The US Securities and Exchange Commission (SEC) voted on December 19, 2018, to propose rules that would require the mandatory use of certain risk mitigation techniques by registered security-based swap dealers and major security-based swap participants (collectively, SBS Entities) for portfolios of uncleared security-based swaps. The proposed rules were published in the Federal Register on February 15.
Proposed Rules 15Fi-3 through 15Fi-5 (the SEC Proposed Rules) would require SBS Entities to
- reconcile outstanding security-based swaps (SBS) with applicable counterparties on a periodic basis;
- engage in certain forms of portfolio compression exercises, as appropriate; and
- execute written SBS trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing an SBS transaction.
Please see below for a more detailed summary of the SEC Proposed Rules.
The SEC says that it has attempted to harmonize the SEC Proposed Rules with the existing rules adopted for swaps by the Commodity Futures Trading Commission (CFTC) pertaining to portfolio reconciliation, portfolio compression, and written trading relationship documentation that have been in effect since 2012 and 2013 (the CFTC Rules). Nevertheless, though the SEC recognized that any SBS Entity that is also registered with the CFTC will already have incurred systems and compliance costs in connection with the corresponding CFTC Rules, the SEC found a number of instances where it concluded that it was appropriate to diverge from the CFTC Rules, which we describe in more detail below.
The comment period for the proposed rules will end on April 16, 2019.
Summary of SEC Proposed Rules
1. Portfolio Reconciliation
a. Proposed Definition of Portfolio Reconciliation
SEC Proposed Rule 15Fi-3 under the Securities Exchange Act of 1934 (the Exchange Act) would require the parties to one or more SBS to engage in “portfolio reconciliation” periodically by
- exchanging the material terms of all SBS in the SBS portfolio between the counterparties;
- exchanging each counterparty’s valuation of all outstanding SBS entered into between the counterparties as of the close of business on the immediately preceding business day; and
- resolving any discrepancies in valuations or material terms.
b. Proposed Definition of Material Terms
The proposed definition of “material terms” in SEC Proposed Rule 15Fi-1(i) would be bifurcated depending on whether an SBS transaction has already been included in an SBS portfolio and reconciled pursuant to SEC Proposed Rule 15Fi-3.
- For any SBS that has not been reconciled as part of an SBS portfolio, “material terms” means each term that must be reported to a registered swap date repository (SDR) or the SEC pursuant to the SEC rules governing the reporting and public dissemination of SBS data (Regulation SBSR).
- For all other SBS within an SBS portfolio, “material terms” continues to mean each term that must be reported under Regulation SBSR, but would exclude any term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the SBS.
c. Proposed Frequency and Discrepancy Resolution Between SBS Entities
SEC Proposed Rule 15Fi-3(a) would require two SBS Entities entering into SBS transactions to engage in portfolio reconciliation with a frequency determined based on the size of the SBS portfolio between the parties. Specifically:
- For SBS portfolios that include 500+ SBS, each business day
- For SBS portfolios that include 51-499 SBS on any business day during the week, weekly
- For SBS portfolios that include 50 or less SBS at any time during the calendar quarter, quarterly
SEC Proposed Rule 15Fi-3(a) would also require that any discrepancy in a material term between two SBS Entities (other than with respect to valuation) must be resolved immediately. The SEC has not proposed a fixed definition of “immediately” in order to allow flexibility depending on the particular circumstances and seeks comment on whether such a flexible approach is preferable to a fixed standard.
With regard to valuation discrepancies, SEC Proposed Rule 15Fi-3(a) would require valuation discrepancies of 10% or greater of the higher valuation to be resolved as soon as possible, but in any event within five business days of identifying the discrepancy. This threshold is to be calculated on a transaction-by-transaction basis and not at the portfolio level.
d. Portfolio Reconciliation Between an SBS Entity and a Non-SBS Entity
SEC Proposed Rule 15Fi-3(b) would apply to SBS portfolios between an SBS Entity and a non-SBS Entity. It would require each SBS Entity to establish, maintain, and enforce written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation with non-SBS Entities with a frequency determined based on the size of the SBS portfolio between the parties (similar to the requirements for SBS between two SBS Entities). Specifically:
- For SBS portfolios that include 101+ SBS at any time during the calendar quarter, quarterly
- For SBS portfolios that include 100 or less SBS at any time during the calendar quarter, annually
The policies and procedures must also provide that any discrepancy in the valuation or in a material term must be resolved in a “timely fashion.” Timely fashion has also been left undefined so as to provide flexibility depending on the circumstances and the SEC has requested comment on what timing would be appropriate.
e. SBS Entity’s Reporting Obligation for Unresolved Valuation Disputes
SEC Proposed Rule 15Fi-3(c) would create a reporting obligation in the event of certain unresolved SBS valuation disputes. An SBS Entity would be required to promptly notify the SEC of any SBS valuation dispute in excess of $20 million (or its equivalent in other currency) at either the transaction or portfolio level if not resolved within
- three business days if the dispute is with an SBS Entity; or
- five business days if the dispute is with a non-SBS Entity.
2. Portfolio Compression
a. Portfolio Compression Between SBS Entities
Portfolio compression allows market participants to eliminate redundant derivatives transactions, normally by terminating or modifying certain contracts and replacing them with a smaller number of substantially similar contracts. SEC Proposed Rule 15Fi-4(a) would apply to SBS portfolios between two SBS entities and would require each SBS Entity to establish, maintain, and follow written policies and procedures for
- evaluating bilateral and multilateral portfolio compression exercises that are initiated, offered, or sponsored by any third party;
- periodically engaging in both bilateral portfolio compression exercise and multilateral portfolio compression exercises, in each case when appropriate, with its SBS Entity counterparties; and
- terminating each fully offsetting SBS with its SBS Entity counterparties in a timely fashion, when appropriate.
b. Portfolio Compression Between an SBS Entity and Non-SBS Entity
Proposed Rule 15Fi-4(b) would apply to SBS portfolios between an SBS Entity and non-SBS Entity and would require the SBS Entity to establish, maintain, and follow written policies and procedures for periodically terminating fully offsetting SBS and for engaging in bilateral or multilateral portfolio compression exercised with the non-SBS Entity when appropriate and to the extent requested by any such counterparty.
3. Trading Relationship Documentation
a. Required Documentation
SEC Proposed Rule 15Fi-5 would require each SBS Entity to establish, maintain, and enforce written policies and procedures reasonably designed to ensure that it executes written SBS trading relationship documentation with each of its counterparties (SBS Entities and/or non-SBS Entities) prior to, or contemporaneously with, executing an SBS with such counterparty. Pursuant to SEC Proposed Rules 15Fi-5(b)(1) and (3), the applicable policies and procedures would need to require that the SBS trading relationship be in writing and include all terms governing the trading relationship, including but not limited to
- 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 terms that must be reported to an SDR pursuant to Regulation SBSR);
- governing law;
- valuation; and
- dispute resolution.
The policies and procedures under SEC Proposed Rule 15Fi-5(b)(3) would also require that the SBS trading relationship documentation include credit support arrangements. Such credit support must contain, among other things and in accordance with applicable requirements under regulations adopted by the SEC or any prudential regulators, and without limitation
- 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 SBS, if any; and
- custodial arrangements for margin assets, including whether margin assets are to be segregated with an independent third party, in accordance with Exchange Act Section 3E(f), if any.
b. Documentation Valuation Methodologies
SEC Proposed Rule 15Fi-5(b)(4) would require that the applicable policies and procedures provide that the relevant swap trading relationship documentation between certain specified types of financial 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 SBS at any time from execution to termination, maturity or expiration of such SBS.
Such valuation methodology would be for the purpose of complying with the margin requirements under Exchange Act Section 15F(e) and the risk-management requirements under Exchange Act Section 15F(j). These documentation requirements will apply to any SBS between
- two SBS Entities; or
- an SBS Entity and a “financial counterparty.”
The SEC Proposed Rules require that the valuation of each SBS be based on recently executed transactions, valuations provided by independent third parties, or other objective criteria, to the maximum extent possible. The rule also specifies that an SBS Entity would not be required to disclose to the counterparty confidential, proprietary information about any model it may use to value an SBS.
The SEC Proposed Rules require a secondary valuation process to be present in the transaction documentation in order to prevent potential harm if there is a valuation dispute with regard to an SBS that must include either
- alternative methods for determining the value of the SBS in the event of the unavailability, or other failure of any input required to value the SBS; or
- a valuation dispute resolution process by which the value of the SBS will be determined for the purposes of complying with the proposed rule.
c. Additional Disclosure Requirements
SEC Proposed Rules 15Fi-5(b)(5) and (6) would require that the policies and procedures governing the applicable trading relationship documentation require SBS Entities to disclose certain information to their counterparties regarding both their legal status and the status of the SBS, such as whether either party to the transaction is an insured depository institution or financial company and its bankruptcy status.
In the case of a cleared SBS transaction, the SEC Proposed Rules would require the SBS trading relationship documentation of each SBS Entity to contain a notice that, upon acceptance of an SBS by a clearing agency
- the original SBS has been extinguished;
- the original SBS is replaced by an equal and opposite SBS with the clearing agency; and
- all terms of the SBS shall conform to the product specifications of the cleared SBS established under the clearing agency’s rules.
SEC 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 SEC Proposed Rule 15Fi-5.
d. Exceptions to the Trading Relationship Documentation Requirements
SEC Proposed Rule 15Fi-5(a)(1) would establish three different exceptions from the basic trading relationship documentation:
- First, an exception for SBS executed prior to the date on which an SBS Entity must be in compliance with the documentation rule;
- Second, an exception for any “clearing transaction” which is defined as an SBS that has a clearing agency as a direct counterparty; or
- Third, an exception for SBS executed anonymously on a national securities exchange or an SBS execution facility, provided that
- such SBS is intended to be cleared and is actually submitted for clearing to a clearing agency;
- all terms of such SBS conform to the rules of the clearing agency; and
- upon acceptance of such SBS by the clearing agency: (1) the original SBS is extinguished; (2) the original SBS is replaced by an equal and opposite SBS with the clearing agency; and (3) all terms of the SBS shall conform to the product specifications of the cleared SBS established under the clearing agency’s rules.
4. Cross-Border Considerations
The SEC proposes to treat the SEC Proposed Rules as entity-level requirements that apply to an SBS Entity’s entire SBS business without exception, including in connection with any SBS business it conducts with foreign counterparties.
The SEC Proposed Rules contain proposed amendments to Rule 3a71-6 to address the potential availability of substituted compliance in connection with SEC Proposed Rules 15Fi-3 through 15Fi-5. In proposing such substituted compliance principles, the SEC notes that the principles associated with substituted compliance as adopted by the SEC in connection with its business conduct requirements and trade acknowledgement and verification requirements should in large part similarly apply to these proposed risk mitigation rules.
Differences Between CFTC Rules and SEC Proposed Rules on Risk Mitigation
In the SEC Proposed Rules, the SEC notes that it has attempted to harmonize the SEC Proposed Rules with the existing CFTC Rules. Nevertheless, the SEC found a number of instances where it concluded that it was appropriate to diverge from the CFTC Rules and seeks comment on the instances where the SEC Proposed Rules deviate from the CFTC Rules. Notably:
1. “Material Terms” Definition
With respect to the phrase “material terms,” the SEC Proposed Rules definition would follow a similar approach to the one taken in the CFTC Rules in that it would base the definition on the terms that must be reported to an SDR pursuant to Regulation SBSR.
Unlike the approach taken by the CFTC, however, which has adopted a single definition of “material terms,” the definition in SEC Proposed Rule 15Fi-1(i) would be bifurcated depending on whether an SBS transaction had already been included in an SBS portfolio and reconciled pursuant to SEC Proposed Rule 15Fi-3. With respect to any SBS that has not yet been reconciled as part of an SBS portfolio, “material terms” would be defined to mean each term that must be reported to a registered SDR pursuant to Regulation SBSR. With respect to all other SBS within a SBS portfolio, the definition of “material terms” would continue to be based on the reporting requirements in Regulation SBSR, but would exclude any term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the SBS.
2. “Business Day” Definition
In the SEC Proposed Rules, the SEC has preliminarily determined not to propose the CFTC Rule’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.”
Specifically, the SEC believes that the existing definition of “business day” is broadly consistent with other uses of the term within the SEC’s rules and does not believe it’s necessary to have two different definitions of the same term promulgated under the same legal authority (i.e., Exchange Act Section 15F(i)), one for purposes of the portfolio reconciliation rules and the other for purposes of the trade acknowledgement and verification rules.
The SEC notes that its 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.
3. Reporting of Valuation Disputes
The SEC Proposed Rules requiring each SBS Entity to promptly notify the SEC of any SBS valuation dispute in excess of $20 million is nearly identical to the CFTC Rule on reporting of valuation disputes. However, the SEC requests comments on whether or not it should adopt the specific aspects of the National Futures Association approach, which listed specific types of disputes that would trigger a notice requirement. Specifically, under the CFTC Rule, a notice requirement is triggered where: (a) the amount of initial margin to be posted or collected pursuant to a collateralized eligible master netting agreement if the dispute exceeds the $20 million reporting threshold; and (b) 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.
4. Portfolio Compression
Except for the two differences noted below, the SEC Proposed Rules regarding portfolio compression are designed to mirror the CFTC Rule in all possible respects and the SEC seeks comments on whether to allow entities regulated by both the CFTC and the SEC to comply with the SEC Proposed Rules by complying with the CFTC Rules for portfolio compression.
Under the SEC Proposed Rules portfolio compression exercise requirements, to the extent that an SBS Entity transacts with counterparties that are non-SBS Entities, the SEC Proposed Rules require portfolio compression exercises occur when appropriate and only to the extent requested by any such counterparty. The corresponding CFTC Rule does not contain the “when appropriate” qualifier. The SEC included this qualifier in order to provide counterparties with more flexibility in their compression exercises.
With regard to the CFTC Rules and SEC Proposed Rules relating to bilateral and multilateral compression exercises, there are two technical differences between the CFTC Rules and the SEC Proposed Rules:
- First, the CFTC Rule requires that any policies and procedures related to multilateral portfolio compression exercises address participation in all multilateral portfolio compression exercises required by CFTC regulation or order. As there are currently no SEC regulations or orders mandating participation in any particular type of portfolio compression exercise, in order to avoid confusion, the SEC has preliminarily decided to not include a comparable requirement.
- Second, the CFTC Rule requires that any policies and procedures related to multilateral portfolio compression exercises evaluate any services that are initiated, offered, or sponsored by any third party. This requirement does not extend to bilateral compression. The SEC Proposed Rules require a third-party evaluation for both multilateral and bilateral compression exercises.
5. Trading Documentation
The SEC Proposed Rule 15Fi-5 regarding trading relationship documentation largely conforms to the corresponding CFTC Rule and the majority of differences are technical changes that are not expected to impact the application of the SEC Proposed Rules. However, the SEC requests comment on any potential substantive differences that could be present. The list of deviations between the CFTC Rules and the SEC Proposed Rules regarding trading documentation include the following, among other things:
The SEC Proposed Rules require that the trading relationship documentation address “applicable regulatory reporting obligations (including pursuant to Regulation SBSR),” which is designed to help address issues with SDRs and is not included in the CFTC version
The SEC Proposed Rules require policies and procedures be approved in writing by a senior officer of the SBS Entity, whereas the CFTC Rules uses the term “senior management”
The SEC Proposed Rules use the term “financial counterparty” instead of the CFTC Rule’s use of “financial entity,” though the meaning of each respective term is substantially the same
6. Audit of SBS Trading Relationship Documentation
As discussed above, SEC Proposed Rule 15Fi-5(c) would require each SBS Entity to have an independent auditor. Such independent auditor would be required to conduct periodic audits sufficient to identify any material weakness in the SBS Entity’s documentation policies and procedures required by SEC Proposed Rule 15Fi-5.
Unlike the corresponding CFTC Rule, which allows for the use of an independent internal auditor, the SEC requires an “independent” auditor, and it is unclear whether an internal auditor could meet the required “independence” test. While the SEC does not categorically state that an internal auditor could never be independent, the SEC does acknowledge that an internal auditor may not be independent due to its employment relationship with the issuer.
7. Cross-Border Considerations
As discussed above, the SEC believes its proposed rules should be treated as entity-level requirements that apply to an SBS Entity’s entire SBS business without exception, including in connection with any SBS business it conducts with foreign counterparties. The CFTC has taken a different approach with regard to corresponding requirements pursuant to the Commodity Exchange Act and categorizes the CFTC Rules as what the CFTC has termed “Category A” transaction level requirements. The SEC has requested comment on whether or not it should treat the risk mitigation measures at the transaction level rather than at the entity level to conform with the CFTC Rules.