On June 21, 2019, the SEC adopted new rules and rules amendments under the Exchange Act that establish (i) capital and margin requirements applicable to broker-dealers entering into security-based swaps ("SBS") and to security-based swap dealers ("SBSDs") that are not banks, and (ii) a collateral segregation regime for SBS customers transacting with broker-dealers and with SBSDs.
As described more fully in a Cadwalader memorandum, the final rules:
- establish minimum capital requirements for nonbank SBSDs and increase the minimum net capital requirements for alternative net capital ("ANC") firms (including for any ANC firms that do not also register as SBSDs);
- implement net capital "haircuts" for SBS and swap positions that will apply to all broker-dealers (even if they do not register as SBSDs and nonbank SBSDs);
- require that all nonbank SBSDs adopt Internal Risk Management Control Systems (ANC broker-dealers and over-the-counter derivatives dealers are already subject to this requirement);
- enact margin requirements for nonbank SBSDs and for broker-dealers (even if not registered as SBSDs) entering into SBS;
- introduce collateral segregation requirements for SBSDs and for broker-dealers (even if not registered as SBSDs) entering into SBS; and
- amend the SEC's existing cross-border SBS rule to provide a means to request substituted compliance with respect to the capital and margin requirements for foreign SBSDs, and provide guidance discussing how the SEC will evaluate requests for substituted compliance.
The structure of the memorandum is as follows:
- Part I provides background on the proposing releases that preceded the final adoption of the rules;
- Part II defines the different types of entities that are subject to variants of the rules;
- Part III provides a very brief summary of the rules;
- Part IV reviews the minimum regulatory capital requirements imposed by the rules;
- Part V reviews the required haircuts from entering into SBS and swap transactions;
- Part VI summarizes the margin requirements that apply to SBS transactions;
- Part VII describes the segregation requirements applicable to SBS transactions and certain of the related insolvency issues;
- Part VIII discusses alternative compliance for CFTC swap dealers;
- Part IX addresses the cross-border aspect of the rules;
- Part X reviews the compliance dates for the rules; and
- Part XI discusses what is still to come, and raises a few additional matters for regulators and firms to consider.
Commentary / Steven Lofchie
This is, all in all, a pretty good rule making effort. That said, as firms start trying to implement the calculation of margin requirements and segregation requirements, no doubt that a lot of operational challenges are going to emerge.
Moving to the effect of these rules, the SEC's adoption of its capital and margin rules significantly crystalizes the competitive landscape for security-based swaps. SEC-registered broker-dealers, except for the very largest that are permitted to compute capital and market requirements, are largely or entirely out of the game. The inability to use models to compute their capital charges will make them uncompetitive.
This means that the competitors in the SBS dealing will consist of (i) U.S. banks subject to the Prudential Regulators; (ii) non-U.S. banks with a U.S. presence that subject to their home country capital requirements; (iii) the vary largest U.S. broker-dealers that are permitted to use models to compute their capital; (iv) "special purpose" SBSDs that only engage in derivative transactions, but not cash market securities transactions; and (v) other non-U.S. dealers to which the SEC affords substituted compliance.
Each of these types of firms will have certain regulatory advantages or disadvantages in terms of measures such as (i) their cost of capital; (ii) the amount of capital that they maintain; (iii) the capital charges to which they are subject; (iv) the amount of margin that they are required to collect; (v) the amount of margin that they are required to post; (vi) their ability to recognize hedging offsets; (vii) the range of products that they are permitted to offer; and (viii) the bankruptcy regimes to which they are subject.
These regulatory factors will to a good degree determine in what range of activities or with what customers any particular SBSD is best able to compete. Accordingly, it will be important for any firm seeking to compete in the SBS business to understand not only the regulations that apply to it, but also the different regulations that apply to its competitors.