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Beginning to Shine a Light on the Opaque Derivatives Market: Defining Dealers and Major Participants in the Cross-Border Context

Commissioner Luis A. Aguilar

June 25, 2014

Dealers and major participants play a crucial role in the derivatives market, a market that has been estimated to exceed $710 trillion worldwide, of which more than $14 trillion represents transactions in security-based swaps.[1]  In the United States, the Commodity Futures Trading Commission (“CFTC”) and the SEC share responsibility for regulating the derivatives market.[2]  Out of the total derivatives market, the SEC is responsible for regulating security-based swaps.  As evidenced in the most recent financial crisis, the unregulated derivatives market had devastating effects on our economy and U.S. investors.  In response to this crisis, Congress enacted the Dodd-Frank Act[3] and directed both the CFTC and SEC to promulgate an effective regulatory framework to oversee the derivatives market.

Unfortunately, to date, the SEC has failed to enact the necessary regulatory scheme for the securities-based swap market, as envisioned by Title VII of the Dodd-Frank Act.  For example, if the Commission acts today, it will be the Commission’s first adoption of the series of proposed rules to regulate cross-border security-based swap activities.[4]  I hope today’s rule adoption will be quickly followed by a series of other adoptions so that the Title VII framework can be fully adopted and implemented, and satisfy the intended objective of preventing future financial crises by reducing systemic risk and increasing transparency in the derivatives marketplace.[5]  Because of the size of this market and its impact on the global economy, the Commission must act so that security-based swaps do not continue to be transacted in an opaque market[6] with significant regulatory gaps.[7]

Let me now turn to today’s rulemaking.  Today, the Commission considers adopting final rules and guidance as to the application of the Title VII definitions of security-based swap dealer and major security-based swap participants in the cross-border context.[8]  Concurrently, the Commission also considers adopting a procedural rule for the submission of applications for substituted compliance, a framework for allowing market participants to satisfy certain Title VII obligations by complying with comparable foreign regulatory requirements.  In addition, the Commission considers adopting a rule confirming the Commission’s broad, cross-border antifraud enforcement authority under Section 929P of the Dodd-Frank Act.[9]

I believe that the final rules considered today are an improvement upon the Commission’s previous proposal, and that these final rules will enhance market transparency and investor protections in a number of ways.  For example:

  • First, there is no longer a loophole for conduit affiliates[10] and security-based swap transactions subject to recourse guarantees.[11]  The final rules on conduit affiliates prevent a U.S. parent company from using its foreign affiliates to enter into security-based swap transactions—on the parent’s behalf—with non-U.S. persons to evade Title VII.  Similarly, the rules on recourse guarantees prevents a U.S. parent company from enticing foreign counterparties to enter into transactions with its foreign affiliates by providing assurances of its foreign affiliates’ performance.
  • Second, there is now stronger oversight of guaranteed foreign affiliates.[12]  Security-based swap transactions entered into by foreign affiliates that are guaranteed by a U.S. parent pose the same financial risks as transactions entered into directly by the U.S. parent.  Thus, it is important that transactions serving the same economic purposes are treated the same way.
  • Finally, the final rules require a person to exercise reasonable care before it can rely on counterparty representations for purposes of ascertaining the counterparty’s U.S.-person status.[13]  These representations are important because they are part of the threshold determination of whether Title VII applies to a person or transaction.

The final rules also remind U.S. parent companies of their disclosures obligations with respect to their security-based swap transactions.[14]  This is particularly critical where a U.S. parent company’s exposures to security-based swap transactions are material to its financial well-being—taking into consideration all of its security-based swap positions that are explicitly or implicitly guaranteed.

With respect to the availability of substituted compliance, and  as I mentioned when the rules were proposed in 2013, I continue to have concerns that permitting compliance with foreign regulatory requirements, as a substitute for compliance with U.S. laws, may inappropriately deny American investors the protection of American laws.  It is very important to me that future applications are required to submit to a transparent and public process.  This will benefit investors, the public, market participants, and the market overall.  To that end, I am pleased to report that the final rules require mandatory public notice and comment for all applications for substituted compliance.[15]

The rules being adopted today are not perfect, and there are concerns that the final rules still leave gaps that can be exploited—such as the risks posed by implicit guarantees—that could create contagion and spillover risks that can impact the U.S. financial system.  In particular, I fear that the regulatory approach to foreign subsidiaries of U.S. parent companies may incentivize U.S. banks to conduct their security-based swap business through their foreign subsidiaries, thereby increasing the potential for regulatory arbitrage and creating risks that will ultimately be borne by U.S. financial institutions and our financial system.[16]

For example, under the final rules, two non-guaranteed foreign subsidiaries of two separate U.S. entities could structure their security-based swap transactions in a way that allows them to engage in unlimited transactions with each other outside the United States and circumvent Title VII.  In times of financial distress, these foreign subsidiaries could rely on their U.S. parents to bail them out through implicit guarantees.  The concern is that, even without an explicit legal obligation, a U.S parent company could likely step in to save its financially troubled subsidiaries and protect its reputation.[17]

Ultimately, however, after numerous in-depth conversations between my office and the staff, especially with the Office of the General Counsel, I have been told repeatedly that the staff’s view is that the Commission’s legal authority to adopt rules to effectively address the implicit guarantee issue is limited and does not allow us to address this gap.  Although it is a disappointment that the Commission is unable to address this gap, in reliance on these representations, I am prepared to move forward to adopt the recommended final rules.


When all is said and done, I believe that the definitions to be adopted today are a significant step forward.  While not perfect, the final rules will close many of the loopholes in our regulatory framework, and they are an initial step forward in accomplishing the goals of the Dodd-Frank Act.  For this reason, I will support today’s recommendation and I thank the staff for their hard work on this rulemaking.

As the Commission continues to adopt the required cross-border Title VII rules, we must remember that a well-regulated market instills investor trust and confidence and protects our economy as a whole.  To that end, the Commission is long overdue in enacting an effective and working regulatory oversight of the securities-based swap market.  It is noteworthy that the Commission will not be acting today on the definition of “transaction conducted within the United States,” a key definition that will address what dealer conduct will be covered under the Title VII regulatory framework.  This definition was proposed at the same time as the other definitions being acted upon today, but instead of being adopted today it continues to be reviewed by the staff. 

There is a lot of important work ahead, and I call upon the Chair, my fellow Commissioners, and the staff to finalize with all appropriate haste the remaining mandated Title VII rulemaking. The derivative reforms required by the Dodd-Frank Act must be faithfully promulgated in order to protect our economy, our financial markets and, more importantly, our investors.

Thank you.

[1] See, e.g., Bank for International Settlements, Semiannual OTC Derivatives Statistics at end of December 2013, Table 19 (June 2014), available at  The security-based swap market was estimated to be more than $14 trillion worldwide.  See id. (according to data published by the Bank for International Settlements, the global notional amounts outstanding in equity forwards and swaps and single-name name credit default swaps as of June 2014 were approximately $2.28 trillion and $11.32 trillion, respectively.  This analysis assumes that all equity forwards and swaps and single-name credit default swaps are security-based swaps, and single-name credit default swaps constitute approximately 80% of the security-based swap market.).

[2] According to one report, as of June 2014, the CFTC has already finalized 36 out of 43 required Title VII rulemakings, or 84%, while the SEC has only finalized 10 out of 29 required Title VII rulemakings, or 35%.  See Davis Polk & Wardwell LLP, Dodd-Frank Progress Report, p. 6 (June 2, 2014), available at

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

[4] Among those proposed rules are many fundamental cross-border rules, including rules to bring transparency and fair dealing to the market for security-based swaps; rules for the registration of dealers and major participants; rules to impose capital, margin, and segregation requirements for dealers and major participants; and rules for cross-border security-based swap activities.  See Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-64766 (June 29, 2011), available at; Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-65543 (Oct. 12, 2011), available at; 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; 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, Release No. 34-69490 (May 1, 2013), available at

[5] Statement at the SEC Open Meeting, SEC Commissioner Luis A. Aguilar, Working to Increase Transparency and Reduce Systemic Risks Caused by the Global Derivatives Market (May 1, 2013), available at; 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; 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

[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] See Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities, Release No. 34-XXXXX (June 25, 2014), available at ________________________ (“Final Rules”).

[9] See Final Rules at VII.A. (Congress provided the Commission with antifraud authority that reaches “conduct occurring outside the United States that has a foreseeable substantial effect within the United States.”  Section 929P(b)(2) of the Dodd-Frank Act.).

[10] See Final Rules at IV.D.2. and V.C.2.  (conduit affiliates are non-U.S. affiliates of U.S. persons that enter into security-based swap transactions with non-U.S. persons, or with certain foreign branches of U.S. banks, on behalf of its U.S. affiliates, and enter into offsetting transactions with its U.S. affiliates to transfer the risks and benefits of those security-based swaps).  The final rules require conduit affiliates to count all of their dealing transactions against the de minimis thresholds.  Final Rules at IV.D.2.  (The final rules distinguish conduit affiliates from other non-U.S. persons by requiring such entities to count all of their dealing transactions against the de minimis thresholds, regardless of the counterparty).  They must also include all of their security-based swap positions in their major security-based swap participant threshold calculations.  Final Rules at V.C.2.  These rules are necessary and appropriate to prevent the use of conduit affiliates to evade the requirements of Title VII.  Final Rules at IV.D.2. and V.C.2.

[11] A recourse guarantee enables a non-U.S. person’s counterparty to look to both the non-U.S. person and its U.S. guarantor for assurance that the non-U.S. person will perform under the terms of the security-based swap transaction.  Final Rules at II.B.2. (the economic reality of this transaction is identical to a transaction entered into directly by the U.S. guarantor, which is generally the parent company).  Under the final rules, a non-U.S. person must count towards its de minimis thresholds all security-based swap transactions in which its counterparty has rights of recourse against a U.S. parent company.  Final Rules at IV.E.1. (Under the final rules, a non-U.S. person, other than a conduit affiliate, must count, against the de minimis thresholds, any security-based swap transaction connected with its dealing activity for which the counterparty to the security-based swap has rights of recourse against a U.S. person that is controlling, controlled by, or under common control with the non-U.S. person.).  This also applies to a non-U.S. person’s major security-based swap participant threshold calculations.  Final Rules at  V.D.3. (A non-U.S. person, other than a conduit affiliate, must include in its major security-based swap participant threshold calculations all of its security-based swap positions for which its counterparty has rights of recourse against a U.S. person).

[12] Under the Final Rules, guaranteed foreign affiliates have to count all of their guaranteed dealing transactions toward their de minimis calculations and all of their guaranteed transactions toward the major participant thresholds, and not just their U.S.-facing transactions, as stated in the proposing release.  Final Rules at IV.E.1. and V.D.3.  Thus, the Final Rules apply dealer and major participant regulations to different organizational structures that served similar economic purposes, as they all pose the same risks to the U.S. financial system.  See id.

[13] Contrary to the proposed rules, the final rules now require a reasonable person standard for reliance on counterparty representations for purposes of ascertaining its U.S. person status.  See Final Rules at IV.C.4.  I flagged this issue at the proposing stage as one that had significant negative ramifications.

[14] Final Rules at IV.E.1.

[15] See Final Rules at VI.B. and § 240.0-13(h).

[16] Comment letter from Better Markets to the SEC, 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 Americans for Financial Reform to the CFTC (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.”).

[17] 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 nonbank subsidiaries, regardless of the formalities of corporate separation.”).  As noted by a commenter, “regardless of whether an affiliate is ‘guaranteed’ by a U.S. person, that affiliate may be effectively guaranteed, having the same connection with and posing the same risks to the United States.  Indeed, both types of affiliates have a proven track record of causing potentially catastrophic losses to the U.S. actual or de facto guarantor.  Both must be bailed out to avoid a loss of market and counterparty confidence, and both are therefore capable of generating huge, systemically significant losses for the actual or de facto guarantor.”  Comment Letter from Better Markets to the SEC, Cross Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rule and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants (Release No. 34-69490; File Nos. S7-02-13; S7-34-10; S7-40-11), at p. 14 (Aug. 21, 2013).

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