United States: SEC Proposes Risk Mitigation Techniques For Uncleared Security-Based Swaps

Last Updated: January 3 2019
Article by Nihal S. Patel

Most Read Contributor in United States, December 2018

The SEC proposed establishing "risk mitigation" requirements applicable to security-based swap dealers ("SBSDs"), including portfolio reconciliation and compression, and swap trading relationship documentation.

In a proposal, the SEC noted that it "attempted to harmonize [its] proposal with the existing CFTC rules wherever possible." The proposing release provides explanations of the relevant differences between the rules.

  • Proposed Rule 15Fi-3 would require SBSDs to engage in portfolio reconciliations. The rule is analogous to CFTC Rule 23.502.
  • Proposed Rule 15Fi-4 would require SBSDs to engage in portfolio compression exercises. The rule is analogous to CFTC Rule 23.503.
  • Proposed Rule 15Fi-5 would require SBSDs to have in place "swap trading relationship documentation" with its counterparties. The rule is analogous to CFTC Rule 23.504.

In addition, the proposal:

  • makes amendments to certain SBSD recordkeeping requirements (primarily to capture certain records that would be generated under the newly proposed rules);
  • requests comments on potential changes to a requirement in Rule 13n-5 that an SDR confirm the accuracy of SBS data with the counterparties to the transaction;
  • provides that the new rules would be considered "entity-level" requirements (i.e., SBSDs would be required to comply without exception, including with foreign counterparties); and
  • makes amendments to SEA Rule 3a71-6 to address the potential availability of substituted compliance with respect to the newly proposed rules.

Comments must be received by the SEC no later than 60 days after the date of publication of the proposal in the Federal Register.

Commentary / Nihal Patel

The proposed rules are essentially intended to match the CFTC rules. The SEC staff does a good job of explaining the differences between the rules and the reasons for the differences. Below are the most notable distinctions (i.e., not including various technical discrepancies highlighted by the SEC in the release).

Portfolio Reconciliation (Proposed Rule 15Fi-3)

  • Unlike the CFTC, the definition of "material terms" to be reconciled would be bifurcated depending on whether the relevant SBS are part of a "portfolio" that was previously reconciled. For swaps not part of such a portfolio, "material terms" would be those terms required to be reported to an SDR. For other SBS, "material terms" would exclude "any term that is not relevant to the ongoing rights and obllgations of the parties and the valuation of the SBS."
  • The SEC did not adopt the CFTC definition of "business day," noting that it wanted to keep the term consistent with its use in the SEC confirmation rules.
  • The SEC requested particular comment as to the time periods for firms to resolve disputes as to valuations with non-SBSD counterparties.
  • The SEC did not adopt the approach to valuation disputes taken by the National Futures Association in an interpretive notice to its Rule 2-49. However, it requested comment on whether it should adopt some or all of the NFA approach.

Trading Relationship Documentation (Proposed Rule 15Fi-5)

  • The SEC requires that policies and procedures relating to documentation be approved by a "senior officer" of the SBSD, and defined consistently with how that term is used in the SEC registration rule. See 80 Fed. Reg. 48964, 48968 n. 29 (Aug. 14, 2015). This is in contrast to the term "senior management," used in CFTC Rule 23.504, which is not defined in the CFTC rules.
  • Unlike the CFTC Rule 23.504, the SEC rules would require STRD to address "applicable regulatory reporting obligations." The SEC said that this provision was included, not just so that reporting arrangements are clarified in advance, but also because the use of such a provision could potentially address issues as to how SDRs verify received information received.
  • The documentation audit requirement in proposed 15Fi-5(c) differs slightly from CFTC Rule 23.504(c) in that it does not provide that an independent auditor may be "internal or external." The SEC said that in its experience with accounting and auditing standards, an internal auditor would report to management, which it viewed as inconsistent with the SEC auditor independence rules.
  • The SEC includes a handful of exceptions to the documentation requirements:
    • SBS entered into prior to the rule's compliance date are not subject to the rule.
    • "Clearing transactions," defined as cleared transactions. Notably, the SEC does not address "intended-to-be-cleared" transactions, which received (somewhat complicated) relief from documentation (and business conduct) rules from the CFTC staff in Letter No. 13-70.
    • Swaps executed anonymously on an exchange or SBSEF and cleared. The discussion indicates that the SEC recognized that that there are potential adverse consequences if a trade is not cleared, and provided that if the trade continues on a bilateral basis, the SBSD would need to have procedures in place to ensure compliance with documentation requirements "promptly" after rejection from clearing.

Cross-Border Matters

  • Treating these rules as "entity-level requirements" would differ from the CFTC, which treats its analogous rules as "transaction-level" requirements, from which non-US dealers are excused when transacting with non-US persons.
  • However, the SEC also proposed an amendment to Rule 3a71-6, which provides that non-US SBSDs could rely on substituted compliance for the newly-proposed rules, where the SEC has made a determination that the relevant non-US rules are comparable.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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