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SEC Proposes Rules for Security-Based Swap Execution Facilities


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Washington, D.C., Feb. 2, 2011 — The Securities and Exchange Commission today voted unanimously to propose rules defining security-based swap execution facilities (SEFs) and establishing their registration requirements, as well as their duties and core principles.

Additional Materials

The Dodd-Frank Wall Street Reform and Consumer Protection Act authorized the SEC to implement a regulatory framework for security-based swaps, which currently trade exclusively in the over-the-counter markets with little transparency or oversight.

The Dodd-Frank Act sought to move the trading of security-based swaps onto regulated trading markets, and therefore created security-based SEFs as a new category of market intended to provide more transparency and reduce systemic risk.

"Our objective here is to provide a framework that allows the security-based swap market to continue to develop in a more transparent, efficient, and competitive manner," said SEC Chairman Mary L. Schapiro. "This is an important and complex undertaking that adds a significant new component to the regulatory framework for over-the-counter derivatives."

The Commission's proposed rules:

  • Interpret the definition of "security-based SEFs" as set forth in Dodd-Frank.
  • Set out the registration requirements for security-based SEFs.
  • Implement the 14 core principles for security-based SEFs that the legislation outlined.
  • Establish the process for security-based SEFs to file rule changes and new products with the SEC.
  • Exempt security-based SEFs from the definition of "exchange" and from most regulation as a broker.

Public comments on the rule proposal should be received by the Commission by April 4, 2011.

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Security-Based Swap Execution Facilities


Division of Authority

The Dodd-Frank Act established a comprehensive framework for regulating the over-the-counter swaps markets. In the process, it divided regulatory authority over swaps between the SEC and the Commodity Futures Trading Commission (CFTC).

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

Security-Based Swaps and Derivatives

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 mechanism for the transfer of market risk or credit risk between two counterparties. Derivatives are incredibly flexible products that can be engineered 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 or whether an event will happen in the future. With derivatives, market participants can track or replicate the economics of holding or shorting an underlying asset, such as a security, thereby enabling participants to gain a desired market or credit exposure without actually holding the underlying asset.

A swap is a type of derivative contract that is traded in the over-the-counter market. One type of swap is a "security-based swap", over which the SEC has authority. Such swaps are broadly defined as swaps based on (1) a single security, (2) a loan, (3) a narrow-based group or index of securities or (4) events relating to a single issuer or issuers of securities in a narrow-based security index.

As an example, in a credit default swap transaction, the party who is seeking to hedge against a loss from a particular credit event, say the default of a bond, is referred to as the credit protection buyer. The credit protection buyer will receive a payment to compensate for its loss in the event that the default occurs. A credit protection seller is the counter-party.

The current market for security-based swaps, which trade over-the-counter, is opaque, with swap dealers acting as liquidity providers, and institutional investors and investment managers acting as liquidity takers. Compared to the exchange-traded markets, there is little pre-trade transparency (the ability to see trading interest prior to a trade being executed) or post-trade transparency (the ability to see transaction information after a trade is executed).

Security-Based Swap Execution Facilities

To ensure greater transparency in the security-based swaps market and reduce systemic risk, the Dodd-Frank Act sought to move the trading of security-based swaps onto regulated trading markets.

As such, Dodd-Frank requires security-based swap transactions that are required to be cleared through a clearing agency to be executed on an exchange or on a new trading system called a security-based swap execution facility. The Dodd-Frank Act, however, states that the transaction need not be executed on a security-based SEF or exchange if no security-based SEF or exchange makes the security-based swap "available to trade."

This newly created entity is defined under the Dodd-Frank Act in relevant part as "a trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce. . . ."

The Core Principles

The Dodd-Frank Act further requires security-based SEFs to be registered with the Commission and specifies that such a registered security-based SEF, among other things, must comply with 14 core principles.

The core principles would require these security-based SEFs to:

  1. Comply with the core principles and any requirement the Commission may impose.

  2. Establish and enforce rules governing, among other things, the terms and conditions of security-based swaps traded on their markets; any limitation on access to the facility; trading, trade processing and participation; and the operation of the facility.

  3. Permit trading only in security-based swaps that are not readily susceptible to manipulation.

  4. Establish rules for entering, executing and processing trades and to monitor trading to prevent manipulation, price distortion, and disruptions through surveillance, including real-time trade monitoring and trade reconstructions.

  5. Have systems to capture information necessary to carry out its regulatory responsibilities and share the collected information with the Commission upon request.

  6. Have rules and procedures to ensure the financial integrity of security-based swaps entered on or through the facility, including the clearance and settlement of security-based swaps.

  7. Have rules allowing it to exercise emergency authority, in consultation with the Commission, including the authority to suspend or curtail trading or liquidate or transfer open positions in any security-based swap.

  8. Make public post-trade information (including price, trading volume, and other trading data) in a timely manner to the extent prescribed by the Commission.

  9. Maintain records of activity relating to the facility's business, including a complete audit, for a period of five years and to report such information to the Commission, upon request.

  10. Not take any action that imposes any material anticompetitive burden on trading or clearing.

  11. Have rules designed to minimize and resolve conflicts of interest.

  12. Have sufficient financial, operational, and managerial resources to conduct its operations and fulfill its regulatory responsibilities.

  13. Establish a risk analysis and oversight program to identify and minimize sources of operational risk and to establish emergency procedures, backup facilities, and a disaster recovery plan, and to maintain such efforts, including through periodic tests of such resources.

  14. Have a chief compliance officer that performs certain duties relating to the oversight and compliance monitoring of the security-based SEF and that submits annual compliance and financial reports to the Commission.

The Proposal

The Commission proposed a series of rules related to security-based SEFs.

Attributes of a Security-Based SEF

The Commission proposed an interpretation of the definition of a security-based SEF. Under its proposed interpretation, a security-based SEF would be a system or platform that allows more than one participant to interact with the trading interest of more than one other participant on the system or platform.

Various types of trading platforms potentially could meet the proposed interpretation. For example, a limit order book system (i.e., a system or platform that allows a participant to submit executable bids and offers for display to all other participants) could meet the proposed interpretation.

Also, the proposed interpretation would accommodate a "request for quote" system that provides a participant with the ability to send a single request for a quote to all participants providing liquidity on that system, or to choose to send the request to fewer than all such participants.

The security-based SEF would not be able to limit the number of liquidity providing participants from whom a quote-requesting participant could request a quote on the SEF. However, the security-based SEF would be able to let the quote-requesting participant choose to send its request for a quote to less than all the liquidity-providing participants.

The security-based SEF also would have to provide a functionality that allows any participant the ability to make and display executable bids and offers accessible to all other participants on the security-based SEF, if the participant chooses to do so. Also, the security-based SEF would have to create and disseminate composite indicative quotes for all swaps that trade on the security-based SEF to all participants.

The Requirements for Registering SEFs

Under the proposed rules, security-based SEFs would be required to register with the Commission by filing a form, Form SB SEF. The SEF also would be required to update its filing when the information becomes inaccurate and file an amended form annually.

The proposed rules also would require that a security-based SEF:

  • File with the Commission proposed changes to its rules as well as the security-based swaps that it intends to trade.

  • Have rules to ensure compliance with the core principles outlined in the Dodd-Frank Act.

  • Have rules regarding access to, and the financial integrity of transactions on, the security-based SEF.

  • Put in place rules governing the procedures for trading on the security-based SEF.

  • Ensure the integrity of security-based SEF systems by having policies and procedures reasonably designed to ensure that its systems have adequate levels of capacity, resiliency, and security.

  • Make and keep certain books and records.

  • Have adequate resources to operate as a security-based SEF.

In addition, the proposal would exempt a security-based SEF from the definition of exchange and from most regulations as a broker.

Previous Related Rulemaking

This proposal coincides with rules the SEC proposed in December that would set out the way in which clearing agencies provide information to the SEC about security-based swaps that the clearing agencies plan to accept for clearing. This information is designed to aid the SEC in determining whether such security-based swaps should be required to be cleared.

In addition, under the Dodd-Frank Act, the SEC has engaged in several additional rulemakings related to the derivatives market:

Defining Security-Based Swap Terms: Proposed jointly with the Commodity Futures Trading Commission new rules that would further define a series of terms related to the security-based swaps market, including "swap dealer," "security-based swap dealer," "major swap participant," "major security-based swap participant" and "eligible contract participant."

Security-Based Swap Reporting: Proposed new rules entailing how security-based swap transactions should be reported and publicly disseminated.

Security-Based Swap Repositories: Proposed rules regarding the registration and regulation of security-based swap data repositories.

Security-Based Swap Fraud: Proposed a new rule to help prevent fraud, manipulation, and deception in connection with the offer, purchase or sale of any security-based swap as well as in connection with ongoing payments and deliveries under a security-based swap.

Security-Based Swap Conflicts: Proposed rules intended to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities, and national securities exchanges that post security-based swaps or make them available for trading.

Reporting of Pre-Enactment Security-Based Swaps: Adopted an interim rule requiring certain swaps dealers and other parties to report any security-based swaps entered into prior to the July 21 passage of the Dodd-Frank Act. This rule applies only to such swaps whose terms had not expired as of July 21.

Confirmation of Transactions: Proposed a rule governing the way in which certain security-based swap transactions are acknowledged and verified by the parties who enter into them.

What's Next

The proposal seeks public comment by April 4, 2011, on a broad range of issues relating to the proposed interpretation, exemptions, rules and form relating to security-based SEFs, including the costs and benefits associated with the proposal. After careful review of comments, the Commission will consider whether to adopt the proposal or modify it.



Modified: 02/02/2011