May 1, 2013
Cross-Border Security-Based Swap Activities
SEC Open Meeting
May 1, 2013
The Dodd-Frank Act — In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Title VII of this Act established a comprehensive framework for regulating the over-the-counter derivatives market.
Under Title VII, the SEC has regulatory authority over a type of derivative known as security-based swaps, as well as certain intermediaries and major players in that market, known as security-based swap dealers and major security-based swap participants. The agency also has authority over certain entities that perform infrastructure functions within the security-based swap market, such as clearing agencies, execution facilities, and data repositories.
Security-Based Swaps — In general, a derivative is a financial instrument or contract, such as a swap, whose value is “derived” from an underlying asset such as a commodity, bond, or equity security. Derivatives provide a way to transfer risk related to the underlying assets between two counterparties. They are flexible products that can be designed to achieve almost any financial purpose.
A security-based swap is a swap tied to a single security, loan, or issuer of securities, a narrow-based security index, or the occurrence of certain events relating to an issuer of securities or the issuers of securities in a narrow-based security index.
The Security-Based Swap Market — The market in security-based swaps involves counterparties located in different countries whose activities frequently span the globe. Indeed, according to data analyzed by SEC staff, the majority of single-name U.S. reference security-based swap transactions by market participants involve one or more counterparties located abroad. In addition, some swaps may be negotiated and executed by persons located in two different countries and then booked in yet other countries.
Implementing Title VII in a Global Market — Regulating this market is challenging because of the global nature and the interconnectedness of this market. These characteristics mean that a market participant located in a foreign country can create concerns within the U.S. of the type addressed by the Dodd-Frank Act. To address these concerns, the U.S. and many other countries are at various stages in the implementation of their own derivatives regulatory reform efforts.
Once the major derivatives jurisdictions adopt regulations, market participants could be subject to multiple and overlapping regulatory regimes, potentially resulting in regulatory conflicts and duplications. This, in turn, could adversely affect liquidity and efficiency in the global security-based swap market.
An SEC webpage — http://www.sec.gov/swaps-chart/swaps-chart.shtml — depicts the regulatory regime for security-based swaps and details what happens as a transaction occurs.
The Framework of the Proposal
In light of these market realities, the proposal includes rules and interpretive guidance that, among other things, would inform parties to a security-based swap transaction which regulatory requirements apply when their transaction occurs in part within and in part outside the U.S.
Security-Based Swap Transactions Involving Activity Within the U.S. Generally Would Be Subject to U.S. Regulation
The proposal generally would subject security-based swap transactions to the requirements of Title VII if they are entered into with a U.S. person or otherwise conducted within the U.S. However, under the proposal, a party may have the ability to instead comply with SEC requirements by complying with some or all of the requirements of a foreign regulatory regime, provided that those requirements have been determined by the Commission to achieve comparable regulatory outcomes.
In addition, the proposal would provide interpretive guidance regarding when a particular market infrastructure is required to register with the SEC.
The proposed rules and interpretive guidance reflect a territorial approach to application of Title VII requirements to security-based swap transactions.
Under this approach, Title VII requirements generally would apply:
- If the transaction is entered into with a U.S. person — The proposal would define the term “U.S. person” in a limited, territorial manner and would mean:
- Any natural person resident in the U.S.
- Any partnership, corporation, trust, or other legal person organized or incorporated under the laws of the U.S. or having its principal place of business in the U.S.
- Any account (whether discretionary or non-discretionary) of a U.S. person. Certain multinational financial organizations would not be treated as U.S. persons for purposes of Title VII, regardless of where they are organized or where their primary place of business is located.
Consistent with rules jointly adopted by the SEC and the CFTC regarding Title VII entity definitions, foreign branches of U.S. banks (and U.S. branches of foreign banks) would not be defined as separate legal persons for purposes of Title VII and therefore would have the same U.S.-person status of the bank’s home office. (As noted below, however, transactions conducted by U.S. banks through foreign branches would be treated, in many cases, similar to transactions conducted by non-U.S. persons.)
- Any natural person resident in the U.S.
- If the transaction is otherwise conducted within the United States — The proposal would define “transaction conducted within the United States” to mean any security-based swap transaction that is solicited, negotiated, executed, or booked within the U.S. by or on behalf of either counterparty to the transaction, regardless of the location, domicile, or residence status of either counterparty to the transaction.
Under the proposed approach, Title VII requirements generally would apply to transactions involving a person in the U.S. engaged in counterparty-facing activity, regardless of whether the transaction is booked in a U.S.-based or a foreign-based booking entity.
But a Party May Then Be Able to Substitute Foreign Regulatory Requirements for U.S. Requirements...
If Title VII requirements apply, market participants, under certain circumstances, may comply with foreign regulatory requirements in substitution for Title VII requirements. The proposal calls this approach “substituted compliance.”
- If foreign requirements are determined to be comparable to U.S. regulatory requirements …
Under substituted compliance, a foreign market participant would be permitted to comply with the requirements imposed by its own home country, so long as those requirements achieve regulatory outcomes comparable with the regulatory outcomes of the relevant provisions of Title VII. If the home country does not have any requirements that achieve comparable regulatory outcomes, substituted compliance would not be permitted and the foreign entity would be required to comply with the applicable U.S. requirements.
- In any of four categories ...
In making the comparability determination, the SEC would separately assess four distinct categories of Title VII requirements. If, for example, a foreign regulatory system achieves comparable regulatory outcomes in three out of the four categories, then the SEC would permit substituted compliance with respect to those three categories, but not for the one, non-comparable category. In other words, the Commission is not proposing an “all-or-nothing” approach.
The four categories are:
- Requirements applicable to registered non-U.S. security-based swap dealers.
- Requirements relating to regulatory reporting and public dissemination of security-based swap data.
- Requirements relating to mandatory clearing for security-based swaps.
- Requirements relating to mandatory trade execution for security-based swaps.
Under this proposal, a market participant or group of market participants could request a substituted compliance determination with respect to a particular category or categories of foreign regulatory requirements. Any determination to grant substituted compliance generally would be available to all market participants in the particular foreign jurisdiction.
- Requirements applicable to registered non-U.S. security-based swap dealers.
- Based on regulatory outcomes, not rule-by-rule comparisons…
In addition, under the proposal, in making the comparability determination, the Commission would take a holistic approach; that is, it would ultimately focus on whether the foreign regime achieves regulatory outcomes that are comparable to the regulatory outcomes of Title VII rather than basing the ultimate determination on a rule-by-rule comparison.
If the foreign regulatory regime does achieve comparable regulatory outcomes, the proposed approach provides that the Commission could make a substituted compliance determination, notwithstanding differences in granular requirements of particular regulatory categories.
Under the proposal, the Commission, on its own initiative, could modify the terms of, or withdraw, a substituted compliance determination, after appropriate notice and opportunity for comment. The Commission also would have the ability to periodically review the substituted compliance determinations it has granted and decide whether the substituted compliance determination should continue to apply.
Highlights of the Proposal
The proposal and interpretive guidance would address, among other things:
When is a non-U.S. person required to register with the Commission as a Security-Based Swap Dealer?
Conducting the De Minimis Calculation — In 2012, the SEC and the CFTC jointly adopted rules indicating that a security-based swap dealer would be required to register with the Commission if its notional amount of dealing transactions conducted in the past 12 months exceeded a de minimis level.
This proposal would require foreign dealers, in determining whether they have exceeded this de minimis amount, generally to count only dealing activity:
- Conducted with U.S. persons.
- Conducted within the U.S.
However, a non-U.S. person would not be required to include in this calculation its security-based swap dealing transactions with foreign branches of U.S. banks. By contrast, the proposal would require U.S. persons to count all of their security-based swap transactions toward the de minimis threshold.
Guaranteed Non-U.S. Dealer Affiliates — Under the proposal, a non-U.S. person that receives a guarantee from a U.S. person on its performance on security-based swaps would not be required to count its dealing transactions with non-U.S. persons outside the United States toward its de minimis threshold.
Aggregating Transactions Involving Dealing Activity of Affiliates — In 2012, the SEC and the CFTC jointly adopted a rule providing that persons engaged in dealing activity would be required to aggregate certain security-based swap dealing transactions of their commonly controlled affiliates. This proposal would clarify that a person may exclude the dealing transactions of any commonly controlled affiliate that is registered with the Commission as a security-based swap dealer from its de minimis calculation, so long as the person’s security-based swap activities are operationally independent from those of its registered security-based swap dealer affiliate.
What regulatory requirements apply to a Security-Based Swap Dealer?
The proposal separates the requirements of a security-based swap dealer into two categories:
- Entity-level requirements, which apply to the security-based swap dealer as a whole (e.g., capital, margin, and risk management requirements).
- Transaction-level requirements, which apply to the security-based swap dealer’s individual security-based swap transactions (e.g., external business conduct requirements).
Under the proposal, registered foreign security-based swap dealers would be required to comply with:
- Entity-level requirements (although they may be able to substitute compliance with comparable requirements in a foreign jurisdiction).
- External business conduct requirements with respect to their U.S. business but not with respect to their foreign business (although they may be able to substitute compliance with comparable requirements in a foreign jurisdiction).
- Segregation requirements generally only with respect to transactions with counterparties who are U.S. persons.
Security-based swap dealers that are U.S. persons would be required to comply with all Title VII requirements, but U.S. banks that conduct security-based swap activity out of a foreign branch would not be required to comply with external business conduct requirements with respect to their foreign business. (The application of non-dealer-specific requirements to activity out of a foreign branch is addressed below.)
The proposal would define U.S. business:
- For non-U.S. persons, as any transaction entered into or offered to be entered into by or on behalf of the foreign security-based swap dealer, with a U.S. person (other than with a foreign branch of a U.S. bank), or any transaction conducted within the U.S.
- For U.S. persons, as any transaction by or on behalf of the U.S.-person security-based swap dealer, wherever it occurs, except for transactions conducted through a foreign branch of a U.S. bank with a non-U.S. person or another foreign branch of a U.S. bank.
The proposal would define foreign business for any security-based swap dealer to be any transactions that are not defined as U.S. business for that dealer.
When is a non-U.S. person required to register with the Commission as a Major Security-Based Swap Participant?
Conducting the Threshold Calculations — In 2012, the SEC and the CFTC jointly adopted rules indicating that a major security-based swap participant would be required to register with the SEC if its security-based swap positions exceed a defined substantial position or substantial counterparty exposure threshold.
The proposal would require that, when determining whether a person falls within the major security-based swap participant definition, a U.S. person consider all security-based swap transactions that it has entered into. A non-U.S. person, on the other hand, would consider only transactions that it has entered into with U.S. persons, including foreign branches of U.S. banks.
Attribution of Guaranteed Positions — A guarantee on a security-based swap allows a counterparty to demand that the person providing the guarantee perform the obligations of the guaranteed entity under the security-based swap. In 2012, the SEC and the CFTC jointly adopted interpretive guidance generally requiring persons to include in their calculations of the major security-based swap threshold any positions resulting from transactions that they guarantee.
The proposal provides interpretive guidance that certain security-based swaps guaranteed by U.S. persons and non-U.S. persons would be attributed for purposes of the major security-based swap participant threshold to the person providing that guarantee.
Under the proposed approach, guaranteed positions would be attributed as follows:
- A non-U.S. person that guarantees performance of the security-based swap obligations of a U.S. person would attribute to itself all of the U.S. person’s security-based swap positions that it guarantees.
- A non-U.S. person that guarantees performance on the security-based swap transactions of another non-U.S. person would attribute to itself only the guaranteed security-based swap positions arising from transactions with U.S. person counterparties.
- A U.S. person that guarantees performance of the security-based swap obligations of a non-U.S. person would attribute to itself all of that non-U.S. person’s security-based swap positions that it guarantees, regardless of whether the non-U.S. person’s positions arise from transactions with a U.S. person counterparty or a non-U.S. person counterparty.
Under the proposed approach, however, a guarantor would not be required to attribute to itself any guaranteed positions entered into by a non-U.S. person that is subject to Basel capital standards.
What regulatory requirements apply to a foreign Major Security-Based Swap Participant?
As with security-based swap dealers, Title VII subjects registered major security-based swap participants to both entity-level and transaction-level requirements. Under the proposed approach, foreign major security-based swap participants would be required to comply with the entity-level requirements.
The proposed approach would not require foreign major security-based swap participants to comply with the transaction-level requirements that are specific to major security-based swap requirements in their transactions with counterparties that are non-U.S. persons.
When does a transaction have to be reported, disseminated, cleared, or executed on a swap execution facility?
The proposal generally would require security-based swap transactions to be reported to a data repository if any of the following are counterparties to the transaction:
- A U.S. person.
- A non-U.S. person that receives a guarantee from a U.S. person.
- A registered security-based swap dealer. Security-based swap transactions that are conducted within the U.S. would also be required to be reported.
In addition, the proposal also generally would require compliance with public dissemination, clearing, and trade execution requirements for security-based swap transactions when:
- A counterparty is a U.S. person (including foreign branches of U.S. banks).
- A counterparty is a non-U.S. person that receives a guarantee from a U.S. person on its performance on security-based swaps.
- A transaction is conducted within the U.S. (subject to certain exceptions with respect to clearing and trade execution requirements).
However, under the proposed approach, these transaction-level requirements generally would not apply to transactions conducted outside the U.S. between:
- A foreign branch of a U.S. bank and an unregistered non-U.S. person that does not receive a guarantee from a U.S. person on its performance of its security-based swap obligations.
- A non-U.S. person that receives a guarantee from a U.S. person on its performance of its security-based swap obligations and an unregistered non-U.S. person that does not receive such a guarantee from a U.S. person.
- A non-U.S. person that is a registered security-based swap dealer and a non-U.S. person that does not receive a guarantee from a U.S. person on its performance of its security-based swap obligations.
- Two non-U.S. persons that are not registered security-based swap dealers and do not receive a guarantee from a U.S. person.
When do security-based swap infrastructures need to register?
Under Title VII, the new regulatory regime would include a number of market infrastructures, such as security-based swap clearing agencies, execution facilities, and data repositories.
The proposal would provide a rule and interpretive guidance regarding when entities that perform these infrastructure functions would be required to register with the Commission. The proposed guidance generally would take a territorial approach to registration, requiring each entity to determine whether it performs the relevant infrastructure function within the U.S.
The focus of this analysis for each type of entity would include, among other things, the following:
- Clearing agencies — Whether they have one or more U.S. persons as members.
- Swap execution facilities — Whether they provide U.S. persons, or non-U.S. persons located in the U.S., with the direct ability to trade or execute security-based swaps on the foreign security-based swap market.
- Swap data repositories — Whether they receive security-based swap data from U.S. persons, and whether they operate within the U.S.
The proposal also provides interpretive guidance regarding availability of exemptions for non-resident infrastructure entities when, among other things, they are subject to comparable regulation in their home countries.
When would a data repository be able to turn over data without requiring an indemnification agreement from the requesting regulator?
Under Title VII, any government agency — foreign or domestic — that seeks information from a security-based swap data repository must first provide the data repository with an indemnification agreement. The agreement would ensure that, if sued, the data repository could be reimbursed by the requesting government agency for any expenses arising from litigation relating to the information.
The proposal would enable the data repository to waive the indemnification requirement if:
- The requesting authority seeks security-based swap information from the security-based swap data repository to fulfill its regulatory mandate or legal responsibility.
- The authority’s request pertains to a person or financial product subject to its jurisdiction, supervision, or oversight.
- The requesting authority has entered into a supervisory and enforcement memorandum of understanding or other arrangement with the SEC that addresses the confidentiality of the security-based swap information provided and any other matters as determined by the Commission.
The comment period for the proposed rules and interpretive guidance will last for 90 days after their publication in the Federal Register.
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