retained for at least three years. Further, all policies and procedures
related to proposed Rules 15Fi-3 through 15Fi-5, all written agreements
between counterparties on terms of portfolio reconciliation, and all
security-based swap trading relationship documentation with
counterparties would need to be retained until at least three years
following the termination of said policies and procedures and/or
documentation.
b. Benefits
In proposing these requirements, the Commission considered the
potential benefits of improving the oversight, transparency, and
documentation of security-based swap activities. The amendments to
Rules 17a-3 and 17a-4, and proposed Rules 18a-5 and 18a-6 are intended
to facilitate effective oversight of SBS Entities, thus the benefits
associated with the proposed amendments related to recordkeeping are
beneficial not only to the SBS Entities, but also are expected to
facilitate regulatory oversight.
Requiring retention of records related to portfolio reconciliation,
portfolio compression, and trading relationship documentation for a
minimum of three years provides SBS Entities with a well-established
track record should disputes about terms of the security-based swap
arise. The benefits of these proposed amendments, to the extent that
they enhance existing practice, could reduce both counterparty credit
risk as well as operational risk for the SBS Entities. Further, the
proposed amendments are expected to facilitate examinations by the
Commission of SBS Entities.
c. Costs
The Commission also recognizes that there will be costs associated
with the new rules and rule amendments. Those costs include the costs
of creating procedures to ensure that records are kept as required by
the proposed rule amendments, and costs associated with ongoing record
maintenance. As the recordkeeping requirements would be amendments to
Rules 17a-3 and 17a-4, and proposed Rules 18a-5 and 18a-6; however, the
incremental costs of compliance with these amendments is likely to be
minimal.
The proposed Rules 15Fi-3 through 15Fi-5 would require that SBS
Entities would establish and maintain written policies and procedures
related to portfolio reconciliation, portfolio compression exercises,
and trading relationship documentation. Further, SBS Entities are
already required to comply with the retention of written policies and
procedures with respect to Rule 15Fi-2 related to trade acknowledgement
and verification, and should have recordkeeping systems previously
instituted. Therefore, only minor modifications would need to be made
in order to make the systems compliant with the proposed amendments
regarding recordkeeping requirements for portfolio reconciliation,
portfolio compression exercises, and trading relationship
documentation.
Generally, the Commission does not expect the amendments to Rules
17a-3 and 17a-4, and proposed Rules 18a-5 and 18a-6 to create material
burdens for registrants, although as noted above the Commission does
expect that there will
[[Page 4668]]
be incremental costs related to complying with the proposed rule
amendments.\317\
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\317\ See supra Section I.F.1.
---------------------------------------------------------------------------
d. Alternatives
The Commission has considered reasonable alternatives to the
proposed amendments. In particular, the costs and benefits associated
with the required recordkeeping horizon have been evaluated. Shorter
horizons (of less than three years) would lessen the overall
recordkeeping burden by reducing the retention requirements and
corresponding storage of records. However, as it may take time for
disputes, particularly in the event of liquidations to be fully
settled, shorter horizons may lead to the elimination of relevant
records prior to resolution. On the other hand, longer horizons for
maintaining records could be costly with respect to storage and system
requirements. However, longer record preservation would reduce the
likelihood that historical records are unavailable if needed at some
point in the future.
Proposed Rule 15Fi-5(c) requires each SBS Entity to have an
independent auditor conduct periodic audits sufficient to identify any
material weakness in it documentation policies and procedures required
by the rule. The Commission considered using the same requirement as
that required by the CFTC that the audit be conducted by an independent
internal or external auditor. The Commission chose not to follow this
approach because in its experience overseeing accounting and auditing
standards in the context of certain disclosure requirements under the
federal securities laws, an internal auditor typically reports to the
management of the applicable entity, which by definition would not
satisfy the test for auditor independence under any existing statutory
or regulatory provision that the Commission administers.\318\ However,
because the proposed rule would still encompass any auditor, whether
external or internal, that is in fact independent, the Commission
preliminarily believes that the practical differences between the
Commission's proposed rule and the corresponding CFTC rule are
negligible.
---------------------------------------------------------------------------
\318\ See supra Section I.D.5.
---------------------------------------------------------------------------
6. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5
In early 2016, the Commission adopted Rule 3a71-6 under the
Exchange Act, which determined that non-U.S. SBS Entities could satisfy
certain requirements of Section 15F by complying with comparable
regulatory requirements of a foreign financial regulatory system.\319\
At the time of the substituted compliance rule, it applied solely to
business conduct standards; however, Rule 3a71-6 was amended in the
Trade Acknowledgement and Verification Adopting Release to provide
foreign SBS Entities with the potential to rely on substituted
compliance to satisfy Title VII trade confirmation requirements.\320\
---------------------------------------------------------------------------
\319\ See Business Conduct Standards Adopting Release, 81 FR at
30074.
\320\ See Trade Acknowledgement and Verification Adopting
Release, 81 FR at 39827-28.
---------------------------------------------------------------------------
a. Requirements
The Commission is proposing to amend further Rule 3a71-6 to allow
non-U.S. SBS Entities to potentially be able to satisfy through
substituted compliance the Title VII portfolio reconciliation,
portfolio compression, and trading relationship documentation
requirements in proposed Rules 15Fi-3 through 15Fi-5. The Commission
has preliminarily determined that the principles previously set forth
in the Business Conduct Standards Adopting Release and the Trade
Acknowledgement and Verification Adopting Release with respect to
substituted compliance should in large part similarly pertain to the
reconciliation, compression, and documentation requirements proposed
herein.
b. Benefits
The Commission proposed amendments to Rule 3a71-6 permit
consideration of substituted compliance in order to reduce the
probability that SBS Entities are subject to potentially duplicative or
conflicting regulation. Market participants that face duplicative
regulatory regimes are likely to attain comparable regulatory outcomes,
but at a cost of increased compliance burdens without an analogous
increase in benefits. The availability of substituted compliance could
decrease the compliance burden for non-U.S. SBS Entities, particularly
as it pertains to portfolio reconciliation, portfolio compression, and
trading relationship documentation. Allowing for the possibility of
substituted compliance may help achieve the risk mitigation
requirements set forth in proposed Rules 15Fi-3 through 15Fi-5, in
particular as it reduces legal uncertainty, counterparty credit risk
exposure, and operational risk for market participants.
Further, the Commission anticipates broader market implications of
substituted compliance, as well, namely an increase in foreign SBS
dealers' activity in the U.S. market, the expansion of access by both
U.S. and foreign SBS Entities to global liquidity, and a reduction in
the possibility of liquidity fragmentation along jurisdictional lines.
The availability of substituted compliance for non-U.S. SBS Entities
also could promote market efficiency, while enhancing competition in
U.S. markets. Increased participation and access to liquidity is likely
to improve efficiencies related to hedging and risk sharing, while
simultaneously increasing competition between domestic and foreign SBS
Entities.
c. Costs
The Commission preliminarily believes that the availability of
substituted compliance for portfolio reconciliation, portfolio
compression, and trading relationship documentation would not
substantially alter the benefits intended by the proposed Rules 15Fi-3
through 15Fi-5. In particular, it is expected that the availability of
substituted compliance will not detract from the risk mitigation
benefits that stem from periodic portfolio reconciliation, as well as
policies and procedures regarding portfolio compression exercises and
trading relationship documentation.
To the extent that substituted compliance reduces duplicative
compliance costs, non-U.S. SBS Entities entering into transactions in
which substituted compliance is available may incur lower overall costs
associated with portfolio reconciliation, portfolio compression, and
documentation exercises with their counterparties than they would
otherwise incur without the option of substituted compliance
availability, either because a non-U.S. SBS Entity may have already
implemented foreign regulatory requirements which have been deemed
comparable by the Commission, or because security-based swap
counterparties eligible for substituted compliance do not need to
duplicate compliance with two sets of comparable requirements.
A substituted compliance request can be made by either a foreign
regulatory jurisdiction on behalf of its market participants, or by the
registered market participant itself.\321\ The decision to request
substituted compliance is voluntary, and therefore, to the extent that
requests are made by individual market participants, such participants
would request substituted compliance
[[Page 4669]]
only if compliance with foreign regulatory requirements was less
costly, in their own assessment, than compliance with both the foreign
regulatory regime and the relevant Title VII requirements, including
portfolio reconciliation, portfolio compression, and trading
relationship documentation requirements. Even after a substituted
compliance determination is made, market participants would only choose
substituted compliance for portfolio reconciliation, compression, and
documentation requirements if the benefits that they expect to receive
from transacting in the U.S. markets exceed the costs that they expect
to bear for doing so.
---------------------------------------------------------------------------
\321\ See Cross-Border Adopting Release, 79 FR at 47277.
---------------------------------------------------------------------------
D. Request for Comment
The Commission requests comment on all aspects of this initial
economic analysis, including whether the analysis has: (i) Identified
all benefits and costs, including all effects on efficiency,
competition, and capital formation; (ii) given due consideration to
each benefit and cost, including each effect on efficiency,
competition, and capital formation; and (iii) identified and considered
reasonable alternatives to the proposed regulations. We request and
encourage any interested person to submit comments regarding the
proposed regulations and our analysis of the potential effects of the
proposed regulations. We request that commenters identify sources of
data and information as well as provide data and information to assist
us in analyzing the economic consequences of the proposed rule and
proposed amendments. We also are interested in comments on the
qualitative benefits and costs we have identified and any benefits and
costs we may have overlooked. In addition to our general request for
comment on the economic analysis associated with the proposed rule and
proposed amendments, we request specific comment on certain aspects of
the proposal:
We request comment on our characterization of current
portfolio reconciliation practices. Do commenters agree that the
proposed portfolio reconciliation rules are similar to current best
practices? If not, how are they different? Are there third party
service providers that offer portfolio reconciliation services? If so,
what are the costs associated with using such services?
We request comment on our characterization of current
portfolio compression practices. Do commenters agree that the proposed
portfolio compression rules are similar to current best practices? If
not, how are they different? The Commission understands that there are
third party service providers that offer portfolio compression
services. What are the direct and indirect costs of using such service
providers?
We request comment on our characterization of current
trading relationship documentation practices. Do commenters agree with
our characterization? If not, how are they different?
We request comment on our characterization of the benefits
of the proposed regulations concerning portfolio reconciliation. The
Commission preliminarily believes that the main benefit of portfolio
reconciliation is improved management of market and credit risks
associated with particular transactions. Do commenters agree with this
characterization of the benefits? Are there other benefits of the
proposed rule that have not been identified in our discussion and that
warrant consideration? Are the assumptions that form the basis of our
analysis of the benefits appropriate? Can commenters provide data that
supports or opposes these assumptions? Can commenters provide data that
would help the Commission quantify the magnitude of the benefits
identified in our discussion or other benefits that we did not identify
in our discussion and that warrant consideration?
We request comment on our characterization of the costs of
the proposed regulations concerning portfolio reconciliation. The
Commission preliminarily believes that making its rules as similar as
practicable to those of the CFTC will mitigate compliance costs for SBS
entities. The Commission also preliminarily believes that ongoing
portfolio reconciliation costs would likely be a function of portfolio
size and the availability of third party service providers. Do
commenters agree with our characterization of the costs? Are there
other costs of the proposed rule that have not been identified in our
discussion and that warrant consideration? Are the assumptions that
form the basis of our analysis of the costs appropriate? Can commenters
provide data that supports or opposes these assumptions? Can commenters
provide data that would help the Commission quantify the magnitude of
the costs identified in our discussion or other costs that we did not
identify in our discussion and that warrant consideration?
We request comment on our characterization of the benefits
of the proposed rules concerning portfolio compression. The Commission
preliminarily believes that the main benefit of the proposed portfolio
compression rule is the potential for reducing the overall risk, cost,
and inefficiencies associated with maintaining offsetting transactions.
Do commenters agree with this characterization of the benefits? Are
there other benefits of the proposed rule that have not been identified
in our discussion and that warrant consideration? Are the assumptions
that form the basis of our analysis of the benefits appropriate? Can
commenters provide data that supports or opposes these assumptions? Can
commenters provide data that would help the Commission quantify the
magnitude of the benefits identified in our discussion or other
benefits that we did not identify in our discussion and that warrant
consideration?
We request comment on our characterization of the costs of
the proposed regulations concerning portfolio compression. The
Commission preliminarily believes the making its rules as similar as
practicable to those of the CFTC will mitigate compliance costs for SBS
entities. Do commenters agree with our characterization of the costs?
Are there other costs of the proposed rule that have not been
identified in our discussion and that warrant consideration? Are the
assumptions that form the basis of our analysis of the costs
appropriate? The Commission preliminarily believes third-party service
providers often facilitate multilateral portfolio compression but lacks
data on the costs to participants of using these services. Can
commenters provide data that supports or opposes these assumptions? Can
commenters provide data that would help the Commission quantify the
magnitude of the costs identified in our discussion or other costs that
we did not identify in our discussion and that warrant consideration?
We request comment on our characterization of the benefits
of the proposed rules concerning trading relationship documentation.
The Commission preliminarily believes that the main benefit of the
proposed trading relationship documentation rule is the potential for
reducing the likelihood of collateral and legal disputes between
counterparties that might expose each side to significant counterparty
credit risk. Do commenters agree with this characterization of the
benefits? Are there other benefits of the proposed rule that have not
been identified in our discussion and that warrant consideration? Are
the assumptions that form the basis of our analysis of the
[[Page 4670]]
benefits appropriate? Can commenters provide data that supports or
opposes these assumptions? Can commenters provide data that would help
the Commission quantify the magnitude of the benefits identified in our
discussion or other benefits that we did not identify in our discussion
and that warrant consideration?
We request comment on our characterization of the costs of
the proposed regulations concerning trading relationship documentation.
The Commission preliminarily believes the widespread use of standard
documentation mitigates the costs of the proposed rule. Do commenters
agree with our characterization of the costs? Are there other costs of
the proposed rule that have not been identified in our discussion and
that warrant consideration? Are the assumptions that form the basis of
our analysis of the costs appropriate? Can commenters provide data that
would help the Commission quantify the magnitude of the costs
identified in our discussion or other costs that we did not identify in
our discussion and that warrant consideration?
Are there any effects on efficiency, competition, and
capital formation that are not identified or are misidentified in our
economic analysis? Please be specific and provide data and analysis to
support your views.
Do commenters believe that the alternatives the Commission
considered are appropriate? Are there other reasonable alternatives
that the Commission should consider? If so, please provide additional
alternatives and how their costs and benefits would compare to the
proposal.
We request and encourage any interested person to submit
comments regarding any aspect of the economic analysis of the proposed
rule, specific issues discussed in the economic analysis, and other
matters that may have an effect on the costs or benefits of the
proposed rule. With regard to any comments, we note that such comments
are of particular assistance to our rulemaking initiative if
accompanied by supporting data and analysis of the issues addressed in
those comments.
VII. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996 (``SBREFA'') \322\ the Commission requests comment on the
potential impact of the proposed rules and amendments on the economy on
an annual basis. The Commission also requests comment on any potential
increases in costs or prices for consumers or individual industries,
and any potential effect on competition, investment, or innovation.
Commenters are requested to provide empirical data and other factual
support for their views to the extent possible.
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\322\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------
VIII. Regulatory Flexibility Act Certification
The Regulatory Flexibility Act of 1980 (``RFA'') \323\ requires the
Commission, in promulgating rules, to consider the impact of those
rules on small entities. Section 603(a) \324\ of the Administrative
Procedure Act,\325\ as amended by the RFA, generally requires the
Commission to undertake a regulatory flexibility analysis of all
proposed rules to determine the impact of such rulemaking on ``small
entities.'' Section 605(b) of the RFA \326\ provides that this
requirement shall not apply to any proposed rule or proposed rule
amendment which, if adopted, would not have a significant economic
impact on a substantial number of small entities.
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\323\ 5 U.S.C. 601 et seq.
\324\ 5 U.S.C. 603(a).
\325\ 5 U.S.C. 551 et seq.
\326\ 5 U.S.C. 605(b).
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For purposes of Commission rulemaking in connection with the
RFA,\327\ a small entity includes: (1) When used with reference to an
``issuer'' or a ``person,'' other than an investment company, an
``issuer'' or ``person'' that, on the last day of its most recent
fiscal year, had total assets of $5 million or less; \328\ or (2) a
broker-dealer with total capital (net worth plus subordinated
liabilities) of less than $500,000 on the date in the prior fiscal year
as of which its audited financial statements were prepared pursuant to
Rule 17a-5(d) under the Exchange Act,\329\ or, if not required to file
such statements, a broker-dealer with total capital (net worth plus
subordinated liabilities) of less than $500,000 on the last day of the
preceding fiscal year (or in the time that it has been in business, if
shorter); and is not affiliated with any person (other than a natural
person) that is not a small business or small organization.\330\ Under
the standards adopted by the Small Business Administration, small
entities in the finance and insurance industry include the following:
(i) For entities engaged in credit intermediation and related
activities, entities with $175 million or less in assets; \331\ (ii)
for entities engaged in non-depository credit intermediation and
certain other activities, entities with $7 million or less in annual
receipts; \332\ (iii) for entities engaged in financial investments and
related activities, entities with $7 million or less in annual
receipts; \333\ (iv) for insurance carriers and entities engaged in
related activities, entities with $7 million or less in annual
receipts; \334\ and (v) for funds, trusts, and other financial
vehicles, entities with $7 million or less in annual receipts.\335\
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\327\ Although Section 601(b) of the RFA defines the term
``small entity,'' the statute permits agencies to formulate their
own definitions. The Commission has adopted definitions for the term
``small entity'' for the purposes of Commission rulemaking in
accordance with the RFA. Those definitions, as relevant to this
proposed rulemaking, are set forth in Rule 0-10 under the Exchange
Act, 17 CFR 240.0-10. See Exchange Act Release No. 18451 (Jan., 28,
1982), 47 FR 5215 (Feb., 4, 1982) (File No. AS-305).
\328\ See 17 CFR 240.0-10(a).
\329\ 17 CFR 240.17a-5(d).
\330\ See 17 CFR 240.0-10(c).
\331\ See 13 CFR 121.201 (Subsector 522).
\332\ See id. at Subsector 522.
\333\ See id. at Subsector 523.
\334\ See id. at Subsector 524.
\335\ See id. at Subsector 525.
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With respect to SBS Entities, based on feedback from market
participants and our information about the security-based swap markets,
and consistent with our position in prior Dodd-Frank Act rulemakings,
the Commission continues to believe that (1) the types of entities that
would engage in more than a de minimis amount of dealing activity
involving security-based swaps--which generally would be large
financial institutions--would not be ``small entities'' for purposes of
the RFA and (2) the types of entities that may have security-based swap
positions above the level required to be ``major security-based swap
participants'' would not be ``small entities'' for purposes of the
RFA.\336\
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\336\ See SBS Entity Registration Adopting Release, 80 FR at
49013; SBS Books and Records Proposing Release, 79 FR at 25296-97
and n.1441; Intermediary Definitions Adopting Release, 77 FR at
30743. See also Sections V (Paperwork Reduction Act) and VI
(Economic Analysis) (discussing, among other things, the economic
impact, including the estimated compliance costs and burdens, of the
amendments).
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For the foregoing reasons, the Commission certifies that neither
proposed Rules 15Fi-3 through 15Fi, nor the proposed amendments to
Rules 3a71-6, 15Fi-1, 17a-3, 17a-4, 18a-5 (proposed) and 18a-6
(proposed) would, if adopted, have a significant economic impact on a
substantial number of small entities. The Commission encourages written
comments regarding this certification. The Commission solicits comment
as to whether the proposed rules could have an effect on small
[[Page 4671]]
entities that has not been considered. The Commission requests that
commenters describe the nature of any impact on small entities and
provide empirical data to support the extent of such impact.
IX. Statutory Basis and Text of Proposed Rules
The Commission is proposing to revise Rules 3a71-6, 15Fi-1, 17a-3,
and 17a-4 under the Exchange Act (17 CFR 240.3a71-6, 17 CFR 240.15Fi-1,
17 CFR 240.17a-3 [as proposed to be amended at 79 FR 25193, May 2,
2014], and 17 CFR 240.17a-4 [as proposed to be amended at 79 FR 25193,
May 2, 2014]), to revise proposed Rules 18a-5 and 18a-6 under the
Exchange Act (17 CFR 240.18a-5 [as proposed to be adopted at 79 FR
25193, May 2, 2014] and 17 CFR 240.18a-6 [as proposed to be adopted at
79 FR 25193, May 2, 2014]) and to add new Rules 15Fi-3, 15Fi-4, and
15Fi-5 under the Exchange Act (17 CFR 240.15Fi-3, 17 CFR 240.15Fi-4,
and 17 CFR 240.15Fi-5) pursuant to the authority conferred by the
Exchange Act, as amended, and particularly sections 3(b), 15F, 17, and
23(a).\337\
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\337\ 15 U.S.C. 78c(b), 78o-10, 78q, 78w(a), and 78mm.
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List of Subjects in 17 CFR Part 240
Reporting and recordkeeping requirements, Securities, Security-
based swaps, Security-based swap dealers, Major security-based swap
participants.
Text of the Amendments
In accordance with the foregoing, the Securities and Exchange
Commission proposes to amend Title 17, chapter II of the Code of
Federal Regulations as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
1. The general authority citation for Part 240 continues to read as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss,77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20,
80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et seq., and
8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350; and
Pub. L. 111-203, 939A, 124 Stat. 1376 (2010), unless otherwise
noted.
0
2. Section 240.3a71-6 is amended by adding paragraph (d)(4) to read as
follows:
Sec. 240.3a71-6 Substituted compliance for security-based swap
dealers and major security-based swap participants.
* * * * *
(d) * * *
(4) Portfolio reconciliation, portfolio compression, and trading
relationship documentation requirements. The portfolio reconciliation,
portfolio compression, and trading relationship documentation
requirements of section 15F(i) of the Act (15 U.S.C. 78o-10(i)) and
Sec. Sec. 240.15Fi-3 through 15Fi-5; provided, however, that prior to
making such a substituted compliance determination the Commission
intends to consider whether the requirements of the foreign financial
regulatory system for engaging in portfolio reconciliation and
portfolio compression and for executing trading relationship
documentation with counterparties, the duties imposed by the foreign
financial regulatory system, and the information that is required to be
provided to counterparties pursuant to the requirements of the foreign
financial regulatory system, are comparable to those required pursuant
to the applicable provisions arising under the Act and its rules and
regulations.
0
3. Revise Sec. 240.15Fi-1 to read as follows:
Sec. 240.15Fi-1 Definitions.
For the purposes of Sec. 240.15Fi-1 through Sec. 240.15Fi-5:
(a) The term bilateral portfolio compression exercise means an
exercise by which two security-based swap counterparties wholly
terminate or change the notional value of some or all of the security-
based swaps submitted by the counterparties for inclusion in the
portfolio compression exercise and, depending on the methodology
employed, replace the terminated security-based swaps with other
security-based swaps whose combined notional value (or some other
measure of risk) is less than the combined notional value (or some
other measure of risk) of the terminated security-based swaps in the
exercise.
(b) The term business day means any day other than a Saturday,
Sunday, or legal holiday.
(c) The term clearing agency means a clearing agency as defined in
section 3(a)(23) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(23)) that is registered pursuant to section 17A of the
Securities Exchange Act of 1934 (15 U.S.C. 78q-1) and provides central
counterparty services for security-based swap transactions.
(d) The term clearing transaction means a security-based swap that
has a clearing agency as a direct counterparty.
(e) The term day of execution means the calendar day of the
counterparty to the security-based swap transaction that ends the
latest, provided that if a security-based swap transaction is
(1) Entered into after 4:00 p.m. in the place of a counterparty; or
(2) Entered into on a day that is not a business day in the place
of a counterparty, then such security-based swap transaction shall be
deemed to have been entered into by that counterparty on the
immediately succeeding business day of that counterparty, and the day
of execution shall be determined with reference to such business day.
(f) The term execution means the point at which the counterparties
become irrevocably bound to a transaction under applicable law.
(g) The term financial counterparty means a counterparty that is
not a security-based swap dealer or a major security-based swap
participant and that is one of the following:
(1) A swap dealer;
(2) A major swap participant;
(3) A commodity pool as defined in section 1a(10) of the Commodity
Exchange Act (7 U.S.C. 1a(10));
(4) A private fund as defined in section 202(a)(29) of the
Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a));
(5) An employee benefit plan as defined in paragraphs (3) and (32)
of section 3 of the Employee Retirement Income Security Act of 1974 (29
U.S.C. 1002); and
(6) A person predominantly engaged in activities that are in the
business of banking, or in activities that are financial in nature, as
defined in section 4(k) of the Bank Holding Company Act of 1956 (12
U.S.C. 1843k).
(h) The term fully offsetting security-based swaps means security-
based swaps of equivalent terms where no net cash flow would be owed to
either counterparty after the offset of payment obligations thereunder.
(i) The term material terms means:
(1) With respect to any security-based swap that has not yet been
included in a security-based swap portfolio and reconciled pursuant to
Sec. 240.15Fi-3, each term that is required to be reported to a
registered swap data repository or the Commission pursuant to Sec.
242.901 of this chapter; and
(2) With respect to all other security-based swaps within a
security-based swap portfolio, each term that is required to be
reported to a registered swap data repository or the Commission
pursuant to Sec. 242.901 of this chapter; provided, however, that such
definition does not include any term that is not
[[Page 4672]]
relevant to the ongoing rights and obligations of the parties and the
valuation of the security-based swap.
(j) The term multilateral portfolio compression exercise means an
exercise by which multiple security-based swap counterparties wholly
terminate or change the notional value of some or all of the security-
based swaps submitted by the counterparties for inclusion in the
portfolio compression exercise and, depending on the methodology
employed, replace the terminated security-based swaps with other
security-based swaps whose combined notional value (or some other
measure of risk) is less than the combined notional value (or some
other measure of risk) of the terminated security-based swaps in the
exercise.
(k) The term national securities exchange means an exchange as
defined in section 3(a)(1) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(1)) that is registered pursuant to section 6 of the
Securities Exchange Act of 1934 (15 U.S.C. 78f).
(l) The term portfolio reconciliation means any process by which
the counterparties to one or more security-based swaps:
(1) Exchange the material terms of all security-based swaps in the
security-based swap portfolio between the counterparties;
(2) Exchange each counterparty's valuation of each security-based
swap in the security-based swap portfolio between the counterparties as
of the close of business on the immediately preceding business day; and
(3) Resolve any discrepancy in valuations or material terms.
(m) The term prudential regulator has the meaning given to the term
in section 3(a)(74) of the Act (15 U.S.C. 78c(a)(74)) and includes the
Board of Governors of the Federal Reserve System, the Office of the
Comptroller of the Currency, the Federal Deposit Insurance Corporation,
the Farm Credit Association, and the Federal Housing Finance Agency, as
applicable to the security-based swap dealer or major security-based
swap participant.
(n) The term security-based swap execution facility means a
security-based swap execution facility as defined in section 3(a)(77)
of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)) that is
registered pursuant to section 3D of the Securities Exchange Act of
1934 (15 U.S.C. 78c-4).
(o) The term security-based swap portfolio means all security-based
swaps currently in effect between a particular security-based swap
dealer or major security-based swap participant and a particular
counterparty.
(p) The term trade acknowledgment means a written or electronic
record of a security-based swap transaction sent by one counterparty of
the security-based swap transaction to the other.
(q) The term valuation means the current market value or net
present value of a security-based swap.
(r) The term verification means the process by which a trade
acknowledgment has been manually, electronically, or by some other
legally equivalent means, signed by the receiving counterparty.
0
4. Section 240.15Fi-3 is added to read as follows:
Sec. 240.15Fi-3 Security-based swap portfolio reconciliation.
(a) Security-based swaps with security-based swap dealers or major
security-based swap participants. Each security-based swap dealer and
major security-based swap participant shall engage in portfolio
reconciliation as follows for all security-based swaps in which its
counterparty is also a security-based swap dealer or major security-
based swap participant.
(1) Each security-based swap dealer or major security-based swap
participant shall agree in writing with each of its counterparties on
the terms of the portfolio reconciliation including, if applicable,
agreement on the selection of any third party service provider who may
be performing the portfolio reconciliation.
(2) The portfolio reconciliation may be performed on a bilateral
basis by the counterparties or by a third party selected by the
counterparties in accordance with paragraph (a)(1) of this section.
(3) The portfolio reconciliation shall be performed no less
frequently than:
(i) Once each business day for each security-based swap portfolio
that includes 500 or more security-based swaps;
(ii) Once each week for each security-based swap portfolio that
includes more than 50 but fewer than 500 security-based swaps on any
business day during the week; and
(iii) Once each calendar quarter for each security-based swap
portfolio that includes no more than 50 security-based swaps at any
time during the calendar quarter.
(4) Each security-based swap dealer and major security-based swap
participant shall resolve immediately any discrepancy in a material
term of a security-based swap identified as part of a portfolio
reconciliation or otherwise.
(5) Each security-based swap dealer and major security-based swap
participant shall establish, maintain, and follow written policies and
procedures reasonably designed to resolve any discrepancy in a
valuation identified as part of a portfolio reconciliation or otherwise
as soon as possible, but in any event within five business days after
the date on which the discrepancy is first identified, provided that
the security-based swap dealer and major security-based swap
participant establishes, maintains, and follows written policies and
procedures reasonably designed to identify how the security-based swap
dealer or major security-based swap participant will comply with any
variation margin requirements under section 15F(e) of the Act (15
U.S.C. 78o-10(e)) and regulations thereunder pending resolution of the
discrepancy in valuation. For purposes of this paragraph, a difference
between the lower valuation and the higher valuation of less than 10
percent of the higher valuation need not be deemed a discrepancy.
(b) Security-based swaps with entities other than security-based
swap dealers or major security-based swap participants. Each security-
based swap dealer and major security-based swap participant shall
establish, maintain, and follow written policies and procedures
reasonably designed to ensure that it engages in portfolio
reconciliation for all security-based swaps in which its counterparty
is neither a security-based swap dealer nor a major security-based swap
participant as follows.
(1) Each security-based swap dealer or major security-based swap
participant shall agree in writing with each of its counterparties on
the terms of the portfolio reconciliation including, if applicable,
agreement on the selection of any third party service provider who may
be performing the reconciliation.
(2) The portfolio reconciliation may be performed on a bilateral
basis by the counterparties or by one or more third parties selected by
the counterparties in accordance with paragraph (b)(1) of this section.
(3) The portfolio reconciliation will be required to be performed
no less frequently than:
(i) Once each calendar quarter for each security-based swap
portfolio that includes more than 100 security-based swaps at any time
during the calendar quarter; and
(ii) Once annually for each security-based swap portfolio that
includes no more than 100 security-based swaps at any time during the
calendar year.
(4) Each security-based swap dealer or major security-based swap
participant shall establish, maintain, and follow
[[Page 4673]]
written procedures reasonably designed to resolve any discrepancies in
the valuation or material terms of each security-based swap identified
as part of a portfolio reconciliation or otherwise with a counterparty
that is neither a security-based swap dealer nor major security-based
swap participant in a timely fashion. For purposes of this paragraph, a
difference between the lower valuation and the higher valuation of less
than 10 percent of the higher valuation need not be deemed a
discrepancy.
(c) Reporting of Security-Based Swap Valuation Disputes. Each
security-based swap dealer and major security-based swap participant
shall promptly notify the Commission, in a form and manner acceptable
to the Commission, and any applicable prudential regulator of any
security-based swap valuation dispute in excess of $20,000,000 (or its
equivalent in any other currency), at either the transaction or
portfolio level, if not resolved within:
(1) Three business days, if the dispute is with a counterparty that
is a security-based swap dealer or major security-based swap
participant; or
(2) Five business days, if the dispute is with a counterparty that
is not a security-based swap dealer or major security-based swap
participant.
(d) Reconciliation of cleared security-based swaps. Nothing in this
section shall apply to any clearing transaction.
0
5. Section 240.15Fi-4 is added to read as follows:
Sec. 240.15Fi-4 Security-based swap portfolio compression.
(a) Portfolio compression with security-based swap dealers and
major security-based swap participants--(1) Bilateral offset. Each
security-based swap dealer and major security-based swap participant
shall establish, maintain, and follow written policies and procedures
for terminating each fully offsetting security-based swap between a
security-based swap dealer or major security-based swap participant and
another security-based swap dealer or major security-based swap
participant in a timely fashion, when appropriate.
(2) Bilateral compression. Each security-based swap dealer and
major security-based swap participant shall establish, maintain, and
follow written policies and procedures for periodically engaging in
bilateral portfolio compression exercises, when appropriate, with each
counterparty that is also a security-based swap dealer or major
security-based swap participant. Such policies and procedures shall
address, among other things, the evaluation of bilateral portfolio
compression exercises that are initiated, offered, or sponsored by any
third party.
(3) Multilateral compression. Each security-based swap dealer and
major security-based swap participant shall establish, maintain, and
follow written policies and procedures for periodically engaging in
multilateral portfolio compression exercises, when appropriate, with
each counterparty that is also a security-based swap dealer or major
security-based swap participant. Such policies and procedures shall
address, among other things, the evaluation of multilateral portfolio
compression exercises that are initiated, offered, or sponsored by any
third party.
(b) Portfolio compression with counterparties other than security-
based swap dealers and major security-based swap participants. Each
security-based swap dealer and major security-based swap participant
shall establish, maintain, and follow written policies and procedures
for periodically terminating fully offsetting security-based swaps and
for engaging in bilateral or multilateral portfolio compression
exercises with respect to security-based swaps in which its
counterparty is an entity other than a security-based swap dealer or
major security-based swap participant, when appropriate and to the
extent requested by any such counterparty.
(c) Portfolio compression of cleared security-based swaps. Nothing
in this section shall apply to any clearing transaction.
0
6. Section 240.15Fi-5 is added to read as follows:
Sec. 240.15Fi-5 Security-based swap trading relationship
documentation.
(a)(1) Applicability. The requirements of this section shall not
apply to:
(i) Security-based swaps executed prior to the date on which a
security-based swap dealer or major security-based swap participant is
required to be in compliance with this section;
(ii) Any clearing transaction; and
(iii) Security-based swaps executed anonymously on a national
securities exchange or a security-based swap execution facility,
Provided that:
(A) Such security-based swaps are intended to be cleared and are
actually submitted for clearing to a clearing agency;
(B) All terms of such security-based swaps conform to the rules of
the clearing agency; and
(C) Upon acceptance of such security-based swap by the clearing
agency:
(1) The original security-based swap is extinguished;
(2) The original security-based swap is replaced by equal and
opposite security-based swaps with the clearing agency; and
(3) All terms of the security-based swap shall conform to the
product specifications of the cleared security-based swap established
under the clearing agency's rules; and Provided further, That if a
security-based swap dealer or major security-based swap participant
receives notice that a security-based swap transaction has not been
accepted for clearing by a clearing agency, the security-based swap
dealer or major security-based swap participant shall be required to
comply with the requirements of this section in all respects promptly
after receipt of such notice.
(2) Policies and procedures. Each security-based swap dealer and
major security-based swap participant shall establish, maintain, and
follow written policies and procedures reasonably designed to ensure
that the security-based swap dealer or major security-based swap
participant executes written security-based swap trading relationship
documentation with its counterparty that complies with the requirements
of this section. The policies and procedures shall be approved in
writing by a senior officer of the security-based swap dealer or major
security-based swap participant, and a record of the approval shall be
retained. Other than trade acknowledgements and verifications of
security-based swap transactions under Sec. 240.15Fi-2, the security-
based swap trading relationship documentation shall be executed prior
to, or contemporaneously with, executing a security-based swap with any
counterparty.
(b) Security-based swap trading relationship documentation. (1) The
security-based swap trading relationship documentation shall be in
writing and shall include all terms governing the trading relationship
between the security-based swap dealer or major security-based swap
participant and its counterparty, including, without limitation, terms
addressing payment obligations, netting of payments, events of default
or other termination events, calculation and netting of obligations
upon termination, transfer of rights and obligations, allocation of any
applicable regulatory reporting obligations (including pursuant to
Sec. Sec. 242.900 to 242.909) of this chapter, governing law,
valuation, and dispute resolution.
(2) The security-based swap trading relationship documentation
shall include all trade acknowledgements and verifications of security-
based swap transactions under Sec. 240.15Fi-2.
(3) The security-based swap trading relationship documentation
shall
[[Page 4674]]
include credit support arrangements, which shall contain, in accordance
with applicable requirements under Commission regulations or
regulations adopted by prudential regulators and without limitation,
the following:
(i) Initial and variation margin requirements, if any;
(ii) Types of assets that may be used as margin and asset valuation
haircuts, if any;
(iii) Investment and re-hypothecation terms for assets used as
margin for uncleared security-based swaps, if any; and
(iv) Custodial arrangements for margin assets, including whether
margin assets are to be segregated with an independent third party, in
accordance with section 3E(f) of the Act (15 U.S.C. 78c-5(f)), if any.
(4)(i) The security-based swap trading relationship documentation
between security-based swap dealers, between major security-based swap
participants, between a security-based swap dealer and major security-
based swap participant, between a security-based swap dealer or major
security-based swap participant and a financial counterparty, and, if
requested by any other counterparty, between a security-based swap
dealer or major security-based swap participant and such counterparty,
shall include written documentation in which the parties agree on the
process, which may include any agreed upon methods, procedures, rules,
and inputs, for determining the value of each security-based swap at
any time from execution to the termination, maturity, or expiration of
such security-based swap for the purposes of complying with the margin
requirements under section 15F(e) of the Act (15 U.S.C. 78o-10(e)) and
regulations thereunder, and the risk management requirements under
section 15F(j) of the Act (15 U.S.C. 78o-10(j)) of the Act and
regulations thereunder. To the maximum extent practicable, the
valuation of each security-based swap shall be based on recently-
executed transactions, valuations provided by independent third
parties, or other objective criteria.
(ii) Such documentation shall include either:
(A) Alternative methods for determining the value of the security-
based swap for the purposes of complying with this paragraph in the
event of the unavailability or other failure of any input required to
value the security-based swap for such purposes; or
(B) A valuation dispute resolution process by which the value of
the security-based swap shall be determined for the purposes of
complying with this paragraph (b)(4).
(iii) A security-based swap dealer or major security-based swap
participant is not required to disclose to the counterparty
confidential, proprietary information about any model it may use to
value a security-based swap.
(iv) The parties may agree on changes or procedures for modifying
or amending the documentation at any time.
(5) The security-based swap trading relationship documentation of a
security-based swap dealer or major security-based swap participant
shall include the following:
(i) A statement of whether the security-based swap dealer or major
security-based swap participant is an insured depository institution
(as defined in 12 U.S.C. 1813) or a financial company (as defined in
section 201(a)(11) of the Dodd-Frank Act, 12 U.S.C. 5381(a)(11));
(ii) A statement of whether the counterparty is an insured
depository institution or financial company;
(iii) A statement that in the event either the security-based swap
dealer or major security-based swap participant or its counterparty
becomes a covered financial company (as defined in section 201(a)(8) of
the Dodd-Frank Wall Street Reform and Consumer Protection Act, 12
U.S.C. 5381(a)(8)) or is an insured depository institution for which
the Federal Deposit Insurance Corporation (FDIC) has been appointed as
a receiver (the ``covered party''), certain limitations under Title II
of the Dodd-Frank Act or the Federal Deposit Insurance Act may apply to
the right of the non-covered party to terminate, liquidate, or net any
security-based swap by reason of the appointment of the FDIC as
receiver, notwithstanding the agreement of the parties in the security-
based swap trading relationship documentation, and that the FDIC may
have certain rights to transfer security-based swaps of the covered
party under section 210(c)(9)(A) of the Dodd-Frank Wall Street Reform
and Consumer Protection Act, 12 U.S.C. 5390(c)(9)(A), or 12 U.S.C.
1821(e)(9)(A); and
(iv) An agreement between the security-based swap dealer or major
security-based swap participant and its counterparty to provide notice
if either it or its counterparty becomes or ceases to be an insured
depository institution or a financial company.
(6) The security-based swap trading relationship documentation of
each security-based swap dealer and major security-based swap
participant shall contain a notice that, upon acceptance of a security-
based swap by a clearing agency:
(i) The original security-based swap is extinguished;
(ii) The original security-based swap is replaced by equal and
opposite security-based swaps with the clearing agency; and
(iii) All terms of the security-based swap shall conform to the
product specifications of the cleared security-based swap established
under the clearing agency's rules.
(c) Audit of security-based swap trading relationship
documentation. Each security-based swap dealer and major security-based
swap participant shall have an independent auditor conduct periodic
audits sufficient to identify any material weakness in its
documentation policies and procedures required by this section. A
record of the results of each audit shall be retained.
0
7. Section 240.17a-3, as proposed to be amended at 79 FR 25193, May 2,
2014 is further amended by adding paragraph (a)(31) to read as follows:
Sec. 240.17a-3 Records to be made by certain brokers and dealers.
* * * * *
(a) * * *
(31)(i) A record of each security-based swap portfolio
reconciliation, whether conducted pursuant to Sec. 240.15Fi-3 or
otherwise, including the dates of the security-based swap portfolio
reconciliation, the number of portfolio reconciliation discrepancies,
the number of security-based swap valuation disputes (including the
time-to-resolution of each valuation dispute and the age of outstanding
valuation disputes, categorized by transaction and counterparty), and
the name of the third-party entity performing the security-based swap
portfolio reconciliation, if any.
(ii) A copy of each notification required to be provided to the
Commission pursuant to Sec. 240.15Fi-3(c).
(iii) A record of each bilateral offset and each bilateral
portfolio compression exercise or multilateral portfolio compression
exercise in which it participates, whether conducted pursuant to Sec.
240.15Fi-4 or otherwise, including the dates of the offset or
compression, the security-based swaps included in the offset or
compression, the identity of the counterparties participating in the
offset or compression, the results of the compression, and the name of
the third-party entity performing the offset or compression, if any.
* * * * *
[[Page 4675]]
0
8. Section 240.17a-4, as proposed to be amended at 79 FR 25193, May 2,
2014 is amended by revising paragraph (b)(1) and adding paragraphs
(e)(10) and (11) to read as follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(1) All records required to be made pursuant to Sec. 240.17a-
3(a)(4), (a)(6), (a)(7), (a)(8), (a)(9), (a)(10), (a)(11), (a)(16),
(a)(18), (a)(19), (a)(20), (a)(24), (a)(25), (a)(26), (a)(27), (a)(28),
(a)(29), (a)(30), and (a)(31), and analogous records created pursuant
to Sec. 240.17a-3(e).
* * * * *
(e) * * *
(10) The written policies and procedures required pursuant to
Sec. Sec. 240.15Fi-3, 240.15Fi-4, and 240.15Fi-5 until three years
after termination of the use of the policies and procedures.
(11) (i) Each written agreement with counterparties on the terms of
portfolio reconciliation with those counterparties as required to be
created under Sec. 240.15Fi-3(a)(1) and (b)(1) until three years after
the termination of the agreement and all transactions governed thereby.
(ii) Security-based swap trading relationship documentation with
counterparties required to be created under Sec. 240.15Fi-5 until
three years after the termination of such documentation and all
transactions governed thereby.
(iii) A record of the results of each audit required to be
performed pursuant to Sec. 240.15Fi-5(c) until three years after the
conclusion of the audit.
* * * * *
0
9. Section 240.18a-5, as proposed to be added at 79 FR 25193, May 2,
2014, is further amended by adding paragraphs (a)(18) and (b)(14) to
read as follows:
Sec. 240.18a-5 Records to be made by certain security-based swap
dealers and major security-based swap participants.
* * * * *
(a) * * *
(18)(i) A record of each security-based swap portfolio
reconciliation, whether conducted pursuant to Sec. 240.15Fi-3 or
otherwise, including the dates of the security-based swap portfolio
reconciliation, the number of portfolio reconciliation discrepancies,
the number of security-based swap valuation disputes (including the
time-to-resolution of each valuation dispute and the age of outstanding
valuation disputes, categorized by transaction and counterparty), and
the name of the third-party entity performing the security-based swap
portfolio reconciliation, if any.
(ii) A copy of each notification required to be provided to the
Commission pursuant to Sec. 240.15Fi-3(c).
(iii) A record of each bilateral offset and each bilateral
portfolio compression exercise or multilateral portfolio compression
exercise in which it participates, whether conducted pursuant to Sec.
240.15Fi-4 or otherwise, including the dates of the offset or
compression, the security-based swaps included in the offset or
compression, the identity of the counterparties participating in the
offset or compression, the results of the compression, and the name of
the third-party entity performing the offset or compression, if any.
* * * * *
(b) * * *
(14)(i) A record of each security-based swap portfolio
reconciliation, whether conducted pursuant to Sec. 240.15Fi-3 or
otherwise, including the dates of the security-based swap portfolio
reconciliation, the number of portfolio reconciliation discrepancies,
the number of security-based swap valuation disputes (including the
time-to-resolution of each valuation dispute and the age of outstanding
valuation disputes, categorized by transaction and counterparty), and
the name of the third-party entity performing the security-based swap
portfolio reconciliation, if any.
(ii) A copy of each notification required to be provided to the
Commission pursuant to Sec. 240.15Fi-3(c).
(iii) A record of each bilateral offset and each bilateral
portfolio compression exercise or multilateral portfolio compression
exercise in which it participates, whether conducted pursuant to Sec.
240.15Fi-4 or otherwise, including the dates of the offset or
compression, the security-based swaps included in the offset or
compression, the identity of the counterparties participating in the
offset or compression, the results of the compression, and the name of
the third-party entity performing the offset or compression, if any.
* * * * *
0
10. Section 240.18a-6, as proposed to be added at 79 FR 25193, May 2,
2014, is further amended by revising paragraphs (b)(1)(i) and (b)(2)(i)
and adding paragraphs (d)(4) and (d)(5) to read as follows:
Sec. 240.18a-6 Records to be preserved by certain security-based
swap dealers and major security-based swap participants.
* * * * *
(b) * * *
(1) * * *
(i) All records required to be made pursuant to Sec. Sec. 240.18a-
5(a)(5), (a)(6), (a)(7), (a)(8), (a)(9), (a)(11), (a)(12), (a)(13),
(a)(14), (a)(15), (a)(16), (a)(17), and (a)(18).
* * * * *
(2) * * *
(i) All records required to be made pursuant to Sec. 240.18a-
5(b)(4), (b)(5), (b)(6), (b)(7), (b)(9), (b)(10), (b)(11), (b)(12),
(b)(13), and (b)(14).
* * * * *
(d) * * *
(4) The written policies and procedures required pursuant to
Sec. Sec. 240.15Fi-3, 240.15Fi-4, and 240.15Fi-5 until three years
after termination of the use of the policies and procedures.
(5)(i) Each written agreement with counterparties on the terms of
portfolio reconciliation with those counterparties as required to be
created under Sec. 240.15Fi-3(a)(1) and (b)(1) until three years after
the termination of the agreement and all transactions governed thereby.
(ii) Security-based swap trading relationship documentation with
counterparties required to be created under Sec. 240.15Fi-5 until
three years after the termination of such documentation and all
transactions governed thereby.
(iii) A record of the results of each audit required to be
performed pursuant to Sec. 240.15Fi-5(c) until three years after the
conclusion of the audit.
* * * * *
By the Commission.
Dated: December 19, 2018.
Brent J. Fields,
Secretary.
[FR Doc. 2018-27979 Filed 2-14-19; 8:45 am]
BILLING CODE 8011-01-P