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FACT SHEET

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FACT SHEET


Proposing Rules Governing Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants

Background

In 2010, Congress passed the Dodd-Frank Act, which established a comprehensive framework for regulating over-the-counter derivatives. In the process, it divided regulatory authority between the SEC and the Commodity Futures Trading Commission (CFTC).

Among other things, Title VII of the Act authorized the SEC to regulate "security-based" swaps and directed it to engage in rulemaking to shape the regulatory framework for such products.

In general, a derivative is a financial instrument or contract whose value is “derived” from an underlying asset such as a commodity, bond, or equity security. The instruments provide a way to transfer market risk or credit risk between two counterparties. Derivatives are flexible products that can be designed to achieve almost any financial purpose.

For instance, a derivative can be used by two parties who have a differing view on whether a particular financial asset price will go up or down in price or whether an event will or will not happen in the future. With derivatives, a market participant can track or reproduce the economic effects of owning or short selling an underlying asset such as a security, thereby enabling that participant to obtain a market or credit exposure without actually owning the underlying asset.

The Commission proposed rules that will determine:

  • How much capital dealers in security-based swaps need to hold.
     
  • When and how these dealers need to collect collateral, or margin, to protect against losses from counterparties.
     
  • How these dealers segregate and protect funds and securities held for customers.

The Commission also proposed capital and margin requirements for major security-based swap participants — entities that do not act as dealers but hold large positions in security-based swaps. Further, the Commission will consider proposing rules to increase capital requirements for the largest broker-dealers that use internal models in calculating how much capital they need to hold.

The SEC has now proposed — or in some cases adopted — substantially all of the rules required by Title VII of the Dodd-Frank Act. Those rules define the various parties who deal in or hold substantial quantities of security-based swaps, provide for trading through entities called security-based swap execution facilities, establish a process to determine whether security-based swaps must be cleared through a clearing agency, describe the requirements to report information about trades to data repositories and the duties of those repositories, and lay out the business conduct requirements that apply to security-based swap dealers.

Proposed Rules

The SEC’s proposal:

  • Sets minimum capital requirements for security-based swap dealers and major security-based swap participants.
     
  • Establishes margin requirements for security-based swap dealers and major security-based swap participants with respect to non-cleared security-based swaps.
     
  • Establishes segregation requirements for security-based swap dealers and notification requirements with respect to segregation for security-based swap dealers and major security-based swap participants.

In addition, the proposal lays out certain risk management requirements for security-based swap dealers.

The CFTC and other regulators have previously proposed corollary capital and margin rules for swap dealers, security-based swap dealers, swap participants, and major security-based swap participants that are subject to their jurisdiction. The CFTC also has adopted segregation requirements for cleared swaps and proposed segregation requirements for non-cleared swaps.

At the same time, the SEC is proposing to raise current capital requirements for firms that use internal models to compute capital charges and are subject to an alternative net capital regime (ANC broker-dealers), and these firms also would be subject to new specific liquidity standards.

A. Capital Requirements

Security-Based Swap Dealers and Broker-Dealers (Rule 18a-1 and Rule 15c3-1 Amendments)

Under the proposal, the capital requirements for security-based swap dealers would be modeled closely on the rule that governs capital for broker-dealers (Securities Exchange Act Rule 15c3-1), and would be designed to accommodate both security-based swap dealers that are dually registered as broker-dealers (broker-dealer SBSDs) and those that are not dually registered (stand-alone SBSDs).

Minimum Net Capital Requirements

In general, the minimum capital requirements would distinguish between broker-dealer SBSDs and stand-alone SBSDs, and also would depend on whether a firm has been approved by the SEC to use internal models in calculating its regulatory capital. Firms that use models would be subject to a “tentative net capital” requirement, in addition to a “minimum net capital” amount. In general, the term “tentative net capital” refers to a firm’s net liquid assets, before deductions for market risk of a firm’s proprietary positions.

Elements of the Capital Requirement

The proposals would establish a fixed dollar minimum as well as a ratio requirement equal to 8 percent of the margin required for cleared and non-cleared security-based swaps. Because the amount of margin required varies with the size and riskiness of the business a firm conducts, this 8 percent margin factor would adjust the capital required based on this factor. In addition, broker-dealer SBSDs would be subject to ratio requirements that presently apply to broker-dealers under Rule 15c3-1. Finally, the fixed minimum capital requirement for all ANC broker-dealers (whether or not they also register as security-based swap dealers) would be increased from $500 million to $1 billion.

The following chart summarizes these proposed requirements

Proposed Minimum Capital Requirements

Type of Registrant Tentative Net Capital Net Capital
    Fixed Dollar Financial Ratio
Rule 18a-1:      
Stand-alone SBSD (not using internal models) N/A $20 million 8% margin factor
Stand-alone SBSD (using internal models) $100 million $20 million 8% margin factor
Rule 15c3-1:      
Broker-dealer SBSD (not using internal models) N/A $20 million 8% margin factor + current Rule 15c3-1 ratio
ANC Broker-dealer(using internal models) $5 billion $1 billion 8% margin factor + current Rule 15c3-1 ratio

Standardized Haircuts

Security-based swap dealers that are not approved to use internal models would have to apply standardized percentage deductions or so-called “haircuts” when computing net capital. Rule 15c3-1 already sets these haircut percentages for most securities and futures. The proposals being considered would establish new standardized deductions for certain derivatives including security-based swaps. For example, a matrix-grid approach would be used for credit default swaps (CDS) that would be based on a CDS’s time to maturity and basis point spread.

Credit Risk Charge for Unsecured Receivables

In general, security-based swap dealers, like broker-dealers presently, would be required to take a capital charge for the full amount of any unsecured receivable, including any current exposure to derivatives counterparties that is not collateralized. Under the proposed capital rules, however, ANC broker-dealers and stand-alone SBSDs using models would be allowed to take a less severe model-based credit charge for uncollateralized exposures to commercial end users.

Risk Management Procedures and Liquidity Stress Test

The proposals also set risk management standards for security-based swap dealers by requiring them to comply with an existing rule (Rule 15c3-4), which presently applies to broker-dealers that are approved to use internal models. In addition, ANC broker-dealers and stand-alone SBSDs using internal models also would be subject to a new liquidity requirement based on specified stress test parameters.

Major Security-Based Swap Participants (Rule 18a-2)

Tangible Net Worth Test

Under the proposal, major security-based swap participants would be required to maintain a positive tangible net worth and would be required to comply with Rule 15c3-4, which establishes specific risk management standards, with respect to their security-based swap activities.

B. Margin Requirements

Security-Based Swap Dealers (Rule 18a-3)

Under the proposal, the margin requirements for security-based swap dealers would generally be modeled on the margin requirements set for broker-dealers by the self-regulatory organizations (SROs). Under Rule 18a-3, a security-based swap dealer would need to collect margin collateral from counterparties to non-cleared security-based swap transactions to cover current exposure and potential future exposure (i.e., variation and initial margin) unless an exception applies.

Daily Calculations and Collection Requirements

Rule 18a-3 would require a security-based swap dealer to perform daily calculations for the account of each counterparty to a non-cleared security-based swap to determine the amount of the current exposure in the account and to produce a potential future exposure measure for the account. On the next business day following the calculations, the security-based swap dealer would be required to collect cash, securities, or money market instruments from the counterparty in an amount at least equal to the negative equity (current exposure or variation margin) in the account plus the margin amount (potential future exposure or initial margin).

Margin Calculations

  • Current Exposure Calculation (Variation Margin): The current exposure would be calculated by marking-to-market the positions and collateral in the account, which would determine the equity in the account.
     
  • Potential Future Exposure Calculation (Initial Margin): The potential future exposure would be calculated by applying the deductions required under the security-based swap dealer capital rule to the positions in the account
     
    • Standardized Haircuts (non-model) — A nonbank security-based swap dealer that is not approved to use internal models would use the standardized haircuts.
       
    • Internal Models — A nonbank security-based swap dealer approved to use internal models for capital purposes could use its value-at-risk model for CDS and fixed-income total return security-based swaps.
       
    • Security-Based Swaps Referencing Equities — For security-based swaps referencing equities, the nonbank security-based swap dealer could use a methodology based on the current methodology in Rule 15c3-1 for calculating haircuts for equity options and related instruments.

Eligible Collateral

Under the proposal, a counterparty would be able to meet its margin requirements by delivering cash, securities, and/or money-market instruments to the security-based swap dealer. Other types of assets would not count towards meeting the margin requirement. In addition, if securities or money market instruments are delivered, only their value after applying prescribed haircuts would count towards meeting the margin requirement.

Special Application of the Margin Rule

Margin would not be required or the application of the margin requirements would vary in certain circumstances:

  • Security-based swap dealers would not need to collect margin collateral to cover current and/or potential future exposure for transactions with commercial end users.
     
  • Security-based swap dealers would not be required to collect margin collateral to cover current and/or potential future exposure with respect to accounts holding legacy security-based swaps (those entered into before the new rules are effective).
     
  • The SEC is proposing in the alternative either:
     
    • Alternative A — security-based swap dealers be required to collect variation, but not initial, margin in transactions with each other.
       
    • Alternative B — security-based swap dealers collect variation and initial margin in all transactions with each other, and that initial margin be held at an independent third party account.
       
  • In general, the rule requires that margin collected by security-based swap dealers be held in an account that is under the security-based swap dealer’s control. The rule provides an exception when a counterparty is exercising its right under the Dodd-Frank Act to have its margin held in an independent third party account.
     
  • When an exception to the requirement to collect margin applies, the security-based swap dealer is generally required to recognize a capital charge equal to the amount of the margin that it would have been required to collect absent the exception. A less significant capital charge is permitted for security-based swap dealers using internal models that are transacting with commercial end users. In that case, rather than taking a 100 percent charge equal to the amount of the foregone margin, they are permitted to take an alternative, model-based credit risk charge.

The chart below sets forth the four exceptions, whether the exception relates to collateral to cover potential and/or future exposure, and any related capital charges:

Proposed Margin Exceptions for Non-bank Security-Based Swap Dealers

  Margin Collateral to Cover Current Exposure Required Margin Collateral to Cover Potential Future Exposure Required Capital Charge in Lieu of Margin Required Alternative Credit Risk Charge Permitted for Firms Using Internal Models
Commercial End User No No Yes Yes
SBSDs — Alternative A Yes No No N/A
Counterparties Electing Third-Party Segregation Yes No Yes No
Accounts Holding Legacy Positions No No Yes No

Risk Management Procedures

A nonbank security-based swap dealer would be required to monitor the risk of each account of a counterparty to a non-cleared security-based swap and establish, maintain, and document procedures and guidelines for monitoring the risks of such accounts.

Major Security-Based Swap Participants

Daily Calculation

Rule 18a-3 would require major security-based swap participants to perform a daily calculation of the amount of equity in the account of each counterparty to a non-cleared security-based swap to determine whether the major security-based swap participant has current exposure to the counterparty or the counterparty has current exposure to the major security-based swap participant. Major security-based swap participants would not be required to calculate a potential future exposure measure because they would not be required to collect margin collateral to cover this amount.

Margin Collection and Posting Requirements

Major security-based swap participants would be required to collect margin collateral to cover their current exposure to a counterparty and to deliver margin collateral to a counterparty to cover the counterparty’s current exposure to the major security-based swap participant.

C. Segregation

Security-Based Swap Dealers (Rule 18a-4)

Dodd-Frank Segregation Provisions

The Dodd-Frank Act amended the Securities Exchange Act to require that collateral for cleared security-based swaps be segregated. It further provided that the collateral could be commingled and segregated pursuant to SEC rules. With respect to collateral for non-cleared security-based swaps, the Dodd-Frank Act amended the Exchange Act to provide that a counterparty could elect to have the collateral segregated away from the security-based swap dealer at an independent third-party custodian or could waive its right to segregation of collateral.

The proposed segregation rule for security-based swap dealers would establish additional segregation requirements for cleared and non-cleared security-based swaps that would allow the collateral of counterparties to be commingled and segregated on an omnibus basis — that is, held in a single account subject to specific conditions.

SBSD Segregation Requirements

Rule 18a-4 would be modeled closely on the broker-dealer segregation rule, Rule 15c3-3, which requires a broker-dealer that maintains custody of customer securities and cash, to take two primary steps to safeguard these assets: (1) maintain physical possession or control over customers’ fully paid and excess margin securities, and (2) maintain a reserve of funds or qualified securities in an account at a bank that is equal in value to the net cash owed to customers.

The requirements under Rule 18a-4 would be as follows:

1. Possession and Control Requirement

A security-based swap dealer would be required to maintain possession and control of all excess securities collateral that have been provided by such customers to the security-based swap dealer.

Excess securities collateral would be defined to mean securities of security-based swap customers held by the security-based swap dealer that exceed the security-based swap dealer’s current exposure to the customer, excluding: (1) securities held by a clearing agency but only to the extent the securities are being used to meet a margin requirement of the clearing agency resulting from a security-based swap transaction of the customer, and (2) securities held by another security-based swap dealer but only to the extent the securities are being used to meet a margin requirement of the other security-based swap dealer resulting from a hedging transaction to mitigate the risk of a non-cleared security-based swap transaction with the customer.

Together, these provisions would permit the security-based swap dealer to use customer securities only to cover the security-based swap dealer’s current exposure to the customer or to finance transactions of the customer. The security-based swap dealer could not use excess securities collateral to finance its own business.

2. Reserve Account Requirement.

A nonbank SBSD would be required to maintain a reserve of funds or qualified securities for the benefit of the security-based swap dealer’s customers in an account at a bank that is equal in value to the net cash owed to security-based swap customers. The amount of net cash owed to customers would be computed pursuant to a formula that is similar to the formula used by broker-dealers in segregating assets for customers.

What’s Next

The proposal will undergo a public comment period that lasts for 60 days after its publication in the Federal Register.