Creating a Regulatory Infrastructure to Address the Lack of Transparency in the Security-Based Swap Market
Commissioner Luis A. Aguilar
Jan. 14, 2015
Today, the Commission considers rules that are designed to address the lack of transparency in the security-based swaps (SBS) market that substantially contributed to the 2008 financial crisis. These rules are the result of the Congressional mandate in the Dodd-Frank Act, which directed the SEC and the CFTC to create a regulatory framework to oversee this market.
The global derivatives market is huge, at an amount estimated to exceed $692 trillion worldwide—and more than $14 trillion represents transactions in SBS regulated by the SEC. The continuing lack of transparency and meaningful pricing information in the SBS market puts many investors at distinct disadvantages in negotiating transactions and understanding their risk exposures. In addition, as trillions of dollars have continued to trade in the OTC market, there is still no mandatory mechanism for regulators to obtain complete data about the potential exposure of individual financial institutions and the SBS market, in general.
To address this lack of transparency, the Commission issued two proposed rules in 2010. Unfortunately, it has been almost five years since these rules were proposed, resulting in an unacceptable delay in providing the protections mandated by Congress. In fact, so much time has passed that, of all the Commissioners sitting here today, I am the only Commissioner that was here when the Commission originally proposed these rules in 2010. I hope that today’s rule adoptions will be followed by the adoption of other needed rules in the very near future, so that we can begin to have appropriate regulatory oversight and achieve the transparency needed in the derivatives marketplace.
Let me now turn to today’s rulemakings:
- First, the Commission considers adopting final rules for Regulation SDR, which, among other things, governs the registration process for SBS data repositories (SDR); assigns duties, core principles, and data collection and maintenance obligations to SDRs; and requires them to designate a Chief Compliance Officer (CCO) with meaningful responsibilities.
- Second, the Commission considers adopting final rules for Regulation SBSR. These set of rules provide for the reporting of SBS information to registered SDRs and provide for the public dissemination of SBS transaction, volume, and pricing information.
- Finally, the Commission considers proposing additional amendments to Regulation SBSR to cover reporting for platforms, clearing agencies, bunched orders, and prime brokerage transactions.
Adoption of Regulation SDR
Let me first talk about Regulation SDR. These final rules establish the foundation for regulatory oversight of SBS data repositories by requiring them to register with the Commission and adhere to specific duties and responsibilities. The rules are designed to make available to the Commission relevant SBS data that will provide an accurate overview of the SBS market. This information should also help the Commission identify and monitor risks, and detect market manipulation, fraud, and other market abuses.
These final rules will help to enhance market transparency and regulatory oversight in a number of ways.
- First, by registering with the Commission, SDRs will be subject to Commission oversight through inspections and examinations that should enable the Commission to monitor risks to the financial markets.
Second, SDRs will be required to establish robust governance structures that, among other things, ensure effective internal controls, provide fair representation of market participants, provide for policies and procedures to prevent conflicts of interest, and provide for direct electronic access to the Commission.
Third, SDRs will be required to designate a CCO, and the final rules prescribe enumerated duties and responsibilities for the CCOs. Furthermore, the rules help to ensure the CCO’s independence and effectiveness. For example, the rules require that a majority of an SDR’s board approve the compensation, appointment, and removal of the CCO—rather than just approval by the CEO or some other senior officer. The Commission recognizes that permitting a senior officer to approve a CCO’s appointment and compensation may unnecessarily create conflicts of interest between the CCO and the senior officer, thereby hindering the CCO’s independence and effectiveness. The rules also require that a designated CCO prepare and sign a compliance report to be filed with the Commission, and certify, under penalty of law, that the compliance report is accurate and complete.
- Finally, similar to an existing rule under the Investment Company Act, the SDR rules include a provision that prohibits officers, directors, or employees of an SDR from lying to an SDR’s CCO in the performance of his or her duties and responsibilities.
One additional protection for SDRs also comes from the recent adoption of Regulation SCI. Although today’s rules do not specifically apply the recently-adopted Regulation SCI to SDRs, it is possible that SDRs will ultimately be covered by Regulation SCI, or by similar rules. For example, an SDR registered with the Commission that is affiliated with an SCI entity will need to comply with the requirements of Regulation SCI. Second, SDRs that are likely to register with the Commission will also likely be registered with the CFTC, and the CFTC has rules similar to Regulation SCI that would cover an SDR’s automated systems. Finally, as mentioned at the time Regulation SCI was adopted, the staff is expected to develop recommendations to expand Regulation SCI’s reach to other market participants. I expect SDRs to be part of that consideration. It is important to make sure that SDRs are covered by rules that provide the needed protections to our capital markets’ underlying technological infrastructure.
Adoption of Regulation SBSR
I will now turn to Regulation SBSR. These rules are designed to provide regulators with access to critical SBS transaction data by, among other things, specifying the information that needs to be reported or disseminated, establishing a reporting hierarchy, and enumerating duties for registered SDRs and market participants.
The Regulation SBSR rules signify a marked improvement from the current status quo, and will help address the lack of transparency in the SBS market, as well as improve investor protection and accountability.
- First, SDRs are required to establish and maintain robust policies and procedures to ensure complete, accurate, and transparent reporting and dissemination of SBS data.
- Second, the final rules plug a loophole for SBS transactions that are subject to recourse guarantee arrangements by clarifying that such arrangements are—in fact—covered by the rules. This will help prevent a U.S. parent company, for example, from structuring SBS transactions through its foreign affiliates to avoid the requirements of Regulation SBSR.
- Finally, the final rules set forth a reporting hierarchy that assigns the reporting duties to the party in the best position to discharge those duties, such as registered SBS dealers and major SBS participants, as well as specify information that SDRs must report, publicly disseminate, or make available to regulators. Moreover, the requirements under Rule 901(d) that reporting sides use trader IDs when reporting SBS information will help regulators detect and investigate suspected market manipulation and abusive trading practices that could disrupt the SBS market, such as trading activities similar to the London Whale debacle in 2012.
Regulation SBSR will also be the Commission’s first use of substituted compliance under Title VII, which, in the context of Regulation SBSR, would apply if at least one of the direct counterparties to the SBS transaction is either a non-U.S. person or a foreign branch. However, as stated in the recently adopted Cross-Border Definitions Release, any future determination on whether to allow substituted compliance will require mandatory public notice and comment. Therefore, at such future time as substituted compliance applications were to be considered, I encourage all relevant stakeholders to share their views with the Commission to ensure the protection of American investors.
Moreover, Regulation SBSR, as with Regulation SDR, envisions that the Commission will provide SDRs with detailed specifications of acceptable formats and taxonomies for the submission of SBS data. To ensure a transparent process, the staff from the Division of Economic and Risk Analysis and the Division of trading and Markets is developing an approach to provide public guidance and address the format and taxonomy issues in the very near future. I hope that the Commission will act on this guidance promptly, so the public will have a better understanding about the full requirements of these rules.
Although Regulation SBSR is a significant improvement over the status quo, there are areas where more is needed. First, the rules do not contemplate real-time reporting at this time. Although the Dodd-Frank Act allows real-time reporting for all SBS trades, the statute provides the Commission with discretion to specify the appropriate time delay for reporting block trades. However, at this time, the staff is unable to define what is, or is not, a block trade. Therefore, the rules provide, for now, that all SBS transactions may be reported up to 24 hours after the execution time. I am hopeful that the reporting time can be shortened. To that end, after the adoption of Regulation SBSR, the staff plans to study, among other things, SBS trade sizes, number of trades, price impact, and other market transactions, in order to prepare a recommendation for defining “block trades” and to determine the reporting timeframe for both block and non-block trades.
Defining block trades has proved difficult, but the definition and treatment of block trades is important to promote transparency and liquidity in the market for SBS. When preparing its recommendation for defining block trades, the Dodd-Frank Act requires that the Commission must take into consideration both the need for public disclosure and the effect on market liquidity. Balancing these two goals is a challenge. Some commenters have argued that if block trade data is made public too quickly, market participants may take advantage of a dealer’s urgent need to hedge its SBS trade by raising prices—and that, as a result, market liquidity would be reduced. Others argue, however, that dealers will be able to hedge block trades without any significant price distortion, even with reporting periods that are much shorter than previously proposed by the Commission.
Unfortunately, as mentioned earlier, the Commission staff currently lacks sufficient trade data to define block trades, and related thresholds, in a way that allows the Commission to anticipate reasonably the impact on market liquidity. Hopefully, the period during which the 24-hour reporting time is implemented will provide the Commission staff with the information it needs to recommend a proposed rule on block trades. Although it is disappointing that the Commission is unable to adopt final rules for block trades at this time, I am hopeful that the staff will develop a recommended definition that will achieve real-time reporting for all trades.
Proposed Rules and Amendments to Regulation SBSR
I will now turn to the amendments to Regulation SBSR that are also being proposed today. These rules would require that, among other things, trading platforms and clearing agencies report SBS data to a registered SDR, and prohibit registered SDRs from charging fees or imposing restrictions on users of the SBS transaction data that they are required to disseminate publicly.
The Regulation SBSR proposal also includes a new compliance schedule for Regulation SBSR that would delay reporting of SBS transactions. Specifically, the reporting of SBS data would be delayed until six months after SDRs begin registering with the Commission, and there would be an additional three months before public dissemination would be required. Among other reasons, the additional time is designed to give market participants time to undertake the necessary steps to link to SDRs and to capture and report information according to SDR specifications. This new proposed compliance schedule is more accelerated than the original proposal, because many of the SDRs likely to register with the Commission appear to be already up and running with the CFTC.
In conclusion, I support the adoption of Regulation SDR, the adoption of Regulation SBSR, and the proposed amendments to Regulation SBSR. These rulemakings signify another step forward in putting together a regulatory infrastructure to promote transparency in the opaque derivatives market, and to enable regulators to obtain data about the potential risk exposures of financial institutions and the financial markets. Clearly, however, there is still a lot of important work ahead to implement fully the Dodd-Frank Title VII mandate. It is my hope that we complete these mandated rulemakings as soon as possible in order to protect our economy, our financial markets, and our nation’s investors.
I thank the staff for their hard work on today’s rulemakings and on the others to come. Thank you.
 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), Pub. L. 111-203, § 410 (2010).
 According to one report, as of December 1, 2014, the CFTC (U.S. Commodity Futures Trading Commission) has 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 (Dec. 1, 2014), available at http://www.davispolk.com/Dodd-Frank-Rulemaking-Progress-Report.
 See, e.g., Bank for International Settlements, Semiannual OTC Derivatives Statistics at end of June 2014, Table 19: amounts outstanding of over-the-counter (OTC) derivatives, BIS Quarterly Review (Dec. 2014), available at http://www.bis.org/statistics/dt1920a.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 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.).
 Commissioner Luis A. Aguilar, Beginning to Shine a Light on the Opaque Derivatives Market: Defining Dealers and Major Participants in the Cross-Border Context (June 25, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370542163686; Commissioner Luis A. Aguilar, Working to Increase Transparency and Reduce Systemic Risks Caused by the Global Derivatives Market (May 1, 2013), available at http://www.sec.gov/News/Speech/Detail/Speech/1365171515904; Commissioner Luis A. Aguilar, Protecting our Economy Demands Adequate Capital and Margin Requirements for Security-Based Swaps (Oct. 17, 2012), available athttp://www.sec.gov/News/Speech/Detail/Speech/1365171491466; Commissioner Luis A. Aguilar, Bringing Transparency and Fair Dealing to the Market for Security-Based Swaps (June 29, 2011), available at http://www.sec.gov/news/speech/2011/spch062911laa.htm.
 See Security-Based Data Repository Registration, Duties, and Core Principles, SEC Release No. 34-_____ (January __, 2015), available at ________________________ (“SDR Final Rules”).
 See Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information, SEC Release No. 34-_____ (January __, 2015), available at ________________________ (“SBSR Final Rules”).
 See id.
 See Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information, SEC Release No. 34-_____ (January __, 2015), available at ________________________ (“SBSR Proposed Rules”).
 Currently, there are four swap data repositories provisionally registered with the CFTC—BSDR LLC, Chicago Mercantile Exchange Inc., DTCC Data Repository LLC, and ICE Trade Vault, LLC—and the Commission expects these entities to register with the Commission as SDRs. See supra note 5, SDR Final Rules at II.B.2.
 See supra note 5, SDR Final Rules at II.A.
 See id.
 See id., SDR Final Rules at VI.A. (Rule 13n-1 and Form SDR).
 See id., SDR Final Rules at VI.D. (Rules 13n-4 and 13n-5). SDRs will also be required, among other things, to preserve the confidentiality of trade information and provide direct electronic access to the Commission in a format that is readily accessible and usable. See id., SDR Final Rules at VI.D. and VI.E. (Rules 13n-5 and 13n-9).
 See id., SDR Final Rules at VI.D. (Rule 13n-11).
 See id.
 See id. SDRs will need to file the compliance report with its annual financial report.
 See Rule 38a-1(c) of the Investment Company Act of 1940 (“Undue influence prohibited. No officer, director, or employee of the fund, its investment adviser, or principal underwriter, or any person acting under such person's direction may directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the fund’s chief compliance officer in the performance of his or her duties under this section.”); Compliance Programs of Investment Companies and Investment Advisers, 68 FR 74714, at 74729 (Dec. 24, 2003), available at http://www.sec.gov/rules/final/ia-2204.pdf. This provision makes it unlawful to mislead, or interfere with, a firm’s CCO in the performance of his or her duties. See Final Rule: Compliance Programs of Investment Companies and Investment Advisers (Dec. 17, 2003), available at http://www.sec.gov/rules/final/ia-2204.htm. Specifically, in its adopting release, the Commission reasoned that it “added a provision to protect the chief compliance officer from undue influence by fund service providers seeking to conceal their or others’ non-compliance with the federal securities laws.” Id. Rule 38a-1(c) addresses a critical regulatory risk area. Indeed, in August 2013, the Commission brought its first ever enforcement action under Rule 38a-1(c) against a portfolio manager who forged documents and misled the firm’s CCO. SEC Press Release No. 2013-165, SEC Sanctions Colorado-Based Portfolio Manager for Forging Documents and Misleading Chief Compliance Officer (Aug. 27, 2013), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539791420.
 See supra note 5, SDR Final Rules at I.C. (Rule 13n-11(h)).
 See supra note 5, SDR Final Rules at VI.F.3.
 See supra note 19, Regulation Systems Compliance and Integrity (discussion on Indirect SCI Systems).
 Supra note 9. See supra note 5 at II.B.2.
 See, e.g., CFTC Rule 49.24, 17 CFR 49.24 (requiring, among other things, periodic, objective testing and review of a swap data repository’s automated systems, and notification to the CFTC of systems malfunctions, cyber-security incidents, and planned changes to automated systems); CFTC Rule 49.24(d), 17 CFR 49.24(d) (requiring, among other things, swap data repositories to have resources to generally enable resumption of swap data repositories’ operations by the next business day following a disruption); CFTC Rule 49.24(e), 17 CFR 49.24(e) (allowing the CFTC to designate a swap data repository as “critical,” which subjects the swap data repository to more stringent requirements); CFTC Rule 49.24(k), 17 CFR 49.24(k) (requiring swap data repositories, to the extent practicable, to coordinate and test their business continuity-disaster recovery plans with other entities, including swap execution facilities and derivatives clearing organizations, and to take into account the business continuity-disaster recovery plans of the swap data repositories’ utilities and other service providers).
 See SEC Commissioner Luis A. Aguilar, Statement at Open Meeting on Regulation SCI (Nov. 19, 2014), available at http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370543491121.
 See generally supra note 6, SBSR Final Rules (Rules 901, 902, 905, 906, and 907)
 See supra note 6, SBSR Final Rules at I.B. (Rule 907). In addition, SDRs are required to provide information to the Commission about SBS transactions, including information related to the timeliness, accuracy, and completeness of data reported to SDRs. See supra note 5,SDR Final Rules at VI.D.2. and supra note 6 SBSR Final Rules at (Rule 907(e)). These requirements will facilitate the Commission’s aggregation and analysis of SBS data to oversee and monitor the financial markets.
 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 SBS transaction. Under the SBSR Final Rules, the Commission is adopting a modified definition of “indirect counterparty” to clarify that the type of guarantor relationship that would cause a person to become an indirect counterparty for purposes of Regulation SBSR includes recourse guarantee arrangements. See supra note 6, SBSR Final Rules at II.B.3 (Rule 900(p); see also Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities, SEC Release No.72472 (June 25, 2014), available at http://www.sec.gov/rules/final/2014/34-72472.pdf (Cross-Border Definitions Release) (discussing recourse guarantees).
 See supra note 6, SBSR Final Rules at II, V.C., and VI (Rules 901 and 902).
 In early 2012, a trading desk of JPMorgan Chase and Company known as the Chief Investment Office executed transactions in synthetic credit derivatives that declined in value by at least $6.2 billion later in the year. Supra note 6, SBSR Final Rules II.B.3.b. (discussing Rule 901(d)(2)). According to a Senate report, these trades were “so large in size that they roiled world credit markets.” Report of the United States Senate Permanent Subcommittee on Investigations, JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses, p.1 (Mar. 15, 2013), available at http://www.hsgac.senate.gov/subcommittees/investigations/hearings/chase-whale-trades-a-case-history-of-derivatives-risks-and-abuses (last visited January 3, 2015).
 See supra note 6, SBSR Final Rules (Rule 908).
 See supra note 27, Cross-Border Definitions Release at § 240.0-13(h).
 See id., Cross-Border Definitions Release at § 240.0-13(h).
 See supra note 5, SDR Final Rules at VI.D.2.
 See id. at II.A., VI.D.2., and VI.E.
 See Section 13(m)(1) of the Securities Exchange Act of 1934.
 See supra note 6, SBSR Final Rules at I.D. (Rule 907).
 See id. at VII.
 The Commission staff’s analysis of post-trade transparency in the swap market concluded that post-trade transparency did not have any negative effect on liquidity and market activity in the swap market. See SEC Division of Trading and Markets and Division of Economic Risk Analysis Memorandum, Analysis of post-trade transparency under the CFTC regime (Oct. 17, 2014), available at http://www.sec.gov/comments/s7-34-10/s73410-183.pdf.
 See Section 13(m)(1)(E) of the Securities Exchange Act of 1934.
 See, e.g., Comment Letter from UBS Securities LLC, Implementation of Real-Time Reporting Requirements for Security-Based Swaps (File Number S7-34-10), p. 1 (Feb. 7, 2011), available at http://www.sec.gov/comments/s7-34-10/s73410-48.pdf.
 See, e.g., Comment Letter from Better Markets, Inc., Proposed Regulation SBSR — Reporting and Dissemination of Security-based Swap Information (File Number S7-34-10), p. 5 (Jan. 18, 2011), available at http://www.sec.gov/comments/s7-34-10/s73410-19.pdf.
 See supra note 8, SBSR Proposed Rules at II. (Rule 901).
 See id, SBSR Proposed Rules at VI. The proposing release also discussed the application of Regulation SBSR to prime brokerage transactions and guidance for the reporting and public dissemination of allocations of cleared SBS. See SBSR Proposed Rules at III and IV.
 See id., SBSR Proposed Rules at VII.
 See id., SBSR Proposed Rules at VII.B.
 See id., SBSR Proposed Rules at VII.B.
 Supra note 9.