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Working to Increase Transparency and Reduce Systemic Risks Caused by the Global Derivatives Market

Commissioner Luis A. Aguilar

May 1, 2013

Today, the Commission considers issuing a release proposing rules and interpretive guidance applicable to certain market intermediaries, participants, clearing agencies, data repositories, and trade execution facilities that are involved in cross-border transactions of security-based swaps.  The proposed release is over 1,000 pages, contains over 2,000 footnotes, and requests comments on more than 630 questions with many subparts.  Although the questions posed are many, they are intended to be balanced and fair to solicit views from all sides.  This is a welcome approach, because it contributes to a healthy debate and dialogue that is vital to the Commission’s processes.1

Today, the Commission also votes to reopen the comment period on the various outstanding rulemaking releases and policy statement concerning security-based swaps and market participants to allow the public additional time to analyze and provide comments in light of our cross-border release.

The length of the cross-border release and the reopening of the comment periods reflect the complexity and importance of the issues involved in securities-based swap transactions.  In issuing today’s proposal and asking for comments on the Commission’s proposed approach to regulating the securities-based swap market, the Commission recognizes the interactions among many important rules in this area.  It is important, therefore, that our rules avoid gaps and loopholes, and that they work together to provide the needed transparency, accountability, and protection to our economy, the markets, and, most importantly, to investors.

During the recent financial crisis, we witnessed the devastating effects of a global derivatives marketplace that, left unchecked, seriously damaged our economy and caused significant losses to U.S. investors.  We also witnessed several regulatory bailouts as we dug our way out of the financial crisis, including the bailout of the American International Group (AIG), the rescue of Bear Stearns, and the failure of Lehman Brothers.2  By one estimate, the financial crisis caused approximately $12.8 trillion in economic damage to our nation3 – a crisis that hurt American families and communities across our nation.  While many factors caused the financial crisis, a major contributor to that crisis was the unregulated global derivatives market.4

These events demonstrate the need for the Commission to develop a comprehensive regulatory framework for the oversight of the derivatives market.  The derivatives market – a market that is estimated to exceed $630 trillion worldwide5 – has for a long time operated in an opaque market6 replete with regulatory gaps.7  In this regard, Title VII of the Dodd-Frank Act8 aims to prevent future financial crises by providing the Commission with the necessary rulemaking authority to reduce systemic risks and increase transparency in the derivatives marketplace.9

Although the Commission has not moved as quickly to implement Title VII as I would have preferred, and there is still work ahead that remains to be completed, the Commission has taken several steps to implement Title VII.  For example, we have adopted joint rules with the Commodity Futures Trading Commission (CFTC) on product and entity definitions;10 rules that establish the procedure by which clearing agencies submit security-based swaps for purposes of mandatory clearing;11 and rules that establish standards for registered clearing agencies.12

To meet the Title VII requirements, the Commission has also proposed rules in a number of important areas, including rules to move transactions onto regulated platforms,13 rules to provide trade transparency,14 rules to reduce systemic risk by requiring central clearing,15 rules to prevent conflicts of interest from hindering fair access to trading and clearing facilities,16 rules to bring transparency and fair dealing to the market for security-based swaps,17 rules for the registration of dealers and major participants,18 and rules to impose capital, margin, and segregation requirements for dealers and major participants.19

A key goal of the Dodd-Frank Act is to increase the transparency and oversight of the derivatives market by, among other things, bringing trading of security-based swaps onto regulated markets.20  In furtherance of that goal, today’s rule proposal focuses on the application of Title VII to cross-border security-based swap activities of market participants.  The rules we propose seek to achieve a number of important objectives, including the following:

  • First, the rules seek to promote Dodd-Frank’s goal of reducing risk, increasing transparency, and improving the integrity of our financial markets by registering and regulating security-based swap dealers and major security-based swap participants involved in cross-border activities within the meaning of Title VII.  As with the rules applicable to domestic activities, today’s rules include requirements designed to protect customer assets,21 lessen the potential impact of institutional failures,22 and promote a culture of compliance and fair dealing.23
  • Second, the rules would require the registration of security-based swap clearing agencies, data repositories, and swap execution facilities involved in cross-border activities within the meaning of Title VII.  Moreover, the rules apply Title VII to certain transactional requirements for reporting and dissemination, clearing, and trade execution for security-based swaps.24

The proposed cross-border rules we consider are important components to achieve Dodd-Frank’s goal of trying to prevent future crises.  However, I have some areas of concern regarding aspects of today’s rule proposal, and I invite public comments on these issues.  For example:

Substituted Compliance and External Business Conduct

The rule proposal seems to rely heavily on “substituted compliance,” a framework under which the Commission would permit compliance with comparable regulatory requirements in a foreign jurisdiction to substitute for compliance with the Securities Exchange Act of 1934 (“Exchange Act”) relating to security-based swaps.  In particular, non-U.S. dealers that are registered with the Commission would be allowed to comply with the U.S. external business conduct rules through “substitute compliance” as an alternative to complying with the Exchange Act.  External business conduct rules are necessary to ensure honesty and high ethical standards in the securities industry, as well as to promote confidence in our securities markets among domestic and foreign investors.  The proposed rules would allow these SEC-registered entities to use “substituted compliance” for external business conduct rules, even as to transactions taking place within the United States involving U.S. persons.

In particular, this approach would allow substituted compliance for transactions between registered non-U.S. dealers and a unique class of counterparties that Congress has identified as “special entities” needing enhanced protections.25  It remains unclear whether these registered non-U.S. dealers, if required, would be able to act in the best interests26 of special entities in the United States.  Under these circumstances, creating a substituted compliance regime may remove these enhanced protections, and, if so, would not seem to be consistent with Congressional intent.

Therefore, I would like commenters’ views as to whether a substituted compliance regime will inappropriately deny American investors the protection of American laws.27

Foreign Subsidiaries and Branches

Moreover, while the rule proposal treats “foreign subsidiaries” of U.S. companies differently from “foreign branches” of U.S. banks, the rule proposal would allow “foreign subsidiaries” to be treated as non-U.S. persons under all circumstances and “foreign branches” to be treated as non-U.S. persons under certain circumstances.  Foreign subsidiaries are entities incorporated outside the U.S. and considered separate entities from the U.S. parent, while foreign branches are considered part of the U.S. entity.

As to subsidiaries, the proposed rule would exclude from the definition of “U.S. person” all subsidiaries of U.S. persons that are incorporated abroad and have their principal place of business abroad, even if a foreign subsidiary is guaranteed by its U.S. parent.  This treatment of foreign subsidiaries seems to overlook the fact that the financial resources of multinational U.S. parent companies are typically integrated with the financial resources of their foreign subsidiaries to be competitive in the global derivatives market.28  As such, a foreign subsidiary of a U.S. parent company is, in reality, an integral and indistinguishable part of the U.S. parent company.29

With respect to foreign branches of U.S. banks, the rule proposal treats them as non-U.S. persons in their foreign businesses, even though they are considered “U.S. persons” for purposes of the proposed rules.  For example, if a foreign branch of a U.S. entity transacts with an unregistered non-U.S. dealer outside the United States, then many Title VII requirements will not apply.

These treatments of “foreign subsidiaries” and “foreign branches” may incentivize U.S. companies to conduct their security-based swap business through their foreign subsidiaries and branches, thereby increasing the potential for regulatory arbitrage and creating risks that will ultimately come to our shores.30  For example, under the proposed rules, two non-guaranteed foreign subsidiaries of two separate U.S. entities could engage in unlimited amounts of security-based swap transactions with each other outside the United States and not be subject to Title VII.31  The proposed rules seem to assume that any failure by these foreign subsidiaries would not financially affect the U.S. parents.  However, even without a legal obligation, a U.S parent company will likely step in to save its financially troubled subsidiaries and protect its reputation.  The proposed rules do not appear to address fully these contagion and spillover risks.

For these reasons, I would like to invite public comments on (1) whether a majority-owned subsidiary of a U.S. parent, regardless of any financial guarantee from the U.S. parent, should be included in the definition of “U.S. Person;” and (2) whether a foreign branch of a U.S. parent should be included in the definition of “U.S. Person” for all purposes under Title VII.32  In particular, commenters should address whether the proposed approach provides sufficient protection to the U.S. financial system.

Counterparty Representations

Finally, the proposed release relies heavily on counterparty representations as to whether a transaction is solicited, negotiated, or executed by a person within the U.S.  Specifically, a person receiving the representations would not be liable under Title VII if the person did not have “actual knowledge” of a misrepresentation.  These representations are important because they are part of the determination whether a person or transaction is subject to Title VII.  I believe that a person receiving such representations should exercise reasonable care and diligence in determining his counterparty’s U.S.-person status and whether the transaction was conducted within the United States.  Therefore, I invite public comments on whether such person should be required to undertake some reasonable due diligence and should be liable under Title VII if the person knew or had reason to know about the misrepresentation.

These, and other issues, require additional thought and I am willing to support today’s proposal because putting this proposal out for public comment is an important step forward in developing effective regulatory oversight over a largely nontransparent and unregulated global derivatives market.  It is important to get public input on these issues and, at my request, the proposed release includes several questions to solicit public comments in these areas.

I will also vote to reopen the comment period on the other Title VII proposals, so that we can benefit from additional comments now that substantially all of the Title VII rule makings have been proposed and commenters can see how these rules would work together.

As we create our rules, we must be reminded of the desperate efforts and massive taxpayer bailout required in response to the 2008 financial crisis and the role that the derivatives market played in destroying storied investment banks, imposing large losses on market participants, and triggering fear and panic on Wall Street and Main Street.  A well-regulated market promotes investor trust and confidence, a necessary ingredient for a vibrant, global financial market.  I am hopeful that the final rules will accomplish the goals of the Dodd-Frank Act.

In closing, I want to thank the staff for many months of tremendous efforts, hard work, and dedication to this rulemaking.  I look forward to the comments we will receive.

Thank you.

1 Cf. U.S. Congress, Before the Subcommittee on Investigations, Oversight and Regulations, Committee on Small Business, U.S. House of Representatives, Testimony on JOBS Act Implementation Update (Apr. 11, 2013), n.18, available at

2 James E. Kelly, Transparency and Bank Supervision, 73 Alb. L. Rev. 421, 424 (2010).

3 Dennis Kelleher, Stephen Hall, and Katelynn Bradley, A Report from Better Markets: The Costs of the Wall Street-Caused Financial Collapse and Ongoing Economic Crisis is More than $12.8 Trillion, at 1 (Sept. 15, 2012), available at

4 See, e.g., Report of the Senate Committee on Banking, Housing, and Urban Affairs regarding The Restoring American Financial Stability Act of 2010, S. Rep. No. 111-176 at 29 (2010) (“Many factors led to the unraveling of this country’s financial sector and the government intervention to correct it, but a major contributor to the financial crisis was the unregulated over-the-counter (‘OTC’) derivatives market.”), available at

5 See, e.g., Bank for International Settlements, Semiannual OTC Derivatives Statistics at end-June 2012, Table 19 (Nov. 13, 2012), available at

6 Frank Partnoy and David A. Skeel Jr., The Promise and Perils of Credit Derivatives, 75 U. Cin. L. Rev. 1019, 1036 (Spring 2007).

7 James E. Kelly, Transparency and Bank Supervision, 73 Alb. L. Rev. 421, 424 (2010).

8 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), Pub. L. 111-203, § 410 (2010).

9 Statement at the SEC Open Meeting,  SEC Commissioner Luis A. Aguilar, Protecting Our Economy Demands Adequate Capital and Margin Requirements for Security-Based Swaps (Oct. 17, 2012), available at http://; Statement at the SEC Open Meeting, SEC Commissioner Luis A. Aguilar, Bringing Transparency and Fair Dealing to the Market for Security-Based Swaps (June 29, 2011), available at

10 See, Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” Release No. 34-66868 (Apr. 27, 2012), available at; Section 15F of the Exchange Act.

11 See, Process for Submissions for Review of Security-Based Swaps for Mandatory Clearing and Notice Filing Requirements for Clearing Agencies; Technical Amendments to Rule 19b-4 and Form 19b-4 Applicable to All Self-Regulatory Organizations, Release No. 34-67286 (June 28, 2012), available at

12  See, Clearing Agency Standards, Release No. 34-68080 (Oct. 22, 2012), available at

13 Registration and Regulation of Security-Based Swap Execution Facilities, Release No. 34-63825 (Feb. 2, 2011), available at

14 Regulation SBSR — Reporting and Dissemination of Security-Based Swap Information, Release No. 34-63346 (Nov. 19, 2010), available at; Security-Based Swap Data Repository Registration, Duties, and Core Principles, Release No. 34-63347 (Nov. 19, 2010), available at

15 End-User Exception to Mandatory Clearing of Security-Based Swaps, Release No. 34-63556 (Dec. 15, 2010), available at

16 Ownership Limitations and Governance Requirements for Security-Based Swap Clearing Agencies, Security-Based Swap Execution Facilities, and National Securities Exchanges with Respect to Security-Based Swaps under Regulation MC, Release No. 34-63107 (Oct. 14, 2010), available at

17 Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-64766 (June 29, 2011), available at

18 Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-65543 (Oct. 12, 2011), available at

19 Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, Release No. 34-68071 (Oct. 18, 2012), available at

20 See, Public Law 111-203, Preamble.

21 See, supra note 19.

22 See, id.

23 See, supra note 17.

24 These rules are designed, among other things, to promote sound management of counterparty risks, reduce systemic risks, and increase transparency and oversight of the derivatives market by increasing centralized clearing, recordkeeping, and trading.  The rules require entities to establish robust risk management systems, keep accurate books and records, establish internal controls, diligently supervise their security-based swap business, and designate a chief compliance officer.  See, Sections 15F(f), 15F(g), 15F(j)(2), 15F(j)(3), 15F(j)(4), 15F(h)(1)(B), and 15F(k) of the Exchange Act.

25 Congress has already identified “special entities” as a specific class of security-based swap counterparties, and applied enhanced and specific protections under the business conduct standards to those counterparties.  See, Section 15F(h) of the Exchange Act.  “Special Entities,” as defined in Section 15F(h)(2)(C) of the Exchange Act, would be considered “U.S. persons” because they are legal persons organized under the laws of the United States.  Section 15F(h)(2)(C) of the Exchange Act defines the term “Special Entity” as “(i) a Federal agency; (ii) a State, State agency, city, county, municipality, or other political subdivision of a State or; (iii) any employee benefit plan, as defined in section 3 of the Employee Retirement Income Security Act of 1974; (iv) any governmental plan, as defined in section 3 of the Employee Retirement Income Security Act of 1974; or (v) any endowment, including an endowment that is an organization described in Section 501(c)(3) of the Internal Revenue Code of 1986.”

26 See, Section 15F(h)(4)(B) of the Exchange Act.

27 I am, of course, mindful about the potential effects of our rules on competition.  I do believe, however, that robust and effective oversight by the Commission will enhance competition, encourage efficiency, and provide liquidity by promoting transparency, reducing systemic risks, protecting counterparties, and ensuring honesty and integrity in the derivatives marketplace.  See, e.g., Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants (“Cross-Border Release”), Section XV.C.2. (Economic Analysis and Competition section; the proposed rules will likely enhance competition and participation in the U.S. market because Title VII requirements will likely promote safety and soundness, transparency, and competition.); id., Section XV.C.3. and accompanying footnotes (Economic Analysis and Efficiency section; the proposed application of Title VII could potentially increase the volume of transactions on transparent venues, and an increase in liquidity could lead to an increase in price efficiency.); see also, The Financial Planning Coalition Survey (Mar. 8, 2013) (the survey shows that 84% of Americans want the federal government to play an active role in protecting investors.), available at; Steve A. Ramirez, Fear and Social Capitalism: The Law and Macroeconomics of Investor Confidence, 42 Washburn L.J. 31, 36-58 (Fall 2002) (financial regulation plays an important role in macroeconomic stability by promoting investor confidence.).

28 See, Michael Greenberger, The Extraterritorial Provisions of the Dodd-Frank Act Protects U.S. Taxpayers from Worldwide Bailouts, UMKC Law Review, 80 UMKC L. Rev. 965, 975-76 (Summer 2012).

29 See, id. at 976.

30 Comment letter from Better Markets to the Securities and Exchange Commission, Cross-Border Regulation, at pp. 2-3 (Apr. 19, 2013) (“Weak cross-border regulatory standards not only raise the specter of global systemic risk and failure, they pose a special threat to U.S. interests…Distinctions like ‘branch’ versus ‘guaranteed subsidiary’ create the illusion of varying degrees of immunity from contagion where in reality none exist.  Moreover, it elevates form over substance and invites regulatory arbitrage.”); Comment letter from American for Financial Reform to the Commodity Futures Trading Commission (June 14, 2012) (“Failure to apply Dodd-Frank protections to the foreign subsidiaries of U.S. banks would permit Wall Street to easily evade U.S. financial regulation by moving their swaps business overseas.”).

31 Under the proposed release, a foreign subsidiary guaranteed by a U.S. entity is treated differently from a non-guaranteed foreign subsidiary.  For example, a guaranteed foreign subsidiary may be subject to the registration requirements of a major security-based swap participant if its transaction amounts exceed the de minimis threshold.  If required to be registered as a major security-based swap participant, it will be subject to, among other things, the capital and margin requirements.  The proposed release assumes that the contagion and spillover risks of a guaranteed foreign subsidiary would be contained through the rules associated with a major security-based swap participant designation.  The $180 billion bailout of AIG by American taxpayers demonstrates how the financial condition of a major U.S. financial institution can be shattered by the spillover and contagion effects of the derivative trading activities of its foreign subsidiary.  See, Greenberger, supra note 28, at 976 (“The American taxpayers’ $183 billion bailout of American International Group (AIG) proves that the financial stability of even a major U.S. financial institution can be undercut by the irresponsible trading practices of a foreign subsidiary.”); see, e.g., Government Accountability Office, Systemic Risk: Regulatory Oversight and Recent Initiatives to Address Risk Posed by Credit Default Swaps, GAO-09-397T (Mar. 2009), at 15 (“The near-collapse of AIG illustrates the risk from large exposures to CDS.”), available at; Tom C.W. Lin, The New Investor, 60 UCLA L. Rev. 678, 715 (Feb. 2013) (“The potential failure in 2008 of credit default swaps conceived by an American International Group (AIG) subsidiary in London and bought by all the major investment banks was at the crux of the financial crisis.”); Seema G. Sharma, Over-The-Counter Derivatives: A New Era of Financial Regulation, 17 L. & Bus. Rev. Am. 279, 287 (Spring 2011) (“Given the size of AIG’s OTC derivatives position, there was grave danger to the stability of the U.S. financial markets from the failure of the insurance giant and, fearing the domino effect of AIG’s bankruptcy, ‘the Federal Reserve and the Treasury put tens of billions of dollars into AIG, the bulk of which went to its derivatives counterparties’ and contained the spillover.”) (citing Rena S. Miller, Key Issues in Derivative Reform, Congressional Research Service R40965, at 4 (2009)); Cross-Border Release, Section II.A.6.(b) and accompanying footnotes (discussion on the “Global Nature and Interconnectedness of the Security-Based Swap Market”).

However, the presence or absence of a financial guarantee may not be determinative of the contagion and spillover risks posed by a foreign subsidiary on its parent company.  See, e.g., Arthur E. Wilmath, Jr., The Transformation of the U.S. Financial Services, 1975-2000: Competition, Consolidation, and Increased Risks, 2002 U. Ill. L. Rev. 215, 446 and n. 1029-1030 (2002) (“Moreover, during an economic crisis–when investors and creditors are most uncertain about the soundness of financial intermediaries–banks and other financial institutions have powerful reputational interests in rescuing their troubled nonbanksubsidiaries, regardless of the formalities of corporate separation.”).  As noted by a commenter, “in situations of market stress, a large trader simply cannot afford the reputational damage associated with allowing a subsidiary to fail, even if that subsidiary is not explicitly guaranteed.”  Comment Letter from Better Markets to the Commodity Futures Trading Commission, Proposed Further Interpretive Guidance and Policy Statement: Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act (RIN 3038-AD85), at p. 3 (Feb. 15, 2013).

32 In general, foreign branches are considered U.S. persons under the definition of “U.S. persons.”  However, foreign branches are treated as non-U.S. persons in their foreign businesses.  On the other hand, foreign subsidiaries of U.S. companies are considered non-U.S. persons under the definition of “U.S. persons” and are also treated as non-U.S. persons in their foreign businesses.

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