Focusing on Dealer Conduct in the Derivatives Market
Commissioner Luis A. Aguilar
April 29, 2015
The financial crisis of 2008 demonstrated the devastating effects of a derivatives marketplace that, left unchecked, seriously damaged the world economy and caused significant losses to investors.[1] As a result, Title VII of the Dodd-Frank Act[2] tasked the SEC and the CFTC[3] to establish a regulatory framework for the over-the-counter swaps market.[4] In particular, the SEC was tasked with regulating the security-based swap (SBS) market and the CFTC was given regulatory authority over all other swaps, such as energy and agricultural swaps.[5]
The Commission has already proposed and/or adopted various rules governing the SBS market—such as rules that establish standards for registered clearing agencies; rules to move transactions onto regulated platforms; rules to bring transparency and fair dealing to the market for SBS; 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 SBS activities.[6]
As part of this process, the specific focus of today’s rules involves the conduct and activities of the dealers that dominate the global derivatives market—a $692 trillion market of which more than $14 trillion represented transactions in security-based swaps.[7] In particular, today’s rules address the cross-border activities of those dealers.
When we adopted our final rules last year on the cross-border activities of SBS dealers and major participants, the Commission indicated that it would re-propose the rules defining the phrase “transaction conducted within the United States,” a key definition addressing what dealer conduct would be covered under Title VII.[8] Accordingly, the Commission today considers Re-Proposed Rules addressing, among other things, the application of the de minimis exception to the dealing activity of non-U.S. persons located in the U.S., and the application of Regulation SBSR[9] to such transactions.[10] The Commission is also re-proposing a rule regarding the application of the external business conduct requirements to the foreign business and U.S. business of registered SBS dealers.[11]
Specifically, today’s rules focus on the activities of SBS dealers and take into account the activity of non-U.S. firms with personnel in the U.S. that are engaged in arranging, negotiating, or executing SBS transactions.[12] In particular, these rules include two main requirements. First, the rules require non-U.S. persons to include their dealing transactions in their de minimis calculations.[13] If these dealing transactions exceed the de minimis threshold,[14] the non-U.S. person will need to register with the SEC as a dealer and be subject to several statutory requirements, including capital, margin, and business conduct requirements.[15] Second, the rules would trigger the application of the external business conduct rules applicable to dealer activities, as described in the Re-Proposed Rules.[16]
By targeting SBS dealing activities, the Re-Proposed Rules would result in approximately 99% of all SBS activities occurring within the United States falling under the regulatory umbrella of our Title VII rules.[17] As stated in today’s release, the SBS activities that would not be covered involve non-dealer transactions in the United States between non-U.S. persons and are not thought to pose significant risks to the U.S. financial system.[18]
The Re-Proposed Rules being considered today would enhance Commission oversight, market transparency, and investor protection in several ways:
- First, the rules ensure that all dealers conducting business in the U.S. are registered with the Commission, and are covered by the external business conduct rules,[19] which are rules that set forth standards for dealers to live up to in their dealings with their counterparties—such as employee benefit plans, endowments, federal agencies, and states.[20]
- Second, the rules will capture a significant number of foreign dealers conducting business in the U.S., a feature that is crucial given that approximately 88% of global SBS transactions involved non-U.S. counterparties.[21]
- Third, the rules are designed to prevent restructuring charades to avoid Title VII—for example, by plugging the loopholes allowing registered SBS dealers to book transactions overseas but otherwise handle the transactions in the U.S.[22] This will prevent dealers from accumulating hidden risks that could ultimately be borne by the U.S. financial system.
- Finally, the rules require public dissemination of all dealing transaction data and not just those that relate to dealing transactions in the U.S.[23] This will improve transparency and oversight of SBS transactions.
Today’s rules recognize the central role that dealers play in SBS transactions and are positive steps toward plugging regulatory gaps and loopholes. We must ensure that our Title VII rules work effectively to provide the much-needed transparency and protection that will ultimately benefit our investors, our capital markets, and our economy.
Conclusion
I will support today’s recommendation. It is a necessary step forward. Nonetheless, I recognize that the SEC still lags behind the CFTC in adopting all the necessary rules for the SBS market, as required by Title VII of the Dodd-Frank Act.[24] Accordingly, I urge my fellow Commissioners to move with urgency and adopt the rest of the long-overdue Title VII rules.[25] These rules are needed to increase transparency in the derivatives market, promote accountability, reduce systemic risk, and prevent future financial crises.
To conclude, I want to thank the staff for your work in this release, especially the staff from the Division of Trading and Markets and the Division of Economic and Risk Analysis for all the time that you spent with my office answering many of our questions.
Thank you.
[1] Dennis Kelleher, Stephen Hall, and Katelynn Bradley, A Report from Better Markets: The Cost of the Wall Street-Caused Financial Collapse and Ongoing Economic Crisis is More than $12.8 Trillion, at 1 (Sept. 15, 2012), available at http://bettermarkets.com/sites/default/files/Cost%20Of%20The%20Crisis_2.pdf. See, e.g., Report of the Senate Committee on Banking, Housing, and Urban Affairs, 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 http://www.gpo.gov/fdsys/pkg/CRPT-111srpt176/pdf/CRPT-111srpt176.pdf.
[2] Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), Pub. L. 111-203, § 410 (2010).
[3] United States Commodity Futures Trading Commission.
[4] See Section 712(a) of the Dodd-Frank Act.
[5] SEC Website, Derivatives, available at https://www.sec.gov/spotlight/dodd-frank/derivatives.shtml (last visited Apr. 21, 2015). The SEC and the CFTC share regulatory authority over “mixed swaps,” which are SBS that have a commodity component. Id.
[6] 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 http://www.sec.gov/rules/final/2012/34-66868.pdf; Section 15F of the Exchange Act; 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 http://www.sec.gov/rules/final/2012/34-67286.pdf; Clearing Agency Standards, Release No. 34-68080 (Oct. 22, 2012), available at http://www.sec.gov/rules/final/2012/34-68080.pdf; Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities, Release No. 34-72472, at 3 (June 25, 2014), available at http://www.sec.gov/rules/final/2014/34-72472.pdf; Security-Based Swap Data Repository Registration, Duties, and Core Principles, Release No. 34-74246 (Feb. 11, 2015), available at http://www.sec.gov/rules/final/2015/34-74246.pdf; Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information, Release No. 34-74244 (Feb. 11, 2015), available at http://www.sec.gov/rules/final/2015/34-74244.pdf; 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 http://www.sec.gov/rules/proposed/2010/34-63107.pdf; End-User Exception to Mandatory Clearing of Security-Based Swaps, Release No. 34-63556 (Dec. 15, 2010), available at http://www.sec.gov/rules/proposed/2010/34-63556.pdf; Registration and Regulation of Security-Based Swap Execution Facilities, Release No. 34-63825 (Feb. 2, 2011), available at http://www.sec.gov/rules/proposed/2011/34-63825.pdf; Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-64766 (June 29, 2011), available at http://www.sec.gov/rules/proposed/2011/34-64766.pdf; Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-65543 (Oct. 12, 2011), available at http://www.sec.gov/rules/proposed/2011/34-65543.pdf; 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 http://www.sec.gov/rules/proposed/2012/34-68071.pdf; 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 http://www.sec.gov/rules/proposed/2013/34-69490.pdf; Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information, Release No. 34-74245 (Feb. 11, 2015), available at http://www.sec.gov/rules/proposed/2015/34-74245.pdf.
[7] See Application of Certain Title VII Requirements to Security-Based Swap Transactions Connected with a Non-U.S. Person’s Dealing Activity That Are Arranged, Negotiated, or Executed By Personnel Located in a U.S. Branch or Office or in a U.S. Branch or Office of an Agent, Release No. 34-74834, at II.B.1. (Apr. 29, 2015), available at http://www.sec.gov/rules/proposed/2015/34-74834.pdf (“Re-Proposed Rules”); see, e.g., Bank for International Settlements, Statistical release: OTC derivatives statistics at end-June 2014, at 15 (Nov. 2014), available at http://www.bis.org/publ/otc_hy1411.pdf. 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 credit default swaps as of June 2014 were approximately $2.43 trillion and $10.85 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.).
[8] See Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities, Release No. 34-72472, at 3 (June 25, 2014), available at http://www.sec.gov/rules/final/2014/34-72472.pdf.
[9] Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information, Release No. 34-74244, (Feb. 11, 2015), available at http://www.sec.gov/rules/final/2015/34-74244.pdf.
[10] See Re-Proposed Rules at I.A.
[11] Id.
[12] See id. at I.A. and § 240.3a71-3(a)(8).
[13] See id. at I.A. and IV.A.
[14] See SEC Website, Fact Sheet, Defining Swaps-Related Terms (Modified: July 29, 2014), available at http://www.sec.gov/News/Article/Detail/Article/1365171492905 (last visited Apr. 21, 2015) (“For credit default swaps that are security-based swaps, the de minimis exception in general is available to persons who enter into up to $3 billion in notional CDS dealing transactions over the prior 12 months.”).
[15] See id.
[16] See Re-Proposed Rules at I.A. and IV.A.
[17] See id. at II.B.1. (“Commission staff analysis of DTCC-TIW transaction records indicates that approximately 99% of single-name CDS price-forming transactions in 2014 involved an ISDA-recognized dealer.”) Similarly, the CFTC’s November 2013 Staff Advisory states that non-U.S. dealers using personnel in the U.S. to arrange, negotiate, and execute a swap are required to comply with Title VII rules. CFTC Division of Swap Dealer and Intermediary Oversight Advisory, Applicability of Transaction-Level Requirements to Activity in the United States, Staff Advisory No. 13-69, at 2 (Nov. 14, 2013), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/13-69.pdf; See Re-Proposed Rules at I.D. The CFTC comment file is available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1452. I note that some commenters have urged the CFTC to adopt its staff advisory as agency policy. See, e.g., Comment Letter from the Americans for Financial Reform, Request for Comment on Application of Commission Regulations to Swaps Between Non-U.S. Swap Dealers and Non-U.S. Counterparties Involving Personnel or Agents of the Non-U.S. Swap Dealers Located in the United States, at 3 (Mar. 10, 2014), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=59791&SearchText (“we urge the Commission to adopt the entire November Staff Advisory as Commission Policy”); see also, Comment Letter from Better Markets, Request for Comment on Application of Commission Regulations to Swaps Between Non-U.S. Swap Dealers and Non-U.S. Counterparties Involving Personnel or Agents of the Non-U.S. Swap Dealers Located in the United States, at 2-3 (Mar. 10, 2014), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=59792&SearchText.
[18] See Re-Proposed Rules at V.D.
[19] See Re-Proposed Rules at I.A., III.A., and IV.A.
[20] Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-64766, at 6-7 (June 29, 2011), available at http://www.sec.gov/rules/proposed/2011/34-64766.pdf.
[21] See Re-Proposed Rules at II.B.2.
[22] See id. at IV.E., VI.B.4.(a); Comment Letter from Better Markets, Request for Comment on Application of Commission Regulations to Swaps Between Non-U.S. Swap Dealers and Non-U.S. Counterparties Involving Personnel or Agents of the Non-U.S. Swap Dealers Located in the United States, at 2-3 (Mar. 10, 2014), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=59792&SearchText (“Allowing [front office derivatives activities within the U.S.] would create a gaping loophole whereby registered swap dealers would ensure that all such transactions be booked overseas, but otherwise handled in the U.S.”). The re-proposing release also reminds U.S. parent companies of their disclosures obligations with respect to their SBS transactions, especially those transactions that pose credit and operational risks that are material to a company’s financial well-being. See Re-Proposed Rules at V.D.
[23] See § 242.98(a)(1).
[24] According to one report, as of December 1, 2014, the CFTC has finalized 36 out of 43 required Title VII rulemakings, or 84%, while the SEC has only finalized ten out of 29 required Title VII rulemakings, or 35%. See Davis Polk & Wardwell LLP, Dodd-Frank Progress Report, at 6 (Dec. 1, 2014), available at http://www.davispolk.com/Dodd-Frank-Rulemaking-Progress-Report. On January 14, 2015, the Commission adopted two sets of rules requiring security-based swap data repositories to register with the SEC (Regulation SDR) and prescribing reporting and public dissemination requirements for security-based swap transaction data (Regulation SBSR). See SEC Press Release, SEC Adopts Rules to Increase Transparency in Security-Based Swap Market (Jan. 14, 2015), available at http://www.sec.gov/news/pressrelease/2015-6.html.
[25] See 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 http://www.sec.gov/rules/proposed/2010/34-63107.pdf; End-User Exception to Mandatory Clearing of Security-Based Swaps, Release No. 34-63556 (Dec. 15, 2010), available at http://www.sec.gov/rules/proposed/2010/34-63556.pdf; Registration and Regulation of Security-Based Swap Execution Facilities, Release No. 34-63825 (Feb. 2, 2011), available at http://www.sec.gov/rules/proposed/2011/34-63825.pdf; Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-64766 (June 29, 2011), available at http://www.sec.gov/rules/proposed/2011/34-64766.pdf; Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-65543 (Oct. 12, 2011), available at http://www.sec.gov/rules/proposed/2011/34-65543.pdf; 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 http://www.sec.gov/rules/proposed/2012/34-68071.pdf; 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 http://www.sec.gov/rules/proposed/2013/34-69490.pdf; Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information, Release No. 34-74245 (Feb. 11, 2015), available at http://www.sec.gov/rules/proposed/2015/34-74245.pdf.