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Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital and Segregation Requirements for Broker-Dealers

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Start Preamble Start Printed Page 43872

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), the Securities and Exchange Commission (“Commission”), pursuant to the Securities Exchange Act of 1934 (“Exchange Act”), is adopting capital and margin requirements for security-based swap dealers (“SBSDs”) and major security-based swap participants (“MSBSPs”), segregation requirements for SBSDs, and notification requirements with respect to segregation for SBSDs and MSBSPs. The Commission also is increasing the minimum net capital requirements for broker-dealers authorized to use internal models to compute net capital (“ANC broker-dealers”), and prescribing certain capital and segregation requirements for broker-dealers that are not SBSDs to the extent they engage in security-based swap and swap activity. The Commission also is making substituted compliance available with respect to capital and margin requirements under Section 15F of the Exchange Act and the rules thereunder and adopting a rule that specifies when a foreign SBSD or foreign MSBSP need not comply with the segregation requirements of Section 3E of the Exchange Act and the rules thereunder.

DATES:

Effective date: October 21, 2019.

Compliance date: The compliance date is discussed in section III.B of this release.

Start Further Info

FOR FURTHER INFORMATION CONTACT:

Michael A. Macchiaroli, Associate Director, at (202) 551-5525; Thomas K. McGowan, Associate Director, at (202) 551-5521; Randall W. Roy, Deputy Associate Director, at (202) 551-5522; Raymond Lombardo, Assistant Director, at 202-551-5755; Sheila Dombal Swartz, Senior Special Counsel, at (202) 551-5545; Timothy C. Fox, Branch Chief, at (202) 551-5687; Valentina Minak Deng, Special Counsel, at (202) 551-5778; Rose Russo Wells, Senior Counsel, at (202) 551-5527; or Nina Kostyukovsky, Special Counsel, at (202) 551-8833, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-7010.

End Further Info End Preamble Start Supplemental Information

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Background

B. Overview of the New Requirements

1. Capital Requirements

2. Margin Requirements for Non-Cleared Security-Based Swaps

3. Segregation Requirements

4. Alternative Compliance Mechanism

5. Cross-Border Application

II. Final Rules and Rule Amendments

A. Capital

1. Introduction

2. Capital Rules for Nonbank SBSDs

3. Capital Rules for Nonbank MSBSPs

4. OTC Derivatives Dealers

B. Margin

1. Introduction

2. Margin Requirements for Nonbank SBSDs and Nonbank MSBSPs

C. Segregation

1. Background

2. Exemption

3. Segregation Requirements for Security-Based Swaps

D. Alternative Compliance Mechanism

E. Cross-Border Application of Capital, Margin, and Segregation Requirements

1. Capital and Margin Requirements

2. Segregation Requirements

F. Delegation of Authority

III. Explanation of Dates

A. Effective Date

B. Compliance Dates

C. Effect on Existing Commission Exemptive Relief

D. Application to Substituted Compliance

IV. Paperwork Reduction Act

A. Summary of Collections of Information Under the Rules and Rule Amendments

1. Rule 18a-1 and Amendments to Rule 15c3-1

2. Rule 18a-2

3. Rule 18a-3

4. Rule 18a-4 and Amendments to Rule 15c3-3

5. Rule 18a-10

6. Amendments to Rule 3a71-6

B. Use of Information

C. Respondents

D. Total Initial and Annual Recordkeeping and Reporting Burden

1. Rule 18a-1 and Amendments to Rule 15c3-1

2. Rule 18a-2

3. Rule 18a-3

4. Rule 18a-4 and Amendments to Rule 15c3-3

5. Rule 18a-10

6. Rule 3a71-6

E. Collection of Information Is Mandatory

F. Confidentiality

G. Retention Period for Recordkeeping Requirements

V. Other Matters

VI. Economic Analysis

A. Baseline

1. Market Participants

2. Counterparty Credit Risk Mitigation

3. Global Regulatory Efforts

4. Capital Regulation

5. Margin Regulation

6. Segregation

7. Historical Pricing Data

B. Analysis of the Final Rules and Alternatives

1. The Capital Rules for Nonbank SBSDs—Rules 15c3-1 and 18a-1

2. The Capital Rule for Nonbank MSBSPs—Rule 18a-2

3. The Margin Rule—Rule 18a-3

4. The Segregation Rules—Rules 15c3-3 and 18a-4

5. Cross-Border Application

6. Rule 18a-10

C. Implementation Costs

D. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency and Capital Formation

2. Competition

VII. Regulatory Flexibility Act Certification

VIII. Statutory Basis

I. Introduction

A. Background

Title VII of the Dodd-Frank Act (“Title VII”) established a new regulatory framework for the U.S. over-the-counter (“OTC”) derivatives markets.[1] Section 764 of the Dodd-Frank Act added Section 15F to the Exchange Act.[2] Section 15F(e)(1)(B) of the Exchange Act provides that the Commission shall prescribe capital and margin requirements for SBSDs and Start Printed Page 43873MSBSPs that do not have a prudential regulator (respectively, “nonbank SBSDs” and “nonbank MSBSPs”).[3] Section 763 of the Dodd-Frank Act added Section 3E to the Exchange Act.[4] Section 3E provides the Commission with the authority to establish segregation requirements for SBSDs and MSBSPs.[5] The Commission also has separate and independent authority under Section 15 of the Exchange Act to prescribe capital and segregation requirements for broker-dealers.[6]

Section 4s(e)(1)(B) of the CEA provides that the CFTC shall prescribe capital and margin requirements for swap dealers and major swap participants for which there is not a prudential regulator (“nonbank swap dealers” and “nonbank swap participants”).[7] Section 15F(e)(1)(A) of the Exchange Act provides that the prudential regulators shall prescribe capital and margin requirements for SBSDs and MSBSPs that have a prudential regulator (respectively, “bank SBSDs” and “bank MSBSPs”). Section 4s(e)(1)(A) of the CEA provides that the prudential regulators shall prescribe capital and margin requirements for swap dealers and major swap participants for which there is a prudential regulator (respectively, “bank swap dealers” and “bank swap participants”).[8] The prudential regulators have adopted capital and margin requirements for bank SBSDs and MSBSPs and for bank swap dealers and major swap participants.[9] The CFTC has adopted margin requirements and proposed capital requirements for nonbank swap dealers and major swap participants.[10] The CFTC also has adopted segregation requirements for cleared and non-cleared swaps.[11]

In October 2012, the Commission proposed: (1) Capital and margin requirements for nonbank SBSDs and MSBSPs, segregation requirements for SBSDs, and notification requirements relating to segregation for SBSDs and MSBSPs; and (2) raising the minimum net capital requirements and establishing liquidity requirements for ANC broker-dealers.[12] The Commission received a number of comment letters in response to the 2012 proposals.[13] In May 2013, the Commission proposed provisions regarding the cross-border treatment of security-based swap capital, margin, and segregation requirements.[14] The Commission received comments on these proposals as well.[15] In 2014, the Commission proposed an additional capital requirement for nonbank SBSDs that was inadvertently omitted from the 2012 proposals.[16]

Finally, in 2018, the Commission reopened the comment period and requested additional comment on the proposed rules and amendments (including potential modifications to proposed rule language).[17] Some commenters supported the reopening of the comment period as a means to help ensure that the final rules reflect current market conditions.[18] One commenter stated that the publication of the potential modifications to the proposed rule language provided important transparency in the development of this rulemaking.[19] Other commenters stated that the Commission did not provide them with an adequate basis upon which to comment, and argued that it was not possible to fully assess the potential modifications to the proposed rules without a full re-proposal.[20] The Commission disagrees. The potential modifications to the proposed rule language published in the release described how the rule text proposed in 2012 could be changed, including specific potential rule language. This approach provided the public with a meaningful opportunity to comment on potential modifications to the proposed rule text.

Today, the Commission is amending existing rules and adopting new rules. In particular, the Commission is amending existing rules 17 CFR 240.15c3-1 (“Rule 15c3-1”), 17 CFR Start Printed Page 43874240.15c3-1a (“Rule 15c3-1a”), 17 CFR 240.15c3-1b (“Rule 15c3-1b”), 17 CFR 240.15c3-1d (“Rule 15c3-1d”), 17 CFR 240.15c3-1e (“Rule 15c3-1e”), 17 CFR 240.15c3-3 (“Rule 15c3-3”) and adopting new Rules 15c3-3b, 18a-1, 18a-1a, 18a1b, 18a1c, 18a-1d, 18a-2, 18a-3, 18a-4, 18a-4a, and 18a-10. The amendments and new rules establish capital and margin requirements for nonbank SBSDs, including for: (1) Broker-dealers that are registered as SBSDs (“broker-dealer SBSDs”); [21] (2) broker-dealers that are registered as MSBSPs (“broker-dealer MSBSPs”); (3) nonbank SBSDs that are not registered as broker-dealers (“stand-alone SBSDs”); and (4) nonbank MSBSPs that are not registered as broker-dealers (“stand-alone MSBSPs”). They also establish segregation requirements for SBSDs and notification requirements with respect to segregation for SBSDs and MSBSPs. Further, the amendments provide that a nonbank SBSD that is also registered as an OTC derivatives dealer is subject to Rules 18a-1, 18a-1a, 18a-1b, 18a-1c, and 18a-1d rather than Rule 15c3-1 and its appendices.

The rule amendments also increase the minimum tentative net capital and net capital requirements for ANC broker-dealers. In addition to the new requirements for ANC broker-dealers, some of the amendments to Rules 15c3-1 and 15c3-3 apply to broker-dealers that are not registered as an SBSD or MSBSP (“stand-alone broker-dealers”) to the extent they engage in security-based swap activities.

Additionally, the Commission is amending its existing cross-border rule to provide a mechanism to seek substituted compliance with respect to the capital and margin requirements for foreign nonbank SBSDs and MSBSPs and providing guidance on how it will evaluate requests for substituted compliance.[22] The Commission is adopting rule-based requirements that address the application of the segregation requirements to cross-border security-based swap transactions.

The Commission also is amending its rules governing the delegation of authority to provide the staff with delegated authority to take certain actions with respect to some of the requirements.

The Commission is not adopting the proposed liquidity stress test requirements at this time.[23] Instead, the Commission continues to consider the comments received on those proposals.

The Commission staff consulted with the CFTC and the prudential regulators in drafting the final rules and amendments.

Finally, the Commission recognizes that the firms subject to the requirements being adopted today are operating in a market that continues to experience significant changes in response to market and regulatory developments. Given the global nature of the security-based swap and swap markets, the regulatory landscape will continue to shift as U.S. and foreign regulators continue to implement and/or modify relevant regulatory frameworks that apply to participants in these markets and to their transactions. For example, the CFTC has proposed but not yet finalized its own capital requirements that will apply to swap dealers, some of which will also likely be registered with the Commission as SBSDs. The Commission intends to monitor these developments during the period before the compliance date for these rules and may consider modifications to the requirements that it is adopting today as circumstances dictate, such as the need to further harmonize with other regulators to minimize the risk of unnecessary market fragmentation, or to address other market developments.[24]

In addition, the Commission intends to monitor the impact of the capital, margin, and segregation requirements being adopted today using data about the security-based swap and swap activities of stand-alone broker-dealers and SBSDs once they are subject to these requirements. The data will include the capital they maintain, the liquidity they maintain, the leverage they employ, the scale of their security-based swap and swap activities, the types and amounts of collateral they hold to address credit exposures, and the risk management controls they establish. The Commission may consider modifications to the requirements in light of these data.

B. Overview of the New Requirements

1. Capital Requirements

a. SBSDs

Broker-dealer SBSDs will be subject to the pre-existing requirements of Rule 15c3-1, as amended, to account for security-based swap and swap activities. Stand-alone SBSDs (including firms also registered as OTC derivatives dealers) will be subject to Rule 18a-1. Rule 18a-1 is structured similarly to Rule 15c3-1 and contains many provisions that correspond to those in Rule 15c3-1, as amended.

These rules prescribe minimum net capital requirements for nonbank SBSDs that are the greater of a fixed-dollar amount and an amount derived by applying a financial ratio. A broker-dealer SBSD must be an ANC broker-dealer (“ANC broker-dealer SBSD”) in order to use models to calculate market and credit risk charges in lieu of applying standardized deductions (also known as haircuts) for certain approved positions. An ANC broker-dealer, including an ANC broker-dealer SBSD, will be subject to a minimum fixed-dollar tentative net capital requirement of $5 billion and a minimum fixed-dollar net capital requirement of $1 billion. Stand-alone SBSDs that use models will be subject to a minimum fixed-dollar tentative net capital requirement of $100 million and a minimum fixed-dollar net capital requirement of $20 million. Broker-dealer and stand-alone SBSDs not authorized to use models will be subject to a fixed-dollar minimum net capital requirement of $20 million but will not be subject to a fixed-dollar tentative net capital requirement.

The financial ratio-derived minimum net capital requirement applicable to an ANC broker-dealer, including an ANC broker-dealer SBSD, and a broker-dealer SBSD not authorized to use models will be the amount computed using one of the two pre-existing (i.e., were part of the rule before today's amendments) financial ratios in Rule 15c3-1 plus an amount computed using a new financial ratio tailored specifically to the firm's security-based swap activities. This new financial ratio requirement is 2% of an amount determined by calculating the firm's exposures to its security-based swap customers (“2% margin factor”). A stand-alone SBSD will be subject to the 2% margin factor but will not be subject to either of the pre-existing financial ratios in Rule 15c3-1. The 2% margin factor multiplier will remain at 2% for 3 years after the compliance date of the Start Printed Page 43875rule. After 3 years, the multiplier could increase to not more than 4% by Commission order, and after 5 years the multiplier could increase to not more than 8% by Commission order if the Commission had previously issued an order raising the multiplier to 4% or less. The final rules further provide that the Commission will consider the capital and leverage levels of the firms subject to these requirements as well as the risks of their security-based swap positions and will provide notice before issuing an order raising the multiplier. This approach will enable the Commission to analyze the impact of the new requirement.

The following table summarizes the minimum net capital requirements applicable to nonbank SBSDs as of the compliance date of the rule.

Type of registrantRuleTentative net capitalNet capital
Fixed-dollarFinancial ratio
Stand-alone SBSD (not using internal models)18a-1N/A$20 million2% margin factor.
Stand-alone SBSD (using internal models)118a-1$100 million20 million2% margin factor.
Broker-dealer SBSD (not using internal models)15c3-1N/A20 million2% margin factor + Rule 15c3-1 ratio.
Broker-dealer SBSD (using internal models)15c3-1$5 billion1 billion2% margin factor + Rule 15c3-1 ratio.
1 Includes a stand-alone SBSD that also is an OTC derivatives dealer.

Nonbank SBSDs will compute net capital by first determining their net worth under U.S. generally accepted accounting principles (“GAAP”). Next, the firms will need to deduct illiquid assets and take other deductions from net worth, and may add qualified subordinated loans. The deductions will be the same as required under the pre-existing requirements of Rule 15c3-1.

In addition, the Commission is prescribing new deductions tailored specifically to security-based swaps and swaps. For example, stand-alone broker-dealers and nonbank SBSDs will be required to take a deduction for under-margined accounts because of a failure to collect margin required under Commission, CFTC, clearing agency, derivatives clearing organization (“DCO”), or designated examining authority (“DEA”) rules (i.e., a failure to collect margin when there is no exception from collecting margin). Nonbank SBSDs also will be required to take deductions when they elect not to collect margin pursuant to exceptions in the margin rules of the Commission and the CFTC for non-cleared security-based swaps and swaps, respectively. These deductions for electing not to collect margin must equal 100% of the amount of margin that would have been required to be collected from the security-based swap or swap counterparty in the absence of an exception (i.e., the size of the deduction will be computed using the standardized or model-based approach prescribed in the margin rules of the Commission or the CFTC, as applicable). These deductions can be reduced by the value of collateral held in the account after applying applicable haircuts to the value of the collateral. In addition, as discussed below, nonbank SBSDs authorized to use models may take credit risk charges instead of these deductions for electing not to collect margin under exceptions in the margin rules of the Commission and the CFTC for non-cleared security-based swaps and swaps.

After taking these deductions and making other adjustments to net worth, the amount remaining is defined as “tentative net capital.” The final steps a stand-alone broker-dealer or nonbank SBSD will need to take in computing net capital are: (1) To deduct haircuts (standardized or model-based) on their proprietary securities and commodity positions; and (2) for firms authorized to use models, to deduct credit risk charges computed using credit risk models.

The haircuts for proprietary securities and commodity positions will be determined using standardized or model-based haircuts. The standardized haircuts for positions—other than security-based swaps and swaps—generally are the pre-existing standardized haircuts required by Rule 15c3-1. With respect to security-based swaps and swaps, the Commission is prescribing standardized haircuts tailored to those instruments. In the case of a cleared security-based swap or swap, the standardized haircut is the applicable clearing agency or DCO margin requirement. For a non-cleared credit default swap (“CDS”), the standardized haircut is set forth in two grids (one for security-based swaps and one for swaps) in which the amount of the deduction is based on two variables: the length of time to maturity of the CDS contract and the amount of the current offered basis point spread on the CDS. For other types of non-cleared security-based swaps and swaps, the standardized haircut generally is the percentage deduction of the standardized haircut that applies to the underlying or referenced position multiplied by the notional amount of the security-based swap or swap.

Instead of applying these standardized haircuts, stand-alone broker-dealers and nonbank SBSDs may apply to the Commission to use a model to calculate market and credit risk charges (model-based haircuts) for their positions, including derivatives instruments such as security-based swaps and swaps. The application and approval process will be similar to the process used for stand-alone broker-dealers applying to the Commission for authorization to use models under the pre-existing provisions of Rules 15c3-1 and 15c3-1e (i.e., stand-alone broker-dealers applying to become ANC broker-dealers). If approved, the firm may compute market risk charges for certain of its proprietary positions using a model.

In addition, an ANC broker-dealer (including an ANC broker-dealer SBSD) and a stand-alone SBSD approved to use models for capital purposes can apply a credit risk charge with respect to uncollateralized exposures arising from derivatives instruments, including exposures arising from not collecting variation and/or initial margin pursuant to exceptions in the non-cleared security-based swap and swap margin rules of the Commission and CFTC, respectively. Consequently, these credit risk charges may be taken instead of the deductions described above when a nonbank SBSD does not collect variation and/or initial margin pursuant to exceptions in these margin rules.

In applying the credit risk charges, an ANC broker-dealer (including an ANC broker-dealer SBSD) is subject to a portfolio concentration charge that has a threshold equal to 10% of the firm's tentative net capital. Under the portfolio Start Printed Page 43876concentration charge, the application of the credit risk charges to uncollateralized current exposure across all counterparties arising from derivatives transactions is limited to an amount of the current exposure equal to no more than 10% of the firm's tentative net capital. The firm must take a charge equal to 100% of the amount of the firm's aggregate current exposure in excess of 10% of its tentative net capital. Uncollateralized potential future exposures arising from electing not to collect initial margin pursuant to exceptions in the margin rules of the Commission and the CFTC are not subject to this portfolio concentration charge. In addition, a stand-alone SBSD, including an SBSD operating as an OTC derivatives dealer, is not subject to a portfolio concentration charge with respect to uncollateralized current exposure. However, all these entities (i.e., ANC broker-dealers, ANC broker-dealer SBSDs, stand-alone SBSDs, and stand-alone SBSDs that also are registered as OTC derivatives dealers) are subject to a concentration charge for large exposures to single a counterparty that is calculated using the existing methodology in Rule 15c3-1e.[25]

The following table summarizes the entities that are subject to the portfolio concentration charge and/or the counterparty concentration charge.

Entity type (must be approved to use models)10% TNC portfolio concentration chargeCounterparty concentration charge
ANC broker-dealerYesYes.
ANC broker-dealer SBSDYesYes.
Stand-alone SBSDNoYes.
Stand-alone SBSD/OTC derivatives dealerNoYes.

Nonbank SBSDs also must comply with Rule 15c3-4. This rule will require them to establish, document, and maintain a system of internal risk management controls to assist in managing the risks associated with their business activities, including market, credit, leverage, liquidity, legal, and operational risks.

b. MSBSPs

Rule 18a-2 prescribes the capital requirements for stand-alone MSBSPs.[26] Under this rule, stand-alone MSBSPs must at all times have and maintain positive tangible net worth. The term “tangible net worth” is defined to mean the stand-alone MSBSP's net worth as determined in accordance with GAAP, excluding goodwill and other intangible assets. All MSBSPs must comply with Rule 15c3-4 with respect to their security-based swap and swap activities.

2. Margin Requirements for Non-Cleared Security-Based Swaps

a. SBSDs

Rule 18a-3 prescribes margin requirements for nonbank SBSDs with respect to non-cleared security-based swaps. The rule requires a nonbank SBSD to perform two calculations with respect to each account of a counterparty as of the close of business each day: (1) The amount of current exposure in the account of the counterparty (also known as variation margin); and (2) the initial margin amount for the account of the counterparty (also known as potential future exposure or initial margin). Variation margin is calculated by marking the position to market. Initial margin must be calculated by applying the standardized haircuts prescribed in Rule 15c3-1 or 18a-1 (as applicable). However, a nonbank SBSD may apply to the Commission for authorization to use a model (including an industry standard model) to calculate initial margin. Broker-dealer SBSDs must use the standardized haircuts (which include the option to use the more risk sensitive methodology in Rule 15c3-1a) to compute initial margin for non-cleared equity security-based swaps (even if the firm is approved to use a model to calculate initial margin). Stand-alone SBSDs (including firms registered as OTC derivatives dealers) may use a model to calculate initial margin for non-cleared equity security-based swaps (and potentially equity swaps if portfolio margining is implemented by the Commission and the CFTC), provided the account of the counterparty does not hold equity security positions other than equity security-based swaps (and potentially equity swaps).

Rule 18a-3 requires a nonbank SBSD to collect collateral from a counterparty to cover a variation and/or initial margin requirement. The rule also requires the nonbank SBSD to deliver collateral to the counterparty to cover a variation margin requirement. The collateral must be collected or delivered by the close of business on the next business day following the day of the calculation, except that the collateral can be collected or delivered by the close of business on the second business day following the day of the calculation if the counterparty is located in another country and more than 4 time zones away. Further, collateral to meet a margin requirement must consist of cash, securities, money market instruments, a major foreign currency, the settlement currency of the non-cleared security-based swap, or gold. The fair market value of collateral used to meet a margin requirement must be reduced by the standardized haircuts in Rule 15c3-1 or 18a-1 (as applicable), or the nonbank SBSD can elect to apply the standardized haircuts prescribed in the CFTC's margin rules. The value of the collateral must meet or exceed the margin requirement after applying the standardized haircuts. In addition, collateral being used to meet a margin requirement must meet conditions specified in the rule, including, for example, that it must have a ready market, be readily transferable, and not consist of securities issued by the nonbank SBSD or the counterparty.

There are exceptions in Rule 18a-3 to the requirements to collect initial and/or variation margin and to deliver variation margin. A nonbank SBSD need not collect variation or initial margin from (or deliver variation margin to) a counterparty that is a commercial end user, the Bank for International Settlements (“BIS”), the European Stability Mechanism, or a multilateral development bank identified in the rule. Similarly, a nonbank SBSD need not collect variation or initial margin (or deliver variation margin) with respect to a legacy account (i.e., an account holding security-based swaps entered into prior to the compliance date of the rule). Further, a nonbank SBSD need not collect initial margin from a Start Printed Page 43877counterparty that is a financial market intermediary (i.e., an SBSD, a swap dealer, a broker-dealer, a futures commission merchant (“FCM”), a bank, a foreign broker-dealer, or a foreign bank) or an affiliate. A nonbank SBSD also need not hold initial margin directly if the counterparty delivers the initial margin to an independent third-party custodian. Further, a nonbank SBSD need not collect initial margin from a counterparty that is a sovereign entity if the nonbank SBSD has determined that the counterparty has only a minimal amount of credit risk.

The rule also has a threshold exception to the initial margin requirement. Under this exception, a nonbank SBSD need not collect initial margin to the extent that the initial margin amount when aggregated with other security-based swap and swap exposures of the nonbank SBSD and its affiliates to the counterparty and its affiliates does not exceed $50 million. The rule also would permit a nonbank SBSD to defer collecting initial margin from a counterparty for two months after the month in which the counterparty does not qualify for the $50 million threshold exception for the first time. Finally, the rule has a minimum transfer amount exception of $500,000. Under this exception, if the combined amount of margin required to be collected from or delivered to a counterparty is equal to or less than $500,000, the nonbank SBSD need not collect or deliver the margin. If the initial and variation margin requirements collectively or individually exceed $500,000, collateral equal to the full amount of the margin requirement must be collected or delivered.

The following table summarizes the exceptions in Rule 18a-3 from collecting initial and/or variation margin and from delivering variation margin.

ExceptionStatus of exception to collecting marginStatus of exception to delivering VM
VMIM
Commercial End UserNeed Not CollectNeed Not CollectNeed Not Deliver.
BIS or European Stability MechanismNeed Not CollectNeed Not CollectNeed Not Deliver.
Multilateral Development BankNeed Not CollectNeed Not CollectNeed Not Deliver.
Financial Market IntermediaryMust CollectNeed Not CollectMust Deliver.
AffiliateMust CollectNeed Not CollectMust Deliver.
Sovereign with Minimal Credit RiskMust CollectNeed Not CollectMust Deliver.
Legacy AccountNeed Not CollectNeed Not CollectNeed Not Deliver.
IM Below $50 Million ThresholdMust CollectNeed Not CollectMust Deliver.
Minimum Transfer AmountNeed Not CollectNeed Not CollectNeed Not Deliver.

Finally, nonbank SBSDs must monitor the risk of each account, and establish, maintain, and document procedures and guidelines for monitoring the risk.

MSBSPs

Rule 18a-3 also prescribes margin requirements for nonbank MSBSPs with respect to non-cleared security-based swaps. The rule requires a nonbank MSBSP to calculate variation margin for the account of each counterparty as of the close of each business day. The rule requires the nonbank MSBSP to collect collateral from (or deliver collateral to) a counterparty to cover a variation margin requirement. The collateral must be collected or delivered by the close of business on the next business day following the day of the calculation, except that the collateral can be collected or delivered by the close of business on the second business day following the day of the calculation if the counterparty is located in another country and more than 4 time zones away. Further, the variation margin must consist of cash, securities, money market instruments, a major foreign currency, the security of settlement of the non-cleared security-based swap, or gold. The rule has an exception pursuant to which the nonbank MSBSP need not collect variation margin if the counterparty is a commercial end user, the BIS, the European Stability Mechanism, or one of the multilateral development banks identified in the rule (there is no exception from delivering variation margin to these types of counterparties). The rule also has an exception pursuant to which the nonbank MSBSP need not collect or deliver variation margin with respect to a legacy account. Finally, there is a $500,000 minimum transfer amount exception to the collection and delivery requirements for nonbank MSBSPs.

3. Segregation Requirements

Section 3E(b) of the Exchange Act provides that, for cleared security-based swaps, the money, securities, and property of a security-based swap customer shall be separately accounted for and shall not be commingled with the funds of the broker, dealer, or SBSD or used to margin, secure, or guarantee any trades or contracts of any security-based swap customer or person other than the person for whom the money, securities, or property are held. However, Section 3E(c)(1) of the Exchange Act also provides, that for cleared security-based swaps, customers' money, securities, and property may, for convenience, be commingled and deposited in the same one or more accounts with any bank, trust company, or clearing agency. Section 3E(c)(2) further provides that, notwithstanding Section 3E(b), in accordance with such terms and conditions as the Commission may prescribe by rule, regulation, or order, any money, securities, or property of the security-based swaps customer of a broker, dealer, or security-based swap dealer described in Section 3E(b) may be commingled and deposited as provided in Section 3E with any other money, securities, or property received by the broker, dealer, or security-based swap dealer and required by the Commission to be separately accounted for and treated and dealt with as belonging to the security-based swaps customer of the broker, dealer, or security-based swap dealer.

Section 3E(f) of the Exchange Act establishes a program by which a counterparty to non-cleared security-based swaps with an SBSD or MSBSP can elect to have initial margin held at an independent third-party custodian (“individual segregation”). Section 3E(f)(4) provides that if the counterparty does not choose to require segregation of funds or other property (i.e., waives segregation), the SBSD or MSBSP shall send a report to the counterparty on a quarterly basis stating that the firm's back office procedures relating to margin and collateral requirements are in compliance with the agreement of the counterparties. The statutory provisions of Sections 3E(b) and (f) are self-executing.

The Commission is adopting segregation rules pursuant to which money, securities, and property of a Start Printed Page 43878security-based swap customer relating to cleared and non-cleared security-based swaps must be segregated but can be commingled with money, securities, or property of other customers (“omnibus segregation”). The omnibus segregation requirements for stand-alone broker-dealers and broker-dealer SBSDs are codified in amendments to Rule 15c3-3. The omnibus segregation requirements for stand-alone SBSDs (including firms registered as OTC derivatives dealers) and bank SBSDs are codified in Rule 18a-4.

The omnibus segregation requirements are mandatory with respect to money, securities, or other property relating to cleared security-based swaps that is held by a stand-alone broker-dealer or SBSD (i.e., customers cannot waive segregation). With respect to non-cleared security-based swap transactions, the omnibus segregation requirements are an alternative to the statutory provisions discussed above pursuant to which a counterparty can elect to have initial margin individually segregated or to waive segregation. However, under the final omnibus segregation rules for stand-alone broker-dealers and broker-dealer SBSDs codified in Rule 15c3-3, counterparties that are not an affiliate of the firm cannot waive segregation. Affiliated counterparties of a stand-alone broker-dealer or broker-dealer SBSD can waive segregation. Under Section 3E(f) of the Exchange Act and Rule 18a-4, all counterparties (affiliated and non-affiliated) to a non-cleared security-based swap transaction with a stand-alone or bank SBSD can waive segregation. The omnibus segregation requirements are the “default” requirement if the counterparty does not elect individual segregation or to waive segregation (in the cases where a counterparty is permitted to waive segregation). Rule 18a-4 also has exceptions pursuant to which a foreign stand-alone or bank SBSD or MSBSP need not comply with the segregation requirements (including the omnibus segregation requirements) for certain transactions.

Under the omnibus segregation requirements, an SBSD or stand-alone broker-dealer must maintain possession or control over excess securities collateral carried for the accounts of security-based swap customers. Generally, excess securities collateral means securities and money market instruments that are not being used to meet a variation margin requirement of the counterparty. In the context of security-based swap transactions, excess securities collateral means collateral delivered to the SBSD or stand-alone broker-dealer to meet an initial margin requirement of the counterparty as well as collateral held by the SBSD or stand-alone broker-dealer in excess of any applicable initial margin requirement (and that is not being used to meet a variation margin requirement). There are two exceptions under which excess securities collateral can be held in a manner that is not in the possession or control of the SBSD or stand-alone broker-dealer: (1) It is being used to meet a margin requirement of a clearing agency resulting from a cleared security-based swap transaction of the security-based swap customer; or (2) it is being used to meet a margin requirement of an SBSD resulting from the first SBSD or stand-alone broker-dealer entering into a non-cleared security-based swap transaction with the SBSD to offset the risk of a non-cleared security-based swap transaction between the first SBSD or broker-dealer and the security-based swap customer.

Under the omnibus segregation requirements, an SBSD or stand-alone broker-dealer must maintain a security-based swap customer reserve account to segregate cash and/or qualified securities in an amount equal to the net cash owed to security-based swap customers. The SBSD or stand-alone broker-dealer must at all times maintain, through deposits into the account, cash and/or qualified securities in amounts computed weekly in accordance with the formula set forth in Rules 15c3-3b or 18a-4a. In the case of a broker-dealer SBSD or stand-alone broker-dealer, this account must be separate from the reserve accounts the firm maintains for “traditional” securities customers and other broker-dealers under pre-existing requirements of Rule 15c3-3.

The formula in Rules 15c3-3b and 18a-4a is modeled on the pre-existing reserve formula in Exhibit A to Rule 15c3-3 (“Rule 15c3-3a”). The security-based swap customer reserve formula requires the SBSD or stand-alone broker-dealer to add up various credit items (amounts owed to security-based swap customers) and debit items (amounts owed by security-based swap customers). If, under the formula, credit items exceed debit items, the SBSD or stand-alone broker-dealer must maintain cash and/or qualified securities in that net amount in the security-based swap customer reserve account. For purposes of the security-based swap reserve account requirement, qualified securities are: (1) Obligations of the United States; (2) obligations fully guaranteed as to principal and interest by the United States; and (3) subject to certain conditions and limitations, general obligations of any state or a political subdivision of a state that are not traded flat and are not in default, are part of an initial offering of $500 million or greater, and are issued by an issuer that has published audited financial statements within 120 days of its most recent fiscal year end.

With respect to non-cleared security-based swaps, Section 3E(f)(1)(A) of the Exchange Act provides that an SBSD and an MSBSP shall be required to notify a counterparty of the SBSD or MSBSP at the beginning of a non-cleared security-based swap transaction that the counterparty has the right to require the segregation of the funds or other property supplied to margin, guarantee, or secure the obligations of the counterparty. SBSDs and MSBSPs must provide this notice in writing to a duly authorized individual prior to the execution of the first non-cleared security-based swap transaction with the counterparty occurring after the compliance date of the rule. SBSDs also must obtain subordination agreements from a counterparty that affirmatively elects to have initial margin held at a third-party custodian or that waives segregation. Finally, a stand-alone or bank SBSD will be exempt from the requirements of Rule 18a-4 if the firm meets certain conditions, including that the firm: (1) Does not clear security-based swap transactions for other persons; (2) provides notice to the counterparty regarding the right to segregate initial margin at an independent third-party custodian; (3) discloses to the counterparty in writing that any collateral received by the SBSD will not be subject to a segregation requirement; and (4) discloses to the counterparty how a claim of the counterparty for the collateral would be treated in a bankruptcy or other formal liquidation proceeding of the SBSD.

4. Alternative Compliance Mechanism

The Commission is adopting an alternative compliance mechanism in Rule 18a-10 pursuant to which a stand-alone SBSD that is registered as a swap dealer and predominantly engages in a swaps business may elect to comply with the capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of complying with Rules 18a-1, 18a-3, and 18a-4. In order to qualify to operate pursuant to Rule 18a-10, the stand-alone SBSD cannot be registered as a broker-dealer or an OTC derivatives dealer. Moreover, in addition to other conditions, the aggregate gross notional amount of the firm's security-based swap positions must not exceed the lesser of a maximum fixed-dollar amount or 10% of the combined Start Printed Page 43879aggregate gross notional amount of the firm's security-based swap and swap positions. The maximum fixed-dollar amount is set at a transitional level of $250 billion for the first 3 years after the compliance date of the rule and then drops to $50 billion thereafter unless the Commission issues an order: (1) Maintaining the $250 billion maximum fixed-dollar amount for an additional period of time or indefinitely; or (2) lowering the maximum fixed-dollar amount to an amount between $250 billion and $50 billion. The final rule further provides that the Commission will consider the levels of security-based swap activity of the stand-alone SBSDs operating under the alternative compliance mechanism and provide notice before issuing such an order.

5. Cross-Border Application

As adopted, the Commission is treating capital and margin requirements under Section 15F(e) of the Exchange Act and Rules 18a-1, 18a-2, and 18a-3 thereunder as entity-level requirements that are applicable to the entirety of the business of an SBSD or MSBSP. Foreign SBSDs and MSBSPs have the potential to avail themselves of substituted compliance to satisfy the capital and margin requirements under Section 15F of the Exchange Act and Rules 18a-1 and 18a-2, and 18a-3 thereunder. The segregation requirements are deemed transaction-level requirements and substituted compliance is not available for them. However, Rule 18a-4 has exceptions pursuant to which a foreign stand-alone or bank SBSD or MSBSP need not comply with the segregation requirements for certain transactions. There are no exceptions from the segregation requirements for cross-border transactions of a stand-alone broker-dealer or a broker-dealer SBSD or MSBSP.

II. Final Rules and Rule Amendments

A. Capital

1. Introduction

The Commission is adopting capital requirements for nonbank SBSDs and MSBSPs pursuant to Sections 15 and 15F of the Exchange Act. More specifically, the Commission is adopting amendments to Rule 15c3-1 and certain of its appendices to address broker-dealer SBSDs and the security-based swap activities of stand-alone broker-dealers. In addition, the Commission is adopting Rule 18a-1, Rules 18a-1a, 18a-1b, 18a-1c and 18a-1d to establish capital requirements for stand-alone SBSDs, including for stand-alone SBSDs that are also registered as OTC derivatives dealers. Rule 18a-1 and its related rules are structured similarly to Rule 15c3-1 and its appendices and contain many provisions that correspond to those in Rule 15c3-1 and its appendices.[27]

As discussed in the proposing release, Rule 15c3-1 imposes a net liquid assets test that is designed to promote liquidity within broker-dealers.[28] For example, paragraph (c)(2)(iv) of Rule 15c3-1 does not permit most unsecured receivables to count as allowable net capital. This aspect of the rule severely limits the ability of broker-dealers to engage in activities that generate unsecured receivables (e.g., as unsecured lending). The rule also does not permit fixed assets or other illiquid assets to count as allowable net capital, which creates disincentives for broker-dealers to own real estate and other fixed assets that cannot be readily converted into cash. For these reasons, Rule 15c3-1 incentivizes broker-dealers to confine their business activities and devote capital to activities such as underwriting, market making, and advising on and facilitating customer securities transactions.

Rule 15c3-1 permits a broker-dealer to engage in activities that are part of conducting a securities business (e.g., taking securities positions) but in a manner that leaves the firm holding at all times more than one dollar of highly liquid assets for each dollar of unsubordinated liabilities (e.g., money owed to customers, counterparties, and creditors). The objective of Rule 15c3-1 is to require a broker-dealer to maintain sufficient liquid assets to meet all liabilities, including obligations to customers, counterparties, and other creditors and to have adequate additional resources to wind-down its business in an orderly manner without the need for a formal proceeding if the firm fails financially.[29] The business of trading securities is one in which success, both for the firms and the investing public, is strongly dependent upon confidence, continuity, and commitment.[30] Generally, almost all trading-related liabilities are payable upon demand and represent a major portion of the firm's liabilities. Emphasis on liquidity helps to ensure that the liquidation of a firm will not result in excessive delay in repayment of the firm's obligations to customers, broker-dealers, and other creditors and therefore assures the continued liquidity of the securities markets. Rule 15c3-1 has been the capital standard for broker-dealers since 1975. Generally, the rule has promoted the maintenance of prudent levels of capital.[31]

Some commenters supported the Commission's proposal to model the nonbank SBSD capital requirements on the broker-dealer capital requirements. A commenter stated that separate standards for stand-alone broker-dealers and nonbank SBSDs would complicate the regulatory framework.[32] A second commenter argued that there should be no difference in the manner in which capital standards are applied to nonbank SBSDs, regardless of whether they are registered as broker-dealers or are affiliated with a bank holding company.[33] A third commenter expressed general support for the approach.[34]

Other commenters expressed concerns with regard to the proposed Start Printed Page 43880approach or encouraged the Commission to harmonize its final rules with those of international standard setters and domestic regulators that have finalized capital and margin requirements.[35] A commenter stated that the Commission's proposed approach would result in very different capital requirements for nonbank SBSDs as compared to nonbank swap dealers subject to CFTC oversight, and that this could potentially prevent entities from dually registering as nonbank SBSDs and swap dealers.[36] The commenter also stated that requiring a multi-registered entity—such as an entity registered as a broker-dealer, FCM, SBSD, and swap dealer—to calculate regulatory capital under the rules of both the Commission and the CFTC and adhere to the greater minimum requirement would provide a strong disincentive to seeking the operational and risk management efficiencies of a consolidated business entity, and would be anticompetitive.

Several commenters encouraged the Commission and CFTC to harmonize their proposed capital rules.[37] A commenter suggested that the Commission coordinate with the CFTC and, as appropriate, the prudential regulators to assure that each agency's respective capital rules are harmonized and do not have the unintended effect of impairing the ability of broker-dealers that are dually registered as FCMs to provide clearing services for security-based swaps and swaps.[38] Another commenter was concerned that the proposed capital requirements for nonbank SBSDs were not comparable to those proposed by other U.S. regulators and that modeling the proposed rules on the broker-dealer capital standard was not appropriate.[39] This commenter argued that the bank capital standard is risk-based, whereas the broker-dealer capital standard is transaction volume-based, and that SBSDs and swap dealers operate in the same markets with the same counterparties and should be subject to comparable capital requirements. Commenters also referenced Section 15F(e)(3)(D)(ii) of the Exchange Act, which provides that the Commission, the prudential regulators, and the CFTC “shall, to the maximum extent practicable, establish and maintain comparable minimum capital requirements. . . .” [40] One commenter argued that divergence of bank and nonbank regulation is leading to some migration of risk to nonbank broker-dealers.[41] A commenter suggested that to avoid undermining the de minimis exception for SBSDs or inhibiting hedging activities by broker-dealers not registered as SBSDs, the Commission should limit the application of the proposed amendments to Rule 15c3-1 to broker-dealers that register as SBSDs.[42] Another commenter stated that a positive tangible net worth test would be more appropriate for nonbank SBSDs.[43]

The Commission has made two significant modifications to the final capital rules for nonbank SBSDs that should mitigate some of these concerns raised by commenters. First, as discussed below in section II.A.2.b.v. of this release, the Commission has modified Rule 18a-1 so that it no longer contains a portfolio concentration charge that is triggered when the aggregate current exposure of the stand-alone SBSD to its derivatives counterparties exceeds 50% of the firm's tentative net capital.[44] This means that stand-alone SBSDs that have been authorized to use models will not be subject to this limit on applying the credit risk charges to uncollateralized current exposures related to derivatives transactions. This includes uncollateralized current exposures arising from electing not to collect variation margin for non-cleared security-based swap and swap transactions under exceptions in the margin rules of the Commission and the CFTC. The credit risk charges are based on the creditworthiness of the counterparty and can result in charges that are substantially lower than deducting 100% of the amount of the uncollateralized current exposure.[45] This approach to addressing credit risk arising from uncollateralized current exposures related to derivatives transactions is generally consistent with the treatment of such exposures under the capital rules for banking institutions.[46]

The second significant modification is an alternative compliance mechanism. As discussed below in section II.D. of this release, the alternative compliance mechanism will permit a stand-alone SBSD that is registered as a swap dealer and that predominantly engages in a swaps business to comply with the capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of complying with the Commission's capital, margin, and segregation requirements.[47] The CFTC's proposed capital rules for swap dealers that are FCMs would retain the existing capital framework for FCMs, which imposes a net liquid assets test similar to the existing capital requirements for stand-alone broker-dealers.[48] However, under the CFTC's proposed capital rules, swap dealers that are not FCMs would have the option of complying with: (1) A capital standard based on the capital rules for banks; (2) a capital standard based on the Commission's capital requirements in Rule 18a-1; or Start Printed Page 43881(3) if the swap dealer is predominantly engaged in non-financial activities, a capital standard based on a tangible net worth requirement.

The Commission acknowledges that under these two modifications a stand-alone SBSD will be subject to: (1) A capital standard that is less rigid than Rule 15c3-1 in terms of imposing a net liquid assets test (in the case of firms that will comply with Rule 18a-1); or (2) a capital standard that potentially does not impose a net liquid assets test (in the case of firms that will operate under the alternative compliance mechanism and, therefore, comply with the CFTC's capital rules). This will decrease the liquidity of these firms and therefore decrease their self-sufficiency. As a result, the risk that a stand-alone SBSD may not be able to self-liquidate in an orderly manner will be increased.

However, stand-alone SBSDs will engage in a more limited business than stand-alone broker-dealers and broker-dealer SBSDs. Thus, they will be less significant participants in the overall securities markets. For example, they will not be dealers in the cash securities markets or the markets for listed options and they will not maintain custody of cash or securities for retail investors in those markets. Given their limited role, the Commission believes that it is appropriate to more closely align the requirements for stand-alone SBSDs with the requirements of the CFTC and the prudential regulators. These modifications to more closely harmonize the rules are designed to address the concerns of commenters noted above about the potential consequences of imposing different capital standards. They also take into account Section 15F(e)(3)(D)(ii) of the Exchange Act, which provides that the Commission, the prudential regulators, and the CFTC “shall, to the maximum extent practicable, establish and maintain comparable minimum capital requirements . . .”

Notwithstanding the modification to Rule 18a-1 described above, the rule continues to be modeled in large part on the broker-dealer capital rule. For example, as is the case with Rule 15c3-1, most unsecured receivables (aside from uncollateralized current exposures relating to derivatives transactions) will not count as allowable capital. Moreover, fixed assets and other illiquid assets will not count as allowable capital. Consequently, stand-alone SBSDs subject to Rule 18a-1 (i.e., firms that do not operate under the alternative compliance mechanism) will remain subject to certain requirements modeled on requirements of Rule 15c3-1 that are designed to promote their liquidity.

Additionally, broker-dealer SBSDs will be subject to Rule 15c3-1 and the stricter (as compared to Rule 18a-1) net liquid assets test it imposes. For example, as discussed below in section II.A.2.b.v. of this release, Rule 15c3-1e, as amended, modifies the existing portfolio concentration charge so that it equals 10% of an ANC broker-dealer's tentative net capital (a reduction from 50% of the firm's tentative net capital).[49] Thus, the ability of these firms to apply the credit risk charges to uncollateralized current exposures arising from derivatives transactions will be more restricted. In addition, as discussed below, broker-dealer and stand-alone SBSDs will be subject to a 100% capital charge for initial margin they post to counterparties because, for example, the counterparty is subject to the margin rules of the CFTC or the prudential regulators.

Consequently, while the two modifications discussed above with respect to stand-alone SBSDs should mitigate commenters' concerns, there likely will be significant differences between the capital requirements for nonbank SBSDs and the capital requirements for bank SBSDs and bank and nonbank swap dealers. In this regard, the Commission has balanced the concerns raised by commenters about inconsistent requirements with the objective of promoting the liquidity of nonbank SBSDs. The Commission believes that the broker-dealer capital standard is the most appropriate alternative for nonbank SBSDs, given the nature of their business activities and the Commission's experience administering the standard with respect to broker-dealers. The objective of the broker-dealer capital standard is to protect customers and counterparties and to mitigate the consequences of a firm's failure by promoting the ability of these entities to absorb financial shocks and, if necessary, to self-liquidate in an orderly manner.

Moreover, certain operational, policy, and legal differences support the distinction between nonbank SBSDs and bank SBSDs. First, based on the Commission staff's understanding of the activities of nonbank dealers in the OTC derivatives markets, nonbank SBSDs are expected to engage in a securities business with respect to security-based swaps that is more similar to the dealer activities of broker-dealers than to the activities of banks, which—unlike broker-dealers—are in the business of making loans and taking deposits. Similar to stand-alone broker-dealers, nonbank SBSDs will not be lending or deposit-taking institutions and will focus their activities on dealing in securities (i.e., security-based swaps).

Second, existing capital standards for banks and broker-dealers reflect, in part, differences in their funding models and access to certain types of financial support. Those same differences also will exist between bank SBSDs and nonbank SBSDs. For example, in general, banks obtain much of their funding through customer deposits (a relatively inexpensive source of funding) and can obtain liquidity through the Federal Reserve's discount window. Broker-dealers do not—and nonbank SBSDs will not—have access to these sources of funding and liquidity. Consequently, in the Commission's judgment, the broker-dealer capital standard is the appropriate standard for nonbank SBSDs because it is designed to promote a firm's liquidity and self-sufficiency (in other words, to account for the lack of inexpensive funding sources that are available to banks, such as deposits and central bank support).

The rules governing ANC broker-dealers and OTC derivatives dealers currently contain provisions designed to address dealing in OTC derivatives by broker-dealers and, therefore, to some extent are tailored to address security-based swap activities of broker-dealers. However, as discussed below, the amendments to Rule 15c3-1 are designed to more specifically address the risks of security-based swaps and swaps and the potential for the increased involvement of broker-dealers in these markets.[50] Moreover, most stand-alone broker-dealers are not subject to Rules 15c3-1e and 15c3-1f and thus will need to take standardized haircuts in calculating their net capital. Therefore, in response to comments, the Commission believes it is appropriate for the amendments to Rule 15c3-1 to apply to broker-dealers irrespective of whether they are registered as SBSDs. This approach will establish requirements (such as standardized haircuts for security-based swaps) that are specifically tailored to security-based swap activities across all broker-dealers (i.e., broker-dealer SBSDs and stand-alone broker-dealers that engage in a de minimis level of security-based swap activities).

The Commission disagrees with the comment that the broker-dealer capital standard is not risk-based. The ratio-Start Printed Page 43882based minimum net capital requirement being adopted today is tied directly to the risk of the firm's customer exposures. Further, the standardized and model-based haircuts that will be used by nonbank SBSDs are tied directly to the market and credit risk of the firm's positions.

For these reasons, Rules 15c3-1, as amended, and 18a-1, as adopted, establish capital requirements for nonbank SBSDs that differ from the capital requirements adopted by the prudential regulators and certain of the capital requirements the CFTC proposed for nonbank swap dealers.[51] The Commission considered these alternative approaches in light of Section 15F(e)(3)(D)(ii) of the Exchange Act, which provides—as discussed above—that the Commission, prudential regulators, and the CFTC to the maximum extent practicable, establish and maintain comparable minimum capital requirements. However, as discussed above, the Commission believes that the capital requirements for nonbank SBSDs should take into account key differences between banks (which are lending institutions) and nonbank SBSDs (which will focus primarily on securities activities). Therefore, the Commission does not believe it would be appropriate to model the Commission's capital requirements for nonbank SBSDs on the bank capital standard.[52]

Further, the Commission does not believe it is necessary to apply a tangible net worth test to nonbank SBSDs, as suggested by a commenter. The CFTC proposed a tangible net worth requirement for swap dealers that are predominately engaged in non-financial activities (e.g., agriculture or energy) because of the potential that some of these entities may need to register as swap dealers due to their use of swaps as part of their non-financial activities.[53] The application of a broker-dealer-based or a bank-based capital approach to entities engaged in non-financial activities could result in inappropriate capital requirements that would not be proportionate to the risk associated with these types of firms. The Commission does not believe that entities predominantly engaged in non-financial activities are likely to deal in security-based swaps to an extent that would trigger registration with the Commission because, for example, the swap market is significantly larger than the security-based swap market and has many more active participants that are non-financial entities.[54] Moreover, a tangible net worth standard would not promote liquidity, as it treats all tangible assets equally, and therefore could incentivize a firm to hold illiquid but higher yielding assets.

Based on staff experience, it is expected that financial institutions will comprise a large segment of the security-based swap market as is currently the case and that these entities are more likely to have affiliates dedicated to OTC derivatives trading and affiliates that are broker-dealers registered with the Commission. Consequently, these affiliates—because their capital structures are geared towards securities trading or because they already are broker-dealers—will not face the types of practical issues that non-financial entities would face if they had to adhere to a capital standard modeled on the broker-dealer capital standard. In addition, many broker-dealers currently are affiliates of bank holding companies. Consequently, these broker-dealers are subject to Rule 15c3-1, while their parent and bank affiliates are subject to bank capital standards. For these reasons, the Commission does not believe it is necessary to adopt a different capital standard to accommodate entities that are predominantly engaged in non-financial activities as was proposed by the CFTC.[55]

The Commission acknowledges that not adopting the CFTC's proposed alternative-capital-standards approach could require nonbank SBSDs that are also registered with the CFTC as swap dealers to, in some cases, perform two different capital calculations. This could cause some firms to separate their nonbank SBSDs and their nonbank swap dealers into separate entities. For nonbank SBSDs that are predominantly swap dealers, the alternative compliance mechanism will avoid this outcome. In addition, the modification to Rule 18a-1 more closely aligns the treatment of uncollateralized current exposures arising from derivatives transactions with the treatment of such exposures under the bank capital rules. The Commission, however, does not believe it would be appropriate to further address this potential consequence by modifying its proposed capital requirements for nonbank SBSDs to permit firms to apply a bank capital standard or tangible net worth test for the reasons discussed above.

In response to commenters' requests that the Commission and CFTC work together and harmonize their respective capital rules, as appropriate, Commission staff has consulted with the CFTC, among others, in drafting the proposals and the amendments and rules being adopted today, and as discussed further below, has sought to make the Commission's capital rule more consistent with the CFTC's proposed capital rules, as appropriate.

For these reasons, the Commission is modeling the capital requirements for nonbank SBSDs on the broker-dealer capital standard in Rule 15c3-1, as Start Printed Page 43883proposed, but with the two significant modifications discussed above with respect to the capital requirements for stand-alone SBSDs.

The Commission is adopting a positive tangible net worth capital standard for stand-alone MSBSPs pursuant to Section 15F of the Exchange Act. As discussed in more detail below, the Commission did not receive comments that specifically objected to this standard for these entities.

2. Capital Rules for Nonbank SBSDs

a. Computing Required Minimum Net Capital

Rule 15c3-1 requires a broker-dealer to maintain a minimum level of net capital (meaning highly liquid capital) at all times. Paragraph (a) of the rule requires the broker-dealer to perform two calculations: (1) A computation of the minimum amount of net capital the broker-dealer must maintain; and (2) a computation of the amount of net capital the broker-dealer is maintaining. The minimum net capital requirement is the greater of a fixed-dollar amount specified in the rule and an amount determined by applying one of two financial ratios: The 15-to-1 aggregate indebtedness to net capital ratio (“15-to-1 ratio”) or the 2% of aggregate debit items ratio (“2% debit item ratio”). The Commission proposed that nonbank SBSDs be subject to similarly structured minimum net capital requirements that varied depending on the type of entity. More specifically, proposed Rule 18a-1 required a stand-alone SBSD not authorized to use internal models when computing net capital to maintain minimum net capital of not less than the greater of $20 million or 8% of the firm's “risk margin amount” as that term was defined in the rule.[56] The risk margin amount was calculated as the sum of:

  • The greater of: (1) The total margin required to be delivered by the stand-alone SBSD with respect to security-based swap transactions cleared for security-based swap customers at a clearing agency: Or (2) the amount of the deductions that would apply to the cleared security-based swap positions of the security-based swap customers pursuant to proposed Rule 18a-1; and
  • The total initial margin calculated by the stand-alone SBSD with respect to non-cleared security-based swaps pursuant to proposed Rule 18a-3.

The total of these two amounts—i.e., the risk margin amount—would be multiplied by 8% to determine the ratio-based minimum net capital requirement (“8% margin factor”). In the 2018 comment reopening, the Commission asked whether the input to the risk margin amount for cleared security-based swaps should be determined solely by the total initial margin required to be delivered by the nonbank SBSD with respect to transactions cleared for security-based swap customers at a clearing agency.[57]

Proposed Rule 18a-1 permitted a stand-alone SBSD to apply to the Commission to use model-based haircuts.[58] The rule required a stand-alone SBSD authorized to use models to maintain: (1) Minimum tentative net capital of not less than $100 million; and (2) minimum net capital of not less than the greater of $20 million or the 8% margin factor.[59] The proposed rule defined “tentative net capital” to mean, in pertinent part, the amount of net capital maintained by the nonbank SBSD before deducting haircuts (standardized or model-based) with respect to the firm's proprietary positions and, for firms authorized to use models, before deducting the credit risk charges discussed below in section II.A.2.b.v. of this release. The minimum tentative net capital requirement was designed to account for the fact that model-based haircuts, while more risk sensitive than standardized haircuts, tend to substantially reduce the amount of the deductions to tentative net capital in comparison to the standardized haircuts. It also was designed to account for the fact that models may miscalculate risks or not capture all risks (e.g., extraordinary losses or decreases in liquidity during times of stress that are not incorporated into the models).

The proposed amendments to Rule 15c3-1 established minimum net capital requirements for a broker-dealer SBSD not authorized to use model-based haircuts.[60] The proposed amendments required these entities to maintain minimum net capital equal of the greater of $20 million or the sum of: (1) The 8% margin factor; and (2) the amount of the financial ratio requirement that applied to the broker-dealer under pre-existing requirements in Rule 15c3-1 (i.e., either the 15-to-1 ratio or 2% debit item ratio).

Under Rule 15c3-1e, a broker-dealer must apply to the Commission for authorization to use the alternative net capital (ANC) computation that permits models to be used to compute haircuts and credit risk charges. Broker-dealers with that authorization—ANC broker-dealers—are subject to minimum net capital requirements specific to these entities. In particular, before today's amendments, paragraph (a)(7)(i) of Rule 15c3-1 required an ANC broker-dealer to maintain minimum tentative net capital of at least $1 billion and minimum net capital of at least $500 million. In addition, paragraph (a)(7)(ii) of Rule 15c3-1 required an ANC broker-dealer to provide the Commission with an “early warning” notice when its tentative net capital fell below $5 billion.

As proposed, a broker-dealer SBSD authorized to use models was subject to the minimum net capital requirements for an ANC broker-dealer, which the Commission proposed increasing.[61] Consequently, under the proposed amendments to Rule 15c3-1, an ANC broker-dealer, including an ANC broker-dealer SBSD, was required to maintain: (1) Tentative net capital of not less than $5 billion; and (2) net capital of not less than the greater of $1 billion, or the amount of the 15-to-1 ratio or 2% debit item ratio (as applicable) plus the 8% margin factor. The Commission also proposed increasing the early warning notification requirement for ANC broker-dealers from $5 billion to $6 billion.

The Commission explained in the proposing release that while raising the tentative net capital requirement under Rule 15c3-1 from $1 billion to $5 billion would be a significant increase, the existing early warning notice requirement for ANC broker-dealers was $5 billion.[62] This $5 billion “early warning” threshold acted as a de facto minimum tentative net capital requirement since ANC broker-dealers seek to maintain sufficient levels of tentative net capital to avoid the necessity of providing this regulatory notice. Accordingly, the objective in raising the minimum capital requirements for ANC broker-dealers was not to require the existing ANC broker-dealers to increase their current capital levels (as they already maintained tentative net capital in excess of $5 billion).[63] Rather, the goal Start Printed Page 43884was to establish new higher minimum requirements designed to ensure that the ANC broker-dealers continue to maintain high capital levels and that any new ANC broker-dealer entrants maintain capital levels commensurate with their peers.

Comments and Final Fixed-Dollar Minimum Net Capital Requirements

Some commenters expressed support for the proposed fixed-dollar minimum tentative net capital and net capital requirements. A commenter stated that the requirements were consistent with pre-existing requirements and practices for OTC derivatives dealers and ANC broker-dealers that have not proven to produce significant disparities with other capital regimes.[64] A second commenter stated that the proposal to require an ANC broker-dealer to provide notification to the Commission if the firm's tentative net capital fell below $6 billion would improve the Commission's monitoring of these key market participants.[65]

One commenter asked the Commission to reconsider the proposed $100 million minimum fixed-dollar tentative net capital requirement for stand-alone SBSDs authorized to use models, particularly for a nonbank SBSD that trades only in cleared security-based swaps.[66] The commenter stated that dealing in cleared security-based swaps should not implicate the same concerns about the use of models that led to the establishment of a higher threshold for other Commission registrants. The Commission believes that the same risks exist with respect to the use of models whether an SBSD is trading cleared or non-cleared security-based swaps. In particular, the minimum tentative net capital requirement is designed to address the possibility that the model might miscalculate risk irrespective of the relative level of risk of the positions (e.g., cleared versus non-cleared security-based swaps) being input into the model.

For these reasons, the Commission is adopting the proposed minimum fixed-dollar tentative net capital and net capital requirements as proposed as well as the $6 billion early warning notification requirement as proposed.[67] Consequently, under the final rules: (1) A stand-alone SBSD not approved to use internal models has a $20 million fixed-dollar minimum net capital requirement; [68] (2) a stand-alone SBSD authorized to use internal models (including a firm registered as an OTC derivatives dealer) has a $100 million fixed-dollar minimum tentative net capital requirement and a $20 million fixed-dollar minimum net capital requirement; [69] (3) a broker-dealer SBSD not authorized to use internal models has a $20 million fixed-dollar minimum net capital requirement; [70] and (4) an ANC broker-dealer, including an ANC broker-dealer SBSD, has a $6 billion fixed-dollar early warning notification requirement, a $5 billion fixed-dollar minimum tentative net capital requirement, and a $1 billion fixed-dollar minimum net capital requirement.[71]

Comments and Final Ratio-Based Minimum Net Capital Requirements

As noted above, the Commission proposed a ratio-based minimum net capital requirement that for a broker-dealer SBSD was the 15-to-1 ratio or 2% debit item ratio (as applicable) plus the proposed 8% margin factor, and for a stand-alone SBSD was only the proposed 8% margin factor.[72] Commenters raised concerns about the proposed 8% margin factor. One commenter suggested that the Commission require broker-dealer SBSDs to comply with a ratio that is modeled on the 2% debit item ratio in Rule 15c3-1.[73] Another commenter stated that a minimum capital requirement that is scalable to the volume, size, and risk of a nonbank SBSD's activities would be consistent with the safety and soundness standards mandated by the Dodd-Frank Act and the Basel Accords and would be comparable to the requirements established by the CFTC and the prudential regulators.[74] The commenter, however, expressed concerns that the proposed 8% margin factor was not appropriately risk-based.[75]

A commenter suggested that, if the proposed 8% margin factor is adopted, the Commission should exclude security-based swaps that are portfolio margined with swaps or futures in a CFTC-supervised account.[76] Another commenter believed that a broker-dealer dually registered as an FCM should be subject to a single risk margin amount calculated pursuant to the CFTC's rules, since the CFTC's proposed calculation incorporates both security-based swaps and swaps.[77] A commenter suggested modifying the proposed definition of “risk margin amount” to reflect the lower risk associated with central clearing by ensuring that capital requirements for cleared security-based swaps are lower than the requirements for equivalent non-cleared security-based swaps.[78]

Commenters also addressed the modifications to the proposed rule text in the 2018 comment reopening pursuant to which the input for cleared security-based swaps in the risk margin amount would be determined solely by reference to the amount of initial margin required by clearing agencies (i.e., not be the greater of those amounts or the amount of the haircuts that would apply to the cleared security-based swap positions). Some commenters supported the potential rule language modifications.[79] Other commenters Start Printed Page 43885opposed them.[80] One commenter opposing the modifications stated that the “greater of” provision creates a backstop to protect against the possibility that varying margin requirements across clearing agencies and over time could be insufficient to reflect the true risk to a nonbank SBSD arising from its customers' positions.[81] Another commenter stated that eliminating the haircut requirement may incentivize clearing agencies to compete on the basis of margin requirements.[82]

The Commission continues to believe a margin factor ratio is the right approach to setting a scalable minimum net capital requirement. The calculation is based on the initial margin required to be posted by an ANC broker-dealer or nonbank SBSD to a clearing agency for cleared security-based swaps and on the initial margin calculated by a nonbank SBSD for a counterparty for non-cleared security-based swaps.[83] Margin requirements generally are scaled to the risk of the positions, with riskier positions requiring higher levels of margin. Therefore, the amount of the ratio-based minimum net capital requirement will be linked to the volume, size, and risk of the firm's cleared and non-cleared security-based swap transactions.

However, in response to comments raising concerns about the potential impact of the proposed 8% margin factor, the Commission believes it would be appropriate to adopt, at least initially, a lower margin factor and create a process through which the percent multiplier can potentially (but not necessarily) be increased over time (i.e., starting at 2% and potentially transitioning from 2% to 8% or less over the course of at least 5 years). Initially using a 2% multiplier could provide ANC broker-dealers and nonbank SBSDs with time to adjust to the requirement if it incrementally increases. The final rule sets strict limits in terms of how quickly the multiplier can be raised and the amount by which it can be raised through the process in the rule because market participants should know when a potential increase in the multiplier using the process could first occur and how much the multiplier could be increased at that time or thereafter. The Commission's objective is to establish an efficient and flexible process, while providing market participants with notice about the potential timing and magnitude of an increase so that they can make informed decisions about how to structure their businesses.

Consequently, under the process set forth in the final rules, the percent multiplier will be 2% for at least 3 years after the compliance date of the rule.[84] After 3 years, the multiplier could increase to not more than 4% by Commission order, and after 5 years the multiplier could increase to not more than 8% by Commission order if the Commission had previously issued an order raising the multiplier to 4% or less. The process sets an upper limit for the multiplier of 8% (the day-1 multiplier under the proposed rules) and requires the issuance of two successive orders to raise the multiplier to as much as 8% (or an amount between 4% and 8%). The first order can be issued no earlier than 3 years after the compliance date of the rules, and the second order can be issued no earlier than 5 years after the compliance date.

The process in the final rules provides that, before issuing an order to raise the multiplier, the Commission will consider the capital and leverage levels of the firms subject to the ratio-based minimum net capital requirement as well as the risks of their security-based swap positions. After the rule is adopted, the Commission will gather data on how the ratio-based minimum net capital requirement using the 2% multiplier (“2% margin factor”) compares to the levels of excess net capital these firms maintain, the risks of their security-based swap positions, and the leverage they employ.[85] This information will assist the Commission in analyzing whether the ratio-based minimum net capital requirement is operating in practice as the Commission intends (i.e., a requirement that sets a prudent level of minimum net capital given the volume, size, and risk of the firm's security-based swap positions). In determining whether to issue an order raising the multiplier, the Commission may also consider, for example, whether further data is necessary to analyze the appropriate level of the ratio-based minimum net capital requirement.

Finally, the process in the final rules provides that the Commission will publish notice of the potential change to the multiplier and subsequently issue an order regarding the change. The Commission intends to provide such notice sufficiently in advance of the order for the public to be aware of the potential change.

As discussed above, a commenter suggested that broker-dealer SBSDs should be subject to a ratio that is modeled on the 2% debit item ratio in Rule 15c3-1. The Commission does not believe there is a compelling reason to adopt a different standard for broker-dealer SBSDs. The standard being adopted today is based on initial margin calculations for cleared and non-cleared security-based swaps. Modeling a requirement on the 2% debit item ratio would require a calculation based on the segregation requirements for security-based swaps. This could result in firms with similar risk profiles in terms of their customers' security-based swap positions having different minimum net capital requirements because for stand-alone SBSDs the requirement would be based on margin calculations and for ANC broker-dealers and broker-dealer SBSDs the requirement would be based on segregation requirements. The Commission believes the more prudent approach is to require all firms subject to this requirement to comply with the same standard in order to avoid the potential competitive impacts of imposing different standards, particularly when the rationale for applying the different standard advocated by the commenter is not grounded in promoting the safety and soundness of the firms.

Similarly, the Commission is not establishing two alternative methods for calculating the 2% margin factor—one for firms that use models and the other for firms that do not use models—as suggested by the commenter. To a certain extent, the 2% margin factor calculation by a nonbank SBSD authorized to use models to calculate initial margin requirements for non-cleared security-based swap transactions will be more risk sensitive than the calculation by nonbank SBSDs that will use the standardized approach to calculate initial margin (i.e., the standardized haircuts). Models generally are more risk sensitive and therefore will result in lower initial Start Printed Page 43886margin requirements than approaches using standardized haircuts. Thus, the firms that use models to calculate initial margin for non-cleared security-based swaps generally will employ a more risk-sensitive approach when calculating the 2% margin factor than firms that do not use models. Further, the Commission believes that most nonbank SBSDs will use models to calculate initial margin to the extent permitted under the final margin rules.

Moreover, a standard based on a firm's aggregate model-based haircuts—the commenter's first suggested alternative—could result in a substantially lower minimum net capital requirement. The Commission's approach requires the firm to calculate the risk margin amount using the initial margin amount calculated for each counterparty's cleared and non-cleared security-based swap positions. The commenter's alternative of using the model-based haircut calculations would net proprietary positions resulting in a lower minimum net capital requirement. The Commission believes the more prudent approach is to base the minimum net capital requirement on the margin calculations for each counterparty's security-based swap positions. For similar reasons, the Commission believes nonbank SBSDs not authorized to use models should base the calculation of the risk margin amount on the standardized margin calculations for their counterparties (rather than the standardized haircut calculation that can be taken for proprietary positions, which permits certain netting of long and short positions). This will be simpler and more consistent with the requirements of Rule 18a-3, as adopted, than the commenter's suggested credit quality approach for nonbank SBSDs that do not use models.

Moreover, as discussed below in section II.A.2.b.v. of this release, the final capital rules for ANC broker-dealers and nonbank SBSDs broaden the application of the credit risk charges as compared to the proposed rules. This should significantly reduce the amount of net capital an ANC broker-dealer or nonbank SBSD will need to maintain with respect to its security-based swap positions (as compared to the treatment of these positions under the proposed rules).[86] Therefore, the Commission believes that largely retaining the proposed approaches to calculating the risk margin amount (and, therefore, the 2% margin factor) is an appropriate trade-off to reducing the application of the capital deductions in lieu of margin.

In response to comments that the Commission exclude security-based swaps that are being portfolio margined under a CFTC-supervised account, the Commission will need to coordinate with the CFTC to implement portfolio margining.[87] A part of any such coordination would be to resolve the question of how to incorporate accounts that are portfolio margined into the minimum net capital requirements under the capital rules of the Commission and the CFTC.

In response to comments, the Commission does not believe it would be appropriate to treat cleared security-based swaps more favorably than non-cleared security-based swaps for purposes of calculating the 2% margin factor. The 2% margin factor is consistent with an existing requirement in the CFTC's net capital rule for FCMs.[88] Currently, FCMs must maintain adjusted net capital in excess of 8% of the risk margin on futures, foreign futures, and cleared swaps positions carried in customer and noncustomer accounts. Moreover, the CFTC has proposed a similar requirement for swap dealers and major swap participants registered as FCMs.[89] The CFTC's proposed minimum capital requirement is 8% of the initial margin for non-cleared swap and security-based swap positions, and the total initial margin the firm is required to post to a clearing agency or broker-dealer for cleared swap and security-based swap positions. Thus, the CFTC's proposed rule does not treat cleared positions more favorably than non-cleared positions (both are based on initial margin calculations).

However, in response to comments, the Commission has modified the final rule so that for cleared security-based swaps the calculation of the risk margin amount is based on the initial margin required to be posted to a clearing agency rather than the greater of that amount or the haircuts that would apply to the positions (as was proposed).[90] Thus, for purposes of the 2% margin factor, the risk of cleared security-based swaps is measured by the amount of initial margin the clearing agency's margin rule requires. This more closely aligns the Commission's rule with the CFTC's proposed rule (as requested by commenters).

In response to commenters who opposed this modification, the Commission recognizes that it will eliminate a component of the proposed rule that was designed to address the potential that clearing agencies might set margin requirements that were lower than the applicable haircuts that would apply to the positions. However, retaining the requirement could have created a disincentive to clear security-based swap transactions. Moreover, eliminating it will simplify the calculation and more closely align the requirement with the CFTC's proposed capital rule. The Commission has weighed these competing considerations and believes that the modification is appropriate.

The Commission does not believe further modifications to distinguish the risk of cleared security-based swaps from non-cleared security-based swaps are necessary. Cleared security-based swaps generally will be less complex than non-cleared security-based swaps. Further, cleared security-based swaps will be more liquid than non-cleared security-based swaps in terms of how long it will take to close them out. These attributes may factor into the margin calculations of the clearing agencies and, consequently, into the risk margin amount. Therefore, the potentially lower risk characteristics of cleared security-based swaps as compared to non-cleared security-based swaps could be incorporated into the 2% margin factor by virtue of relying solely on the clearing agency margin requirements.

For these reasons, the Commission is adopting the 2% margin factor with modifications to the term “risk margin amount” and the potential phase-in of the percent multiplier, as discussed above.[91] Stand-alone SBSDs will need to calculate the 2% margin factor to determine their ratio-based minimum net capital requirement. ANC broker-dealers and broker-dealer SBSDs will need to calculate the 2% margin factor and the 15-to-1 ratio or 2% debit item ratio (as applicable) to determine their ratio-based minimum net capital requirement.

b. Computing Net Capital

The Commission proposed the net liquid assets test embodied in Rule 15c3-1 as the regulatory capital Start Printed Page 43887standard for all nonbank SBSDs. The standard (maintaining net liquid assets) is imposed through the computation requirements set forth in paragraph (c)(2) of Rule 15c3-1, which defines the term “net capital.” The first step in a net capital calculation is to compute the broker-dealer's net worth under GAAP. Next, the broker-dealer must make certain adjustments to its net worth. These adjustments are designed to leave the firm in a position in which each dollar of unsubordinated liabilities is matched by more than a dollar of highly liquid assets.[92] There are fourteen categories of net worth adjustments, including adjustments resulting from the application of standardized or model-based haircuts.[93] The Commission proposed that a broker-dealer SBSD compute net capital pursuant to the pre-existing provisions in paragraph (c)(2) of Rule 15c3-1, as proposed to be amended, to account for security-based swap and swap activities, and that stand-alone SBSDs compute net capital in a similar manner pursuant to proposed Rule 18a-1.[94]

i. Deduction for Posting Initial Margin

If a stand-alone broker-dealer or nonbank SBSD delivers initial margin to a counterparty, it must take a deduction from net worth in the amount of the posted collateral.[95] The Commission recognizes that the imposition of this deduction could increase transaction costs for stand-alone broker-dealers and nonbank SBSDs.[96] Consequently, the Commission sought comment on whether it should provide a means for a firm to post initial margin to counterparties without incurring the deduction with respect to Rules 15c3-1 and 18a-1, under specified conditions. The potential conditions included that the initial margin requirement is funded by a fully executed written loan agreement with an affiliate of the firm and that the lender waives re-payment of the loan until the initial margin is returned to the firm.[97]

Several commenters expressed support for this general approach but suggested modifications. A commenter supported requiring no deduction if the posted initial margin is: (1) Subject to an agreement that satisfies the specified conditions, or (2) maintained at a third-party custodian in accordance with the recommendations the Basel Committee on Banking Supervision (“BCBS”) and the Board of the International Organization of Securities Commissions (“IOSCO”) made with respect to margin requirements for non-cleared derivatives (“BCBS/IOSCO Paper”).[98] Another commenter supported the policy behind the Commission's approach recognizing the role of an SBSD as a subsidiary of a larger banking organization, but recommended that the Commission evaluate whether inter-company liquidity and funding arrangements and loss absorbing capacity mandated by resolution planning guidance should be recognized as a second alternative to deductions for initial margin posted away.[99] This commenter also encouraged the Commission to reconcile its guidance with the CFTC's proposed capital rules, which do not require initial margin posted to a third-party custodian to be deducted from net worth in computing capital.[100] Finally, a commenter raised concerns regarding the potential guidance suggesting that the effect of the conditions would be to reduce the amount of capital SBSDs are required to hold, increasing risk.[101]

The Commission is providing the following interpretive guidance as to how a stand-alone broker-dealer or nonbank SBSD can avoid taking a deduction from net worth when it posts initial margin to a third party. Under the guidance, initial margin provided by a stand-alone broker-dealer or nonbank SBSD to a counterparty need not be deducted from net worth when computing net capital if:

  • The initial margin requirement is funded by a fully executed written loan agreement with an affiliate of the stand-alone broker-dealer or nonbank SBSD;
  • The loan agreement provides that the lender waives re-payment of the loan until the initial margin is returned to the stand-alone broker-dealer or nonbank SBSD; and
  • The liability of the stand-alone broker-dealer or the nonbank SBSD to the lender can be fully satisfied by delivering the collateral serving as initial margin to the lender.[102]

Stand-alone broker-dealers and nonbank SBSDs may apply this guidance to security-based swap and swap transactions.[103] In response to comments, the Commission does not believe this interpretive guidance will increase risk to a stand-alone broker-dealer or nonbank SBSD because the conditions require that an affiliate fund the initial margin requirement, resulting in no decrease to the capital of the broker-dealer or nonbank SBSD. In contrast, these conditions may decrease risks to a stand-alone broker-dealer or nonbank SBSD by making additional capital available to the firm for liquidity or other purposes, given that it will not need to use its own capital to fund the initial margin requirement of the counterparty. Further, the Commission does not believe that initial margin posted by a stand-alone broker-dealer or nonbank SBSD with respect to a swap transaction should be exempt from the firm's net capital requirements, since collateral posted away from the firm would not be available for other purposes, and, therefore, the firm's liquidity would be reduced. Finally, in response to comments, the Commission does not believe it would be appropriate at this time to permit a stand-alone broker-dealer or nonbank SBSD to look to collateral held by an affiliate as part of resolution planning as a means for the firm to avoid taking a deduction for initial margin posted to a counterparty. The collateral held by the affiliate may not be available to the stand-alone Start Printed Page 43888broker-dealer or nonbank SBSD, particularly in a time of market stress when it is most needed.

ii. Deductions for not Collecting Margin

The pre-existing provisions of paragraph (c)(2)(xii) of Rule 15c3-1 require a broker-dealer to take a deduction from net worth for under-margined accounts. The Commission proposed to amend Rule 15c3-1 to require a stand-alone broker-dealer or broker-dealer SBSD to take a deduction from net worth for the amount of cash required in the account of each security-based swap customer to meet a margin requirement of a clearing agency, DEA (such as FINRA), or the Commission to which the firm was subject, after application of calls for margin, marks to the market, or other required deposits which are outstanding one business day or less.[104] Proposed Rule 18a-1 had an analogous provision, although it did not refer to margin requirements of DEAs because stand-alone SBSDs will not be members of self-regulatory organizations (“SROs”) and therefore will not have a DEA.

These proposed under-margined account provisions required a stand-alone broker-dealer or nonbank SBSD to take a deduction from net worth when a customer or security-based swap customer did not meet a margin requirement of a clearing agency, DEA, or the Commission pursuant to a rule that applied to the stand-alone broker-dealer or nonbank SBSD after one business day from the date the margin requirement arises. The proposed deductions were designed to address the risk to stand-alone broker-dealers and nonbank SBSDs that arises from not collecting collateral to cover their exposures to counterparties. The Commission asked whether the deductions should also be extended to failing to collect margin required under margin rules for swap transactions that apply to a stand-alone broker-dealer or nonbank SBSD.[105]

The Commission also proposed deductions from net worth to address situations in which an account of a security-based swap customer is meeting all applicable margin requirements, but the margin requirements result in the collection of an amount of collateral that is insufficient to address the risk of the positions in the account.[106] The proposals separately addressed cleared and non-cleared security-based swaps.

For cleared security-based swaps, the Commission proposed a deduction that applied if a nonbank SBSD collects margin from a counterparty in an amount that is less than the deduction that would apply to the security-based swap if it was a proprietary position of the nonbank SBSD (i.e., the collected margin was less than the amount of the standardized or model-based haircuts, as applicable). This proposed requirement was designed to account for the risk of the counterparty defaulting by requiring the nonbank SBSD to maintain capital in the place of collateral in an amount that is no less than required for a proprietary position. It also was designed to ensure that there is a standard minimum coverage for exposure to cleared security-based swap counterparties apart from the individual clearing agency margin requirements, which could vary among clearing agencies and over time. In the 2018 comment reopening, the Commission asked whether this proposed rule should be modified to include a risk-based threshold under which the deduction need not be taken, and provided modified rule text to apply the deduction to cleared swap transactions.[107]

For non-cleared security-based swaps, the Commission proposed requirements that imposed deductions to address 3 exceptions in the nonbank SBSD margin requirements of proposed Rule 18a-3. Under these 3 exceptions, a nonbank SBSD would not be required to collect (or, in one case, hold) variation and/or initial margin from certain types of counterparties. Consequently, the Commission proposed deductions to serve as an alternative to collecting margin.

The first proposed deduction applied when a nonbank SBSD does not collect sufficient margin under an exception in proposed Rule 18a-3 for counterparties that are commercial end users. The second proposed deduction applied when the nonbank SBSD does not hold initial margin under an exception in proposed Rule 18a-3 for counterparties requiring that the collateral be segregated pursuant to Section 3E(f) of the Exchange Act. Section 3E(f) of the Exchange Act, among other things, provides that the collateral must be carried by an independent third-party custodian. Collateral held in this manner would not be in the physical possession or control of the nonbank SBSD, nor would it be capable of being liquidated promptly by the nonbank SBSD without the intervention of another party. Consequently, it would not meet the collateral requirements in proposed Rule 18a-3. The third proposed deduction applied when a nonbank SBSD does not collect sufficient margin under an exception in proposed Rule 18a-3 for legacy accounts (i.e., accounts holding security-based swap transactions entered into prior to the effective date of the rule). The Commission also sought comment on whether there should be deductions in lieu of margin for non-cleared swaps with commercial end users and counterparties that elect to have initial margin held at a third-party custodian as well as for non-cleared swaps in legacy accounts.[108]

In the 2018 comment reopening, the Commission provided potential rule language that would establish deductions in lieu of margin for non-cleared security-based swaps and swaps.[109] The amount of the deduction for non-cleared security-based swaps would be the initial margin calculated pursuant to proposed Rule 18a-3 (i.e., using the standardized haircuts in the nonbank SBSD capital rules or a margin model). The amount of the deduction for non-cleared swaps would be the standardized haircuts in the nonbank SBSD capital rules or the amount calculated using a margin model approved for purposes of proposed Rule 18a-3.

The Commission also asked in the 2018 comment reopening whether there should be an exception to taking the deduction for initial margin collateral held by an independent third-party custodian pursuant to Section 3E(f) of the Exchange Act or Section 4s(l) of the CEA under conditions that promote the SBSD's ability to promptly access the collateral if needed.[110] Specifically, the Commission sought comment on whether there should be such an exception under the following conditions: (1) The custodian is a bank; (2) the nonbank SBSD enters into an agreement with the custodian and the counterparty that provides the nonbank Start Printed Page 43889SBSD with the same control over the collateral as would be the case if the nonbank SBSD controlled the collateral directly; and (3) an opinion of counsel deems the agreement enforceable. In addition, the Commission stated it was considering providing guidance on ways a nonbank SBSD could structure the account control agreement to meet a requirement that the nonbank SBSD have the same control over the collateral as would be the case if the nonbank SBSD controlled the collateral directly.[111]

Comments and Final Requirements for Deductions for Under-Margined Accounts

As noted above, the Commission proposed a deduction from net worth for failing to collect margin required by a rule of a clearing agency, DEA, or the Commission that applied to the stand-alone broker-dealer or nonbank SBSD.[112] A commenter urged the Commission to permit firms a one-day grace period before the deduction would apply in the case of an under-margined account of an affiliate if the affiliate is subject to U.S. or comparable non-U.S. prudential regulation.[113] The commenter stated that applying an immediate deduction with respect to a security-based swap transaction with a regulated affiliate before there is operationally a means for transferring collateral to the SBSD would only serve to undermine beneficial risk management activities within a corporate group.

In response to the comment, the final margin rule being adopted today provides a nonbank SBSD or MSBSP an additional day (i.e., two business days) to collect required margin from a counterparty (including variation margin due from an affiliate) if the counterparty is located in a different country and more than 4 time zones away.[114] In addition, the exceptions for when nonbank SBSDs need not collect initial margin from a counterparty have been expanded.[115] For example, the financial market intermediary exception has been expanded so that it not only applies to counterparties that are SBSDs but also to other types of financial market intermediaries, including foreign and domestic banks and broker-dealers.[116] There also is an exception from collecting initial margin from affiliates.[117] In addition, the final margin rule includes an initial margin exception when the aggregate credit exposure of the nonbank SBSD and its affiliates to the counterparty and its affiliates is $50 million or less.[118] These modifications to the final margin rule should substantially mitigate the commenter's concerns, given that in many instances there will be no requirement to collect initial margin, and the timeframe for collecting margin has been lengthened for counterparties located in other countries when they are more than 4 time zones away.

Nonetheless, when margin is required by a rule that applies to an entity, it should be collected promptly.[119] Margin is designed to protect the stand-alone broker-dealer or nonbank SBSD from the consequences of the counterparty defaulting on its obligations. This deduction for failing to collect required margin will serve as an incentive for stand-alone broker-dealers and nonbank SBSDs to have a well-functioning margin collection system, and the capital needed to take the deduction will protect them from the consequences of the counterparty's default.

For the foregoing reasons, the Commission is adopting the deduction for under-margined accounts with the modification to include a deduction for failing to collect required margin with respect to swap transactions.[120] In addition, as discussed above, the Commission has modified Rule 18a-3 to permit an extra business day to collect margin from a counterparty that is located in another country and more than 4 time zones away. Further, it is possible that other margin requirements for security-based swaps and swaps may provide more than one business day to collect required margin.[121] Therefore, the final rules have been modified to provide that the deduction for uncollected margin can be reduced by calls for margin, marks to the market, or other required deposits which are outstanding within the required time frame to collect the margin, mark to the market, or other required deposits.[122] As proposed, the rules provided that the deduction could be reduced by calls for margin, marks to the market, or other required deposits which are outstanding one business day or less. Consequently, under the final rules, if the firm has sent the counterparty a margin call within the required time frame for collecting the margin, a stand-alone broker-dealer or nonbank SBSD can reduce the deduction for required margin that has not been collected from a counterparty by the amount of that call. If the counterparty does not post the margin within that time frame, the deduction must be taken.

Comments and Final Requirements for Deductions In Lieu of Margin for Cleared Transactions

As noted above, the Commission proposed a deduction from net worth that applied if a nonbank SBSD collects margin from a counterparty for a cleared security-based swap in an amount that is less than the deduction that would apply to the security-based swap if it was a proprietary position of the nonbank SBSD.[123] In the 2018 comment reopening, the Commission asked whether this proposal should be modified to include a risk-based threshold under which the proposed deduction need not be taken.[124]

A commenter stated that the requirement to take a deduction in lieu Start Printed Page 43890of margin with respect to cleared security-based swaps would “harm customers because it would provide an incentive for the collection of margin by SBSDs beyond the amount determined by the clearing agency.” [125] The commenter recommended that the Commission eliminate this proposed deduction. Several commenters stated that the Commission should address any concerns regarding clearing agency minimum margin requirements directly through its regulation of clearing agencies.[126] One commenter stated that the deduction could drive business to firms willing to incur the deduction instead of collecting sufficient margin.[127] The commenter believed that this would provide an advantage to the largest clearing firms possessing the greatest amount of excess net capital, thereby exacerbating concentration in the market for clearing services. Another commenter stated that a low margin level for cleared swaps should not be viewed as a deficiency of clearing models but as an advantage of central clearing.[128] This commenter stated that a threshold such as the one described in the 2018 comment reopening would not address the commenter's concerns and that the proposed deduction should be eliminated. Another commenter recommended that the Commission impose the cleared security-based swap deduction only to the extent it exceeds 1% of the SBSD's tentative net capital, consistent with the Commission's CDS portfolio margin exemption.[129] One commenter opposed the inclusion of a potential threshold in the final rule, believing it would reduce capital requirements and increase risk.[130] Some commenters opposed applying the proposed deduction to cleared swaps, arguing it would interfere with the CFTC's comprehensive regulation of cleared swaps margin requirements.[131] A commenter noted that client clearing markets in the United States are, in their current composition, dominated by CFTC-regulated swaps and believed that integration of Commission net capital rules with CFTC net capital rules is particularly important in the case of client clearing.[132]

The Commission is persuaded by commenters that the proposed deduction could provide an unintended advantage to the largest clearing firms and that potential issues regarding clearing agency and DCO minimum margin requirements may be addressed through direct regulation of clearing agencies and DCOs. Therefore, the Commission is eliminating the proposed deduction from the final rules. The CFTC did not propose a similar deduction related to clearing agency margin requirements. Therefore, eliminating this deduction from the final rules may result in the two agencies having more closely aligned capital requirements.

In response to comments that elimination of the proposed deduction will decrease capital requirements and increase risk, the Commission believes that existing requirements for clearing agencies and DCOs as well as the risk management requirements for nonbank SBSDs being adopted today will address the potential risk of a counterparty defaulting on a requirement to post margin for a cleared security-based swap or swap transaction. For example, since the issuance of the proposing release in 2012, the Commission has enhanced its clearing agency standards. More specifically, in 2016, the Commission adopted final rules to establish enhanced standards for the operation and governance of registered clearing agencies that meet the definition of “covered clearing agency.” [133] Under these rules, a covered clearing agency that provides central clearing services must establish, implement, maintain, and enforce written policies and procedures reasonably designed to, as applicable, cover its credit exposures to its participants by establishing a risk-based margin system that meets certain minimum standards prescribed in the rule.[134] The CFTC also has adopted enhanced requirements for systemically important DCOs.[135] In addition, nonbank SBSDs must establish and maintain a risk management control system that complies with Rule 15c3-4. This rule requires that the system address various risks, including credit risk. Consequently, nonbank SBSDs will need to have risk management systems designed to mitigate the risk of a counterparty defaulting on a requirement to post margin for a cleared security-based swap or swap transaction.

For the foregoing reasons, the Commission believes it is appropriate to eliminate from the final rules the deductions related to the margin requirements for cleared security-based swap and swap transactions.

Comments and Final Requirements for Deductions In Lieu of Margin for Non-Cleared Transactions

As noted above, the Commission proposed deductions from net worth in lieu of margin for non-cleared security-based swaps, and sought comment on whether these proposed deductions should be expanded to include non-cleared swaps.[136] In the 2018 comment reopening, the Commission provided potential rule language that would establish deductions in lieu of margin for non-cleared security-based swaps and swaps.[137] The amount of the deduction for non-cleared security-based swaps would be the initial margin calculated pursuant to proposed Rule 18a-3 (i.e., using the standardized haircuts in the nonbank SBSD capital rules or a margin model approved for the purposes of Rule 18a-3). The amount of the deduction for non-cleared swaps would be the standardized haircuts in the nonbank SBSD capital rules or the amount calculated using a margin model approved for the purposes of proposed Rule 18a-3.

Comments on these matters generally fell into one of 3 categories: (1) Comments requesting or supporting the ability to apply credit risk charges instead of these deductions for a broader range of counterparties than only commercial end users; (2) comments objecting to the deduction when counterparties elect to have initial margin held at a third-party custodian and suggesting modifications to the potential exception to avoid the deduction; and (3) comments objecting to the deduction for legacy accounts and requesting the ability to use credit risk charges for these accounts.

As discussed in more detail below, the Commission is adopting the proposed deductions in lieu of margin for non-cleared security-based swap and swap transactions, but with two significant modifications that are designed to address the concerns raised by commenters. First, as discussed Start Printed Page 43891below in section II.A.2.b.v. of this release, the Commission has expanded the circumstances under which a nonbank SBSD authorized to use models may apply credit risk charges instead of taking the deduction in lieu of margin.[138] Under the final rules, the credit risk charges may be applied when the nonbank SBSD does not collect variation or initial margin subject to any exception in Rule 18a-3 or the margin rules of the CFTC with respect to non-cleared security-based swap and swap transactions, respectively. However, an ANC broker-dealer SBSD is subject to a portfolio concentration charge with respect to uncollateralized current exposure (including current exposure resulting from not collecting variation margin) equal to 10% of the firm's tentative net capital.[139] A stand-alone SBSD is not subject to a portfolio concentration charge.[140]

Second, the Commission has added a provision in the final rule that allows a nonbank SBSD to treat initial margin with respect to a non-cleared security-based swap or swap held at a third-party custodian as if the collateral were delivered to the nonbank SBSD and, thereby, avoid taking the deduction for failing to hold the collateral directly.[141] This modification should help mitigate concerns raised by commenters about the impact the deduction would have on nonbank SBSDs and their counterparties. Further, it responds to commenters who suggested that third-party custodial arrangements could be structured to provide the nonbank SBSD with sufficient control over the collateral to address the Commission's concern that the nonbank SBSD would not be able to promptly liquidate collateral in the event of the counterparty's default. As discussed in more detail below, the final rule is designed so that existing custodial agreements established pursuant to the margin rules of the CFTC and the prudential regulators should meet the conditions of the exception.

The Commission—as indicated above—has also modified the final requirements so that the deductions will apply to uncollected margin with respect to non-cleared swap transactions (in addition to non-cleared security-based swap transactions).[142] A commenter objected to applying the deductions in lieu of margin to non-cleared swaps transactions because, in the commenter's view, it would interfere with policy choices of the CFTC such as that agency's requirement that initial margin be held at a third-party custodian.[143] The commenter also objected to calculating the amount of the deduction using the standardized haircuts in the nonbank SBSD capital rules or a model approved for purposes of Rule 18a-3. The commenter recommended that the deduction be calculated using the methods for calculating initial margin prescribed in the CFTC's rules.

In response to the commenter's concerns about applying the deductions with respect to non-cleared swaps, the failure to collect sufficient margin from a counterparty with respect to a swap transaction exposes the nonbank SBSD to the same credit risk that arises from failing to collect sufficient margin with respect to a security-based swap transaction. The deduction in lieu of margin is designed to address this risk by requiring the nonbank SBSD to hold capital (instead of collateral) to protect itself from the consequences of the default of the counterparty. Applying the deduction in lieu of margin to non-cleared swap transactions is designed to promote the safety and soundness of the nonbank SBSD.[144] Moreover, as discussed below, the Commission has modified the exception from taking the deduction when a counterparty's initial margin is held at a third-party custodian (including initial margin for non-cleared swap transactions) in a manner that is designed to accommodate custodial arrangements entered into pursuant to the CFTC's margin rules. In addition, as discussed below in section II.A.2.b.v. of this release, the ability to use credit risk charges has been expanded to swap transactions.

The Commission is persuaded by the commenter's second point that the amount of the deduction should be calculated using the methods for calculating initial margin prescribed in the CFTC's margin rules. Consequently, unlike the potential rule language in the 2018 comment reopening, the amount of the deduction is calculated using the methodology required by the margin rules for non-cleared swaps adopted by the CFTC. For example, if the CFTC has approved the firm's use of a margin model, the firm can use the model to calculate the amount of the deduction in lieu of margin.

Under the final rules, a nonbank SBSD must deduct from net worth when computing net capital unsecured receivables, including receivables arising from not collecting variation margin under an exception in the margin rule for non-cleared security-based swaps.[145] The final rules also require a nonbank SBSD to deduct the initial margin amount for non-cleared security-based swaps calculated under Rule 18a-3 with respect to a counterparty or account, less the margin value of collateral held in the account.[146] Consequently, if the nonbank SBSD does not collect and hold variation and/or initial margin for an account pursuant to an exception in Rule 18a-3, the nonbank SBSD will be required to take a 100% deduction for the uncollateralized amount of the exposure. For uncollected variation margin, the amount of the exposure is the mark-to-market value of the security-based swap; for initial margin, the amount of the exposure is the initial margin amount calculated pursuant to Rule 18a-3. However, as discussed below in section II.A.2.b.v. of this release, an ANC broker-dealer SBSD and stand-alone SBSD authorized to use models can apply a credit risk model to Start Printed Page 43892these exposures instead of taking these deductions.

With respect to swaps, the final rules provide that a nonbank SBSD must deduct from net worth when computing net capital unsecured receivables, including receivables arising from not collecting variation margin under an exception in the non-cleared swaps margin rules of the CFTC.[147] The final rules also require a nonbank SBSD to deduct initial margin amounts calculated pursuant to the margin rules of the CFTC, less the margin value of collateral held in the account of a swap counterparty at the SBSD.[148] Consequently, if the nonbank SBSD does not collect and hold variation and/or initial margin for an account pursuant to an exception in the CFTC's margin rules, the nonbank SBSD will be required to take a 100% deduction for the uncollateralized amount of the exposure. For uncollected variation margin, the amount of the exposure is the mark-to-market value of the swap; for uncollected initial margin, the amount of the exposure is the initial margin amount calculated pursuant to the CFTC's margin rules. However, as discussed below in section II.A.2.b.v. of this release, an ANC broker-dealer and nonbank SBSD authorized to use models can apply a credit risk model to these exposures instead of taking these deductions.

Deductions related to margin held at third-party custodians. In terms of the deductions related to counterparties that elect to have initial margin held at a third-party custodian, commenters stated that it would discourage the use of third-party custodians, which security-based swap customers have a right to elect under Section 3E(f) of the Exchange Act.[149] They also claimed that the deduction would result in substantial costs to the affected nonbank SBSD, which would be passed on to the security-based swap customer. A commenter noted that other regulators have finalized or proposed swap capital rules that do not include a special deduction for initial margin held at a third-party custodian.[150]

Various commenters stated that a nonbank SBSD will have legal “control” over collateral pledged to it and held at a third-party custodian when the parties properly structure a custodial agreement.[151] Some of these commenters also stated that properly structured tri-party account control agreements could address the Commission's concern about the nonbank SBSD's lack of control over initial margin held at a third-party custodian.[152] Some commenters argued that even though physical control is lacking under tri-party custodial arrangements, legal control of the securities collateral, under properly structured tri-party custodial arrangements, exists pursuant to Article 8 of the Uniform Commercial Code.[153] Commenters noted that pledgors, secured parties, and securities intermediaries typically memorialize the pledge of securities and grant “control” of the securities to the secured party through a tri-party account control agreement.[154] A commenter noted that courts have recognized the legitimacy of account control agreements and enforced them in accordance with their terms.[155] Finally, another commenter suggested that the account control agreement should provide the nonbank SBSD with legal control over, and access to, the counterparty's initial margin in the event of enforcement of the firm's rights against such initial margin.[156]

As noted above, the Commission asked in the 2018 comment reopening whether there should be an exception to the deduction when collateral is held by an independent third-party custodian as initial margin pursuant to Section 3E(f) of the Exchange Act or Section 4s(l) of the CEA.[157] The Commission asked whether the capital charge should be avoided in these circumstances if: (1) The independent third-party custodian is a bank as defined in Section 3(a)(6) of the Exchange Act that is not affiliated with the counterparty; (2) the firm, the independent third-party custodian, and the counterparty that delivered the collateral to the custodian have executed an account control agreement governing the terms under which the custodian holds and releases collateral pledged by the counterparty as initial margin that provides the firm with the same control over the collateral as would be the case if the firm controlled the collateral directly; and (3) the firm obtains a written opinion from outside counsel that the account control agreement is legally valid, binding, and enforceable in all material respects, including in the event of bankruptcy, insolvency, or a similar proceeding.

As a preliminary matter, two commenters addressed the potential rule language in the preface to the exception that stated that it could apply with respect to collateral held by an independent third-party custodian as initial margin pursuant to Section 3E(f) of the Exchange Act or Section 4s(l) of the CEA.[158] One of these commenters noted that the CFTC and the prudential regulators adopted their margin rules pursuant to Section 4s(e) of the CEA and Section 15F(e) of the Exchange Act, respectively.[159] The commenter further noted that the margin rules of the CFTC and the prudential regulators require that initial margin be segregated at a third-party custodian. Consequently, the commenter was concerned that initial margin held at a third-party custodian pursuant to those margin rules would not qualify for the exception. The commenter also noted that foreign regulators' rules could require that Start Printed Page 43893initial margin collateral be held at a third-party custodian.

The margin rules of the CFTC and the prudential regulators require initial margin to be held at a third-party custodian and prescribe specific requirements for the custodial arrangements as well as requirements to document agreements with counterparties governing the exchange of margin.[160] The margin rules of other jurisdictions could have similar requirements. In the specific context of this exception from taking a deduction, the reason why the collateral is held at a third-party custodian is less important than taking the necessary steps to enter into a custodial arrangement that meets the conditions discussed below for qualifying for the exception. The conditions are designed to provide the nonbank SBSD, as the secured party, with prompt access to the collateral held at the third-party custodian when the collateral is needed to protect the nonbank SBSD against the consequences of the counterparty's default. The fact that the collateral is held at the third-party custodian at the election of the counterparty or because a domestic or foreign law requires it to be held at the custodian should not be dispositive as to whether a given custodial arrangement can qualify for this exception.

Moreover, the second and third conditions discussed below are designed to ensure that the custodial agreement legally provides the nonbank SBSD with the right to promptly access the collateral if necessary. These conditions therefore will address any concerns regarding potential interference with that right. For these reasons, the Commission agrees with the commenters that the preface to the exception need not limit the legal bases for why the collateral is being held at a third-party custodian. Consequently, the final rules do not reference Section 3E(f) of the Exchange Act or Section 4s(l) of the CEA in the preface to the exception.[161]

Commenters addressed the first potential condition set forth in the 2018 comment reopening that the independent third-party custodian be a bank as defined in Section 3(a)(6) of the Exchange Act that is not affiliated with the counterparty. One commenter stated that the condition that the custodian be an unaffiliated bank is reasonable and practical.[162] Other commenters suggested that the Commission expand the range of permissible custodians to include U.S. securities depositories and clearing agencies, foreign banks, and foreign securities depositories.[163] The Commission also received comments prior to the 2018 comment reopening that are relevant to this potential condition. Two commenters supported allowing the collateral to be held at an affiliate of the nonbank SBSD.[164] One commenter suggested that the third-party custodian must be a legal entity that is separate from both the nonbank SBSD and the counterparty (but not necessarily unaffiliated with the nonbank SBSD or counterparty).[165] This commenter stated that this position would appropriately recognize well established, ordinary course custody and trading practices of market participants, including registered funds.

The Commission agrees with commenters that it would be appropriate to recognize third-party custodians that are not a bank. In the U.S., clearing organizations and depositories registered with the Commission or the CFTC could serve as custodians. As these entities are subject to oversight and regulation, the Commission does not believe the rule should exclude them from serving as custodians. In addition, if foreign securities or currencies are used as collateral to meet an initial margin requirement, it may be impractical to have them held at a U.S. custodian. Accordingly, the Commission believes it would be appropriate to recognize a foreign bank, clearing organization, or depository that is supervised (i.e., subject to oversight by a government authority) if the collateral consists of foreign securities or currencies and the custodian customarily maintains custody of such foreign securities or currencies. For these reasons, the final rules recognize domestic and foreign banks, custodians, and depositories, subject to the conditions discussed above.

The Commission also agrees with commenters that the final rules should permit the third-party custodian to be an affiliate of the nonbank SBSD (but not the counterparty). In particular, an affiliate may be less likely to interfere with the legal right of the nonbank SBSD to exercise control over the collateral in the event of a default of the counterparty. Consequently, the final rules permit the custodian to be an affiliate of the nonbank SBSD but not the counterparty.[166]

Commenters addressed the second potential condition set forth in the 2018 comment reopening that the firm, the independent third-party custodian, and the counterparty that delivered the collateral to the custodian must have executed an account control agreement that provides the firm with the same control over the collateral as would be the case if the firm controlled the collateral directly. Commenters generally supported the view that a nonbank SBSD, as the secured party, should have prompt access to the collateral held at the third-party custodian.[167] However, a commenter objected to the “same control” language and argued it could be read to mean that nonbank SBSDs would be allowed to re-hypothecate and use collateral posted to a third-party custodian.[168] Another commenter argued that collateral covered by an agreement meeting the conditions of the exception would no longer be segregated in any meaningful sense, and may violate the plain language of the Dodd-Frank Act that initial margin be segregated for the benefit of the counterparty.[169] A commenter argued that this type of Start Printed Page 43894provision would be costly, operationally burdensome, and inconsistent with current market practices for third-party custodial arrangements.[170]

The Commission agrees with commenters that the “same control” standard could create practical obstacles that would make it difficult to execute an account control agreement that would be sufficient to avoid the deduction when initial margin is held by a third-party custodian. Moreover, meeting the standard could have required the re-drafting of existing agreements that are in place in accordance with the third-party custodian and documentation requirements of the CFTC and the prudential regulators. Doing so would be a costly and burdensome process. At the same time, the Commission also agrees with commenters that the account control agreement should provide the nonbank SBSD, as the secured party, with the right to promptly access the collateral held at the third-party custodian if necessary.

The Commission has balanced these considerations in crafting final rules. In this regard, the Commission believes it would be appropriate to adopt final rules that align more closely with the third-party custodian requirements of the CFTC and the prudential regulators. Consequently, the final rules provide that the account control agreement must be a legal, valid, binding, and enforceable agreement under the laws of all relevant jurisdictions, including in the event of bankruptcy, insolvency, or a similar proceeding of any of the parties to the agreement.[171] The rules further provide that the agreement must provide the nonbank SBSD with the right to access the collateral to satisfy the counterparty's obligations to the nonbank arising from transactions in the account of the counterparty.[172] This is the fundamental purpose of the agreements and should not raise the same practical issues as the “same control” standard. At the same time, it is designed to require an agreement that achieves this fundamental purpose and by doing so will provide the nonbank SBSD, as the secured party, with prompt access to the collateral held at the third-party custodian when the collateral is needed to protect the nonbank SBSD against the consequences of the counterparty's default. While the provision requires an agreement, the Commission has crafted it with the objective that existing agreements with counterparties entered into for the purposes of the third-party custodian and documentation rules of the CFTC and the prudential regulators will suffice.

Commenters addressed the third potential condition set forth in the 2018 comment reopening that the firm obtain a written opinion from outside counsel that the account control agreement is legally valid, binding, and enforceable in all material respects, including in the event of bankruptcy, insolvency, or a similar proceeding. Some commenters opposed the requirement for an opinion of outside legal counsel on the basis of cost and impracticability, arguing it is inconsistent with market practice and operationally burdensome to implement.[173] One commenter stated that the requirement was unnecessary because existing account control agreements and laws provide substantial protections.[174] Another commenter suggested that the Commission consider alternatives to the requirement, such as permitting a nonbank SBSD to recognize initial margin so long as it has a well-founded basis to conclude that the collateral arrangement is enforceable.[175]

The Commission acknowledges that requiring a formal written legal opinion by outside counsel could be a costly burden and, on further consideration, may not be necessary. At the same time, the Commission believes the nonbank SBSD should take steps to analyze whether the custodial agreement will provide the firm, as the secured party, with the right to access the collateral to satisfy the counterparty's obligations to the firm arising from transactions in the account of the counterparty. In other words, the firm should analyze whether a tri-party custodial agreement intended to provide this right is a legal, valid, binding, and enforceable agreement under the laws of all relevant jurisdictions, including in the event of bankruptcy, insolvency, or a similar proceeding of any of the parties to the agreement. The Commission's view that this analysis should be performed is consistent with the views of the CFTC and the prudential regulators. In particular, those agencies, in explaining the requirements of their rules governing tri-party custodial agreements, stated that the secured party would need to conduct a sufficient legal review to conclude with a well-founded basis that, in the event of a legal challenge, including one resulting from the default or from the receivership, conservatorship, insolvency, liquidation, or similar proceedings of the custodian or counterparty, the relevant court or administrative authorities would find the custodial agreement to be legal, valid, binding, and enforceable under the law.[176]

The Commission has balanced the cost and potential practical difficulties in obtaining a written opinion of outside legal counsel with the need for the nonbank SBSD to enter into a tri-party custodial agreement that will operate as intended under the relevant laws. The Commission has concluded that a written legal opinion of outside counsel is not the only way to provide assurance that the tri-party custodial agreement will operate as intended. For example, the nonbank SBSD could perform its own legal analysis rather than pay outside counsel to provide the legal opinion or be a member of a competent industry association that makes legal analysis available to its members. Therefore, the final rules do not require the nonbank SBSD to obtain a legal opinion of outside counsel. Instead, the rules require the firm to maintain written documentation of its analysis that in the event of a legal challenge the relevant court or administrative authorities would find the account control agreement to be legal, valid, binding, and enforceable under the applicable law, including in the event of the receivership, conservatorship, insolvency, liquidation, or a similar proceeding of any of the parties to the agreement.[177] Among other things, the documentation could be a written Start Printed Page 43895opinion of outside legal counsel, reflect the firm's own “in-house” legal research, or be the research of a competent industry association. The documentation will reflect how the firm analyzed the legality of the account control agreement.

Legacy accounts. In terms of the deductions related to legacy accounts, one commenter stated that “the costs of this requirement will ultimately flow back to the counterparties, penalizing all counterparties who trade with any affected [nonbank SBSD]” and that “the retroactive effect of such a requirement—which effectively requires [nonbank SBSDs] to revise the price terms of pre-effective [security-based swaps]—is contrary to the prospective nature of the rest of Dodd-Frank's Title VII.” [178] A second commenter argued that the deduction is inconsistent with how dealers currently do business, as they do not typically collect margin from certain credit-worthy counterparties.[179] Commenters stated that the legacy account deduction is inconsistent with the proposed capital regimes of the CFTC and the prudential regulators.[180] A commenter argued that this inconsistency could result in regulatory arbitrage.[181] Commenters indicated that the proposed legacy account deduction would unfairly penalize nonbank SBSDs and their customers.[182] A commenter stated that the deduction would negatively affect the pricing and liquidity of transactions with counterparties.[183] Commenters also argued that the proposed deduction could lead some market participants that cannot afford the costs to exit the market or cease engaging in new security-based swaps activity.[184]

In response to the comment that the deduction in lieu of margin related to legacy accounts is contrary to the prospective nature of Title VII of the Dodd-Frank Act and will require re-pricing of existing security-based swaps,[185] the legacy account exception is designed to address the impracticality of renegotiating contracts governing security-based swap transactions that predate the compliance date of Rule 18a-3.[186] Further, as discussed below in section II.A.2.b.v. of this release, the ability to apply the credit risk charges has been expanded to exposures arising from electing not to collect variation or initial margin with respect to legacy accounts. This should help to mitigate the concern of this commenter and others that the 100% deduction could cause nonbank SBSDs to pass the costs of the capital requirement to counterparties. This also should help to mitigate concerns of commenters who argued that the 100% deduction was inconsistent with the capital requirements of other regulators. As one commenter stated, applying a credit risk charge for a nonbank SBSD's legacy account positions would more closely align the Commission's capital standards with the approaches of the CFTC and the prudential regulators.[187]

The Commission acknowledges that, even with the modification expanding the application of the credit risk charge, the final rule will result in costs to nonbank SBSDs as well as to their security-based swap and swap counterparties. However, the Commission has sought to strike an appropriate balance between addressing the concerns of commenters and promulgating a final rule that promotes the safety and soundness of nonbank SBSDs.[188] The Commission believes it has achieved this objective by taking a measured approach to modifying the rule to reduce the impact of the deductions for uncollected variation and initial margin.

iii. Standardized Haircuts

The final step in the process of computing net capital under Rule 15c3-1 is to apply the standardized or model-based haircuts to the firm's proprietary positions, thereby reducing the firm's tentative net capital amount to an amount that constitutes the firm's net capital.[189] Most stand-alone broker-dealers use the standardized haircuts, which are prescribed in Rules 15c3-1, 15c3-1a, and 15c3-1b. ANC broker-dealers may apply model-based haircuts to positions for which they have been authorized to use models pursuant to Rule 15c3-1e. For all other types of positions, they must use the standardized haircuts.

The pre-existing provisions of paragraph (c)(2)(vi) of Rule 15c3-1 prescribe standardized haircuts for marketable securities and money market instruments. The amounts of the standardized haircuts are based on the type of security or money market instrument and, in the case of certain debt instruments, the time-to-maturity of the bond. Broker-dealer SBSDs will be subject to these pre-existing standardized haircut provisions in paragraph (c)(2)(vi) of Rule 15c3-1. Proposed Rule 18a-1 required stand-alone SBSDs to apply the pre-existing standardized haircuts in paragraph (c)(2)(vi) of Rule 15c3-1 by cross-referencing that paragraph.[190] The pre-existing provisions of Rules 15c3-1a and 15c3-1b prescribe standardized haircuts for equity option positions and commodities positions, respectively. The provisions in Rule 15c3-1b incorporate deductions in the CFTC's capital rule for FCMs.[191] Broker-dealer SBSDs will be subject to the pre-existing standardized haircut provisions in Rules 15c3-1a and 15c3-1b. The Commission proposed Rules 18a-1a and 18a-1b to prescribe standardized haircuts for stand-alone SBSDs modeled on the pre-existing requirements in Rules 15c3-1a and 15c3-1b, respectively.[192]

However, the pre-existing provisions of Rule 15c3-1 and Rule 15c3-1b did not prescribe standardized haircuts tailored specifically for security-based swaps and swaps.[193] Consequently, the Commission proposed amending paragraph (c)(2)(vi) of Rule 15c3-1 and Rule 15c3-1b to establish standardized Start Printed Page 43896haircuts for security-based swaps and swaps that would apply to stand-alone broker-dealers and broker-dealer SBSDs.[194] The Commission proposed parallel standardized deductions tailored for security-based swaps and swaps in proposed Rules 18a-1 and 18a-1b, respectively, that would apply to stand-alone SBSDs.

The proposed standardized haircut for a CDS was determined using one of two maturity grids: One for a CDS that is a security-based swap and the other for a CDS that is a swap.[195] The proposed grids prescribed standardized haircuts based on two variables: The length of time to maturity of the CDS and the amount of the current offered basis point spread on the CDS. The standardized haircut for an unhedged short position in a CDS (i.e., selling protection) was the applicable percentage specified in the grid. The deduction for an unhedged long position in a CDS (i.e., buying protection) was 50% of the applicable deduction specified in the grid. The amount of the deductions in the maturity grid for a CDS that was a swap were one-third less than the comparable deductions in the maturity grid for a CDS that was a security-based swap. The proposed rules provided for reduced grid-derived deductions based on netting positions.

For a security-based swap that is not a CDS, the proposed standardized haircuts required multiplying the notional amount of the security-based swap by the amount of the standardized haircut percent that applied to the underlying position pursuant to the pre-existing provisions of Rule 15c3-1.[196] For example, paragraph (c)(2)(vi)(J) of Rule 15c3-1 prescribes a standardized haircut for an exchange traded equity security equal to 15% of the mark-to-market value of the security. Consequently, the standardized haircut for a security-based swap referencing an exchange traded equity security was a deduction equal to the notional amount of the security-based swap multiplied by 15%. The same approach applied to a security-based swap (other than a CDS) referencing a debt instrument. For example, paragraph (c)(2)(vi)(F)(1)(v) of Rule 15c3-1 prescribes a 7% standardized haircut for a corporate bond that has a maturity of five years, is not traded flat or in default as to principal or interest, and has a minimal amount of credit risk. Therefore, the proposed standardized haircut for a security-based swap referencing such a bond was a deduction equal to the notional amount of the security-based swap multiplied by 7%.

For a swap that is not a CDS or interest rate swap, the Commission proposed a similar approach that required multiplying the notional amount of the swap by a certain percent.[197] To determine the applicable percent, the Commission proposed a hierarchy approach. Under this approach, if the pre-existing provisions of Rule 15c3-1 prescribed a standardized haircut for the type of asset, obligation, or event underlying the swap, the percent deduction of the Rule 15c3-1 standardized haircut applied. For example, if the swap referenced an equity security index, the pre-existing standardized haircut in Rule 15c3-1 applicable to baskets of securities and equity index exchange traded funds applied. If the pre-existing provisions of Rule 15c3-1 did not prescribe a standardized haircut for the type of asset, obligation, or event underlying the swap but the pre-existing provisions in Rule 15c3-1b did, the percent deduction in the Rule 15c3-1b standardized haircut applied. This would be the case if the swap referenced a type of commodity for which CFTC Rule 1.17 prescribes a standardized haircut, and the Rule 1.17 haircut is incorporated into Rule 15c3-1b. Finally, if neither Rules 15c3-1 nor 15c3-1b prescribed a standardized haircut for the type of asset, obligation, or event underlying the swap but Rule 1.17 did, the percent deduction in the Rule 1.17 standardized deduction applied. This could be the case, for example, if the swap was a type of swap for which the CFTC had prescribed a specific standardized haircut.

For interest rate swaps, the Commission proposed a similar standardized haircut approach that required multiplying the notional amount of the swap by a certain percent.[198] The percent was determined by referencing the standardized haircuts in Rule 15c3-1 for U.S. government securities with comparable maturities to the swap's maturity. However, the proposed haircut for interest rate swaps had a floor of 1% (whereas U.S. government securities with a maturity of less than 9 months are subject to haircuts of 3/4 of 1%, 1/2 of 1%, or 0% depending on the time to maturity). This 1% floor was designed to account for potential differences between the movement of interest rates on U.S. government securities and interest rates upon which swap payments are based.

Under the proposed standardized haircuts for a security-based swap that is not a CDS, stand-alone broker-dealers and nonbank SBSDs were permitted to recognize portfolio offsets.[199] In particular, these entities were permitted to include an equity security-based swap in a portfolio of related equity positions (e.g., long and short cash and options positions involving the same security) under the pre-existing provisions of Rule 15c3-1a, which produces a single haircut for a portfolio of equity options and related positions.[200] Similarly, they were permitted to treat a debt security-based swap and an interest rate swap in the same manner as debt instruments are treated in pre-existing debt-maturity grids in Rule 15c3-1 in terms of allowing offsets between long and short positions where the instruments are in the same maturity categories, subcategories, and in some cases, adjacent categories.

Comments and Final Requirements for Standardized Haircuts

A commenter stated that, based on its estimates, the standardized haircuts in the proposed CDS maturity grids would be significantly greater than the capital charges that would apply to the same positions using an internal model.[201] The commenter stated that the Commission should conduct further review of empirical data regarding the historical market volatility and losses given default associated with CDS positions and modify the proposed standardized haircuts. This commenter argued that excessive standardized haircuts may disproportionately affect smaller and mid-size firms.[202] The commenter further stated that these types of firms may be limiting their security-based swaps business so they will not be required to register as a nonbank SBSD or may try to develop internal models to avoid having to use the standardized haircuts.

In response to these comments, the economic analysis performed for these Start Printed Page 43897final rules determined that the standardized haircuts being adopted today generally were not set at the most conservative level. As stated in the analysis, the Commission believes that, in general, haircuts are intended to strike a balance between being sufficiently conservative to cover losses in most cases, including stressed market conditions, and being sufficiently nimble to allow nonbank SBSDs to operate efficiently in all market conditions. Based on the results of the analysis, the Commission believes the standardized haircuts in the final rules take into account this tradeoff.[203]

Nonetheless, the Commission recognizes that the standardized haircuts for non-cleared security-based swaps are less risk-sensitive than the model-based haircuts and, therefore, in many cases will be greater than the model-based haircuts. This difference in the deductions that result from applying standardized haircuts as opposed to model-based haircuts is part of the pre-existing provisions of Rule 15c3-1. The rule has permitted ANC broker-dealers and OTC derivatives dealers to apply model-based haircuts, whereas all other broker-dealers must apply the standardized haircuts. These differences are why broker-dealers applying the model-based haircuts are subject to higher capital standards, including minimum tentative net capital requirements.[204] These additional and higher capital requirements account for the generally lower deductions that result from applying model-based haircuts as opposed to standardized haircuts. Because nonbank SBSDs that do not use model-based haircuts will not be subject to these additional or higher capital requirements, the Commission believes that it is an appropriate trade-off that they will employ the less risk-sensitive standardized haircuts. Further, the Commission believes that most nonbank SBSDs will seek approval to use model-based haircuts.

The standardized haircuts are designed to account for more than just market and credit risk—they also are intended to address other risks such as operational, leverage, and liquidity risks.[205] The standardized haircuts are intended to account for more risks because the firms that will use them, as discussed above, are subject to lower minimum net capital requirements.

Commenters also recommended that for cleared security-based swaps, the Commission apply a standardized haircut based on the initial margin requirement of the clearing agency, similar to the treatment of futures in Rule 15c3-1b.[206] A commenter stated that the clearing agencies use risk-based models to calculate initial margin and, therefore, relying on their margin calculations would allow firms that do not use models to indirectly get the benefit of a more risk-sensitive approach.[207]

The Commission is persuaded that it would be appropriate to establish standardized haircuts for cleared security-based swaps and swaps that are determined using the margin requirements of the clearing agency or DCO where the position is cleared. Consequently, the Commission is modifying the proposed standardized haircut requirements for cleared security-based swaps and swaps to require that the amount of the deduction will be the amount of margin required by the clearing agency or DCO where the position is cleared.[208] This will align the treatment of these cleared products with the treatment of futures products. It also will establish standardized haircuts that potentially are more risk sensitive, as suggested by the commenter. This will benefit stand-alone broker-dealers and nonbank SBSDs that have not been authorized to use models to determine market risk charges for their security-based swap and swap positions.

A commenter supported the Commission's proposal to allow standardized haircuts for portfolios of equity security-based swaps and related equity positions using the methodology in Rule 15c3-1a.[209] The commenter believed this would allow stand-alone broker-dealers and nonbank SBSDs to employ a more risk-sensitive approach to computing net capital than if a position were treated in isolation. The Commission agrees with the commenter's reasoning and continues to believe that cleared equity security-based swaps should be permitted to be included in the portfolios of equity positions for purposes of Rules 15c3-1a and 18a-1a and that this treatment should be extended to cleared equity-based swaps. Therefore, the Commission is modifying the requirement to permit equity-based swaps (in addition to equity security-based swaps) to be included as related or underlying instruments for purposes of Rules 15c3-1a and 18a-1a.[210] Further, as discussed above, the standardized haircut for cleared security-based swaps and swaps being adopted today is determined using the margin requirements of the clearing agency or DCO where the position is cleared. However, as an alternative to that standardized haircut, a stand-alone broker-dealer and nonbank SBSD can use the methodology prescribed in Rules 15c3-1a and 18a-1a to derive a portfolio-based standardized haircut for cleared security-based swaps that reference an equity security or narrow-based equity index and swaps that reference a broad-based equity index.[211]

A commenter opposed the 1% minimum standardized haircut for interest rate swaps as being too severe.[212] Based on its analysis of sample positions, this commenter believed that the proposed standardized haircut calculations that include the 1% minimum haircut would result in market risk charges that are nearly 35 times higher than charges without the 1% minimum.[213] The Commission is persuaded that the proposed 1% minimum haircut was too conservative, Start Printed Page 43898particularly when applied to tightly hedged positions such as those in the commenter's examples. As discussed above, the standardized haircut for cleared swaps, including interest rate swaps, being adopted today is determined by the margin required by the DCO where the position is cleared. Therefore, the 1% minimum standardized haircut for cleared security-based swaps is being eliminated.

However, the Commission continues to believe that a minimum haircut should be applied to non-cleared interest rate swaps. Under the final rules being adopted today, the standardized haircuts for non-cleared interest rate swaps are determined using the maturity grid for U.S. government securities in paragraph (c)(2)(vi)(A) of Rule 15c3-1.[214] Moreover, the standardized haircuts for non-cleared security-based swaps and swaps (other than CDS) being adopted today permit a stand-alone broker-dealer and nonbank SBSD to reduce the deduction by an amount equal to any reduction recognized for a comparable long or short position in the reference security under the standardized haircuts in Rule 15c3-1.[215] The standardized haircuts in paragraph (c)(2)(vi)(A) of Rule 15c3-1 permit a stand-alone broker-dealer to take a capital charge on the net long or short position in U.S. government securities that are in the same maturity categories in the rule. This treatment will apply to interest rate swaps. Therefore, if a stand-alone broker-dealer or nonbank SBSD has long and short positions in interest rate swaps, the amount of the standardized haircut applied to these positions could be greatly reduced and could potentially be 0% for positions that are tightly hedged. This could permit the firm to substantially leverage its interest rate swaps and hold little or no capital against them. Further, potential differences between the movement of interest rates on U.S. government securities and interest rates upon which swap payments are based could impose a level of additional risk even to tightly hedged interest rate positions.

For these reasons, the Commission believes that a minimum standardized haircut for non-cleared interest rate swaps is appropriate. However, the Commission is persuaded by the commenter that the proposed 1% minimum haircut was too conservative. Therefore, the Commission is modifying the standardized haircut for non-cleared interest rate swaps so that it can be no less than 1/8 of 1% of a long position that is netted against a short position in the case of a non-cleared swap with a maturity of 3 months or more.[216] The standardized haircuts in paragraph (c)(2)(vi)(A) of Rule 15c3-1 require a 0% haircut for the unhedged amount of U.S. government securities that have a maturity of less than 3 months. Therefore, the standardized haircuts for interest rate swaps will treat hedged and unhedged positions with maturities of less than 3 months identically in that there will be no haircut required to be applied to the positions.

The next lowest standardized haircut in paragraph (c)(2)(vi)(A) of Rule 15c3-1 applies to unhedged positions with a maturity of 3 months but less than 6 months. For these positions, the haircut is 1/2 of 1%. Therefore, the minimum standardized haircut for hedged interest rate swaps with a maturity of 3 months or more (i.e., 1/8 of 1%) will be one-quarter of the standardized haircut for unhedged positions with a maturity 3 months but less than 6 months. The Commission believes this modified minimum haircut for interest rate swaps strikes an appropriate balance in terms of addressing commenters' concerns that the 1% minimum was too conservative and the prudential concern with permitting a stand-alone broker-dealer or nonbank SBSD to substantially leverage its non-cleared interest rate swaps positions.

Another commenter stated that the Commission appears to have proposed different and substantially higher haircuts for cleared swaps regulated by the CFTC, such as cleared interest rate swaps and cleared index CDS, than those proposed under the CFTC's rules.[217] This commenter stated that dual registrants should not be subject to conflicting requirements for the same instrument and urged the Commission to work with the CFTC to harmonize applicable requirements for cleared swaps that are regulated by the CFTC. The commenter also noted that increasing harmonization will promote the portfolio margining of cleared security-based swaps and swaps. The CFTC has not finalized its capital rules under Title VII of the Dodd-Frank Act; however, as discussed above, the Commission has modified the standardized haircuts for cleared CDS and interest rate swaps so that the deduction equals the margin requirement of the clearing agency or DCO where the positions are cleared. This should alleviate the commenter's concerns about the magnitude of the standardized haircuts for cleared swaps. In terms of harmonizing the Commission's standardized haircuts with the CFTC's standardized haircuts, the Commission intends to continue coordinating with the CFTC as that agency finalizes its capital requirements under Title VII of the Dodd-Frank Act.

For the foregoing reasons, the Commission is adopting the standardized haircuts for security-based swaps and swaps with the modifications discussed above and with certain non-substantive modifications to conform the final rule text in Rule 15c3-1, as amended, and Rule 18a-1, as adopted.[218]

iv. Model-Based Haircuts

The Commission proposed to allow nonbank SBSDs to apply model-based haircuts.[219] Broker-dealer SBSDs that were not already ANC broker-dealers needed Commission authorization to use model-based haircuts and were subject to the requirements governing the use of models by ANC broker-dealers (i.e., they would need to operate as an ANC broker-dealer SBSD). Stand-alone SBSDs similarly needed Commission authorization to apply model-based haircuts and were subject to requirements governing the use of them modeled on the requirements for ANC broker-dealers.

Under the proposals, nonbank SBSDs seeking authorization to use model-based haircuts needed to submit an application to the Commission (“ANC application”).[220] The pre-existing provisions of paragraphs (a)(1) through (a)(3) of Rule 15c3-1e set forth in detail the information that must be submitted Start Printed Page 43899by a stand-alone broker-dealer in an ANC application. The pre-existing provisions of paragraph (a)(4) provide that the Commission may request that the applicant supplement the ANC application with other information. The pre-existing provisions of paragraph (a)(5) prescribe when an ANC application is deemed filed with the Commission and provides that the application and all submissions in connection with it are accorded confidential treatment to the extent permitted by law. The pre-existing provisions of paragraph (a)(6) provide that if any information in an ANC application is found to be or becomes inaccurate before the Commission approves the application, the stand-alone broker-dealer must notify the Commission promptly and provide the Commission with a description of the circumstances in which the information was inaccurate along with updated, accurate information. The pre-existing provisions of paragraph (a)(7) provide that the Commission may approve, in whole or in part, an ANC application or an amendment to the application, subject to any conditions or limitations the Commission may require, if the Commission finds the approval to be necessary or appropriate in the public interest or for the protection of investors. A broker-dealer SBSD seeking authorization to use internal models would be subject to these pre-existing application requirements in paragraph (a) of Rule 15c3-1e. A stand-alone SBSD seeking authorization to use internal models would be subject to similar application requirements in proposed Rule 18a-1.

As part of the ANC application approval process, the Commission staff reviews the operation of the stand-alone broker-dealer's model, including a review of associated risk management controls and the use of stress tests, scenario analyses, and back-testing. As part of this process, the applicant provides information designed to demonstrate to the Commission staff that the model reliably accounts for the risks that are specific to the types of positions the firm intends to include in the model computations. During the review, the Commission staff assesses the quality, rigor, and adequacy of the technical components of the model and of related governance processes around the use of the model as well as the firm's risk management policies, procedures, and controls. Under the proposals, nonbank SBSDs seeking authorization to use internal models would be subject to similar reviews during the application process.[221]

The pre-existing provisions of paragraph (a)(8) of Rule 15c3-1e require an ANC broker-dealer to amend its ANC application and submit it to the Commission for approval before materially changing its model or its internal risk management control system. Further, the pre-existing provisions of paragraph (a)(10) require an ANC broker-dealer to notify the Commission 45 days before the firm ceases to use internal models to compute net capital. Finally, the pre-existing provisions of paragraph (a)(11) provide that the Commission, by order, can revoke an ANC broker-dealer's exemption that allows it to use internal models if the Commission finds that the ANC broker-dealer's use of models is no longer necessary or appropriate in the public interest or for the protection of investors. In this case, the firm would need to revert to applying the standardized haircuts for all positions. Under the proposal, an ANC broker-dealer SBSD would be subject to these pre-existing application requirements in paragraph (a) of Rule 15c3-1e. A stand-alone SBSD authorized to use internal models would have been subject to similar application requirements in proposed Rule 18a-1.[222]

The pre-existing provisions of paragraph (d)(1) of Rule 15c3-1e require an ANC broker-dealer to comply with qualitative requirements that specify among other things that: (1) The model must be integrated into the ANC broker-dealer's daily internal risk management system; (2) the model must be reviewed periodically by the firm's internal audit staff, and annually by an independent public accounting firm; and (3) the measure computed by the model must be multiplied by a factor of at least 3 but potentially a greater amount based on the number of exceptions to the measure resulting from quarterly back-testing exercises.[223] The pre-existing provisions of paragraph (d)(2) prescribe quantitative requirements that specify that the model must, among other things: (1) Use a 99%, one-tailed confidence level with price changes equivalent to a 10-business-day movement in rates and prices; [224] (2) use an effective historical observation period of at least one year; (3) use historical data sets that are updated at least monthly and are reassessed whenever market prices or volatilities change significantly; and (4) take into account and incorporate all significant, identifiable market risk factors applicable to positions of the ANC broker-dealer, including risks arising from non-linear price characteristics, empirical correlations within and across risk factors, spread risk, and specific risk for individual positions. An ANC broker-dealer SBSD would be subject to these pre-existing qualitative and quantitative requirements in paragraph (d) of Rule 15c3-1e. A stand-alone SBSD authorized to use internal models would have been subject to similar qualitative and quantitative requirements in proposed Rule 18a-1.[225]

The pre-existing provisions of paragraph (b) of Rule 15c3-1e prescribe the model-based haircuts an ANC broker-dealer must deduct from tentative net capital in lieu of the standardized haircuts. This deduction is an amount equal to the sum of four charges: (1) A portfolio market risk charge for all positions that are included in the ANC broker-dealer's models (i.e., the amount measured by the model multiplied by a factor of at least 3); [226] (2) a “specific risk” charge for positions where specific risk was not captured in the model; [227] (3) a charge for positions not included in the model where the ANC broker-dealer is approved to use scenario analysis; and (4) a charge for all other positions that is determined using the standardized haircuts. An ANC broker-dealer SBSD would be subject to these pre-existing model-based haircut requirements in paragraph (b) of Rule 15c3-1e. A stand-alone SBSD authorized to use internal models would have been subject to similar requirements in proposed Rule 18a-1.[228]

Finally, ANC broker-dealers are subject to ongoing supervision with respect to their internal risk management, including their use of models. In this regard, the Commission staff meets regularly with senior risk managers at each ANC broker-dealer to Start Printed Page 43900review the risk analytics prepared for the firm's senior management. These reviews focus on the performance of the risk measurement infrastructure, including statistical models, risk governance issues such as modifications to and breaches of risk limits, and the management of outsized risk exposures. In addition, Commission staff and personnel from an ANC broker-dealer hold regular meetings (scheduled and ad hoc) focused on financial results, the management of the firm's balance sheet, and, in particular, the liquidity of the firm's balance sheet.[229] The Commission staff also monitors the performance of the ANC broker-dealer's internal models through regular submissions of reported model changes by the firms and quarterly discussions with the firm's quantitative modeling personnel. Material changes to the internal models used to determine regulatory capital require advance notification, Commission staff review, and pre-approval before implementation. Stand-alone SBSDs authorized to use model-based haircuts would be subject to similar monitoring and reviews.

Comments and Final Requirements for Model-Based Haircuts

A commenter expressed support for the Commission's proposal that nonbank SBSDs be authorized to use model-based haircuts for proprietary securities positions, including security-based swap positions, in lieu of standardized haircuts, subject to application to, and approval by, the Commission and satisfaction of the qualitative and quantitative requirements set forth in Rule 15c3-1e.[230] However, other commenters raised concerns about permitting nonbank SBSDs to use model-based haircuts. A commenter stated that model-based haircuts should be “floored” at a level set by a standardized approach.[231] This commenter also stated that the Commission's continued reliance on model-based haircuts would represent a step away from the evolving practice of prudential regulators. This commenter and others also generally argued that the failure by significant market participants to accurately measure risk using models in the run-up to and during the 2008 financial crisis demonstrated that such models do not successfully measure risk and do not enable firms to make optimal judgments about risk.[232] One of these commenters argued that the firms using models are the most systemically risky and have a financial incentive to keep the measures low.[233] Other commenters argued that models can be manipulated and create perverse incentives for risk management staff to minimize capital charges.[234] A commenter indicated that it will be difficult for Commission staff to examine, duplicate, and back-test model estimates.[235] A second commenter believed models tend to fail during volatile market conditions particularly during a crisis.[236] Another commenter, in light of various reforms by banking regulators, urged the Commission to place more limitations on ANC broker-dealers because they use internal models to determine capital charges.[237]

Commenters also argued that allowing the use of models for capital purposes can create competitive advantages for larger firms that are able to reduce their capital requirements through internal modeling relative to smaller firms that are engaged in similar activities but are subject to different capital requirements.[238] A commenter stated that allowing the use of models will incentivize firms to organize themselves in ways that reduce their capital requirements and increase their leverage in order to enhance return on capital.[239] This commenter also stated that capital requirements should be the same regardless of firms' activities and that the only reason for different treatment should be the aggregate exposures taken by individual firms.

The Commission continues to believe that the capital rules for ANC broker-dealers and nonbank SBSDs should permit these entities to use model-based haircuts. Models are used by financial institutions to manage risk and, therefore, permitting their use will allow firms to integrate their risk management processes with their capital computations.

The Commission, however, acknowledges the concerns raised by commenters about the efficacy of models, particularly in times of market stress. In response to these concerns and the comment that ANC broker-dealers should be subject to more limitations, ANC broker-dealers and nonbank SBSDs using models will be subject to higher minimum capital requirements as well as the Commission's ongoing monitoring of their use of models. In particular, the minimum tentative net capital requirements that apply to ANC broker-dealers (which are being substantially increased by today's amendments) and stand-alone SBSDs authorized to use model-based haircuts are designed to address the concerns raised by commenters that the models may fail to accurately measure risk, firms may calibrate the models to keep values low, firms might manipulate models, and models may fail during volatile market conditions. More specifically, tentative net capital is the amount of a firm's net capital before applying the haircuts.

Today's amendments and new rules will require ANC broker-dealers (including ANC broker-dealer SBSDs) to maintain at least $5 billion in tentative net capital and subject them to a minimum fixed-dollar net capital requirement of $1 billion. Stand-alone SBSDs authorized to use models will be required to maintain at least $100 million in tentative net capital and will be subject to a minimum fixed-dollar net capital requirement of $20 million. Consequently, for each type of nonbank SBSD, the fixed-dollar minimum tentative net capital requirement is five times the fixed-dollar minimum net capital requirement. Thus, nonbank SBSDs that use models will need to maintain minimum tentative net capital in an amount that far exceeds their minimum fixed-dollar net capital requirement. The larger tentative net capital requirement is designed to address the risk associated with using model-based haircuts. To the extent a nonbank SBSD's model fails to accurately calculate the risk of its positions, the tentative net capital requirement will serve as a buffer to account for the difference between the calculated haircut amount and the actual risk of the positions. Further, the Commission's ongoing supervision of the firms' use of models as well as the qualitative and quantitative requirements governing the use of models (e.g., backtesting) provide additional checks on the use of models that are designed to address the risks Start Printed Page 43901identified by the commenters. Finally, ANC broker-dealers and nonbank SBSDs are subject to Rule 15c3-4, which requires them to establish, document, and maintain a system of internal risk management controls to assist in managing the risks associated with their business activities, including market, credit, leverage, liquidity, legal, and operational risks.

Although one commenter stated that the Commission's continued reliance on internal models would represent a step away from the evolving practice of prudential regulators, this has not been the case. Financial supervisors and regulators, in the United States and elsewhere, have continued to permit the use of internal models as a component of establishing and measuring capital requirements for financial market participants, including with respect to bank SBSDs and bank swap dealers. Similarly, the CFTC has proposed to allow nonbank swap dealers to use models. The Commission's final rules and amendments will promote consistency with these other rules. For these reasons, the Commission is adopting the provisions relating to the use of model-based haircuts substantially as proposed.[240]

Finally, a commenter recommended that the Commission adopt an expedited review and approval process for models that have been approved and are subject to periodic assessment by the Federal Reserve or a qualifying foreign regulator.[241] This commenter suggested that if the Commission has previously approved a model for use by one registrant, the Commission should automatically approve the use of that model by an affiliate subject to the same risk management program as the affiliate whose model was previously approved. Other commenters recommended that the Commission permit a nonbank SBSD to use internal credit risk models approved by other regulators, and that the Commission generally defer to the other regulator's ongoing oversight of the model (including model governance).[242] Another commenter supported a provisional approval process for internal capital models.[243]

In response to these comments, the Commission encourages prospective registrants to reach out to the Commission staff as early as possible in advance of the registration compliance date to begin the model approval process. The staff will work diligently to review the models before the firm must register as an SBSD. However, the Commission acknowledges the possibility that it may not be able to make a determination regarding a firm's model before it is required to register as an SBSD. Consequently, the Commission is modifying Rule 15c3-1e and Rule 18a-1 to provide that the Commission may approve, subject to any condition or limitations that the Commission may require, the temporary use of a provisional model by an ANC broker-dealer, including an ANC broker-dealer SBSD, or a stand-alone SBSD for the purposes of computing net capital if the model had been approved by certain other supervisors.[244] Further, as discussed below in section II.B.2.a.i. of this release, the Commission also may approve, subject to any condition or limitations that the Commission may require, the temporary use of a provisional model by a nonbank SBSD for the purposes of calculating initial margin pursuant to the requirements of Rule 18a-3, as adopted.

To qualify, the firm must have a complete application pending for approval to use a model.[245] The requirement that a complete application be pending is designed to limit the amount of time that the firm uses the provisional model and incentivize firms to promptly file applications for model approval.

In addition, to be approved by the Commission, the use of the provisional model must have been approved by a prudential regulator, the CFTC, a CFTC-registered futures association, a foreign financial regulatory authority that administers capital and/or margin requirements that the Commission has found are eligible for substituted compliance, or any other foreign supervisory authority that the Commission finds has approved and monitored the use of the provisional model through a process comparable to the process set forth in the final rules.[246] This condition is designed to ensure that the provisional model has been approved by a financial regulator that is administering a program for approving and monitoring the use of models that is consistent with the Commission's program, including with respect to the qualitative and quantitative requirements for models in the final rules being adopted today.

v. Credit Risk Models

The pre-existing provisions of paragraph (a)(7) of Rule 15c3-1 and paragraph (c) of Rule 15c3-1e permit an ANC broker-dealer to treat uncollateralized current exposure to a counterparty arising from derivatives transactions as part of its tentative net capital instead of deducting 100% of the value of the unsecured receivable (as is required with respect to most unsecured receivables under Rule 15c3-1).[247] These provisions further require the ANC broker-dealer to take a credit risk charge to tentative net capital (along with the market risk charges—the model-based haircuts—discussed above in section II.A.2.b.iv. of this release) to compute its net capital. The credit risk charge typically will be significantly less than the 100% deduction to net worth that would have otherwise applied to the unsecured receivable since the credit risk charge is a percentage of the amount of the receivable. The pre-existing provisions of paragraph (c) of Rule 15c3-1e prescribe the method for calculating credit risk charges (“ANC credit risk model”). In particular, the credit risk charge is the sum of 3 calculated amounts: (1) A counterparty exposure charge; (2) a concentration charge if the current exposure to a single counterparty exceeds certain thresholds; and (3) a portfolio concentration charge if the aggregate current exposure to all counterparties exceeds 50% of the firm's tentative net capital.

The capital rules governing OTC derivatives dealers similarly permit them to include uncollateralized current exposures to a counterparty arising from derivatives transactions in their tentative net capital, and require them to take a credit risk charge to tentative net capital with respect to these exposures to compute net capital.[248] Start Printed Page 43902Paragraph (d) of Rule 15c3-1f prescribes the method for computing the credit risk charges for OTC derivatives dealers (“OTCDD credit risk model”). The OTCDD credit risk model is similar to the ANC credit risk model except that the former does not include a portfolio concentration charge.[249]

Commission staff reviews an ANC broker-dealer's use of the ANC credit risk model as part of the overall review of the firm's ANC application and monitors the firm's use of the model thereafter. Moreover, the process is subject to the pre-existing provisions of paragraphs (a)(8), (a)(10), and (a)(11) of Rule 15c3-1e, which provide, respectively, that: (1) An ANC broker-dealer must amend and submit to the Commission for approval its ANC application before materially changing its ANC credit risk model; (2) an ANC broker-dealer must notify the Commission 45 days before it ceases using its ANC credit risk model; and (3) the Commission, by order, can revoke an ANC broker-dealer's ability to use the ANC credit risk model. Commission staff also reviews and monitors an OTC derivatives dealer's use of its OTCDD credit risk model.[250]

Under the pre-existing provisions of Rule 15c3-1e, an ANC broker-dealer approved to use an ANC credit risk model can apply the model to unsecured receivables arising from OTC derivatives instruments from all types of counterparties. The Commission proposed to narrow this treatment so that ANC broker-dealers could apply the ANC credit risk model to unsecured receivables arising exclusively from security-based swap transactions with commercial end users (i.e., unsecured receivables arising from other types of derivative transactions were subject to the 100% deduction from net worth).[251]

The Commission proposed that stand-alone SBSDs authorized to use models also could apply a credit risk model to unsecured receivables arising from security-based swap transactions with commercial end users.[252] The proposed credit risk model for stand-alone SBSDs was modeled on the ANC credit risk model (as opposed to the OTCDD credit risk model). Consequently, the credit risk model for stand-alone SBSDs included a portfolio concentration charge if aggregate current exposures to all counterparties exceeded 50% of the firm's tentative net capital.

In the 2018 comment reopening, the Commission asked whether the final rules should cap the ability of ANC broker-dealers and stand-alone SBSDs authorized to use models to apply the credit risk models to uncollateralized current exposures arising from security-based swap and swap transactions with commercial end users. The Commission asked whether this cap should equal 10% of the firm's tentative net capital.[253] In addition, the Commission asked whether the use of the credit risk models by ANC broker-dealers and stand-alone SBSDs should be expanded to apply to uncollateralized potential exposures to counterparties arising from electing not to collect initial margin for non-cleared security-based swap and swap transactions pursuant to exceptions in the margin rules of the Commission and the CFTC. This treatment would be an alternative to taking the 100% deduction to net worth in lieu of collecting initial margin.

Comments and Final Requirements for Using Credit Risk Models

A commenter urged the Commission not to limit the circumstances in which the credit risk models could be used.[254] The commenter stated that uncollateralized receivables arising from a counterparty failing to post margin typically result from operational issues that are temporary in nature (i.e., that are addressed in a matter of days) and are liquidated if they last for longer periods of time. The commenter stated that a credit risk charge adequately addresses the risks of under-collateralized positions during the interim period before margin is posted and that “a punitive 100% deduction is unnecessary.” The commenter also stated that requiring a nonbank SBSD to hold additional capital for each dollar of margin it did not collect from a non-financial entity for a swap would effectively undermine an exception proposed by the CFTC, which the commenter indicated would deter the dual registration of nonbank SBSDs as swap dealers. The commenter also requested that the Commission permit ANC broker-dealers and stand-alone SBSDs authorized to use models to apply a counterparty credit risk charge in lieu of a 100% deduction for security-based swaps and swaps with sovereigns, central banks, supranational institutions, and affiliates to the extent that an exception to applicable margin requirements applies. Similarly, another commenter recommended that the Commission calibrate the capital charges so that they do not make compliance with other regulators' margin rules punitive.[255]

A commenter stated that ANC broker-dealers and stand-alone SBSDs should be permitted to apply the credit risk models to uncollateralized exposures to multilateral development banks in which the U.S. is a member.[256] This commenter stated that the Commission's proposal to limit use of the models to commercial end users is unwarranted, on either risk-based or policy grounds. A commenter stated that requiring a 100% deduction for unsecured receivables from commercial end users with respect to swap transactions (as compared to security-based swap transactions for which the credit risk models would apply) will make it difficult, if not impossible, to maintain a dually-registered nonbank SBSD and swap dealer.[257] Another commenter urged the Commission to modify its proposal to avoid the pass-through of costs to commercial end users that the commenter argued would result if SBSDs are required to hold capital to cover unsecured credit exposures to them.[258] This commenter also recommended that the Commission allow nonbank SBSDs and nonbank MSBSPs that are not approved to use internal models to take the credit risk charge (i.e., not limit its use to ANC broker-dealers and stand-alone SBSDs authorized to use models). One commenter suggested that the Commission substitute a credit risk charge or a credit concentration charge in place of the 100% charge for legacy accounts, with an exception permitting SBSDs to exclude any currently non-cleared positions for which a clearing agency has made an application to the Commission to accept for clearing.[259]

In response to the 2018 comment reopening, a commenter expressed support for expanding the use of credit risk models to uncollected initial margin from legacy accounts.[260] This commenter argued that this would be comparable to capital rules for bank SBSDs. Similarly, a commenter supported expanding the use of credit Start Printed Page 43903risk models, noting that it would be consistent with the Basel capital standards as well as the manner in which the current net capital rule applies to ANC broker-dealers.[261] Conversely, a commenter opposed expanding the use of credit risk models.[262]

Finally, a commenter raised concerns about the potential rule language in the 2018 comment reopening because it narrowed the ability to use credit risk models for transactions in security-based swaps and swaps.[263] The commenter noted that the current capital rules permit ANC broker-dealers to use the ANC credit risk models with respect to derivatives instruments, which encompass—among other things—OTC options that are not security-based swaps or swaps.

In response to these comments, the Commission is persuaded that the ability to apply the credit risk models should not be narrowed as proposed in 2012 (i.e., to exposures arising from uncollected variation and initial margin from commercial end users). The Commission believes the better approach is to maintain the existing provision in Rule 15c3-1 that permits an ANC broker-dealer to apply the ANC credit risk model to credit exposures arising from all derivatives transactions. The Commission further believes that Rule 18a-1 should permit stand-alone SBSDs authorized to use models to similarly apply the credit risk model. Consequently, under the final rules, the credit risk models can be applied to uncollateralized current exposures to counterparties arising from all derivatives instruments, including such exposures arising from not collecting variation margin from counterparties pursuant to exceptions in the margin rules of the Commission and the CFTC.[264]

The final rules also permit use of the credit risk models instead of taking the 100% deductions to net worth for electing not to collect initial margin for non-cleared security-based swaps and swaps pursuant to exceptions in the margin rules of the Commission and the CFTC, respectively. This broader application of the credit risk models with respect to security-based swap and swap transactions—which will reduce the amount of the capital charges—should mitigate concerns raised by commenters about the impact that the 100% deductions to net worth would have on nonbank SBSDs and their counterparties. It also responds to commenters who requested that the ability to use the credit risk models be expanded to a broader range of transactions. In addition, the broader application of credit risk models should mitigate the concerns raised by commenters that applying the 100% deduction to net worth with respect to swap transactions would make it difficult, if not impossible, to maintain an entity dually-registered as a nonbank SBSD and swap dealer.

As noted above, the 2018 comment reopening described a potential cap equal to 10% of the firm's tentative net capital that would limit the firm's ability to apply the credit risk models to uncollateralized current exposures arising from electing not to collect variation margin.[265] Under this potential threshold, a firm would need to take a capital charge equal to the aggregate amount of uncollateralized current exposures that exceeded 10% of the firm's tentative net capital.

Commenters addressed this potential cap. One commenter recommended that rather than an aggregate cap, the Commission adopt a counterparty-by-counterparty threshold equal to 1% of the firm's tentative net capital.[266] In the alternative, this commenter suggested using a 20% cap, if the Commission deemed it necessary to impose an aggregate limit. Another commenter suggested that the Commission not adopt the 10% cap and instead rely on the existing portfolio concentration charge in Rule 15c3-1e that is part of the credit risk model used to calculate the credit risk charges.[267]

In response to the comments, the 10% cap was designed to limit the amount of a firm's capital base that is comprised of unsecured receivables. These assets generally are illiquid and cannot be readily converted to cash, particularly in a time of market stress. Permitting additional unsecured receivables to be allowable assets for capital purposes (in the form of either a higher aggregate cap or alternative thresholds) could substantially impair the firm's liquidity and ability to withstand a financial shock. Moreover, as discussed above, the Commission is broadening the application of the credit risk models to all types of counterparties and transactions that are subject to exceptions in the margin rules for non-cleared security-based swaps and swaps.

For these reasons, the Commission believes it is an appropriate and prudent measure to adopt the 10% cap for ANC broker-dealers, including ANC broker-dealer SBSDs. These firms engage in a wide range of securities activities beyond dealing in security-based swaps, including maintaining custody of securities and cash for retail customers. They are significant participants in the securities markets and, accordingly, the Commission believes it is appropriate to adopt rules that promote their safety and soundness by limiting the amount of unsecured receivables that can be part of their regulatory capital. Thus, the Commission does not believe increasing the 10% cap to a 20% cap would be appropriate.

Consequently, under the final rule, these firms are subject to a portfolio concentration charge equal to 100% of the amount of the firm's aggregate current exposure to all counterparties in excess of 10% of the firm's tentative net capital.[268] Thus, unsecured receivables arising from electing not to collect variation margin are included in the portfolio concentration charge. The charge does not include potential future exposure arising from electing not to collect initial margin.

In response to comments, the Commission has reconsidered the proposed portfolio concentration charge for stand-alone SBSDs (including stand-alone SBSDs registered as OTC derivatives dealers).[269] These firms will engage in a much more limited securities business as compared to ANC broker-dealers, including ANC broker-dealer SBSDs. Consequently, they will be a less significant participant in the broader securities market. Moreover, under existing requirements, OTC derivatives dealers are not subject to a portfolio concentration charge.[270] Therefore, not including a portfolio concentration charge for stand-alone SBSDs will more closely align the credit risk model for these firms with the OTCDD credit risk model. The Commission believes this is appropriate as both types of entities are limited in the activities they can engage in as compared to ANC broker-dealers. Further, as discussed above in section II.A.4. of this release, a stand-alone SBSD that also is registered as an OTC derivatives dealer will be subject to Start Printed Page 43904Rules 18a-1, 18a-1a, 18a-1b, 18a-1c and 18a-1d rather than Rule 15c3-1 and its appendices (and, in particular, Rule 15c3-1f). Consequently, not including a portfolio concentration charge in Rule 18a-1 will avoid having two different standards: one for OTC derivatives dealers that also are SBSDs and the other for OTC derivatives dealers that are not SBSDs. For these reasons, the credit risk model for stand-alone SBSDs in Rule 18a-1 has been modified from the proposal to eliminate the portfolio concentration charge.[271]

In addition to the foregoing modifications to the credit risk models for ANC broker-dealers and stand-alone SBSDs, the Commission is making an additional modification to the term “collateral” as defined in the rules for purposes of the models.[272] In particular, the existing definition in Rule 15c3-1e and the proposed definition in Rule 18a-1 provided that in applying the credit risk model the fair market value of collateral pledged by the counterparty could be taken into account if, among other conditions, the firm maintains possession or control of the collateral.[273] Consequently, under the existing and proposed rules, collateral held at a third-party custodian could not be taken into account because it was not in the possession or control of the firm.

As discussed above in section II.A.2.b.ii. of this release, the Commission believes it would be appropriate to recognize a broader range of custodians for purposes of the exception to taking the deduction to net worth when initial margin is held at a third-party custodian. Consequently, the Commission modified that provision so that, for purposes of the exception, a stand-alone broker-dealer or nonbank SBSD could recognize collateral held at a bank as defined in Section 3(a)(6) of the Exchange Act or a registered U.S. clearing organization or depository that is not affiliated with the counterparty or, if the collateral consists of foreign securities or currencies, a supervised foreign bank, clearing organization, or depository that is not affiliated with the counterparty and that customarily maintains custody of such foreign securities or currencies.[274] The Commission believes the same types of custodians should be recognized for purposes of the credit risk models and accordingly is modifying the definitions of “collateral” in Rules 15c3-1e, as amended, and 18a-1, as adopted, to permit an ANC broker-dealer or nonbank SBSD to take into account collateral held at a third-party custodian that is one of these entities, subject to the same conditions with respect to foreign securities and currencies.[275]

A commenter urged the Commission to modify the proposed application of the credit risk models to avoid the pass-through of costs to commercial end users that the commenter argued would result if nonbank SBSDs are required to hold capital to cover unsecured credit exposures to these counterparties.[276] The commenter recommended that the Commission allow nonbank SBSDs not authorized to compute model-based haircuts to use the credit risk models (i.e., not limit the use of credit risk models to ANC broker-dealers and stand-alone SBSDs authorized to use models). Another commenter suggested that nonbank SBSDs that have not been approved to use models for capital purposes also be allowed to compute credit risk charges for uncollected initial margin by multiplying the exposure by 8% and a credit-risk-weight factor.[277]

In response, the Commission does not believe it would be appropriate to permit stand-alone SBSDs that are not authorized to use models to apply model-derived credit risk charges. First, the credit risk models used by ANC broker-dealers and nonbank SBSDs require a calculation of maximum potential exposure to the counterparty multiplied by a back-testing-determined factor.[278] The maximum potential exposure amount is a charge to address potential future exposure and is calculated using the firm's market risk model (i.e., the model to calculate model-based haircuts) as applied to the counterparty's positions after giving effect to a netting agreement with the counterparty, taking into account collateral received from the counterparty, and taking into account the current replacement value of the counterparty's positions. Second, ANC broker-dealers and stand-alone SBSDs authorized to use models are subject to higher minimum tentative net capital and net capital requirements. These enhanced minimum capital requirements are designed to account for the lower deductions that result from using models. Nonbank SBSDs that have not been authorized to use models will not be subject to these additional requirements. Moreover, as a practical matter, the Commission expects that most nonbank SBSDs will apply to use models.

A commenter argued that adopting an exception from collecting initial margin from another SBSD for a non-cleared security-based swap transaction without imposing a deduction from net worth would be inappropriate.[279] The commenter argued that these counterparties could default, which, in turn, could increase systemic risk. In response, as discussed above in section II.A.2.b.ii. of this release, the final rules require a nonbank SBSD to take a deduction in lieu of margin when it does not collect initial margin from a counterparty, including an SBSD. The capital charge is designed to achieve the same objective as collecting margin (i.e., protect the nonbank SBSD from the consequences of the counterparty's default). Moreover, a nonbank SBSD will be required to collect variation margin from other financial market intermediaries such as SBSDs.

A commenter stated that uncollateralized receivables arising from a counterparty failing to post margin typically result from operational issues that are temporary in nature (i.e., that are addressed in a matter of days) and are liquidated if they last for longer periods of time.[280] Consequently, the commenter requested that the Commission expand the use of credit risk models to instances when the nonbank SBSD does not collect required margin (i.e., as distinct from when the SBSD elects not collect margin pursuant to an exception in the margin rules). As discussed above in section II.A.2.b.ii. of this release with respect to under-margined accounts, when margin is required it should be collected promptly, as it is designed to protect the nonbank SBSD from the consequences of the counterparty defaulting on its obligations. The 100% deduction from net worth for failing to collect required margin will serve as an incentive for nonbank SBSDs to have a well-Start Printed Page 43905functioning margin collection system and the capital needed to take the deduction will protect the nonbank SBSD from the consequences of the counterparty's default. However, the final margin rule being adopted today provides a nonbank SBSD or MSBSP an additional day to collect required margin from a counterparty (including variation margin due from an affiliate) if the counterparty is located in a different country and is more than 4 time zones away.[281] This should mitigate the commenter's concern about having to take a deduction when required margin is not collected in a timely manner.

Finally, a commenter requested that the Commission permit a nonbank SBSD to substitute the credit risk charge that would apply to a transaction with a counterparty with the credit risk charge that would apply to a transaction with a different counterparty that hedges the transaction with the first counterparty, as permitted under bank capital rules under certain conditions.[282] The commenter cited a bank regulation that permits this shifting of credit risk charges.[283] The bank regulation cited in support of this comment is integrated into the broader set of bank capital regulations. The commenter did not describe why such a provision would be appropriate for a nonbank or which bank regulations would need to be codified into the ANC broker-dealer and nonbank SBSD capital rules to prudently and effectively implement it. Consequently, the Commission is not incorporating such a provision into the ANC broker-dealer and nonbank SBSD capital rules.[284]

For the foregoing reasons, the Commission is adopting final rules that permit ANC broker-dealers and stand-alone SBSDs authorized to use credit risk models to apply the credit risk charges with the modifications discussed above.[285] The Commission also is adopting final rules regarding the operation of the credit risk models with the modifications discussed above.[286]

c. Risk Management

ANC broker-dealers and OTC derivatives dealers are subject to a risk management rule.[287] Rule 15c3-4 requires these firms to, among other things, establish, document, and maintain a system of internal risk management controls to assist in managing the risks associated with their business activities, including market, credit, leverage, liquidity, legal, and operational risks. The Commission proposed that nonbank SBSDs be required to comply with Rule 15c3-4 to promote the establishment of effective risk management control systems by these firms.[288]

Commenters expressed support for the Commission's proposal.[289] A commenter stated that requiring nonbank SBSDs to comply with Rule 15c3-4 “will better enable nonbank SBSDs to identify and mitigate and manage the risks they are facing.” [290] A second commenter stated that Rule 15c3-4 should already contemplate the unique needs of a dealer in derivatives.[291] The Commission is adopting, as proposed, the requirement that nonbank SBSDs comply with Rule 15c3-4.[292]

d. Other Rule 15c3-1 Provisions Incorporated Into Rule 18a-1

i. Debt-Equity Ratio Requirements

Paragraph (d) of Rule 15c3-1 sets limits on the amount of a stand-alone broker-dealer's outstanding subordinated loans. The debt-to-equity limits are designed to ensure that a stand-alone broker-dealer has a base of permanent capital in addition to any subordinated loans, which—as discussed above—are permitted to be added back to net worth when computing net capital. Paragraph (h) of proposed Rule 18a-1 contained parallel debt-to-equity limits.[293] The Commission did not receive comments concerning the debt-to-equity limits in proposed Rule 18a-1 and for the reasons discussed in the proposing release is adopting them as proposed.[294]

ii. Capital Withdrawal Requirements

Paragraph (e)(1) of Rule 15c3-1 requires that a stand-alone broker-dealer provide notice when it seeks to withdraw capital in an amount that exceeds certain thresholds. Paragraph (e)(2) of Rule 15c3-1 permits the Commission to issue an order temporarily restricting a stand-alone broker-dealer from withdrawing capital or making loans or advances to stockholders, insiders, and affiliates under certain circumstances. The Commission proposed parallel requirements for stand-alone SBSDs.[295] The Commission did not receive comments concerning the proposed capital withdrawal requirements for stand-alone SBSDs and for the reasons discussed in the proposing release is adopting them as proposed.[296]

iii. Appendix C

Appendix C to Rule 15c3-1 requires a stand-alone broker-dealer in computing its net capital and aggregate indebtedness to consolidate, in a single computation, assets and liabilities of any subsidiary or affiliate for which it guarantees, endorses, or assumes, directly or indirectly, obligations or liabilities.[297] The assets and liabilities of a subsidiary or affiliate whose liabilities and obligations have not been guaranteed, endorsed, or assumed directly or indirectly by the stand-alone broker-dealer may also be consolidated. Subject to certain conditions in Appendix C to Rule 15c3-1, a stand-alone broker-dealer may receive flow-through net capital benefits because the consolidation may serve to increase the firm's net capital and thereby assist it in Start Printed Page 43906meeting the minimum requirements of Rule 15c3-1. However, based on Commission staff experience and information from an SRO, very few stand-alone broker-dealers consolidate subsidiaries or affiliates to obtain the flow-through capital benefits permitted under Appendix C to Rule 15c3-1.

Consequently, the Commission proposed a parallel requirement for a stand-alone SBSD to include in its net capital computation all liabilities or obligations of a subsidiary or affiliate of the stand-alone SBSD that the SBSD guarantees, endorses, or assumes either directly or indirectly, but the Commission did not propose parallel provisions permitting flow-through capital benefits.[298] The Commission did not receive comments on this proposed consolidation requirement and for the reasons discussed in the proposing release is adopting it as proposed.[299]

iv. Appendix D

Paragraph (c)(2)(ii) of Rule 15c3-1 permits a stand-alone broker-dealer when computing net capital to exclude liabilities that are subordinated to the claims of creditors pursuant to a satisfactory subordination agreement. Excluding these liabilities has the effect of increasing the firm's net capital. Appendix D to Rule 15c3-1 (Rule 15c3-1d) sets forth minimum and non-exclusive requirements for satisfactory subordination agreements.[300] There are two types of subordination agreements under Rule 15c3-1d: (1) A subordinated loan agreement, which is used when a third party lends cash to a stand-alone broker-dealer;[301] and (2) a secured demand note agreement, which is a promissory note in which a third party agrees to give cash to a stand-alone broker-dealer on demand during the term of the note and provides cash or securities to the broker-dealer as collateral.[302] Based on Commission staff experience, stand-alone broker-dealers infrequently utilize secured demand notes as a source of capital, and the amounts of these notes are relatively small in size.

Certain of the provisions in Rule 15c3-1d are tied to the minimum net capital requirements of stand-alone broker-dealers. Consequently, the Commission proposed amendments to the rule to reflect the proposed minimum net capital requirements of broker-dealer SBSDs so that they could realize the net capital benefits of qualified subordination agreements.[303] The Commission also included parallel provisions in proposed Rules 18a-1 and 18a-1d so that stand-alone SBSDs could realize the net capital benefits of qualified subordination agreements.[304] However, because stand-alone broker-dealers rarely use secured demand notes, the proposed provisions for stand-alone SBSDs did not include this option for entering into a qualified subordinated agreement. The Commission did not receive comments on the proposed amendments to Rule 15c3-1d or the proposed parallel provisions for stand-alone SBSDs and for the reasons discussed in the proposing release is adopting them with certain non-substantive modifications.[305]

v. Capital Charge for Unresolved Securities Differences

Paragraph (c)(2)(v) of Rule 15c3-1 requires a stand-alone broker-dealer to take a capital charge for short securities differences that are unresolved for seven days or longer and for long securities differences where the securities have been sold before they are adequately resolved. These capital charges were inadvertently omitted from the text of Rule 18a-1 when it was proposed and, consequently, the Commission proposed to include them in the rule when proposing the recordkeeping and reporting rules for SBSDs and MSBSPs.[306] The Commission received one comment, which addressed concerns regarding short sale buy-in requirements that are beyond the scope of this rulemaking.[307] For the reasons discussed in the proposing release, the Commission is adopting the capital charges as proposed with minor non-substantive changes.[308]

3. Capital Rules for Nonbank MSBSPs

The Commission proposed Rule 18a-2 to establish capital requirements for nonbank MSBSPs.[309] Under the proposal, nonbank MSBSPs were required at all times to have and maintain positive tangible net worth. The Commission proposed a tangible net worth standard, rather than the net liquid assets test in Rule 15c3-1, because the entities that may need to register as nonbank MSBSPs may engage in a diverse range of business activities different from, and broader than, the securities activities conducted by stand-alone broker-dealers or SBSDs. As proposed, the term “tangible net worth” was defined to mean the nonbank MSBSP's net worth as determined in accordance with GAAP, excluding goodwill and other intangible assets. Consequently, the definition of “tangible net worth” allowed nonbank MSBSPs to include as regulatory capital assets that would be deducted from net worth under Rule 15c3-1, such as property, plant, equipment, and unsecured receivables. At the same time, it would require the deduction of goodwill and other intangible assets.

The Commission also proposed that nonbank MSBSPs must comply with Rule 15c3-4 with respect to their security-based swap and swap activities. Requiring nonbank MSBSPs to be subject to Rule 15c3-4 was intended to promote sound risk management practices with respect to the risks associated with OTC derivatives.

Commenters expressed support for the Commission's proposed requirements for nonbank MSBSPs.[310] A commenter stated that the positive tangible net worth test is more appropriate than the net liquid assets test particularly for entities that have never been prudentially regulated before.[311] Another commenter supported “the proposed requirement Start Printed Page 43907that MSBSPs maintain a positive tangible net worth.” [312] However, the commenter also stated that the proposed rule “should recognize and respect state insurance regulators' role in ensuring the capital adequacy of financial guaranty insurers, and should accordingly recognize that, in the case of a financial guaranty insurer, any positive tangible net worth requirement should be satisfied if an insurer maintains the minimum statutory capital and complies with the investment requirements under applicable insurance law.” [313] This commenter also stated that, to the extent that financial guaranty insurers use affiliates to write CDS that they in turn insure, and insofar as such affiliates are designated as MSBSPs, the positive tangible net worth test should refer back to the financial guaranty insurer itself, as that is the entity that the CDS counterparties look to for paying the affiliates' obligations under the insured CDS.

With respect to the Commission's proposal that nonbank MSBSPs comply with Rule 15c3-4, the commenter stated that it recognized the need for nonbank MSBSPs to maintain strong internal risk controls, but cautioned the Commission against imposing unnecessarily burdensome, duplicative, and costly risk management controls on financial guaranty insurers. This commenter also stated that financial guaranty insurers that are determined to be MSBSPs should be able to establish compliance with Rule 15c3-4 by virtue of compliance with the New York Department of Financial Services Circular Letter No. 14, which calls for the establishment of comprehensive internal risk management controls.

The Commission has considered the comments on its proposed requirements for nonbank MSBSPs and is adopting the requirements substantially as proposed.[314] The requirement that nonbank MSBSPs at all times have and maintain positive tangible net worth is intended to be a less rigorous requirement than the net liquid assets test applicable to stand-alone broker-dealers and nonbank SBSDs. It will provide a workable standard for entities that engage in a diverse range of business activities that differ from, and are broader than, the securities activities conducted by stand-alone broker-dealers or SBSDs.

In response to the comment that the rule should recognize and respect existing state insurance law capital adequacy standards, the commenter supported the proposed tangible net worth requirement for nonbank MSBSPs.[315] The final rule imposes a relatively simple capital standard—the requirement to maintain positive tangible net worth (i.e., positive net worth after deducting intangible assets). This should not impose a significant burden on nonbank MSBSPs, including firms that also are subject to capital requirements under state insurance laws. If it is possible that a nonbank MSBSP's capital position could drop below a positive tangible net worth but at the same time still comply with a state insurance law capital requirement, the Commission believes the rule's positive tangible net worth standard should be the binding constraint with respect to the nonbank MSBSP's activities as an MSBSP. The Commission does not believe it would be appropriate to permit a nonbank MSBSP to continue to operate as an MSBSP if it cannot meet the capital requirement of the positive tangible net worth test. In such a case, the firm's precarious capital position would pose a significant risk to its security-based swap counterparties.

In response to the comment about nonbank MSBSPs with CDS insured by an affiliate, the commenter did not identify an alternative capital standard that should apply to such nonbank MSBSPs. If the commenter was suggesting that these nonbank MSBSPs should be subject to a lesser requirement than the positive tangible net worth standard, the Commission disagrees. As discussed above, the Commission believes this standard will not impose a substantial burden on nonbank MSBSPs. Further, to the extent the affiliate insuring the CDS fails, the nonbank MSBSP will need to rely on its own financial resources.

The Commission also is adopting, as proposed, the requirement that MSBSPs comply with Rule 15c3-4.[316] Although a commenter cautioned the Commission against imposing unnecessarily burdensome, duplicative, and costly risk management controls on financial guaranty insurers, the Commission believes that establishing and maintaining a strong risk management control system that complies with Rule 15c3-4 is necessary for entities engaged in a security-based swaps business. Participants in the securities markets are exposed to various risks, including market, credit, leverage, liquidity, legal, and operational risk. Risk management controls promote the stability of the firm and, consequently, the stability of the marketplace. A firm that adopts and follows appropriate risk management controls reduces its risk of significant loss, which also reduces the risk of spreading the losses to other market participants or throughout the financial markets as a whole. Moreover, to the extent an entity, such as a financial guaranty insurer, complies with existing risk management requirements applicable to its business, the entity will likely have in place some, if not many, of the required risk management controls. Thus, the incremental burdens and costs associated with complying with Rule 15c3-4 should not be great.

4. OTC Derivatives Dealers

OTC derivatives dealers are limited purpose broker-dealers that are authorized to trade in OTC derivatives (including a broader range of derivatives than security-based swaps) and to use models to calculate net capital. They are required to maintain minimum tentative net capital of $100 million and minimum net capital of $20 million.[317] OTC derivatives dealers also are subject to Rule 15c3-4.

A commenter stated that OTC derivatives dealers will register as nonbank SBSDs in order to conduct an integrated equity derivatives business (i.e., trade in equity security-based swaps and equity OTC options).[318] The commenter requested that the Commission modify its framework for OTC derivatives dealers to allow them to register as nonbank SBSDs. The commenter further stated that the Commission should permit an OTC derivatives dealer that is dually registered as a nonbank SBSD to deal in OTC options and qualifying forward contracts, subject to the rules applicable to the nonbank SBSD.

The Commission agrees with the commenter that entities may seek to deal in a broader range of OTC derivatives that are securities other than dealing in just security-based swaps. In order to engage in this broader securities activity, the entity would need to register as a broker-dealer. The capital Start Printed Page 43908rules the Commission is adopting today address entities that will register as broker-dealer SBSDs. In response to the comments, the Commission believes it would be appropriate to also adopt final rules to address OTC derivatives dealers that will register as nonbank SBSDs. Accordingly, the final rules provide that an OTC derivatives dealer that is registered as a nonbank SBSD must comply with Rule 18a-1, as adopted, and Rules 18a-1a, 18a-1b, 18a-1c and 18a-1d instead of Rule 15c3-1 and its appendices.[319] This will simplify the capital rules for such an entity by requiring the firm to comply with a single set of requirements.

Moreover, the provisions of Rule 18a-1 and related rules are similar to the provisions of Rule 15c3-1 and its appendices. For example, the minimum fixed-dollar capital requirements in both sets of rules are $100 million in tentative net capital and $20 million in net capital. Both sets of rules permit the firms to compute net capital using models. In addition, as discussed above in section II.A.2.b.v. of this release, the methodology for computing the credit risk charges in Rule 18a-1 does not include the proposed portfolio concentration charge. As a result of this modification, both sets of rules are consistent in that they do not require this charge. Stand-alone SBSDs and OTC derivatives dealers also are both subject to Rule 15c3-4. For these reasons, the Commission believes a stand-alone SBSD should be able to efficiently incorporate its activities as an OTC derivatives dealer into its capital and risk management requirements under Rule 18a-1, as adopted.

B. Margin

1. Introduction

The Commission is adopting Rule 18a-3 pursuant to Section 15F of the Exchange Act to establish margin requirements for nonbank SBSDs and MSBSPs with respect to non-cleared security-based swaps. The Commission modeled Rule 18a-3 on the margin rules applicable to stand-alone broker-dealers (the “broker-dealer margin rules”).[320] A commenter supported the Commission's decision to base its proposal on the existing margin rules for stand-alone broker-dealers, noting that it is critically important that the Commission maintain a level playing field for similar financial instruments.[321]

A number of commenters raised concerns about the Commission's decision to model proposed Rule 18a-3 on the broker-dealer margin rules to the extent that doing so resulted in inconsistencies with the margin rules of the CFTC and the prudential regulators as well as with the recommendations in the BCBS/IOSCO Paper.[322] A commenter argued that the broker-dealer margin rules are not consistent with the restrictions on re-hypothecation recommended by the BCBS/IOSCO Paper.[323] This commenter stated that the Commission needed to tailor its margin requirements to the realities of the security-based swap and swap markets.

Another commenter appreciated that the Commission largely modeled its proposed margin rules on the broker-dealer margin rules in an effort to promote consistency with existing rules, but suggested that the Commission more closely conform its final rules to the recommendations in the final BCBS/IOSCO Paper to promote the comparability of margin requirements among jurisdictions.[324] A second commenter noted that material differences and inconsistencies between the proposal and domestic and international standards could cause a need for separate documentation and tri-party arrangements for security-based swaps and swaps, which could lead to separate margin calls and different netting sets.[325]

A commenter suggested that the Commission coordinate its margin rules with the CFTC and the prudential regulators and raised a concern that the cumulative effects of multiple regulations potentially could tie up significant amounts of financial resources.[326] Other commenters recommended re-proposing the margin rule after publication of the final recommendations of the BCBS/IOSCO Paper, as well as coordinating and harmonizing with the margin rules of the CFTC and other foreign and domestic regulators.[327] A commenter argued that inconsistent rules potentially could be incompatible in practice and that international adoption of the recommended standards in the BCBS/IOSCO Paper will prevent regulatory arbitrage and lead to a more level playing field between competitors in different jurisdictions.[328] Other commenters argued that the Commission should more closely align its margin requirements to the recommended standards in the BCBS/IOSCO Paper to promote more comparable margin requirements across jurisdictions.[329] One commenter argued that several components of the proposed margin rules differ from the recommended framework in the BCBS/IOSCO Paper and would generally make nonbank SBSDs uncompetitive with bank SBSDs and foreign SBSDs.[330] The commenter argued that the Commission could best address these differences by permitting OTC derivatives dealers and stand-alone SBSDs to collect and maintain margin in a manner consistent with the recommendations in the BCBS/IOSCO Paper.

Section 15F(e)(3)(D) of the Exchange Act requires that, to the maximum extent practicable, the Commission, the CFTC, and the prudential regulators shall establish and maintain comparable minimum initial and variation margin requirements for SBSDs and MSBSPs. In response to the comments above, the Commission has modified the proposal to more closely align the final rule with the margin rules of the CFTC and the prudential regulators and, in doing so, Start Printed Page 43909the recommendations in the IOSCO/BCBS Paper. As discussed in more detail below, these modifications to harmonize the final rule include:

  • An extra day to collect margin in the event a counterparty is located in a different country and more than 4 time zones away;
  • A requirement that SBSDs post variation margin to most counterparties;
  • An exception pursuant to which a nonbank SBSD need not collect initial margin to the extent that the initial margin amount when aggregated with other security-based swap and swap exposures of the nonbank SBSD and its affiliates to the counterparty and its affiliates does not exceed a fixed-dollar $50 million threshold;
  • An exception pursuant to which a nonbank SBSD need not collect initial margin from a counterparty that is an affiliate of the nonbank SBSD;
  • An exception pursuant to which a nonbank SBSD need not collect variation or initial margin from a counterparty that is the BIS, the European Stability Mechanism, or certain multilateral development banks;
  • An exception pursuant to which a nonbank SBSD need not collect initial margin from a counterparty that is a sovereign entity with minimal credit risk;
  • An option for nonbank SBSDs to use models to calculate initial margin that are different from the models they use to calculate capital charges;
  • An option for nonbank SBSDs to use models developed by third parties (which will permit the use of an industry standard model such as ISDA's SIMMTM model); [331]
  • An option for stand-alone SBSDs to use a model to calculate initial margin for equity security-based swaps subject to certain conditions;
  • An option for nonbank SBSDs to collect and deliver collateral that is eligible under the CFTC's margin rules; and
  • An option for nonbank SBSDs to use the standardized haircuts prescribed in the CFTC's margin rule to determine deductions for collateral received or delivered as margin.

While differences remain, the Commission believes the final nonbank SBSD margin rule for non-cleared security-based swaps is largely comparable to the margin rules of the CFTC and the prudential regulators. The main differences are that the Commission's rule:

  • Does not require (but permits) nonbank SBSDs to collect initial margin from counterparties that are financial market intermediaries such as SBSDs, swap dealers, FCMs, and domestic and foreign broker-dealers and banks;
  • Does not require (but permits) nonbank SBSDs to post initial margin to a counterparty;
  • Does not contain the exceptions from the requirement to collect margin for counterparties such as financial end users that do not have material exposures to security-based swaps and swaps; and
  • Does not require (but permits) initial margin to be held at a third-party custodian.

These differences between the Commission's final rule and the margin rules of the CFTC and the prudential regulators reflect the Commission's judgment of how “to help ensure the safety and soundness” of nonbank SBSDs and MSBSPs as required by Section 15F(e)(3)(i) of the Exchange Act. The Commission has sought to strike an appropriate balance between addressing the concerns of commenters and promulgating a final margin rule that promotes the safety and soundness of nonbank SBSDs.[332] For these reasons, the Commission is adopting a final rule—Rule 18a-3—that is modeled on the broker-dealer margin rule but with the significant modifications noted above. These modifications further harmonize the rule with the final margin rules of the CFTC and the prudential regulators. In particular, and as discussed in more detail below, these changes are intended, in part, to permit firms that are registered as SBSDs and swap dealers to collect initial margin and collect and deliver variation margin in a manner consistent with current practices under the CFTC's margin rules, which should in turn reduce operational burdens that would arise due to differences in these requirements.[333] Moreover, while paragraphs (c)(4) and (5) of Rule 18a-3, as adopted, respectively require netting and collateral agreements to be in place,[334] the rule does not impose a specific margin documentation requirement as do the margin rules of the CFTC and the prudential regulators.[335] Consequently, an existing netting or collateral agreement with a counterparty that was entered into by the nonbank SBSD in order to comply with the margin documentation requirements of the CFTC or the prudential regulators will suffice for the purposes of Rule 18a-3, as adopted, if the agreement meets the requirements of paragraph (c)(4) or (5), as applicable.

2. Margin Requirements for Nonbank SBSDs and Nonbank MSBSPs

a. Daily Calculations

i. Nonbank SBSDs

Proposed Rule 18a-3 required a nonbank SBSD to perform two calculations for the account of each counterparty: (1) The amount of equity in the account (variation margin); and (2) the initial margin amount for the account.[336] The term “equity” was defined to mean the total current fair market value of securities positions in an account of a counterparty (excluding the time value of an over-the-counter option), plus any credit balance and less any debit balance in the account after applying a qualifying netting agreement with respect to gross derivatives payables and receivables meeting the requirements of the rule. As indicated by the definition, the Commission proposed that the nonbank SBSD could offset payables and receivables relating to derivatives in the account by applying a qualifying netting agreement with the counterparty. Proposed Rule 18a-3 set forth the requirements for a netting agreement to qualify for this treatment. The equity in the account was the amount that resulted after Start Printed Page 43910marking-to-market the securities positions and adding the credit balance or subtracting the debit balance (including giving effect to qualifying netting agreements). An account with negative equity was subject to a variation margin requirement unless an exception from collecting collateral to cover the negative equity (i.e., the nonbank SBSD's current exposure) applied.

The proposed rule set forth a standardized and a model-based approach for calculating initial margin.[337] The rule divided security-based swaps into two classes for purposes of the standardized approach: (1) CDS; and (2) all other security-based swaps. In both cases, the initial margin amount was to be calculated using the standardized haircuts in the proposed capital rules for nonbank SBSDs.

Proposed Rule 18a-3 provided that, if the nonbank SBSD was authorized to use model-based haircuts, the firm could use them to calculate initial margin for security-based swaps for which the firm had been approved to apply such haircuts.[338] However, model-based haircuts could not be used to calculate initial margin for equity security-based swaps. Initial margin for equity security-based swaps needed to be calculated using standardized haircuts in order to be consistent with SRO margin rules for cash equity positions. Consequently, a nonbank SBSD authorized to use model-based haircuts for certain types of debt security-based swaps could use these haircuts to calculate initial margin for the same types of positions. For all other positions, a nonbank SBSD needed to use the standardized haircuts. Nonbank SBSDs not authorized to use model-based haircuts needed to use the standardized haircuts to calculate initial margin for all types of positions.

Finally, proposed Rule 18a-3 required a nonbank SBSD to increase the frequency of the variation and initial margin calculations (i.e., perform intra-day calculations) during periods of extreme volatility and for accounts with concentrated positions.[339]

Comments and Final Requirements To Calculate Variation Margin

A commenter sought clarification as to whether the mark-to-market value of security-based swap positions would only be counted in the definition of “equity” as part of the credit balance or the debit balance, as appropriate.[340] This commenter believed the absence of credit and debit balance definitions created a potential issue that the mark-to-market value of non-cleared security-based swap positions would be double counted in the calculation of the equity in a counterparty's account. In response, a nonbank SBSD should only include the mark-to-market value of a security-based swap once when calculating equity in determining the variation margin requirement.

Another commenter stated that counterparties should be permitted to reference third parties for dispute resolution, valuations, and inputs in relation to their account equity variation margin calculations.[341] In response, the Commission agrees that price and valuation information from third parties can be useful in validating the nonbank SBSD's variation margin calculations and in the dispute resolution process.

The Commission is adopting the requirement to calculate variation margin for the account of a counterparty on a daily basis, with certain non-substantive modifications to the rule, in response to comments and to use terms that are more commonly used in the security-based swap market.[342] In the final rule, the Commission has deleted the term “equity” and the definitions of “positive equity” and “negative equity” and has included the phrase “current exposure” without defining it.[343] The phrase “current exposure” is used more commonly in the non-cleared security-based swap market when describing uncollateralized mark-to-market gains or losses.

Comments and Final Requirements To Calculate Initial Margin Using the Standardized Approach

Commenters argued that the standardized approach to calculating initial margin was too conservative and not sufficiently risk sensitive.[344] A commenter stated that the standardized approach would result in excessive margin requirements because the standardized haircuts in the capital rules were applied to gross notional amounts and only permitted limited netting.[345] This commenter also argued that it was unclear how the proposed grids applied to more complex products.

In response to these concerns, nonbank SBSDs may seek authorization to calculate initial margin using the model-based approach. Based on staff experience and the ongoing implementation of margin rules for non-cleared security-based swaps and swaps by other regulators and market participants, the Commission believes that most nonbank SBSDs will seek authorization to use a model. The availability of an initial margin model and the widespread use of initial margin models by industry participants should alleviate commenters' concerns that using standardized haircuts to calculate initial margin will lead to excessive initial margin requirements. While the Commission agrees that standardized haircuts likely will lead to more conservative requirements in contrast to the model-based initial margin calculations, the Commission does not believe these requirements will be excessive. The standardized haircuts have been used by stand-alone broker-dealers for many years. Moreover, as discussed below, the Commission is modifying the proposal to add a threshold under which initial margin need not be collected. This should mitigate the concern raised by the commenter with regard to using the standardized haircuts to calculate initial margin. Finally, the ability to use the simpler standardized haircuts for initial margin calculations may be preferable for nonbank SBSDs that occasionally trade in non-cleared security-based swaps but not in a substantial enough Start Printed Page 43911volume to justify the initial and ongoing systems and personnel costs that may be associated with the implementation and operation of an initial margin model.

Commenters argued that nonbank SBSDs should be permitted to use approaches other than the standardized approach to calculate initial margin for equity security-based swaps.[346] One commenter stated that the standardized haircuts in the capital rules that would be used to calculate initial margin for equity security-based swaps—including the more risk sensitive standardized haircut approach in Rule 15c3-1a and proposed Rule 18a-1a (“Appendix A methodology”)—are inadequate and inefficient for a proper initial margin calculation and do not sufficiently recognize portfolio margining. This commenter argued that the Appendix A methodology does not incorporate critical factors such as volatility, and, as a result, initial margin on equity security-based swaps would likely be insufficient in times of market stress (in contrast to a model-based approach). Finally, this commenter stated that requiring the Appendix A methodology for non-cleared equity security-based swaps would place U.S.-based nonbank SBSDs at a competitive disadvantage in the market because no other jurisdiction (or other U.S. regulator) has proposed to prohibit the use of models for specific asset classes.[347] Another commenter similarly raised concerns that applying the Appendix A methodology (as compared to a model) would result in initial margin requirements that are substantially less sensitive to the economic risks of a security-based swap portfolio, and suggested that the Commission permit a nonbank SBSD to use a model to calculate initial margin for equity security-based swaps.[348] Several other commenters endorsed the use of models to compute initial margin for equity security-based swaps.[349]

The Commission continues to believe it is important to maintain parity between the margin requirements in the cash equity markets and the margin requirements for equity security-based swaps. The only method currently available to portfolio margin positions in the cash equity markets is the Appendix A methodology.[350] Consequently, the Commission is adopting the requirement to use the standardized approach to calculate initial margin for non-cleared equity security-based swaps, but with a modification to address commenters' concerns.[351] In particular, the Commission is modifying the margin rule to permit a stand-alone SBSD to use a model to calculate initial margin for non-cleared equity security-based swaps, provided the account does not hold equity security positions other than equity security-based swaps and equity swaps (e.g., the account cannot hold long and short positions, options, or single stock futures).[352] The Commission believes permitting the model-based approach under these limited circumstances strikes an appropriate balance in terms of addressing commenters' concerns and maintaining regulatory parity between the cash equity market and the equity security-based swap market. Moreover, a nonbank stand-alone SBSD could seek authorization to use a model to portfolio margin equity security-based swaps with equity swaps. Similarly, as discussed above in relation to the standardized haircuts, the Commission modified the Appendix A methodology from the proposal to permit equity swaps to be included in a portfolio of equity products. The ability to use the model-based approach for equity security-based swaps (and potentially equity swaps) and the modification to the Appendix A methodology will facilitate portfolio margining of equity security-based swaps and equity swaps, though the Commission and the CFTC will need to coordinate further to implement this type of portfolio margining.[353]

Comments and Final Requirements To Calculate Initial Margin Using the Model-Based Approach

Comments addressing the model-based approach to calculating initial margin generally fell into one of two broad categories: (1) Comments raising concerns about the risks of using models; and (2) comments supporting the use of models but suggesting modifications to the proposal or seeking clarifications as to how the proposal would work in practice.

In terms of concerns about the risks of models, one commenter argued that using models for capital and margin calculations likely will make capital and margin more pro-cyclical because market data used in the models will show less risk during strong periods of the economic cycle and more risk during downturns.[354] This commenter recommended, among other things, that if internal models continue to be used, they should be “floored” at the level set by standardized approaches (e.g., those used in bank capital regimes), and that the Commission should continue with a review of the implications of the use of internal models. Another commenter stated that netting derivatives exposures (a component of model-based initial margin calculations) when calculating potential losses is an unsound risk management practice.[355] According to the commenter, even if two positions appear to offset one another, liquidity conditions, replacement costs, and counterparty credit risk may vary considerably.

The Commission acknowledges the concerns expressed by commenters about the efficacy of models, particularly in times of market stress. The Commission nonetheless believes it is appropriate to permit firms to employ a model to calculate initial margin. The Commission's supervision of the firms' use of models as well as the conditions that will be imposed governing their use will provide checks that are designed to address the risks identified by the Start Printed Page 43912commenters, such as the potential for firms to manipulate their collateral needs. In addition, the CFTC, the prudential regulators, and foreign financial regulators permit the use of internal models to calculate initial margin. Permitting nonbank SBSDs to use models for this purpose will further harmonize the Commission's margin rule with the rules of domestic and foreign regulators and, therefore, minimize potential competitive impacts of imposing different requirements.

Commenters supporting the use of models commented on the proposed requirement that the initial margin model needed to be the same model used by the nonbank SBSD to calculate haircuts for purposes of the proposed capital rules. These commenters supported the Commission's potential modification to permit nonbank SBSDs to use models other than proprietary capital models to compute initial margin, including an industry standard model.[356] A commenter stated that the rule should provide a nonbank SBSD with the option to choose between internal and third-party models to avoid an uneven playing field among counterparties, noting that not all entities have sufficient resources to develop internal models.[357] This commenter argued that permitting a nonbank SBSD to use a third-party model would reduce the time and resources needed for the Commission to authorize the use of the model. A second commenter requested that nonbank SBSDs be permitted to use an industry standard model to compute initial margin and argued that such a model would result in efficiency, transparency, and consistency in the marketplace.[358] Other commenters generally supported the use of an industry standard model to compute initial margin.[359]

Making a similar point about the benefits of model transparency, a commenter suggested that internal models should be available to counterparties upon request.[360] Similarly, commenters suggested that the ability of a counterparty to replicate a firm's initial margin model should be a condition of the Commission's approval of the model, or that the calculation of initial margin should be independently verifiable.[361] A commenter argued that external models, in some cases, are preferable to internal models because there is less potential for firms to manipulate their collateral needs.[362] The commenter also supported the use of pre-approved clearing agency and DCO models as one input in the calculation of initial margin for non-cleared positions, but cautioned that additional inputs should be required. The commenter opposed the use of vendor-supplied models for the calculation of margin due to concerns that vendors may develop models that would help firms minimize required margin.

Commenters also addressed the potential offsets that could be permitted with respect to the model-based initial margin calculations. A commenter argued that netting should be limited to exactly offsetting positions and that positions that are potentially correlated due to, for example, long and short positions in the same broad industry should not be permitted to be offset.[363] On the other hand, another commenter requested that counterparties be permitted to use a broader product set to calculate initial margin than the set required by each counterparty's applicable regulation.[364] The commenter stated that this broader product set potentially could include a wide set of bilaterally traded products, even if such products are not swaps or derivatives. Other commenters asked the Commission to clarify whether cleared and non-cleared security-based swaps could be offset.[365] A commenter stated that if U.S. registrants must structure their activities so as to margin non-centrally cleared security-based swaps and swaps separately from other non-centrally cleared derivatives, they would be at a significant competitive disadvantage to foreign competitors.[366] Another commenter encouraged the Commission to consider allowing participants to calculate the risk of positions within broad asset classes and then sum the risk calculations for each asset class.[367] A commenter also stated that it is essential that national supervisors provide consistent and more comprehensive guidance regarding model inputs (including baseline stress scenarios) and the adjustment of model inputs.[368] Commenters supported the cross-margining of security-based swaps with other products under a single cross-product netting agreement, as well as the portfolio margining of cleared security-based swaps and swaps.[369]

Commenters also requested that the Commission facilitate portfolio margining.[370] A commenter supported the Commission's proposal to allow portfolio margining between cash market securities and security-based swaps, and encouraged the Commission to work with other regulators to make such an approach as expansive as possible.[371] Other commenters encouraged the Commission to permit a nonbank SBSD (including a broker-dealer SBSD) to portfolio margin non-cleared security-based swaps with non-cleared swaps in accordance with the CFTC's margin and segregation rules, subject to appropriate conditions (including appropriately calibrated capital charges and waiver of customer protection rules).[372] Another commenter argued that the CFTC, in turn, should expand its existing relief allowing a swap dealer to collect and post margin on a portfolio basis for swaps and security-based swaps under the CFTC's margin rules by reciprocally allowing a dually registered swap dealer and nonbank SBSD to portfolio margin security-based swaps and swaps under the Commission's margin rules.[373] One commenter suggested that the Commission clarify that the portfolio margining of cleared and non-cleared Start Printed Page 43913security-based swaps and swaps should be permitted and encouraged the Commission to coordinate with the CFTC to determine appropriate conditions for enhanced portfolio margining.[374]

To expedite the approval process, some commenters suggested that the Commission permit the use of initial margin models approved by other domestic and foreign regulators, or a model already approved for a firm's parent company.[375] One commenter suggested that the Commission provisionally approve proprietary models used by nonbank SBSDs when the margin rules first become effective subject to further Commission review.[376] The commenter argued that such a process would prevent those firms whose models were reviewed earlier from having an unfair market advantage over those firms that are positioned later in the Commission's review schedule.

Other commenters argued that the Commission should restrict the use of portfolio margining to ensure greater security for market participants, or stated that the Commission did not provide an explanation as to how the Commission would oversee portfolio margin models.[377]

In response to comments, the Commission made the following modifications to the proposed model-based approach to calculating initial margin: (1) Nonbank SBSDs may use a model other than their capital model; (2) the final rule provides more clarity as to the offsets permitted of an initial margin model; (3) the final rule permits stand-alone SBSDs to use a model to portfolio margin equity security-based swaps and will permit these entities to include equity swaps in the portfolio, subject to further coordination with the CFTC; and (4) as discussed above in section II.A.2.b.iv. of this release, the final capital rule provides that the Commission may approve the temporary use of a provisional model by a nonbank SBSD for the purposes of calculating initial margin if the model had been approved by certain other supervisors.

As indicated, the final rule does not limit a nonbank SBSD to using its capital model to calculate initial margin.[378] For example, after the Commission proposed Rule 18a-3, the CFTC and the prudential regulators adopted final margin rules permitting the use of a model to calculate initial margin subject to the approval of the CFTC or a firm's prudential regulator.[379] The first compliance date for these rules for both variation and initial margin was September 1, 2016 for the largest firms.[380] The Commission understands that the firms subject to these final rules have widely adopted the use of an industry standard model to compute initial margin.[381] Based on these developments, the Commission believes that most nonbank SBSDs likely will apply to the Commission to use the industry standard model to compute initial margin. The final rule permits the use of such a model, subject to approval by the Commission.

The Commission believes that the ability to use an initial margin model (other than the firm's capital model)—including the industry standard model that has been widely adopted by market participants—will mitigate many of the concerns raised by commenters. Counterparties will be better able to replicate the initial margin calculations of the nonbank SBSDs with whom they transact. Giving counterparties the ability to meaningfully estimate potential future initial margin calls will allow them to prepare for contingencies and minimize the risk of their failure to meet a margin call. This increased transparency will benefit the nonbank SBSD and the counterparty. Consequently, widespread use of an industry standard model to calculate initial margin may increase transparency and decrease margin disputes. This should mitigate commenters' concerns regarding the transparency of a nonbank SBSD's proprietary model used to calculate initial margin, as the Commission believes that most nonbank SBSDs likely will apply to the Commission to use the industry standard model to compute initial margin.

The Commission acknowledges that some nonbank SBSDs may choose to use models other than the industry standard model. However, the anticipated widespread use of the industry standard model will provide counterparties with the option of taking their business to nonbank SBSDs that use this model to the extent they are concerned about a lack of transparency with respect to other models used by nonbank SBSDs. Moreover, this could incentivize firms that use other models to make them more transparent to market participants.

The final rule also provides that the initial margin model must use a 99%, one-tailed confidence level with price changes equivalent to a 10 business-day movement in rates and prices, and must use risk factors sufficient to cover all the material price risks inherent in the positions for which the initial margin amount is being calculated, including foreign exchange or interest rate risk, credit risk, equity risk, and commodity risk, as appropriate.[382] Several commenters opposed a 10 business-day movement in rates and prices as part of the quantitative requirements for using a model and recommended that the Commission reduce the close-out period to 3 or 5 days.[383] One of these commenters argued that a 10-day period substantially overstates the risk of many non-cleared security-based swaps and will create unnecessarily high initial margin requirements.[384] Other commenters recommended that the Commission establish a more flexible, risk-specific approach to determine and adjust the appropriate liquidation time horizon by product type or asset class.[385]

The Commission believes the prudent approach is to retain the proposed 10 business-day period in the final requirements governing the use of models to calculate initial margin.[386] The 10-day standard has been part of the quantitative requirements for broker-dealers in calculating model-based haircuts under the net capital rule since Start Printed Page 43914the rule permitted the use of models. The Commission does not believe it would be appropriate to have a less conservative standard for calculating initial margin (which is designed to account for the risk of the counterparty's positions) than for calculating model-based haircuts under Rule 15c3-1e, as amended, and Rule 18a-1, as adopted (which is designed to account for the risk of the nonbank SBSD's own positions). Further, the Commission does not believe that a period of less than 10 business days—such as the 3 to 5 business-day period typically used by clearing agencies and DCOs—would be appropriate given that non-cleared security-based swaps may be, in some cases, less liquid than cleared security-based swaps in terms of how long it would take to close them out. Moreover, the initial margin model requirements of the CFTC and the prudential regulators mandate a 10-day standard and, therefore, the Commission's rule is harmonized with their rules.[387]

The final rule provides more clarity as to the offsets permitted in calculating initial margin using a model. In particular, it provides that an initial margin model must use risk factors sufficient to cover all the material price risks inherent in the positions for which the initial margin is being calculated, including foreign exchange or interest rate risk, credit risk, equity risk, and commodity risk, as appropriate.[388] The final rule also provides that empirical correlations may be recognized by the model within each broad risk category, but not across broad risk categories. This means that each non-cleared security-based swap and related position must be assigned to a single risk category for purposes of calculating initial margin. Thus, the initial margin calculation can offset cleared and non-cleared security-based swaps (in answer to the question raised by some commenters) to the extent they are within the same asset class.[389]

The presence of any common risks or risk factors across asset classes (e.g., credit, commodity, and interest rate risks) cannot be recognized for initial margin purposes. This approach is designed to help ensure a conservative and robust margin regime that potentially reduces counterparty exposures to offset the greater risk to the nonbank SBSD and the financial system arising from the use of non-cleared security-based swaps.[390] Margin calculations that limit correlations to asset classes generally will result in more conservative initial margin amounts than calculations that permit offsets across different asset classes. Finally, this approach is consistent with the final margin rules adopted by the CFTC and the prudential regulators, and with the industry standard model being used today to comply with the margin rules of the CFTC and the prudential regulators.[391]

The final rule permits stand-alone SBSDs to use a model to calculate initial margin for equity security-based swaps and will permit these entities to include equity swaps in the portfolio, subject to further coordination with the CFTC.[392] Under the final rule, these entities are not required to use the standardized approach to calculate initial margin for equity security-based swaps. However, the account of a counterparty for which the stand-alone SBSD provides model-based portfolio margining may not hold equity security positions other than equity security-based swaps and equity swaps. Therefore, cash market positions such as long and short equity positions, listed options positions, and single stock futures positions cannot be held in the accounts or otherwise included in the portfolio margin calculations. This is designed to ensure that a stand-alone SBSD cannot provide more favorable treatment for these types of equity positions than a stand-alone or ANC broker-dealer that is subject to the margin requirements of the Federal Reserve's Regulation T and the margin rules of the SROs.

A commenter requested that qualified netting agreements be permitted in calculating initial margin.[393] Other commenters argued that effective netting agreements lower systemic risk by reducing both the aggregate requirement to deliver margin and trading costs for market participants.[394] A commenter stated that netting, among other things, is an important tool for the reduction of counterparty credit risk.[395] Another commenter supported the Commission's proposal to permit certain netting under a qualified netting agreement to determine margin requirements, stating that netting obligations under derivatives and other trading positions reduces counterparty credit risk and allows market participants to make the most efficient use of their capital.[396] Finally, a commenter stated that differences in the security-based swap and swap margin rules may fragment the market by causing firms to engage only in a security-based swaps business through a Commission-regulated nonbank SBSD.[397] The commenter stated that, upon the insolvency of a nonbank SBSD and an affiliated swap dealer, a counterparty would likely be unable to close out and net security-based swaps entered into with the nonbank SBSD with swaps entered into with the swap dealer because the entities are not the same. This commenter also believed that the Commission's proposals may undermine the mutuality of obligations for close-out netting, stating that the Commission appeared to treat a nonbank SBSD as an agent of the counterparty rather than a direct counterparty, which may cause a bankruptcy court to reject attempts by a counterparty to close out derivatives positions with the debtor.

In response, the Commission has modified the rule to clarify that qualified netting agreements may be used in the calculation of initial margin (in addition to variation margin).[398] Generally, industry practice is to use netting in variation and initial margin calculations. Further, the Commission believes that in most cases a counterparty entering into a non-cleared security-based swap transaction with a nonbank SBSD will be a direct counterparty of the nonbank SBSD. In response to the comment regarding potential fragmentation of the market Start Printed Page 43915and the proposed rule's effects on close-out netting, as discussed above, the Commission believes the final margin rule for non-cleared security-based swaps is largely comparable to the final margin rules of the CFTC and the prudential regulators.[399] In addition, as discussed above, the Commission has modified the final rules to facilitate the portfolio margining of security-based swaps and swaps, subject to further coordination with the CFTC.[400] For example, the Commission modified Rules 15c3-1a and 18a-1a to permit swaps to be included in the Appendix A methodology, which can be used by broker-dealer SBSDs to calculate initial margin.[401] Moreover, the Commission modified paragraph (d)(2) of Rule 18a-3 to permit stand-alone SBSDs to use a model to portfolio margin equity security-based swaps with equity swaps, subject to certain conditions. The Commission believes that these modifications will provide a means for market participants to conduct security-based swap and swap activity in the same legal entity without incurring significant additional operational or compliance costs.

A commenter stated that the Commission's potential modification of the proposed rules to permit the use of an industry standard model provides too little information concerning the parameters that would be required for such models and the process for nonbank SBSDs to approve, establish, maintain, review, and validate margin models.[402] In response, the final rule provides that a nonbank SBSD seeking approval to use a model (including an industry standard model) to calculate initial margin will be subject to the application process in Rule 15c3-1e, as amended, or paragraph (d) of Rule 18a-1, as adopted, as applicable, governing the use of model-based haircuts.[403] As part of the application process, the Commission staff will review whether the model meets the qualitative and quantitative requirements of Rule 18a-3. Therefore, a nonbank SBSD will need to submit sufficient information to allow the Commission to make a determination regarding the performance of the nonbank SBSD's initial margin model. The use of internal models, industry standard models, or other models to calculate initial margin by nonbank SBSDs will be subject to the same application and approval process under the final rule. The application process and any condition imposed in connection with Commission approval of the use of the model should mitigate the risk that nonbank SBSDs will compete by implementing lower initial margin levels and should also help ensure that initial margin levels are set at sufficiently prudent levels to reduce risk to the firm and, more generally, systemic risk.

If an industry standard model is widely used by nonbank SBSDs, concerns about competing through lower margin requirements should be further mitigated. However, the Commission reiterates that each nonbank SBSD individually must receive approval from the Commission to use an initial margin model, including an industry standard model, because, among other things, each firm must submit a comprehensive description of its internal risk management control system and how that system satisfies the requirements set forth in Rule 15c3-4. Thus, any approval by the Commission for a particular nonbank SBSD to use a specific model to calculate initial margin will not be deemed approval for another nonbank SBSD to use the same model.

As noted above, some commenters made suggestions about how to expedite the model approval process.[404] In response to these comments, the Commission recognizes that the timing of such approvals could raise competitive issues if one nonbank SBSD is authorized to use a model before one or more other firms. Timing issues may also arise with respect to the review and approval process if multiple firms simultaneously apply to the Commission for approval to use a model. The Commission is sensitive to these issues and, similar to the capital model approval process, encourages all firms that intend to register as nonbank SBSDs and seek model approval to begin working with the staff as far in advance of their targeted registration date as is feasible. However, as discussed above with respect to capital models, the Commission acknowledges the possibility that it may not be able to make a determination regarding a firm's margin model before it is required to register as an SBSD. Consequently, the Commission is modifying Rule 15c3-1e and Rule 18a-1 to provide that the Commission may approve the temporary use of a provisional model by a nonbank SBSD for the purposes of calculating initial margin if the model had been approved by certain other supervisors.

Two commenters suggested the Commission allow market participants to delegate the duty to run a model to a counterparty or third party noting that it is an accepted market practice for a counterparty to agree that a dealer will make determinations for a security-based swap in the dealer's capacity as calculation agent.[405] In response to this comment, a nonbank SBSD could enter into a commercial arrangement to serve as a third-party calculation agent for entities that are not required to calculate initial margin pursuant to Rule 18a-3, as adopted. In addition, a nonbank SBSD's model can use third-party inputs (e.g., price calculations). However, a nonbank SBSD retains responsibility for the model-based initial margin calculations required by Rule 18a-3, as adopted. As discussed above, paragraph (c)(1)(i) of Rule 18a-3, as adopted, requires a nonbank SBSD to calculate an initial margin amount for each counterparty as of the close of each business day. Under paragraph (d) of Rule 18a-3, the nonbank SBSD must use the standardized or model-based approach, as applicable, to calculate the initial margin amount. The fact that a nonbank SBSD uses a model to perform the calculation and that the model uses third-party inputs does not eliminate or diminish the firm's underlying obligation under the rule to calculate an initial margin amount for each counterparty as of the close of each business day. In light of the comment and the Commission's response that third-party inputs may be used, the Commission believes it would be appropriate to make explicit in the rule that the nonbank SBSD retains responsibility for model-based initial margin calculations. Accordingly, the Commission is modifying the proposed rule text to make this clear.[406]

In summary, the Commission is adopting the model-based approach to calculating initial margin, with the Start Printed Page 43916modifications discussed above. The final rule will require a nonbank SBSD to calculate with respect to each account of a counterparty as of the close of each business day: (1) The amount of the current exposure in the account; and (2) the initial margin amount for the account.[407] As discussed above, in response to comments, the Commission modified paragraph (d) of Rule 18a-3 to establish a margin model authorization process that is distinct from the net capital rule model authorization process. This modification will provide flexibility to allow nonbank SBSDs that do not use a model for purposes of the net capital rule to seek authorization to use a model for purposes of the margin rule.[408] It also will permit firms to use an industry standard model such as the model currently being used to comply with the margin rules of the CFTC and the prudential regulators.

Comments and Final Requirements To Increase the Frequency of the Calculations

Two commenters supported the proposed requirement to perform more frequent calculations under specified conditions.[409] Another commenter requested that the Commission clarify that the requirement for a nonbank SBSD to perform calculations more frequently in specified circumstances does not give rise to a regulatory requirement for the nonbank SBSD to collect intra-day margin from its counterparties.[410] The commenter argued that requiring a nonbank SBSD to collect margin more frequently than daily would be operationally difficult and contrary to current market practice.

The Commission is adopting the requirement to increase the frequency of the required calculations during periods of extreme volatility and for accounts with concentrated positions, as proposed, with some non-substantive modifications.[411] In response to the comment about collecting margin intra-day, the Commission clarifies that the rule does not require a nonbank SBSD to collect intra-day margin, although it may choose to do so (such as through a house margin requirement). In addition, more frequent calculations are only required during periods of extreme volatility and for accounts with concentrated positions. However, nonbank SBSDs are subject to Rule 15c3-4, which requires, among other things, that they have a system of internal controls to assist in managing the risks associated with their business activities, including credit risk. In designing a system of internal controls pursuant to Rule 15c3-4, a nonbank SBSD generally should consider whether there are circumstances where the collection of intra-day margin in times of volatility and for accounts with concentrated positions would be necessary to effectively manage credit risk. In addition, a nonbank SBSD generally should consider these factors in its risk monitoring procedures required under paragraph (e)(7) of Rule 18a-3, as adopted, which is discussed below.

ii. Nonbank MSBSPs

As proposed, Rule 18a-3 required nonbank MSBSPs to collect collateral from counterparties to which the nonbank MSBSP has current exposure and provide collateral to counterparties that have current exposure to the nonbank MSBSP.[412] Consequently, a nonbank MSBSP needed to calculate as of the close of business each day the amount of equity in each account of a counterparty. Consistent with the proposal for nonbank SBSDs, a nonbank MSBSP was required to increase the frequency of its calculations during periods of extreme volatility and for accounts with concentrated positions.

A commenter stated that it believed that nonbank MSBSPs should be required to calculate initial margin for each counterparty and collect or post initial margin because doing so would allow nonbank MSBSPs to better measure and understand their aggregate counterparty risk.[413] The commenter believed that nonbank MSBSPs should have the personnel necessary to operate daily initial margin programs. Another commenter, who supported bilateral margining for both variation and initial margin, stated that not requiring the bilateral exchange of initial margin is inconsistent with the BCBS/IOSCO Paper and the re-proposals of the CFTC and the prudential regulators.[414] A commenter supported the proposal that nonbank MSBSPs should not have to collect initial margin.[415] Another commenter stated that MSBSPs should be provided flexibility as to whether and to what extent they should be required to pledge initial margin to financial firms.[416]

In response to comments that nonbank MSBSPs should calculate and collect and post initial margin, the margin requirements for nonbank MSBSPs are designed to “neutralize” the credit risk between a nonbank MSBSP and its counterparty. This requirement is intended to account for the fact that nonbank MSBSPs will be subject to less stringent capital requirements than nonbank SBSDs. Consequently, in the case of a nonbank MSBSP, the Commission believes it is more prudent to not require the firm to collect initial margin from counterparties, as doing so would increase the counterparties' exposures to the nonbank MSBSP. Therefore, the Commission is not adopting requirements for nonbank MSBSPs to calculate and post or deliver initial margin.

The Commission acknowledges that the final rule, in this case, is not consistent with the final margin rules of the CFTC and the prudential regulators, which generally require nonbank major swap participants, bank MSBSPs, and bank major swap participants to collect and post initial margin from and to specified counterparties.[417] However, the Commission believes that minimizing a counterparty exposure to a nonbank MSBSP by not requiring it to deliver initial margin is prudent, as these firms will not be subject to as robust a capital framework as SBSDs or bank MSBSPs. Similarly, the Commission believes it is prudent to limit the exposure of the nonbank MSBSP to the counterparty by not requiring it to post initial margin, as the counterparty may not be subject to any capital requirement. While the final rule does not impose a requirement to post or deliver initial margin, nonbank MSBSPs and their counterparties are permitted to agree to the exchange of initial margin. For these reasons, the Commission is adopting paragraph (c)(2)(i) of Rule 18a-3 substantially as proposed.[418]

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b. Account Equity Requirements

i. Nonbank SBSDs

As discussed above, a nonbank SBSD must calculate variation and initial margin amounts with respect to the account of a counterparty as of the close of each business day. Proposed Rule 18a-3: (1) Required a nonbank SBSD to collect margin from the counterparty unless an exception applied; (2) set forth the time frame for when that collateral needed to be collected; (3) prescribed the types of assets that could serve as eligible collateral; (4) prescribed additional requirements for the collateral; (5) prescribed when collateral must be liquidated; and (6) set forth certain exceptions to collecting the collateral.[419]

More specifically, proposed Rule 18a-3 required that a nonbank SBSD collect from the counterparty by noon of the following business day cash, securities, and/or money market instruments in an amount at least equal to the “negative equity (current exposure) in the account plus the initial margin amount unless an exception applied. Assets other than cash, securities, and/or money market instruments were not eligible collateral. The proposed rule further provided that the fair market value of securities and money market instruments (“securities collateral”) held in the account of a counterparty needed to be reduced by the amount of the standardized haircuts the nonbank SBSD would apply to the positions pursuant to the proposed capital rules for the purpose of determining whether the level of equity in the account met the minimum margin requirements. Securities collateral with no “ready market” or that could not be publicly offered or sold because of statutory, regulatory, or contractual arrangements or other restrictions effectively could not serve as collateral because it would be subject to a 100% deduction pursuant to the standardized haircuts in the proposed capital rules, which were to be used to take the collateral deductions for the purposes of proposed Rule 18a-3.

In addition, proposed Rule 18a-3 contained certain additional requirements for cash and securities to be eligible as collateral. These requirements were designed to ensure that the collateral was of stable and predictable value, not linked to the value of the transaction in any way, and capable of being sold quickly and easily if the need arose. The requirements included that the collateral was: (1) Subject to the physical possession or control of the nonbank SBSD; (2) liquid and transferable; (3) capable of being liquidated promptly without the intervention of a third party; (4) subject to a legally enforceable collateral agreement, (5) not securities issued by the counterparty or a party related to the counterparty or the nonbank SBSD; and (6) a type of financial instrument for which the nonbank SBSD could apply model-based haircuts if the nonbank SBSD was authorized to use such haircuts. Proposed Rule 18a-3 also required a nonbank SBSD to take prompt steps to liquidate collateral consisting of securities collateral to the extent necessary to eliminate the account equity deficiency.

The Commission proposed five exceptions to the account equity requirements. The first applied to counterparties that were commercial end users. The second applied to counterparties that were nonbank SBSDs. The third applied to counterparties that were not commercial end users and that required their collateral to be segregated pursuant to Section 3E(f) of the Exchange Act. The fourth proposed exception applied to accounts of counterparties that were not commercial end users and that held legacy non-cleared security-based swaps. The fifth provided for a $100,000 minimum transfer amount with respect to a particular counterparty.

Comments and Final Requirements Regarding the Collection and Posting of Margin

As noted above, proposed Rule 18a-3 required a nonbank SBSD to collect margin from the counterparty by noon of the next business day unless an exception applied.[420] Generally, the comments on this aspect of the proposal fell into two categories: (1) Comments requesting that nonbank SBSDs be required to deliver margin (in addition to collecting it); and (2) comments requesting that the required time frame for collecting margin be lengthened.

In terms of requiring nonbank SBSDs to deliver margin, commenters stated that doing so would promote consistency with the recommendations in the BCBS/IOSCO Paper.[421] Commenters also argued that bilateral margining would help to reduce systemic risk.[422] A commenter argued that not requiring a nonbank SBSD to post margin could create an incentive to avoid clearing security-based swaps counter to the Dodd-Frank Act's objective of promoting central clearing.[423] One commenter stated that the Commission did not adequately consider the potential for one-way margining to harm investors and the security-based swap market.[424] This commenter argued that making two-way margining mandatory would provide important risk mitigation benefits to the markets, and protect counterparties of all sizes, not just those large enough to negotiate for two-way margining.[425] Some commenters suggested that the rule should permit the counterparty to require the nonbank SBSD to deliver margin at the counterparty's discretion.[426] Another commenter stated that nonbank SBSDs and financial end users should have the flexibility to determine whether nonbank SBSDs should be required to post initial margin to financial end users.[427]

In response to these comments, the Commission is persuaded that requiring nonbank SBSDs to deliver variation margin to counterparties would provide an important protection to the counterparties by reducing their uncollateralized current exposure to SBSDs. The Commission also believes it would be appropriate to require nonbank SBSDs to deliver variation margin to counterparties in order to further harmonize Rule 18a-3 with the margin rules of the CFTC and the prudential regulators.[428] For these reasons, the Commission has modified the final rule to require a nonbank SBSD to deliver variation margin to a counterparty unless an exception applies. However, as discussed below, the nonbank SBSD is not required to collect or deliver variation or collect initial margin from a commercial end user, a security-based swap legacy account, or a counterparty that is the BIS, the European Stability Mechanism, or one of the multilateral development banks identified in the rule.[429]

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The Commission does not believe it would be appropriate to require nonbank SBSDs to deliver initial margin and, therefore, the final rule does not require it. Requiring nonbank SBSDs to deliver initial margin could impact the liquidity of these firms. Delivering initial margin would prevent this capital of the nonbank SBSD from being immediately available to the firm to meet liquidity needs. If the delivering SBSD is undergoing financial stress or the markets more generally are in a period of financial turmoil, a nonbank SBSD may need to liquidate assets to raise funds and reduce its leverage. Assets in the control of a counterparty would not be available for this purpose. For these reasons, under the net capital rule, most unsecured receivables must be deducted from net worth when the nonbank SBSD computes net capital. The final rule, however, does not prohibit a nonbank SBSD from delivering initial margin. For example, a nonbank SBSD and its counterparty can agree to commercial terms pursuant to which the nonbank SBSD will post initial margin to the counterparty.

In terms of lengthening the time frame for collecting margin, a commenter requested flexibility for nonbank SBSDs to collect initial margin on a different schedule and frequency than variation margin.[430] A second commenter sought clarification concerning how often initial margin needed to be collected and noted that the overall initial margin amount for a portfolio could change even if no new transactions occur because existing transactions may mature or significant market moves may impact values.[431] A third commenter suggested that the Commission require nonbank SBSDs to begin collecting initial margin on a weekly basis and phase in more frequent collections.[432] Another commenter recommended that consistent with the CFTC's and prudential regulators' margin rules, the Commission should require an SBSD to collect margin by the end of the business day following the day of execution and at the end of each business day thereafter, with appropriate adjustments to address operational difficulties associated with parties located in different time zones.[433]

Other commenters recommended a longer time period than one business day to collect margin, citing cross-border transactions as possibly requiring more time.[434] One commenter stated that the time zone differences between the Unites States and certain jurisdictions will cause major operational challenges, and could lead to delayed payments, disputes, and broadly greater operational risk.[435] Another commenter noted that the settlement and delivery periods for securities to be posted as collateral are longer than the time period for collection under the proposed rule, particularly in a cross-border context.[436] A commenter stated that the proposed one business-day requirement did not reflect the operational realities of security-based swap trading, payment, and collateral transfer processes.[437] The commenter argued that the need for additional time was especially critical with respect to transactions with counterparties in countries such as Japan and Australia.

The Commission recognizes that it will take time for nonbank SBSDs to implement processes to collect variation and initial margin on a daily basis if the entity is not currently collecting margin at this frequency. The Commission, therefore, is establishing compliance and effective dates discussed below in section III.B. of this release designed to give nonbank SBSDs and their counterparties a reasonable period of time to implement the operational, legal, and other changes necessary to come into compliance with requirements to collect and deliver margin on a daily basis.

In terms of lengthening the period to collect or deliver margin beyond one business day, promptly obtaining collateral to cover credit risk exposures is vitally important to promoting the financial responsibility of nonbank SBSDs and protecting their counterparties. Collateral protects the nonbank SBSD from consequences of the counterparty's default and the counterparty from the consequences of the nonbank SBSD's default. However, the Commission is modifying the next-day collection requirement in two ways that should mitigate the concerns of commenters. First, the Commission is lengthening time for nonbank SBSDs and MSBSPs to collect or post required margin from noon to the close of business on the next business day.[438] Second, the Commission is lengthening from one to two business days the time frame in which the nonbank SBSD or MSBSP must collect or deliver required margin if the counterparty is located in another country and more than 4 time zones away. These changes should mitigate the concerns of commenters about cross-border transactions.

For the foregoing reasons, the Commission is adopting the proposed requirements to collect variation and initial margin with the modifications discussed above and with certain other non-substantive modifications.[439]

Comments and Final Requirements for Collateral and Taking Deductions on Collateral

As noted above, proposed Rule 18a-3 permitted cash, securities, and money market instruments to serve as collateral to meet variation and initial margin requirements and, if securities or money market instruments were used, required the nonbank SBSD to apply the standardized haircuts in the capital rules to the collateral when computing the equity in the account.[440] Generally, comments addressing these requirements fell into two categories: (1) Comments requesting that the scope of assets qualifying as collateral be broadened, or modified to conform with requirements of the prudential regulators, the CFTC, or the recommendations in the BCBS/IOSCO Paper; and (2) comments requesting that the deductions to securities or money market instruments serving as collateral be calculated using methods other than Start Printed Page 43919the standardized haircuts in the capital rules.

In terms of the scope of eligible collateral, commenters supported the broad categories of securities and money market instruments that qualified under the proposal, but asked that the final rule be more consistent with the recommendations in the BCBS/IOSCO Paper or the rules of the CFTC and the prudential regulators.[441] A commenter stated that the Commission should define the term “eligible collateral,” preferably by adopting the CFTC's “forms of margin” approach.[442] A second commenter recommended that the Commission carefully parallel the collateral approach recommended in the BCBS/IOSCO Paper.[443] This commenter noted that the examples of collateral listed in the BCBS/IOSCO Paper were not exhaustive. Another commenter suggested that regulators and market participants develop a set of consistent definitions for the categories of eligible collateral.[444]

In response to these comments, the BCBS/IOSCO Paper recommends that national supervisors develop their own list of collateral assets, taking into account the conditions of their own markets, and based on the key principle that assets should be highly liquid and should, after accounting for an appropriate haircut, be able to hold their value in a time of financial stress.[445] The examples of collateral in the BCBS/IOSCO Paper are: (1) Cash; (2) high-quality government and central bank securities; (3) high-quality corporate bonds; (4) high-quality covered bonds; (5) equities included in major stock indices; and (6) gold.[446] Eligible securities collateral under the margin rules of the CFTC and the prudential regulators includes: (1) U.S. Treasury securities; (2) certain securities guaranteed by the U.S.; (3) certain securities issued or guaranteed by the European Central Bank, a sovereign entity, or the BIS; (4) certain corporate debt securities; (5) certain equity securities contained in major indices; and (6) certain redeemable government bond funds.[447] Under the Commission's proposed margin rule, these types of securities would be permitted as collateral if they had a ready market. The margin rules of the CFTC and the prudential regulators also permit major foreign currencies, the currency of settlement for the security-based swap, and gold to serve as collateral. The Commission's proposed rule permitted “cash” but did not permit foreign currencies to serve as collateral, and the proposed rule did not permit gold to serve as collateral.

The Commission is modifying proposed Rule 18a-3 in response to commenters' concerns about the rule excluding collateral types that are permitted by the CFTC and the prudential regulators. Consequently, the final rule permits cash, securities, money market instruments, a major foreign currency, the settlement currency of the non-cleared security-based swap, or gold to serve as eligible collateral.[448] This will avoid the operational burdens of having different sets of collateral that may be used with respect to a counterparty depending on whether the nonbank SBSD is entering into a security-based swap (subject to the Commission's rule) or a swap (subject to the CFTC's rule) with the counterparty. It also will avoid potential unintended competitive effects of having different sets of collateral for non-cleared security-based swaps under the margin rules for nonbank SBSDs and bank SBSDs. Finally, by giving the option of aligning with the requirements of the CFTC and the prudential regulators, the final rule should avoid the necessity of amending existing collateral agreements that may specifically reference the forms of margin permitted by those requirements.

Commenters requested that certain types of assets be permitted to serve as collateral when dealing with commercial end users and special purpose vehicles.[449] One commenter requested that the Commission expand the collateral permitted under the rule to include shares of affiliated registered funds or clarify that a fund of funds could post shares of an affiliated registered fund to meet a margin requirement under the rule.[450] Another commenter requested that the Commission adopt a definition of collateral that includes U.S. government money market funds.[451] In response to these comments, the final rule does not specifically exclude any type of security provided it has a ready market, is readily transferable, and does not consist of securities and/or money market instruments issued by the counterparty or a party related to the nonbank SBSD or MSBSP, or the counterparty.[452] Generally, U.S. government money market funds should be able to serve as collateral under these conditions.

In terms of applying the standardized haircuts in the nonbank SBSD capital rules to securities and money market instruments serving as collateral, a commenter advocated aligning with the prudential regulators' proposed rules for ease of application and consistency of treatment across instruments, as well as to minimize the opportunity for regulatory arbitrage.[453] Comments received after the CFTC and the prudential regulators adopted their final margin rules supported aligning the haircuts in the Commission's margin rule with the standardized haircuts adopted by the CFTC and the prudential regulators.[454]

The haircuts in proposed Rule 18a-3 (i.e., the standardized haircuts in the proposed nonbank SBSD capital rules) and the haircuts in the margin rules of the CFTC and the prudential regulators (which are based on the recommended standardized haircuts in the BCBS/IOSCO Paper) are largely comparable.[455] However, the Commission also recognizes that there are differences. For example, the Commission's standardized haircuts in some cases are more risk sensitive than those required by final margin rules of the CFTC and the prudential regulators.[456]

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At the same time, the Commission believes it would be appropriate to provide nonbank SBSDs the option either to use the standardized haircuts in the nonbank SBSD capital rules as proposed or to use the collateral haircuts in the CFTC's margin rules. Consequently, the final margin rule provides nonbank SBSDs with the option of choosing to use the standardized haircuts in the capital rules or the standardized haircuts in the CFTC's margin rules.[457] The final rule further provides that if the nonbank SBSD uses the CFTC's standardized haircuts it must apply them consistently with respect to the counterparty.[458] This requirement is designed to prevent a nonbank SBSD from “cherry picking” either the nonbank SBSD capital haircuts or the CFTC haircuts at different points in time depending on which set provides the more advantageous haircut.

Similar to aligning the sets of eligible collateral, giving the option of aligning the collateral haircuts with the CFTC's collateral haircuts will allow a firm to avoid the operational burdens of having different haircut requirements with respect to a counterparty depending on whether the nonbank SBSD is entering into a security-based swap (subject to the Commission's rule) or a swap (subject to the CFTC's rule) with the counterparty. This option also will avoid potential unintended competitive effects of having different sets of collateral for non-cleared security-based swaps under the margin rules for nonbank SBSDs and bank SBSDs. Finally, by aligning with the requirements of the CFTC and the prudential regulators, the final rule should reduce the likelihood that SBSDs will seek to amend existing collateral agreements that may specifically reference the haircuts in the margin rules of the CFTC or prudential regulators.[459]

With respect to the proposed collateral haircuts, a commenter suggested that the deductions applicable to high-grade corporate debt or liquid structured credit instruments be calculated using the option-adjusted spread (“OAS”).[460] A second commenter noted that the BCBS/IOSCO Paper provides that the haircuts can be determined by a model that is approved by a regulator, in addition to a standardized schedule set forth in the BCBS/IOSCO Paper.[461] In response to these comments, the Commission believes that the simpler and more transparent approach of using the standardized haircuts will establish appropriately conservative discounts on eligible collateral. Moreover, using models to determine haircuts on collateral would not be consistent with the final rules of the CFTC and the prudential regulators.[462]

Finally, a commenter recommended that the Commission apply a 100% haircut to a structured product, asset-backed security, re-packaged note, combination security, and any other complex instrument.[463] In response, the final margin rule requires margin collateral to have a ready market.[464] This is designed to exclude collateral that cannot be promptly liquidated.

A nonbank SBSD must apply the collateral haircuts to collateral used to meet a variation margin requirement and an initial margin requirement as was proposed.[465] However, the Commission is making a conforming modification to require a nonbank SBSD to apply the deductions prescribed in paragraph (c)(3)(i) or (ii) of Rule 18a-3 to variation margin that the firm delivers to a counterparty to meet a variation margin requirement. As discussed above, the final rule now requires nonbank SBSDs to deliver variation margin to counterparties, and applying the haircuts to collateral used for this purpose will serve the same purpose of determining whether the level of equity in the account met the minimum margin requirements, as applying them to collateral collected by the nonbank SBSD. In addition, applying a haircut to collateral delivered by the nonbank SBSD to a counterparty is consistent with the requirements of the CFTC and the prudential regulators.

Comments and Final Requirements Regarding Additional Collateral and Liquidation Requirements

As noted above, proposed Rule 18a-3 prescribed additional requirements for collateral (e.g., it must be liquid and transferable) and required the prompt liquidation of the collateral to eliminate a margin deficiency.[466] A commenter requested that only “excess securities collateral” as defined in proposed Rule 18a-4 for purposes of the segregation requirements be subject to the possession or control requirement in proposed Rule 18a-3.[467] The commenter noted that the proposed segregation requirements only required excess securities collateral to be in the SBSD's possession or control. Thus, the commenter argued that imposing a Start Printed Page 43921possession or control requirement on a broader range of collateral could impose “serious” funding costs on SBSDs by requiring them to fund initial and variation margin payments for offsetting transactions through their own resources rather than through the collateral posted by security-based swap customers in accordance with proposed Rule 18a-3. Another commenter requested that the Commission amend paragraph (c)(4)(i) of proposed Rule 18a-3 to recognize initial margin collateral that is held at an independent third-party custodian as being in the control of the nonbank SBSD.[468]

The Commission did not intend the possession or control requirement in proposed Rule 18a-3 to conflict with the proposed possession or control requirement in Rule 18a-4. More specifically, under Rule 18a-4, as proposed, a nonbank SBSD could re-hypothecate collateral received as initial margin pursuant to Rule 18a-3 in limited circumstances and subject to certain conditions. The Commission clarifies that under Rule 18a-3, as adopted, initial margin that is held at a clearing agency to meet a margin requirement of the customer is in the control of the nonbank SBSD for purposes of the rule. Additionally, as discussed above in sections II.A.2.b.ii. and II.A.2.b.v. of this release, the Commission has adopted final capital rules for stand-alone broker-dealers and nonbank SBSDs that permit them to recognize collateral held at a third-party custodian for purposes of: (1) The exception from taking the capital charge when initial margin is held at a third-party custodian; [469] and (2) computing credit risk charges.[470] In each case, the collateral can be recognized if the custodian is a bank as defined in Section 3(a)(6) of the Exchange Act or a registered U.S. clearing organization or depository that is not affiliated with the counterparty or, if the collateral consists of foreign securities or currencies, a supervised foreign bank, clearing organization, or depository that is not affiliated with the counterparty and that customarily maintains custody of such foreign securities or currencies.

The Commission believes collateral held at a third-party custodian also should be recognized for the purposes of determining the account equity requirements in Rule 18a-3. Consequently, the Commission is modifying paragraph (c)(4) in the final rule to provide that the collateral must be either: (1) Subject to the physical possession or control of the nonbank SBSD or MSBSP and may be liquidated promptly by the firm without intervention by any other party (as was proposed); or (2) carried by an independent third-party custodian that is a bank as defined in Section 3(a)(6) of the Exchange Act or a registered U.S. clearing organization or depository that is not affiliated with the counterparty or, if the collateral consists of foreign securities or currencies, a supervised foreign bank, clearing organization, or depository that is not affiliated with the counterparty and that customarily maintains custody of such foreign securities or currencies.[471] This will address the second commenter's concern about recognizing collateral that is held at a third-party custodian.

As discussed above, the Commission has modified proposed Rule 18a-3 to provide a nonbank SBSD with the option to use the collateral haircuts required by the CFTC's rules.[472] In light of this modification, the Commission is modifying the final margin rule to explicitly require that the collateral have a ready market.[473] The requirement that the collateral have a ready market was incorporated into the proposed rule because, as discussed above, the nonbank SBSD was required to use the standardized haircuts in the proposed capital rules for purposes of the collateral deductions. The proposed nonbank SBSD capital rules required the firm to take a 100% deduction for a security or money market instrument that does not have a ready market (as do the final capital rules). Consequently, by incorporating those standardized haircuts into proposed Rule 18a-3, a nonbank SBSD would need to deduct 100% of the value of a security or money market instrument it received as margin if the security or money market instrument did not have a ready market. In other words, the security or money market instrument would have no collateral value for purposes of meeting the account equity requirements in proposed Rule 18a-3. The Commission's modification will retain the proposed requirement that collateral without a ready market has no collateral value and, in particular, will apply that requirement when the standardized haircuts of the CFTC are used, as they do not explicitly impose a ready market test. However, the CFTC, in describing its requirements for collateral, stated that margin assets should share the following fundamental characteristics: They “should be liquid and, with haircuts, hold their value in times of financial stress.” [474] The CFTC further stated in describing collateral permitted under its rule that it consists of “assets for which there are deep and liquid markets and, therefore, assets that can be readily valued and easily liquidated.” The Commission believes that modifying the final rule to make explicit that the ready market test applies when the CFTC's standardized haircuts are used is consistent with these statements by the CFTC about collateral permitted under its margin rule.

For the foregoing reasons, the Commission is adopting the proposed collateral requirements with the modifications discussed above and certain additional non-substantive modifications.[475]

Start Printed Page 43922

Finally, the Commission did not receive any comments addressing the prompt liquidation requirement and is adopting it with several non-substantive modifications.[476]

Comments and Final Requirements Regarding Exceptions to Collecting Margin

Commercial End Users. As noted above, the Commission proposed five exceptions to the account equity requirements, and the first exception applied to counterparties that are commercial end users.[477] This exception provided that a nonbank SBSD need not collect variation or initial margin from a counterparty that was a commercial end user. A commenter opposed any exceptions in the rule, stating that failing to collect and deliver margin contributed significantly to the 2008 financial crisis.[478] Another commenter argued that commercial end users carry market risk and can default on their obligations to the nonbank SBSD, which may then be faced with liquidity challenges.[479] This commenter stated that the lack of margin from these market participants can be a source of systemic risk that can “ripple through the financial market ecosystem.”

After Rule 18a-3 was proposed, the Terrorism Risk Insurance Program Reauthorization Act of 2015 (“TRIPRA”) was enacted.[480] Title III of TRIPRA amended Section 15F(e) of the Exchange Act to provide that the requirements of Section 15F(e)(2)(B)(ii) (which requires the Commission to adopt margin requirements for nonbank SBSDs with respect to non-cleared security-based swaps) shall not apply to a security-based swap in which a counterparty qualifies for an exception under Section 3C(g)(1) of the Exchange Act or that satisfies the criteria in Section 3C(g)(4) of the Exchange Act (the exceptions from mandatory clearing for commercial end users). Consequently, Congress mandated an exception for commercial end users from the Commission's margin rules for non-cleared security-based swaps.[481] While the statutory provision establishes a commercial end user exception, defining the term “commercial end user” will serve an important purpose. In particular, the definition will implement the statutory provision and serve as a cross-reference for the term “commercial end user,” which is referenced in other parts of the Commission's rules. Consequently, the Commission is adopting the exception and related definition with modifications to conform the definition to the statutory text.[482] In the final rule, the term “commercial end user” is defined to mean a counterparty that qualifies for an exception from clearing under section 3C(g)(1) of the Exchange Act and implementing regulations or satisfies the criteria in Section 3C(g)(4) of the Exchange Act and implementing regulations.[483]

In response to the concerns raised by the commenters regarding the exception, a nonbank SBSD will be required to take a capital deduction in lieu of margin or credit risk charge if it does not collect margin from a commercial end user counterparty. The capital deduction or charge is intended to require a nonbank SBSD to set aside net capital to address the risks that would be mitigated through the collection of initial margin.[484] The set-aside net capital will serve as an alternative to obtaining collateral for this purpose. Consequently, the final capital rules and amendments work in tandem with the margin rules to require capital deductions or credit risk charges that will require nonbank SBSDs to allocate capital against the market and credit exposures resulting from transactions with commercial end users, which may not be fully collateralized.

In addition, as discussed below, a nonbank SBSD will be required to establish, maintain, and document procedures and guidelines for monitoring the risk of accounts holding non-cleared security-based swaps. Among other things, a nonbank SBSD will be required to have procedures and guidelines for determining, approving, and periodically reviewing credit limits for each counterparty to a non-cleared security-based swap.[485] Consequently, nonbank SBSDs that do not collect variation and/or initial margin from a commercial end user will need to establish a credit limit for the end user and periodically review the credit limit in accordance with their risk monitoring guidelines.[486] The final rule also does not prohibit a nonbank SBSD from requiring a commercial end user to post variation and initial margin under its own house margin requirements.

Financial Market Intermediaries. The second exception to collecting margin applied when the counterparty was another SBSD.[487] More specifically, the Commission proposed two alternatives with respect to SBSD counterparties. Under the first alternative, a nonbank SBSD would need to collect variation margin but not initial margin from the other SBSD (“Alternative A”). Under the second alternative, a nonbank SBSD would be required to collect variation and initial margin from the other SBSD Start Printed Page 43923and the initial margin needed to be held at a third-party custodian (“Alternative B”).[488]

Some commenters supported Alternative A. One of these commenters argued that the requirement to collect initial margin from other SBSDs under Alternative B would severely curtail the use of non-cleared security-based swaps for hedging.[489] The commenter argued that this result would disrupt key financial services, such as those that facilitate the availability of home loans and corporate finance. The commenter argued that the requirement to collect initial margin from another SBSD would have detrimental pro-cyclical effects because it would increase collateral demands in times of market stress. A second commenter believed that Alternative B could limit credit availability, be destabilizing, and have undesirable pro-cyclical effects.[490] While generally supporting harmonization of the Commission's margin rules with the recommendations of the BCBS/IOSCO Paper, this commenter supported Alternative A. The commenter stated that harmonization in this case is not appropriate because it would put stress on the funding models of U.S. nonbank SBSDs if they were required to post initial margin to other SBSDs.[491] A third commenter argued that the proposal to require the exchange of large amounts of liquid initial margin come at a time when other regulators and regulations are also focusing on and imposing new requirements with respect to liquidity in the financial sector.[492] This commenter urged the Commission to evaluate initial margin requirements in light of the changing financial regulatory environment and to establish regulations that will support capital growth and customer protection while minimizing systemic risk. Some commenters also supported expanding the Alternative A approach so that nonbank SBSDs would not be required to collect initial margin from swap dealers, stand-alone broker-dealers, banks, foreign banks, and foreign broker-dealers.[493]

Other commenters supported Alternative B, arguing that it was more consistent with the intent of the Dodd-Frank Act and that Alternative A would permit an inappropriate build-up of systemic risk within the financial system.[494] One commenter argued that the Commission should not be swayed by claims that Alternative B would make it difficult for nonbank SBSDs to hedge transactions, or that it would shrink the size of the global security-based swap market.[495] Another commenter argued that it would be inappropriate to allow a nonbank SBSD to have non-cleared security-based swap exposure to another SBSD without any requirement to collect initial margin or to take a capital charge to address the risk of the non-cleared security-based swap.[496] Some commenters noted that the CFTC and the prudential regulators require the exchange of initial margin between SBSDs and swap dealers, and the Commission should do so as well in order to harmonize its rules with the rules of the CFTC and the prudential regulators.[497] One commenter argued that a lack of harmonization would reduce the likelihood of achieving substituted compliance determinations.[498] Finally, a commenter responding to the 2018 comment reopening argued that the proposed rule text modifications were made despite the fact that insufficient margin and capital were two of the triggers of the financial crisis.[499]

In the Commission's judgment, Alternative A is the prudent approach because it will promote the liquidity of nonbank SBSDs by not requiring them to deliver initial margin to other SBSDs. As discussed above, delivering initial margin would prevent this capital of the nonbank SBSD from being immediately available to be used by the firm. If the delivering SBSD is undergoing financial stress or the markets more generally are in a period of financial turmoil, a nonbank SBSD may need to liquidate assets to raise funds and reduce its leverage. However, if assets are in the control of another SBSD, they would not be available for this purpose. For these reasons, the nonbank SBSD capital rule treats most unsecured receivables as assets that must be deducted from net worth when the firm computes net capital.

In addition, the Commission believes that nonbank SBSDs serve an important function in the non-cleared security-based swap market by providing liquidity to market participants and by performing important market making functions. Thus, the Commission believes its margin rule for non-cleared security-based swaps should promote the liquidity of these entities, which, in turn, will help ensure their safety and soundness. Further, the Commission believes these considerations support expanding the exception beyond SBSD counterparties to include other financial market intermediary counterparties such as swap dealers, FCMs, stand-alone broker-dealers, banks, foreign banks, and foreign broker-dealers.[500] The Commission believes it is appropriate to expand the list given their importance to the securities markets, the liquidity impact on these entities if they are required to post initial margin, and the fact that these entities will be subject to a regulatory capital standard that would incentivize them to collateralize exposures to their security-based swap counterparties.

A nonbank SBSD will be required to take a capital deduction in lieu of margin or credit risk charge if it does not collect initial margin from a counterparty that is a financial market intermediary. As discussed above, the capital deduction or credit risk charge is intended to require a nonbank SBSD to set aside net capital to address the risks that are mitigated through the collection of initial margin. Furthermore, the nonbank SBSD will be required to establish, maintain, and document procedures and guidelines for monitoring the risk of accounts holding non-cleared security-based swaps.[501] These include procedures for determining, approving, and periodically reviewing credit limits for each counterparty. Consequently, a nonbank SBSD will need to establish credit limits for each counterparty to a non-cleared security-based swap, including counterparties that are financial market intermediaries.

While Alternative A is not consistent with the final rules of the CFTC and the Start Printed Page 43924prudential regulators, the rule does not prohibit nonbank SBSDs from collecting initial margin from another financial intermediary as a house margin requirement or by agreement. In addition, the adoption of Alternative A as one requirement in the margin rule should not negatively affect potential substituted compliance determinations because the Commission expects regulators will focus on regulatory outcomes as a whole rather than on requirement-by-requirement similarity.[502] Finally, the adoption of Alternative A with modifications discussed above should alleviate commenters' concerns that imposing initial margin requirements would severely curtail the use of non-cleared security-based swaps for hedging.

For these reasons, the Commission is adopting Alternative A with the modifications discussed above.[503]

Counterparties that Use Third-Party Custodians. The third proposed exception applied to counterparties that are not commercial end users and that elect to have their initial margin segregated pursuant to Section 3E(f) of the Exchange Act.[504] Among other things, Section 3E(f) provides that a counterparty may elect to have its initial margin segregated in an account carried by an independent third-party custodian. Under the proposed exception, the nonbank SBSD did not need to directly hold the initial margin required from the counterparty. This accommodated the counterparty's right under Section 3E(f) to elect to have the third-party custodian hold the initial margin. The Commission did not receive any comments specifically addressing this provision but is modifying it to remove the reference to Section 3E(f) to address the potential that the initial margin might be held at a third-party custodian pursuant to other provisions. For the foregoing reasons, the Commission is adopting this exception with the modification described above and certain non-substantive modifications.[505]

Legacy Accounts. The fourth proposed exception applied to accounts of counterparties that are not commercial end users and that hold legacy non-cleared security-based swaps.[506] Under this proposed exception, the nonbank SBSD did not need to collect variation or initial margin from the counterparty.

Some commenters expressed support for this exception. One of these commenters suggested that the Commission except legacy transactions, unless both counterparties agree that margin should be exchanged.[507] A second commenter suggested that legacy trades be excepted unless the nonbank SBSD includes them in a netting set with new transactions.[508] Some commenters also provided suggestions as to what should be deemed a legacy transaction, citing novated contracts and existing legacy security-based swaps that have been modified for loss mitigation purposes, or contracts that have been amended to replace references to the London Inter-bank Offered Rate (“LIBOR”).[509] Commenters also requested clarification as to whether the legacy account exception for nonbank SBSDs applies to both variation and initial margin or to initial margin only.[510] A commenter argued that initial margin requirements should not apply to legacy security-based swaps, but that the exception should only apply until the legacy contracts expire or are revised.[511] This commenter further argued that the exception should not apply to variation margin because, without this type of protection, counterparties are exposed to potential losses as a consequence of the default of trading partners.

The Commission is adopting the proposed exception for accounts holding legacy security-based swaps [512] with a modification to make explicit that the exception applies to variation and initial margin in response to comments seeking clarification on that point.[513] Under the final rule, nonbank SBSDs can collect variation or initial margin with respect to legacy transactions pursuant to house requirements or agreement.

With regard to the comment that counterparties should be required to post variation margin since they may be exposed to potential losses, a nonbank SBSD will be required to take a capital deduction in lieu of margin or credit risk charge if it does not collect variation and/or initial margin with respect to a legacy account. Furthermore, the nonbank SBSD will be required to establish, maintain, and document procedures and guidelines for monitoring the risk of legacy accounts. With respect to the comment about the effect of the replacement of references to LIBOR in security-based swap contracts, the Commission intends to consult and coordinate with other regulators on this question.

Minimum Transfer Amount. The fifth exception established a minimum transfer amount.[514] Under this provision, a nonbank SBSD was not required to collect margin if the total amount of the requirement was equal to or less than $100,000. If this amount was exceeded, the nonbank SBSD needed to collect margin to cover the entire amount of the requirement, not just the amount that exceeded $100,000.

Several commenters supported this exception, or supported increasing it to amounts that ranged from $250,000 to Start Printed Page 43925$500,000.[515] Commenters also asked the Commission to clarify whether the proposed minimum transfer amount applies to both initial and variation margin, and recommended that different jurisdictions use the same currency to designate thresholds.[516] A commenter also supported consistent minimum transfer amounts across domestic regulators.[517] The CFTC and the prudential regulators adopted a minimum transfer amount of $500,000.[518] One commenter opposed a minimum transfer amount for variation margin.[519]

The Commission agrees with commenters that the minimum transfer amount should be increased to $500,000. This will reduce operational burdens for nonbank SBSDs and their counterparties by not requiring them to transfer small amounts of collateral on a daily basis. It also will align the rule with the minimum transfer amount adopted by the CFTC and the prudential regulators and, thereby, reduce potential operational burdens and competitive impacts that could result from inconsistent requirements.

In response to the commenter concerned about applying the minimum transfer amount to variation margin, a nonbank SBSD will be required to take a capital deduction in lieu of margin or credit risk charge if it does not collect variation and/or initial margin pursuant to the minimum transfer amount exception.

For these reasons, the Commission is adopting the minimum transfer amount exception with an increase to $500,000, and with minor modifications.[520]

The Commission also clarifies that the minimum transfer amount applies to both initial and variation margin. Thus, required initial and variation margin need not be collected if the combined requirements are below $500,000. However, if the $500,000 level is exceeded, the entire amount must be collected (i.e., not the just amount that exceeds $500,000). Finally, in response to a comment, nonbank SBSDs may negotiate a lower “house” minimum transfer amount with their counterparties.

Initial Margin Threshold. The CFTC and the prudential regulators have adopted a fixed-dollar $50 million threshold under which initial margin need not be collected.[521] The CFTC defines its initial margin threshold amount to mean an aggregate credit exposure of $50 million resulting from all non-cleared swaps of a swap dealer and its affiliates with a counterparty and its affiliates.[522] The prudential regulators adopted a similar threshold, except that it covers aggregate credit exposure resulting from all non-cleared security-based swaps and swaps.[523]

Some commenters requested that the Commission adopt a threshold consistent with the thresholds adopted by the CFTC and the prudential regulators, and with the recommendations in the BCBS/IOSCO Paper.[524] A commenter stated that initial margin thresholds can be a useful means for reducing the aggregate liquidity impact of mandatory initial margin requirements while still protecting an SBSD from large uncollateralized potential future exposures to counterparties.[525] Another commenter suggested that if pension plans are subject to initial margin requirements, then dealers should be able to set initial margin thresholds for them on a case-by-case basis.[526] A third commenter suggested that low-risk financial end users should be allowed an uncollateralized threshold of $100 million.[527] Other commenters raised concerns about the consequences of breaching the threshold and noted that doing so would trigger the need to execute agreements to address the posting of initial margin.[528]

In the 2018 comment reopening, the Commission asked whether it would be appropriate to establish a risk-based threshold where, for example, a nonbank SBSD would not be required to collect initial margin to the extent the amount does not exceed the lesser of: (1) 1% of the SBSD's tentative net capital; or (2) 10% of the net worth of the counterparty.[529] The Commission stated that the purpose would be to establish a threshold that is scalable and has a more direct relation to the risk to the nonbank SBSD arising from its security-based swap activities. The Commission also stated that a fixed-dollar threshold, depending on the size and activities of the nonbank SBSD, could either be too large and, therefore, not adequately address the risk, or too small and, therefore, overcompensate for the risk.

In response to the potential risk-based threshold discussed in the comment period reopening, most commenters argued that the Commission should adopt a fixed-dollar $50 million threshold consistent with the final margin rules of the CFTC and the prudential regulators.[530] A commenter suggested that this would result in benefits such as predictability and transparency.[531] This commenter also argued that a threshold harmonized with that of other regulators would prevent opportunities for counterparties to engage in regulatory arbitrage, and recommended that any drawbacks (such as the threshold being too large in relation to a nonbank SBSD's net capital) be addressed through additional capital charges.[532] A commenter raised concerns that a different threshold Start Printed Page 43926would result in significant compliance challenges if trading desks that trade both security-based swaps and swaps were required to apply different standards to the same counterparty.[533] Another commenter believed that a scalable threshold would cause significant operational challenges and inefficiencies by subjecting individual SBSDs to different thresholds for the collection of initial margin.[534]

Several commenters argued against including an initial margin threshold in the final rule. Two stated that there is no threshold in the margin rules for cleared security-based swaps, and establishing one for non-cleared security-based swaps would increase systemic risk.[535] One commenter argued that the Commission did not explain its views on why a counterparty specific threshold (e.g., $50 million) should be rejected in favor of a measure that would be tied to a percentage of the nonbank SBSD's tentative net capital.[536]

In response to comments, the Commission believes that it would be appropriate to establish a threshold that is more consistent with the thresholds adopted by the CFTC and the prudential regulators. This will eliminate potential competitive disparities and address operational concerns raised by commenters. For these reasons, the Commission is adopting a fixed-dollar $50 million initial margin threshold below which initial margin need not be collected.[537] As discussed below, the threshold in the Commission's final margin rule is consistent with the threshold in the prudential regulators' margin rules.

Pursuant to the threshold, an SBSD need not collect the calculated amount of initial margin to the extent that the sum of that amount plus all other credit exposures resulting from non-cleared security-based swaps and swaps of the nonbank SBSD and its affiliates with the counterparty and its affiliates does not exceed $50 million. The threshold will be calculated across all non-cleared security-based swaps and swaps of the nonbank SBSD and its affiliates with the counterparty and its affiliates, with the exception that non-cleared security-based swap transactions with commercial end users and non-cleared swap transactions that are exempted under Section 4s(e)(4) of the CEA need not be included in the calculation. The margin rules of the CFTC and the prudential regulators similarly exclude transactions with commercial end users from their respective fixed-dollar $50 million thresholds. Moreover, as discussed above, the TRIPRA statute precludes the Commission from adopting margin requirements for commercial end users.

The Commission's fixed-dollar $50 million threshold is consistent with the threshold established by the prudential regulators in that the calculation includes both non-cleared security-based swaps and swaps (in contrast to the CFTC's threshold, which includes only swaps in the calculation). Including both non-cleared security-based swaps and swaps in the calculation will result in a more prudent requirement that takes into account a broader range of exposures. Further, because bank SBSDs can deal in security-based swaps, aligning the nonbank SBSD threshold with the bank threshold will eliminate a potential competitive disparity between the two types of U.S. entities that deal in security-based swaps. Also, if the calculation of the Commission's threshold were limited to security-based swaps, SBSDs and counterparties potentially would need to make 3 threshold calculations: One for the Commission's rule (security-based swaps only), one for the CFTC's rule (swaps only), and one for the prudential regulators' rule (security-based swaps and swaps). By conforming to the prudential regulator's rule, SBSDs and counterparties need only make two calculations (the Commission/prudential regulator threshold and the CFTC threshold). Further, a counterparty that breaches the Commission's fixed-dollar $50 million threshold will not necessarily breach the CFTC's fixed-dollar $50 million threshold exception given that the former calculation includes security-based swap and swap exposures and the latter includes only swap exposures.

The Commission recognizes that a fixed-dollar threshold (as opposed to a scalable threshold) does not necessarily bear a relation to the financial condition of the nonbank SBSD and its counterparty. To address this issue, as discussed above, and as suggested by a commenter, a nonbank SBSD will be required to take a capital deduction in lieu of margin or a credit risk charge if it does not collect initial margin pursuant to the fixed-dollar $50 million threshold exception. Furthermore, the nonbank SBSD will be required to establish, maintain, and document procedures and guidelines for monitoring counterparty risk. Consequently, the Commission does not believe the fixed-dollar $50 million threshold exception will unduly increase systemic risk as suggested by a commenter. For these reasons, the Commission believes it is appropriate to adopt the exception to promote greater consistency with the margin requirements of the prudential regulators.

Finally, commenters raised concerns about the consequences of breaching a fixed-dollar $50 million threshold and noted that doing so would trigger the need to execute agreements to address the posting of initial margin.[538] The Commission recognizes that after a breach counterparties may need time to execute agreements, establish processes for exchanging initial margin, and take other steps to comply with the initial margin requirement.[539] Therefore, the Commission is modifying the final rule to permit a nonbank SBSD to defer collecting the initial margin amount for up to two months following the month in which a counterparty no longer qualifies for the fixed-dollar $50 million threshold exception for the first time.[540] This is designed to provide the counterparty with sufficient time to take the steps necessary to begin posting initial margin pursuant to the final rule.

Affiliates. The margin rules of the CFTC and the prudential regulators have exceptions for counterparties that are affiliates.[541] Some commenters requested that the Commission also adopt exceptions for affiliates.[542] One Start Printed Page 43927commenter stated that inter-affiliate transactions do not increase the overall risk profile or leverage of the SBSD.[543] Another commenter noted that some affiliates enter into security-based swap transactions with their nonbank SBSD affiliates, either for individual hedging purposes or as part of the consolidated group's broader risk strategy.[544]

Other commenters opposed an exception for affiliates.[545] One of these commenters urged the Commission to impose strong margin requirements for security-based swaps between bank affiliates and other entities under the Commission's authority.[546]

The Commission is persuaded that there should an exception for affiliates in order to reduce potential competitive disparities, and to promote consistency with the margin requirements of the CFTC. Therefore, the Commission is modifying the final rule to establish an initial margin exception when the counterparty is an affiliate of the SBSD.[547]

Although they will not be required to collect initial margin from affiliates, a nonbank SBSD must collect variation margin from them. In addition, as discussed above, a nonbank SBSD will be required to take a capital deduction in lieu of margin or credit risk charge if it does not collect initial margin from an affiliate. The nonbank SBSD also will be required to establish, maintain, and document procedures and guidelines for monitoring the risk of affiliates. Moreover, the final rule does not prohibit a nonbank SBSD from requiring an affiliate to post initial margin under its own house margin requirements.

The BIS, European Stability Mechanism, Multilateral Development Banks, and Sovereigns. The margin rules of the CFTC and the prudential regulators have exceptions for counterparties that are not a financial end user as that term is defined in their rules.[548] Their definitions of financial end user exclude the BIS, multilateral development banks, and sovereign entities.[549]

Some commenters requested that the Commission adopt exceptions for these types of entities to be consistent with the margin rules of the CFTC and the prudential regulators, and with the recommendations in the BCBS/IOSCO Paper.[550] One of these commenters argued that international consistency among covered entities subject to margin requirements, including the definition of public sector entities, is critical to competitive parity and comity.[551] Another commenter argued that the approach to margin for foreign sovereign governments, central banks, and multilateral lending or development organizations should be determined through international consensus.[552] A commenter recommended that the Commission adopt a definition of “financial end user” consistent with the margin rules of the CFTC and the prudential regulators, which—as noted above—results in exceptions for sovereign entities, multilateral development banks, and the BIS.[553] The commenter argued that different treatment of these entities will create unnecessary competitive disparities.

The Commission is persuaded that there should be some exceptions for these types of entities in order to reduce potential competitive disparities. However, the Commission also believes that the exception for sovereign entities should be more limited, given the wide range of potential counterparties that would be within this category and their differing levels of creditworthiness. Limiting the exception for sovereign entities will help ensure the safety and soundness of nonbank SBSDs.

For these reasons, the Commission is adopting an exception from collecting variation and initial margin if the counterparty is the BIS, the European Stability Mechanism, or one of a number of multilateral development banks identified in the rule.[554] These multilateral development banks are the International Bank for Reconstruction and Development, the Multilateral Investment Guarantee Agency, the International Finance Corporation, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the European Bank for Reconstruction and Development, the European Investment Bank, the European Investment Fund, the Nordic Investment Bank, the Caribbean Development Bank, the Islamic Development Bank, the Council of Europe Development Bank, and any other multilateral development bank that provides financing for national or regional development in which the U.S. government is a shareholder or contributing member. These specific counterparties also are not required to collect and/or post variation margin under the final margin rules of the CFTC and/or the prudential regulators.[555] The Commission believes these counterparties pose minimal credit risk and, therefore, it is an appropriate trade-off to except them from the margin requirements (which are designed to protect the nonbank SBSD from counterparty risk) in order to eliminate the potential competitive disparities and operational burdens of treating them differently than under the rules of the CFTC and the prudential regulators.[556]

The exception for sovereign entities is more limited. Specifically, the final rule excepts a nonbank SBSD from collecting initial margin from a counterparty that is a sovereign entity if the nonbank SBSD has determined that the Start Printed Page 43928counterparty has only a minimal amount of credit risk pursuant to policies and procedures or credit risk models established under applicable net capital rules for nonbank SBSDs.[557] The final capital rules for nonbank SBSDs require these entities to have policies and procedures for assessing the creditworthiness of certain types of securities or money market instruments for purposes of applying standardized haircuts.[558] The rules also require firms authorized to use models to compute haircuts to have a model for determining credit risk charges. The firms will need to use these policies and procedures or models (as applicable) to determine whether a sovereign entity has a minimal amount of credit risk in order to apply this exception. A sovereign entity that the nonbank SBSD has determined has a minimal amount of credit risk for purposes of the nonbank capital rules would qualify for the initial margin exception in Rule 18a-3.

Nonbank SBSDs must collect variation margin from and deliver variation margin to counterparties that are sovereign entities under the final rule. In contrast, the final margin rules of the CFTC and the prudential regulators do not require an SBSD or swap dealer to exchange variation margin with a counterparty that is a sovereign entity.[559] Collecting variation margin from sovereign entity counterparties is an important means of managing credit exposure to these entities and limiting the amount of unsecured receivables that comprise the firm's capital. As discussed above, in contrast to the multilateral development banks identified in the rule, the Commission believes that the exception for sovereign entities should be more limited given the wide range of potential counterparties in this category and their differing levels of creditworthiness. Limiting the exception for sovereign entities and requiring that these counterparties post variation margin will help ensure the safety and soundness of nonbank SBSDs. Therefore, the Commission does not believe it is appropriate to except such counterparties from the variation margin requirements of the final rule.

Requests for Other Exceptions

Commenters suggested that the Commission except other counterparties from the margin requirements in Rule 18a-3. The proposed exceptions included: Pension plans; [560] securitization and similar special purpose vehicles; [561] state and municipal government entities; [562] low risk financial end users; [563] financial end users such as captive financial affiliates and mutual life insurance companies; [564] emerging market counterparties that constitute only a certain percentage of a nonbank SBSD's volume; [565] and counterparties trading non-cleared derivatives below a certain notional amount (e.g., financial end users without material swaps exposure).[566] Other commenters suggested that the Commission adopt exceptions to the margin requirements recommended in the BCBS/IOSCO Paper, including for entities that have less than a specified gross notional amount of outstanding non-centrally cleared swaps.[567]

A commenter opposed any exceptions, arguing that exceptions for certain market participants were a significant contributor to the systemic risk disruptions during the 2008 financial crisis.[568] A commenter specifically opposed exceptions for asset-backed security issuers.[569]

The Commission does not believe it is necessary or prudent to establish special exceptions for these specific types of counterparties. The Commission acknowledges that not establishing special exceptions for some of these types of counterparties may lead to different margin requirements across both foreign and domestic regulators. On balance, however, the Commission believes that, given the funding profiles of nonbank SBSDs and the role of margin in promoting liquidity and self-sufficiency and managing credit exposure, the expansion of the exceptions in the manner suggested by commenters would not be prudent. The addition of the fixed-dollar $50 million threshold exception should provide relief to many of these counterparties from the requirement to deliver initial margin. Moreover, as discussed above, the Commission is providing SBSDs with a deferral period that should provide sufficient time for them and their counterparties to implement any documentation, custodial, or operational arrangements that they deem necessary to comply with Rule 18a-3.[570]

ii. Nonbank MSBSPs

As discussed earlier, proposed Rule 18a-3 required a nonbank MSBSP to calculate as of the close of each business day the amount of equity in the account of each counterparty to a non-cleared security-based swap.[571] By noon of the next business day, the nonbank MSBSP was required to either collect or deliver cash, securities, and/or money market instruments to the counterparty depending on whether there was negative or positive equity in the account of the counterparty.[572] In other words, the nonbank MSBSP was required to either collect or deliver variation margin but not required to collect or deliver initial margin. The proposed rule did not require the nonbank MSBSP to apply the Start Printed Page 43929standardized haircuts to securities or money market instruments when calculating the variation margin requirement for an account because the proposed capital rule for these entities did not use standardized haircuts (or model-based haircuts).

Under the proposal, a nonbank MSBSP was subject to certain of the account equity requirements that applied to nonbank SBSDs and were discussed above. First, the types of assets that could be used to meet the nonbank MSBSP's obligation to either collect or deliver variation margin were limited to cash, securities, or money market instruments. Second, the nonbank MSBSP was subject to the additional collateral requirements designed to ensure that the collateral was of stable and predictable value, not linked to the value of the transaction in any way, and capable of being sold quickly and easily if the need arises. Third, the nonbank MSBSP was subject to the requirement to take prompt steps to liquidate collateral consisting of securities or money market instruments to the extent necessary to eliminate an account equity deficiency (though the measure of a deficiency related solely to required variation margin, as these entities were not required to collect initial margin).

Proposed Rule 18a-3 also provided exceptions under which a nonbank MSBSP was not required to collect and, in some cases, deliver variation margin. The first exception applied to counterparties that were commercial end users. Under this exception, the nonbank MSBSP was not required to collect variation margin from the commercial end user. The second exception applied to counterparties that were SBSDs. Under this exception, the nonbank MSBSP was not required to collect variation margin from the SBSD. However, under proposed Rule 18a-3, a nonbank SBSD was required to collect variation and initial margin from an MSBSP. The third exception applied to legacy accounts. Under this exception, the nonbank MSBSP was not required to collect or deliver variation margin with respect to positions in a legacy account. The fourth exception was the $100,000 minimum transfer amount provision. Under this exception, the nonbank MSBSP was not required to collect or deliver variation margin if the margin requirement was less than $100,000.

Comments and Final Account Equity Requirements for Nonbank MSBSPs

A commenter stated that nonbank MSBSPs should be required to apply haircuts to the value of securities and money market instruments when determining whether the level of equity in the account meets the minimum requirement.[573] Under the final rules being adopted today, nonbank MSBSPs are not subject to a capital standard that uses standardized or model based haircuts. Consequently, the Commission believes it would not be appropriate to require these firms to apply the standardized haircuts to the variation margin they receive from counterparties.

The Commission did not receive any specific comments on the commercial end user exception and is adopting it as proposed, with a non-substantive modification.[574] As discussed above, however, the Commission modified the definition of “commercial end user” as a result of amendments to Section 15F(e) of the Exchange Act.

The Commission did not receive any specific comments on the exception for SBSD counterparties. The Commission, however, is removing this exception from the final rule because it is unnecessary. The final rule requires nonbank SBSDs to collect and post variation margin with respect to most counterparties including nonbank MSBSPs, and, consequently, a specific exception from collecting variation margin from nonbank SBSDs would be inconsistent with the requirement that they deliver variation margin to counterparties, including nonbank MSBSPs.

Several commenters supported the Commission's proposed legacy account exception for nonbank MSBSPs.[575] Commenters stated that applying the new rules to legacy accounts would be highly disruptive as the underlying agreements were negotiated based on the law in effect at the time of execution, and that, specifically, financial guarantee insurers are subject to extensive regulation by state insurance companies, and their security-based swap guarantees reflect the restrictions and obligations imposed by those regimes.[576] The Commission is adopting the legacy account exception for nonbank MSBSPs substantially as proposed.[577]

The Commission is making several conforming modifications to the account equity requirements for nonbank MSBSPs in light of modifications made to the account equity requirements for nonbank SBSDs discussed above in section II.B.2.i. of this release. First, the final rule provides that the nonbank MSBSP must collect or deliver variation margin by the close of business on the next business day following the day of the calculation, except that the collateral can be collected or delivered by the close of business on the second business day following the day of the calculation if the counterparty is located in another country and more than four time zones away.[578] Second, the modifications to the collateral requirements in paragraph (c)(4) of Rule 18a-3, as adopted, apply to nonbank MSBSPs, including that the collateral to meet a margin requirement must consist of cash, securities, money market instruments, a major foreign currency, the security of settlement of the non-cleared security-based swap, or gold.[579] Third, the final rule includes an exception from collecting variation margin if the counterparty is the BIS, the European Stability Mechanism, or one of the multilateral development banks identified in the rule (there is no exception from delivering variation margin to these types of counterparties).[580] Fourth, the Commission is making the minimum transfer amount a specific exception to the account equity requirements for nonbank MSBSPs and raising the amount from $100,000 to $500,000.[581]

Finally, a commenter stated that commercial end users do not normally operate under the fiduciary obligations applicable to financial firms for the safekeeping of client funds and, therefore, are unequipped to handle collateral while a contract is open.[582] Therefore, the commenter suggested that margin that a nonbank MSBSP is required to deliver to a commercial end user be held at a third-party custodian. In response, the final rules do not Start Printed Page 43930prevent a nonbank MSBSP from entering into an agreement with a commercial end user under which variation margin required to be delivered to the commercial end user is held at a third-party custodian.

For the foregoing reasons, the Commission is adopting the proposed account equity requirements for nonbank MSBSPs with the modifications discussed above.[583]

c. Risk Monitoring and Procedures

Under proposed Rule 18a-3, a nonbank SBSD was required to monitor the risk of the positions in the account of each counterparty to a non-cleared security-based swap and establish, maintain, and document procedures and guidelines for monitoring those risks.[584] The nonbank SBSD also was also required to review, in accordance with written procedures, and at reasonable periodic intervals, its non-cleared security-based swap activities for consistency with the risk monitoring procedures and guidelines. The Commission did not receive any comments on these proposed requirements and for the reasons discussed in the proposing release is adopting them as proposed.[585]

C. Segregation

1. Background

The Commission is adopting security-based swap segregation requirements for SBSDs and stand-alone broker-dealers pursuant to Sections 3E and 15(c)(3) of the Exchange Act.[586] Section 3E(b) of the Exchange Act provides that, for cleared security-based swaps, the money, securities, and property of a security-based swap customer shall be separately accounted for and shall not be commingled with the funds of the broker, dealer, or SBSD or used to margin, secure, or guarantee any trades or contracts of any security-based swap customer or person other than the person for whom the money, securities, or property are held. However, Section 3E(c)(1) of the Exchange Act also provides that, for cleared security-based swaps, customers' money, securities, and property may, for convenience, be commingled and deposited in the same one or more accounts with any bank, trust company, or clearing agency. Section 3E(c)(2) further provides that, notwithstanding Section 3E(b), in accordance with such terms and conditions as the Commission may prescribe by rule, regulation, or order, any money, securities, or property of the security-based swaps customer of a broker, dealer, or SBSD described in Section 3E(b) may be commingled and deposited as provided in Section 3E with any other money, securities, or property received by the broker, dealer, or SBSD and required by the Commission to be separately accounted for and treated and dealt with as belonging to the security-based swaps customer of the broker, dealer, or SBSD.

Section 3E(f) of the Exchange Act establishes a program by which a counterparty to non-cleared security-based swaps with an SBSD or MSBSP can elect to have initial margin held at an independent third-party custodian (individual segregation). Section 3E(f)(4) provides that if the counterparty does not choose to require segregation of funds or other property (i.e., waives segregation), the SBSD or MSBSP shall send a report to the counterparty on a quarterly basis stating that the firm's back office procedures relating to margin and collateral requirements are in compliance with the agreement of the counterparties. The statutory provisions of Sections 3E(b) and (f) are self-executing.

Finally, Section 15(c)(3)(A) of the Exchange Act provides, in pertinent part, that no broker-dealer shall make use of the mails or any means or instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security (except a government security) or commercial paper, bankers' acceptances, or commercial bills) in contravention of such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest or for the protection of investors to provide safeguards with respect to the financial responsibility and related practices of brokers-dealers including, but not limited to, the acceptance of custody and use of customers' securities and the carrying and use of customers' deposits or credit balances. The statute further provides, in pertinent part, that the rules and regulations shall require the maintenance of reserves with respect to customers' deposits or credit balances. The Commission adopted Rule 15c3-3 pursuant to this authority in Section 15(c)(3)(A) of the Exchange Act.[587]

The Commission is adopting omnibus segregation requirements pursuant to which money, securities, and property of a security-based swap customer relating to cleared and non-cleared security-based swaps must be segregated but can be commingled with money, securities, or property of other customers. The omnibus segregation requirements for stand-alone SBSDs (including firms registered as OTC derivatives dealers) and bank SBSDs are codified in Rules 18a-4 and 18a-4a.[588] The omnibus segregation requirements for stand-alone broker-dealers and broker-dealer SBSDs are codified in amendments to Rules 15c3-3 and 15c3-3b.[589]

The omnibus segregation requirements are mandatory with respect to money, securities, or other property relating to cleared security-based swaps that is held by a stand-alone broker-dealer or SBSD (i.e., customers cannot waive segregation). With respect to non-cleared security-based swap transactions, the omnibus segregation requirements are an alternative to the statutory provisions discussed above pursuant to which a counterparty can elect to have initial margin individually segregated or to waive segregation. However, under the final omnibus segregation rules for stand-alone broker-dealers and broker-dealer SBSDs in Rule 15c3-3, counterparties that are not an affiliate of the firm cannot waive segregation. Affiliated counterparties of a stand-alone broker-dealer or broker-dealer SBSD can waive segregation. Under Section 3E(f) of the Exchange Act and Rule 18a-4, all counterparties (affiliated and non-affiliated) to a non-cleared security-based swap transaction with a stand-alone or bank SBSD can waive segregation. The omnibus segregation requirements are the “default” requirement if the counterparty does not elect individual segregation or to waive segregation (in the cases where a counterparty is permitted to waive segregation). As discussed below in section II.E.2. of this release, Rule 18a-4 also has exceptions pursuant to which a foreign stand-alone or bank SBSD or MSBSP need not comply with the Start Printed Page 43931segregation requirements (including the omnibus segregation requirements) for certain transactions.

The omnibus segregation requirements do not apply to MSBSPs.[590] However, if an MSBSP requires initial margin from a counterparty with respect to non-cleared security-based swaps, the counterparty can request that the collateral be held at a third-party custodian pursuant to Section 3E(f) of the Exchange Act.[591]

As proposed, the segregation requirements for all types of SBSDs would have been codified in Rules 18a-4 and 18a-4a. However, a commenter requested that Rule 15c3-3 be amended so that initial margin delivered to a stand-alone broker-dealer by a counterparty to a cleared security-based swap and which the stand-alone broker-dealer in turn delivers to a clearing agency could be treated under the proposed omnibus segregation requirements.[592] In the 2018 comment reopening, the Commission asked whether omnibus segregation requirements parallel to those in proposed Rule 18a-4 should be codified in Rule 15c3-3, in which case they would apply to stand-alone broker-dealers and broker-dealer SBSDs.[593] One commenter argued that the Commission should apply the omnibus segregation requirements of Rule 15c3-3 to a broker-dealer SBSD, but recommended a single possession or control requirement for all positions, including those that are portfolio margined.[594] Another commenter supported the integration of security-based swap segregation requirements for stand-alone broker-dealers into Rule 15c3-3, including the express recognition in Rule 15c3-3 of margin posted by a stand-alone broker-dealer to a clearing agency.[595] Other commenters stated that the Commission should consider raising segregation requirements to achieve regulatory consistency, or harmonize rules with other regulators to avoid operational issues that could fragment the security-based swap market.[596]

The Commission believes it is appropriate to codify the omnibus segregation requirements for stand-alone broker-dealers and broker-dealer SBSDs in Rules 15c3-3 and 15c3-3b. Absent this modification, a stand-alone broker-dealer that engages in security-based swap activity would continue to be subject to the segregation requirements of Rules 15c3-3 and 15c3-3a as they existed prior to today's amendments. However, as discussed in more detail below, these pre-existing requirements are not tailored to security-based swaps in the way that the omnibus segregation requirements are tailored. Consequently, by codifying the omnibus segregation requirements in Rules 15c3-3 and 15c3-3b, stand-alone broker-dealers also will be subject to the tailored requirements and will meet their pre-existing segregation obligations through them. Furthermore, Section 3E(b) of the Exchange Act imposes self-executing segregation requirements on stand-alone broker-dealers (as well as SBSDs) that would place strict restrictions on, and not permit the commingling of, collateral for a cleared security-based swap unless the Commission, pursuant to Section 3E(c), permits it by rule, regulation, or order. The omnibus segregation requirements being adopted in Rules 15c3-3 and 15c3-3b will permit stand-alone broker-dealers to commingle this collateral and take other actions with respect to it that otherwise would have been prohibited. Thus, the Commission believes that stand-alone broker-dealers will benefit by being subject to more tailored and flexible segregation requirements.

As discussed above, non-affiliated customers of a stand-alone broker-dealer or broker-dealer SBSD will not be permitted to waive segregation. Section 15(c)(3) of the Exchange Act does not have a provision that is analogous to Section 3E(f)(4), which provides that if the counterparty does not choose to require segregation of funds or other property with respect to non-cleared swaps, the SBSD or MSBSP shall send a report to the counterparty on a quarterly basis stating that the firm's back office procedures relating to margin and collateral requirements are in compliance with the agreement of the counterparties. Under Section 15(c)(3) of the Exchange Act and Rule 15c3-3 thereunder, persons—other than affiliates—are not permitted to waive segregation. This reflects the important protection that segregation provides to customers. It also serves to promote the safety and soundness of stand-alone broker-dealers. Segregating securities and cash of customers makes these assets readily available to be returned to the customers and therefore makes it more likely that a stand-alone broker-dealer (and a broker-dealer SBSD) can meet its obligations to the customers. Thus, segregation protects customers and supports the liquidity of stand-alone broker-dealers (and will have the same effect on broker-dealer SBSDs). Moreover, segregation reduces the risk that customers will “run” on a stand-alone broker-dealer when it is experiencing financial difficulty or the securities markets are in turmoil (and will have the same effect on broker-dealer SBSDs). Customers whose assets are being segregated know that the assets are being protected. Conversely, persons whose assets are not being segregated may act precipitously to withdraw them from a firm if they perceive that the firm is experiencing financial difficulty or the markets are in turmoil. This could put severe liquidity pressure on the firm, particularly since the assets these persons are seeking to withdraw may not be readily available to the firm (e.g., they may be re-hypothecated or serving as collateral for loans to the broker-dealer). Affiliates are less likely to create this “run” risk as they will have more information about the financial condition of the firm and their shared parent holding company.

In addition, as discussed below, a number of commenters have raised questions about how claims would be handled in the liquidation of a broker-dealer SBSD. In addition, one commenter argued that stand-alone broker-dealers and broker-dealer SBSDs should be subject to a single set of omnibus segregation requirements for security-based swaps and related cash and all other types of securities and related cash.[597] This commenter argued that separating security-based swap positions from all other security positions for purposes of the possession or control and reserve account requirements of the omnibus segregation rule could foster legal uncertainty in a SIPA liquidation. As discussed below in sections II.C.3.a. and II.C.3.b. of this release, the Commission does not believe at this time that security-based swaps should be combined with other types of securities positions for the purposes of the possession or control and reserve account calculations.598 Start Printed Page 43932However, the Commission does share the commenter's concern about taking steps to avoid legal uncertainty. In this regard, customers could be harmed in cases where a stand-alone broker-dealer or broker-dealer SBSD that holds cash and securities for persons who waived segregation with respect to their non-cleared security-based transactions, but did not (because they could not) waive segregation with respect to cash and securities that are not related to non-cleared security-based swap transactions. More specifically, there could be questions about the status of a particular person's claim in a liquidation proceeding and potentially result in the amount of cash and securities that were segregated by the stand-alone broker-dealer or broker-dealer SBSD being insufficient to satisfy the claims of all persons who a court ultimately determines are customers under SIPA and are entitled to a pro rata share of customer property.

For these reasons, the omnibus segregation requirements are being codified in Rule 15c3-3 to apply to stand-alone broker-dealers and broker-dealer SBSDs with a limitation that non-affiliates cannot waive segregation with respect to non-cleared security-based swap transactions (in addition to not being able to waive segregation with respect to all other securities transactions). In order to implement this limitation, the Commission is modifying the subordination provisions in the final rule to provide that only an affiliate of the stand-alone broker-dealer or broker-dealer SBSD can waive segregation with respect to non-cleared security-based swap transactions. In particular, the Commission is modifying the definition of “security-based swap customer” to provide that, with respect to persons who subordinate their claims, the term excludes an affiliate of the stand-alone broker-dealer or broker-dealer SBSD.[599] Thus, a person who is not an affiliate will be a “security-based swap customer” (regardless of whether the person attempts to subordinate) and therefore cash and securities of the customer related to non-cleared security-based swaps will be subject to the omnibus segregation requirements. The Commission is making a conforming amendment to the requirement that the stand-alone broker-dealer or broker-dealer SBSD obtain a subordination agreement from a person who waives segregation with respect to non-cleared security-based swaps to provide that the provision applies to affiliates that waive segregation because persons who are not affiliates cannot waive segregation.[600]

Commenters sought clarification on how customer collateral held by an SBSD as initial margin to secure a security-based swap would be treated in the event of the SBSD's insolvency.[601] A commenter requested clarification on how counterparties to an entity that is both an SBSD and CFTC-regulated swap dealer would be treated in the event of the insolvency of the firm.[602] The same commenter stated that it is unclear how claims of a security-based swap customer of a broker-dealer SBSD would be treated relative to the claims of other types of customers of the firm, including whether security-based swaps would be subject to SIPA protections.

In response to commenters' requests for clarification, Section 3E(g) of the Exchange Act applies the customer protection elements of the stockbroker liquidation provisions to cleared security-based swaps and related collateral, and to collateral delivered as margin for non-cleared security-based swaps if collateral is subject to a customer protection requirement under Section 15(c)(3) of the Exchange Act or a segregation requirement. The Dodd-Frank Act also amended the U.S. Bankruptcy Code, and the CFTC has promulgated rules to implement that amendment, to provide the protections of Subchapter IV of Chapter 7 of the Bankruptcy Code and CFTC Regulation Part 190 to collateral associated with cleared swaps.[603] Finally, SIPA protects customers of SIPC-member broker-dealers. SIPA defines a “customer” as any person (including any person with whom the broker-dealer deals as principal or agent) who has a claim on account of securities received, acquired, or held by the broker-dealer in the ordinary course of its business as a broker-dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral, security, or for purposes of effecting transfer.[604]

The omnibus segregation requirements will apply to stand-alone broker-dealers and broker-dealer SBSDs pursuant to new paragraph (p) of Rule 15c3-3, as discussed above. They also will apply to stand-alone and bank SBSDs if they elect to clear security-based swap transactions for other persons or otherwise do not meet the conditions of the exemption discussed below in section II.C.2. of this release. In this regard, Section 3E of the Exchange Act authorizes the Commission to promulgate segregation rules for all types of SBSDs. In contrast, Section 15F of the Exchange Act authorizes the prudential regulators to promulgate capital and margin rules for bank SBSDs. Further, the requirements of the prudential regulators with respect to segregating initial margin apply to non-cleared security-based swaps (i.e., they do not address cleared security-based swaps). As discussed above, with respect to cleared security-based swaps, Section 3E(b) of the Exchange Act imposes self-executing segregation requirements on stand-alone broker-dealers and SBSDs that place strict restrictions on, and do not permit the commingling of, collateral for a cleared security-based swap unless the Commission, pursuant to Section 3E(c), permits it by rule, regulation, or order. Therefore, the Commission believes the statute itself imposes strict segregation requirements on bank SBSDs with respect to cleared security-based swaps in the absence of Commission rulemaking. The Commission's omnibus segregation requirements implement Section 3E(c) in a manner that is designed to protect security-based swap customers, but in a tailored way that will permit stand-alone broker-dealers and SBSDs to commingle collateral with respect to cleared security-based swaps and take other actions with respect to the collateral that otherwise would have been prohibited. Consequently, bank SBSDs (along with nonbank SBSDs and stand-alone broker-dealers) will benefit from the flexibility offered by the omnibus segregation requirements to the extent they elect to clear security-based swap transactions for other persons. However, as noted above and discussed below in section II.C.2. of this release, stand-alone and bank SBSDs will be exempt from the omnibus segregation requirements of Rule 18a-4 under certain conditions, including that they do not clear security-based swaps for other persons.[605] The Commission expects that bank SBSDs will operate under this exemption, because in order to clear swaps for other persons they would need to be registered as an FCM, which would subject them to CFTC capital requirements in addition to the Start Printed Page 43933capital requirements imposed by their prudential regulator.

Commenters recommended that the Commission adopt individual segregation requirements for cleared security-based swaps. A commenter stated that the European Commission has finalized regulations mandating that central counterparties allow customers to choose between omnibus segregation and individual segregation for their cleared derivatives assets and positions.[606] A second commenter stated that if the stand-alone broker-dealer or SBSD defaults, any cleared security-based swap customer collateral that is individually segregated would likely be outside the estate of the stand-alone broker-dealer or SBSD for bankruptcy purposes, thereby facilitating customers' retrieval of their collateral.[607] This commenter also indicated that cleared security-based swap customers registered with the Commission under the Investment Company Act of 1940 may be precluded from having their collateral held at an SBSD that is not a bank. A third commenter argued that collateral posted as margin should be segregated by client, rather than on an omnibus basis.[608] A number of these commenters advocated that the Commission modify its proposal for cleared security-based swaps to allow for the approach adopted by the CFTC, known as legal separation with operational comingling (“LSOC”).[609] Under the CFTC's LSOC rules, the collateral of multiple cleared swap customers can be commingled in one account.[610]

Implementing an individual segregation regime for cleared security-based swaps, including an LSOC-like approach, would require implementing new rules governing the treatment of collateral held by clearing agencies. For example, under the CFTC's rules, the DCO and the FCM that is a member of the DCO must take certain steps to ensure that the collateral attributable to non-defaulting swap customers is not used to pay for obligations arising from other defaulting swap customers. Implementing such rules would be outside the scope of this rulemaking, which involves segregation requirements for SBSDs (not clearing agencies).

A commenter requested clarification as to how property remaining in a portfolio margin account of a security-based swap customer should be treated when all the security-based swap positions in the account are temporarily closed out or expire before the customer enters into a new security-based swap transaction.[611] As noted above, this commenter also argued that the Commission should apply the omnibus segregation requirements of Rule 15c3-3 to a broker-dealer SBSD, but recommended a single possession or control requirement for all positions, including those that are portfolio margined.[612] As stated above, implementing portfolio margining will require further coordination with the CFTC. If the entity is a broker-dealer, the security-based swap customer could request that cash and securities in the security-based swap account be transferred to a traditional securities account, in which case it would be subject to the segregation requirements of Rules 15c3-3 and 15c3-3a that existed prior to today's amendments.[613] A commenter argued that swaps should be permitted to be held in a security-based swap account to facilitate portfolio margining for related or offsetting positions in the account.[614] As discussed above with respect to Rule 18a-3, the Commission has modified the rule to accommodate portfolio margining of security-based swaps and swaps.

A commenter stated that if MSBSPs are not required to comply with the proposed omnibus segregation requirements, many firms will apply to register as MSBSPs as a way to circumvent them.[615] The Commission does not agree. First, Section 3E(a) of the Exchange Act makes it unlawful for a person to accept any money, securities, or property (or to extend credit in lieu thereof) from, for, or on behalf of a security-based swap customer to margin, guarantee, or secure a cleared security-based swap unless the person is registered as a broker-dealer or an SBSD. This prohibition severely limits the activities a stand-alone MSBSP can engage in with respect to effecting transactions for cleared security-based swap customers (as compared to the activities permitted of broker-dealers and SBSDs). Second, the omnibus segregation requirements as applied to non-cleared security-based swaps are designed to provide a third segregation option to security-based swap customers in addition to the statutory options of individual segregation or waiving segregation altogether. The Commission believes that SBSDs will favor having the ability to utilize this third option. Third, a firm with security-based swap activity exceeding the de minimis threshold must register as an SBSD.[616] A firm that does not want to comply with the omnibus segregation requirements by virtue of being an SBSD will need to restrict its activities to stay below the de minimis threshold. For these reasons, the Commission does not believe firms will seek to register as MSBSPs to avoid the omnibus segregation requirements.

Moreover, MSBSPs will be subject to the self-executing segregation provisions in Section 3E(f) of the Exchange Act for collateral relating to non-cleared security-based swap transactions, and, consequently, their customers can request individual segregation. Therefore, an MSBSP will be subject to a rigorous statutory segregation requirement. Finally, the omnibus segregation requirements may not be practical for stand-alone MSBSPs, given the potentially wide range of business models under which they may operate, and the uncertain impact that requirements designed for broker-dealers could have on these commercial entities.

For the reasons discussed above, the Commission is adopting the omnibus segregation requirements for SBSDs modeled on the segregation requirements for broker-dealers but, as discussed below, with an exemption for stand-alone and bank SBSDs if they meet the conditions in the final rule, including that they do not clear security-based swaps transactions for other persons.

2. Exemption

In the 2018 comment reopening, the Commission asked whether there are aspects of the proposed omnibus segregation requirements where greater clarity regarding the operation of the rule would be helpful.[617] One commenter supported the use of third-party custodians to avoid the omnibus Start Printed Page 43934segregation requirements.[618] Several commenters recommended that the Commission modify its final segregation requirements based on entity type and whether or not the entity offered counterparty clearing.[619] More specifically, one commenter recommended that no customer protection and segregation requirements should apply to a stand-alone broker-dealer if it does not clear security-based swap transactions.[620] Instead, the firm should be required to provide certain notices to customers: (1) Regarding their right to request that initial margin related to non-cleared security-based swaps be held at a third-party custodian; and (2) disclosing that the customer has no customer claim in the event of the SBSD's insolvency.[621] Another commenter recommended that the Commission not impose the omnibus segregation requirements on bank SBSDs, foreign SBSDs, and stand-alone SBSDs.[622] This commenter argued that the proposed omnibus segregation requirements could conflict with bank liquidation or resolution schemes, could cause jurisdictional disputes, and would not be consistent with the Exchange Act. In addition, this commenter argued that the omnibus segregation requirements would impair hedging and funding activities for stand-alone SBSDs. Another commenter was concerned about the application of omnibus segregation requirements to foreign SBSDs that are not registered broker-dealers.[623] With respect to non-cleared security-based swaps, this commenter suggested that the proposed omnibus segregation requirements not apply at all.

These comments echoed comments the Commission previously received opposing the application of the omnibus segregation requirements to a bank. Commenters argued that imposing the omnibus segregation requirements on banks was unnecessary because rules of the prudential regulators require initial margin for non-cleared security-based swaps to be segregated at a third-party custodian.[624] One of these commenters recommended that the Commission adopt an approach similar to that of the Department of Treasury, which exempts government securities dealers from customer protection requirements if the entity is a bank that meets certain conditions.[625]

The Commission is persuaded that it would be appropriate to exempt from the omnibus segregation requirements stand-alone and bank SBSDs that do not clear security-based swaps for other persons. As discussed above, the omnibus segregation requirements implement the provisions of Section 3E of the Exchange Act that require Commission rulemaking to permit SBSDs to commingle their customers' cleared security-based swaps. If the stand-alone or bank SBSD does not clear security-based swaps for other persons then there is no need for the omnibus segregation requirements with respect to those positions. Moreover, as discussed above, with respect to non-cleared security-based swaps, the omnibus segregation requirements provide an alternative to the statutory options available to counterparties to request individual segregation or to waive segregation. Thus, counterparties will have the option of protecting their initial margin for non-cleared security-based swaps by exercising their statutory right to individual segregation.

This modification from the proposed rule is designed to mitigate commenters' concerns that the proposed omnibus segregation requirements may conflict with bank liquidation or resolution schemes. In addition, as discussed above, Section 3E(g) of the Exchange Act applies the customer protection elements of the stockbroker liquidation provisions to cleared security-based swaps and related collateral, and to collateral delivered as initial margin for non-cleared security-based swaps if the collateral is subject to a customer protection requirement under Section 15(c)(3) of the Exchange Act or a segregation requirement. Consequently, a stand-alone SBSD that does not have cleared security-based swap customers and is not subject to a segregation requirement with respect to collateral for non-cleared security-based swaps will not implicate the stockbroker liquidation provisions.

For the foregoing reasons, the final rule exempts stand-alone and bank SBSDs from the requirements of Rule 18a-4 if the SBSD meets certain conditions, including that the SBSD does not clear security-based swap transactions for other persons, provides notice to the counterparty regarding the right to segregate initial margin at an independent third-party custodian, and discloses in writing that any collateral received by the SBSD for non-cleared security-based swaps will not be subject to a segregation requirement and regarding how a claim of the counterparty for the collateral would be treated in a bankruptcy or other formal liquidation proceeding of the SBSD.[626]

Under the first condition, the stand-alone or bank SBSD must not: (1) Effect transactions in cleared security-based swaps for or on behalf of another person; (2) have any open transactions in cleared security-based swaps executed for or on behalf of another person; and (3) hold or control any money, securities, or other property to margin, guarantee, or secure a cleared security-based swap transaction executed for or on behalf of another person (including money, securities, or other property accruing to another person as a result of a cleared security-based swap transaction).[627] For the reasons discussed above, this condition will ensure that the exemption is only available to stand-alone SBSDs or bank SBSDs that do not clear security-swaps for other persons.

Under the second condition, the stand-alone or bank SBSD must provide the notice required pursuant to Section 3E(f)(1)(A) of the Exchange Act in writing to a duly authorized individual prior to the execution of the first non-cleared security-based swap transaction with the counterparty occurring after the compliance date of the rule.[628] Section 3E(f)(1)(A) of the Exchange Act provides that an SBSD and an MSBSP shall be required to notify the counterparty at the “beginning” of a non-cleared security-based swap transaction about the right to require segregation of the funds or other property supplied to margin, guarantee, or secure the obligations of the counterparty.[629] This condition will require a stand-alone or bank SBSD to provide the notice in writing to a counterparty prior to the execution of the first non-cleared security-based swap transaction with the counterparty occurring after the compliance date.[630] Consequently, the stand-alone or bank SBSD must give the notice in writing before the counterparty is required to Start Printed Page 43935deliver margin to the SBSD. This will give the counterparty an opportunity to determine whether to elect individual segregation or to waive segregation.

Under the third condition, the stand-alone or bank SBSD must disclose in writing to a counterparty before engaging in the first non-cleared security-based swap transaction with the counterparty that any margin collateral received and held by the SBSD will not be subject to a segregation requirement and how a claim of the counterparty for the collateral would be treated in a bankruptcy or other formal liquidation proceeding of the SBSD.[631] This condition is designed to provide the counterparty with additional information to determine whether to elect individual segregation or to waive segregation by describing the potential consequences of waiving segregation.

3. Segregation Requirements for Security-Based Swaps

a. Possession or Control of Excess Securities Collateral

i. Requirement To Obtain Possession or Control

Paragraph (b)(1) of Rule 15c3-3, as it existed before today's amendments, requires a stand-alone broker-dealer that carries customer securities and cash (“carrying broker-dealer”) to promptly obtain and thereafter maintain physical possession or control of all customer fully paid and excess margin securities. Fully paid and excess margin securities, as defined in paragraphs (a)(3) and (a)(5) of the rule, respectively, generally are securities the carrying broker-dealer is carrying for customers that are not being used as collateral arising from margin loans to the customer or to facilitate a customer's short sale of a security. Physical possession or control as used in paragraph (b)(1) of Rule 15c3-3 under these pre-existing requirements means the carrying broker-dealer cannot lend or hypothecate securities and must hold them itself or, as is more common, at a satisfactory control location.

As part of the omnibus segregation requirements, the Commission proposed that SBSDs be required to promptly obtain and thereafter maintain physical possession or control of all excess securities collateral carried for the accounts of security-based swap customers.[632] The Commission modeled these proposed requirements for SBSDs on the pre-existing requirements in paragraph (b)(1) of Rule 15c3-3 and intended that physical possession or control have the same meaning in terms of prohibiting the SBSD from lending or hypothecating the excess securities collateral and requiring the SBSD to hold the collateral itself or in a satisfactory control location.

The term “security-based swap customer” was defined to mean any person from whom or on whose behalf the SBSD has received or acquired or holds funds or other property for the account of the person with respect to a cleared or non-cleared security-based swap transaction. The proposed definition excluded a person to the extent that person has a claim for funds or other property which by contract, agreement or understanding, or by operation of law, is part of the capital of the SBSD or is subordinated to all claims of security-based swap customers of the SBSD. The term “excess securities collateral” was defined to mean securities and money market instruments (“securities collateral”) carried for the account of a security-based swap customer that have a market value in excess of the current exposure of the SBSD to the customer. Thus, securities collateral held by the SBSD that was not being used to meet a variation margin requirement of the customer needed to be protected by maintaining physical possession or control of it. This would be the case with respect to securities collateral held by the SBSD to meet the customer's initial margin requirement or that had a value in excess of the initial margin requirement.

The definition of excess securities collateral had two exclusions that permitted an SBSD to use, under certain narrowly prescribed circumstances, securities collateral of a security-based swap customer not being held to meet a variation margin requirement of the customer. Under the first exclusion, the SBSD could use the securities collateral to meet a margin requirement of a clearing agency resulting from a security-based swap transaction of the customer. This exclusion was designed to accommodate the margin requirements of clearing agencies, which will require SBSDs to deliver collateral to cover exposures arising from cleared security-based swaps of the SBSD's security-based swap customers. The exclusion required that the securities collateral be held in a qualified clearing agency account. The term “qualified clearing agency account” was defined to mean an account of the SBSD at a clearing agency that met certain conditions designed to ensure that the securities collateral was isolated from the proprietary assets of the SBSD and identified as property of the firm's security-based swap customers. Excluding the securities collateral from the definition of excess securities collateral meant it was not subject to the physical possession or control requirement. This allowed the clearing agency to hold the securities collateral against obligations of the SBSD's customers without the SBSD violating the physical possession or control requirement.[633]

Under the second exclusion from the definition of “excess securities collateral,” the SBSD could use securities collateral to meet a margin requirement of a second SBSD resulting from the first SBSD entering into a non-cleared security-based swap transaction with the second SBSD. However, the transaction with the second SBSD needed to be for the purpose of offsetting the risk of the non-cleared security-based swap transaction between the first SBSD and the security-based swap customer. This exclusion was designed to accommodate the practice of dealers in OTC derivatives transactions maintaining “matched books” of transactions in which an OTC derivatives transaction with a counterparty is hedged with an offsetting transaction with another dealer.

The exclusion required that the securities collateral be held in a qualified registered security-based swap dealer account. The term “qualified registered security-based swap dealer account was defined to mean an account at a second unaffiliated SBSD that met certain conditions designed to ensure that the securities collateral provided to the second SBSD was isolated from the proprietary assets of the first SBSD and identified as property of the firm's security-based swap customers. Further, the account and the assets in the account could not be subject to any type of subordination agreement. This condition was designed to ensure that if the second SBSD fails, the first SBSD would be treated as a security-based swap customer in a liquidation proceeding and, therefore, accorded applicable protections under the bankruptcy laws. Thus, because the account was at a second SBSD, the second SBSD needed to treat the first SBSD as a customer and the first SBSD's account was subject to the proposed omnibus segregation requirements. Excluding the securities collateral from Start Printed Page 43936the definition of “excess securities collateral” meant that the first SBSD did not have to hold them in accordance with the physical possession or control requirement. This allowed the first SBSD to finance customer transactions in non-cleared security-based swaps by using the customer's securities collateral to secure an offsetting transaction with a second SBSD.

Comments and Final Physical Possession or Control Requirements

A commenter stated that the proposed use of market value rather than haircut value for the securities collateral posted in connection with non-cleared security-based swaps would require that an SBSD use its own resources to fund margin requirements.[634] The Commission did not intend this result and is modifying the definition of “excess securities collateral” so that stand-alone broker-dealers or SBSDs may use securities collateral for non-cleared security-based swaps in an amount that equals the regulatory margin requirement of the SBSD with whom they are entering into a hedging transaction taking into account haircuts required by that regulatory requirement.[635] For purposes of this modification, the Commission clarifies that “regulatory margin requirement” means the amount of initial margin the SBSD-hedging counterparty is required to collect from the stand-alone broker-dealer or SBSD and not any greater “house” margin amount the SBSD-hedging counterparty may require as a supplement to the regulatory requirement. If the SBSD-hedging counterparty imposes a supplemental “house” margin requirement, the stand-alone broker-dealer or SBSD cannot use the customer's securities collateral to meet the additional requirement. Securities collateral used in this manner will not be excluded from the definition of “excess securities collateral” and therefore must be in the physical possession or control of the stand-alone broker-dealer or SBSD. Thus, the stand-alone broker-dealer or SBSD would need to fund the supplemental “house” margin requirement of the SBSD-hedging counterparty using proprietary cash or securities.

In the 2018 comment reopening, the Commission asked whether it should modify the definition of “excess securities collateral” to account for the fact that the prudential regulators require initial margin to be held at a third-party custodian.[636] As discussed above, the proposed second exclusion from the definition of “excess securities collateral” required that the securities collateral be held in a qualified registered security-based swap dealer account (i.e., an account at a second SBSD). Thus, the proposed definition of “qualified registered security-based swap dealer account” did not contemplate holding the securities collateral at a third-party custodian. Absent modification, the proposed rule would have created the unintended consequence of preventing an SBSD from posting a customer's securities collateral to a third-party custodian in accordance with the requirements of the prudential regulators. Thus, the SBSD would have been required to use proprietary securities or cash to enter into a hedging transaction with a bank SBSD.

Consequently, in the 2018 comment reopening, the Commission asked whether the definition of “excess securities collateral” should exclude securities collateral held in a third-party custodial account, subject to the same limitations and conditions as apply to securities collateral re-hypothecated directly to a second SBSD. The Commission asked whether the term “third-party custodial account” should be defined to mean an account carried by an independent third-party custodian that meets the following conditions:

  • It is established for the purposes of meeting regulatory margin requirements of another SBSD;
  • The account is carried by a bank under Section 3(a)(6) of the Exchange Act;
  • The account is designated for and on behalf of the SBSD for the benefit of its security-based swap customers and the account is subject to a written acknowledgement by the bank provided to and retained by the SBSD that the funds and other property held in the account are being held by the bank for the exclusive benefit of the security-based swap customers of the SBSD and are being kept separate from any other accounts maintained by the SBSD with the bank; and
  • The account is subject to a written contract between the SBSD and the bank which provides that the funds and other property in the account shall at no time be used directly or indirectly as security for a loan or other extension of credit to the SBSD by the bank and shall be subject to no right, charge, security interest, lien, or claim of any kind in favor of the bank or any person claiming through the bank.

The conditions in the definition of “third-party custodial account” in the 2018 comment reopening were designed to ensure that securities collateral posted to the custodian is isolated from the proprietary assets of the SBSD and identified as property of its security-based swap customers.[637] The objective was to facilitate the prompt return of the securities collateral to the customers if the SBSD fails.

As discussed above, commenters suggested that the Commission recognize a broader range of custodians for purposes of the provisions in the final capital rules that permit stand-alone broker-dealers and nonbank SBSDs to avoid taking a capital charge when initial margin is held at a third-party custodian.[638] These same commenters similarly suggested that the definition of “third-party custodial account” for purposes of the segregation rules include a broader range of custodians. One of these commenters suggested that the definition of “third-party custodial account” for purposes of the segregation rules be modified to include domestic clearing agencies and depositories.[639] The second commenter suggested that the definition include foreign banks.[640]

For the reasons discussed above, the final segregation rules being adopted today modify the proposed definition of “excess securities collateral” to exclude securities collateral held in a “third-party custodial account” as that term is defined in the rules.[641] The final segregation rules also incorporate the definition of “third-party custodial account” that was included in the 2018 comment reopening but with the modifications suggested by the commenters to broaden the definition to include domestic clearing organizations and depositories and foreign supervised banks, clearing organizations, and depositories.[642] As a result of these modifications, the definition of “third-party custodial account” in the final segregation rules means, among other Start Printed Page 43937conditions, an account carried by a bank as defined in Section 3(a)(6) of the Exchange Act or a registered U.S. clearing organization or depository or, if the collateral to be held in the account consists of foreign securities or currencies, a supervised foreign bank, clearing organization, or depository that customarily maintains custody of such foreign securities or currencies. Thus, the definition includes the same types of custodians as are permitted by the final capital rules for purposes of the exception from taking the capital charge when initial margin is held at a third-party custodian [643] and computing credit risk charges.[644] These same types of custodians also are permitted by Rule 18a-3 for the purposes of calculating the account equity requirements.[645]

In addition to these modifications, the Commission believes it is appropriate to modify the proposed definition of “qualified registered security-based swap dealer account” to remove the limitation that the account be held at an unaffiliated SBSD. This limitation would have had the unintended consequence of impeding a financial institution from centralizing its risk management of security-based swaps in a central booking entity through affiliate transactions or of transferring risk from one affiliate to another to manage the risk of the position in the jurisdiction where the underlying security is traded, for example. Therefore, the Commission is not adopting the affiliate limitation in the final rule.[646]

For the foregoing reasons, the Commission is adopting the proposed physical possession or control requirements with the modifications discussed above and certain other non-substantive modifications.[647]

A commenter urged the Commission to conform its proposal to the recommendations in the BCBS/IOSCO Paper with respect to re-hypothecation of collateral for non-cleared security-based swaps, by limiting re-hypothecation of securities collateral to circumstances that facilitate hedging of derivatives transactions entered into with customers.[648] The Commission agrees that securities collateral with respect to non-cleared security-based swaps should be re-hypothecated only in order to hedge a transaction with a security-based swap customer. Consequently, as discussed above, the final rules permit re-hypothecation only for this purpose.

A commenter questioned whether it was necessary for the Commission to promulgate a possession or control requirement for security-based swap customers that is separate from and in addition to the requirement for traditional securities customers under Rules 15c3-3 given the common insolvency treatment of securities and security-based swap customers.[649] The commenter argued that requiring separate calculations could increase operational risk. In response, the possession or control requirement is tailored to security-based swaps activity. For example, the definition of excess securities collateral, which is tied to the security-based swap possession or control requirement, is different than the definitions of “fully paid” and excess margin securities, which are tied to the existing possession or control requirement in Rule 15c3-3. The Commission believes it is appropriate to have separate requirements to help ensure that stand-alone and broker-dealer SBSDs appropriately account for excess securities collateral in the context of security-based swap activities and fully paid and excess margin securities in the context of traditional securities activities.

Commenters asked the Commission to permit re-hypothecation of securities collateral for non-cleared security-based swap transactions to entities other than other SBSDs.[650] One of these commenters noted that SBSDs may use products such as cleared and non-cleared swaps, cleared security-based swaps, and futures to hedge security-based swap transactions.[651] Conversely, another commenter opposed the re-hypothecation of initial margin.[652]

In response, the exemption from Rule 18a-4 being adopted today will permit SBSDs that operate under the exemption to re-hypothecate initial margin collateral received from counterparties for non-cleared security-based swaps unless the counterparty elects to have the initial margin held at a third-party custodian. The Commission anticipates that most stand-alone and bank SBSDs will operate under this exemption because, for example, to clear swaps for others the firms would need to register with the CFTC as an FCM and be subject to the specific rules governing FCMs.

If a stand-alone or bank SBSD does not operate under the exemption because it clears security-based swaps for others, the Commission believes the strict limits on re-hypothecation should apply. This type of firm will receive and hold initial margin for both cleared and non-cleared security-based swaps. Securities and cash collateral held directly by the firm would be fungible and, therefore, the Commission believes it should be subject to the strict limitations of the omnibus segregation requirements in order to facilitate the prompt return of the collateral to cleared and non-cleared security-based swap customers of the SBSD.

The Commission designed the hedging exception for non-cleared security-based swap collateral to accommodate a limited scenario: The industry practice of dealers in OTC derivatives maintaining “matched books” of transactions.[653] The Commission does not believe it would be appropriate at this time to either broaden the exception to permit the securities collateral to be used in connection with other types of products, or to prohibit the re-hypothecation of initial margin. The second SBSD must treat the securities collateral it receives in the hedging transaction in accordance with the omnibus segregation requirements being adopted today for security-based swaps. This is designed to ensure that the securities collateral posted by the first SBSD to the second Start Printed Page 43938SBSD remains within the omnibus segregation program.

ii. Good Control Locations

As discussed above, paragraph (b) of Rule 15c3-3, as it existed before today's amendments, requires a carrying broker-dealer to promptly obtain and thereafter maintain physical possession or control of a customer's fully paid and excess margin securities. The pre-existing provisions of paragraph (c) of the rule identify locations that are deemed to be under the control of the carrying broker-dealer. As part of the omnibus segregation requirements, the Commission proposed five locations where an SBSD could hold excess securities collateral and be deemed in control of it.[654] The Commission modeled these proposed requirements for SBSDs on the pre-existing requirements in paragraph (c) of Rule 15c3-3. The identification of these satisfactory control locations was designed to limit where the SBSD could hold excess securities collateral. The identified locations were places from which securities collateral can promptly be retrieved and returned to security-based swap customers. The Commission did not receive any comments addressing these specific provisions and for the reasons discussed in the proposing release is adopting them as substantially as proposed.[655]

iii. Steps To Obtain Possession or Control

Paragraph (d) of Rule 15c3-3, as it existed before today's amendments, requires a carrying broker-dealer to determine each business day the quantity of fully paid and excess margin securities it has in its physical possession or control based on its books and records and the quantity of such securities it does not have in its possession or control. If a quantity of fully paid and excess margin securities is not in the carrying broker-dealer's physical possession or control, the firm must initiate steps to bring them within its physical possession or control.

As a component of the omnibus segregation requirements, the Commission proposed to require that each business day an SBSD must determine from its books and records the quantity of excess securities collateral that the firm had in its physical possession or control as of the close of the previous business day and the quantity of excess securities collateral the firm did not have in its physical possession or control on that day.[656] The SBSD also needed to take steps to retrieve excess securities collateral from certain specifically identified non-control locations if securities collateral of the same issue and class are at the locations. The Commission modeled these proposed requirements for SBSDs on the pre-existing requirements in paragraph (d) of Rule 15c3-3. The Commission did not receive any comments addressing these specific provisions and for the reasons discussed in the proposing release is adopting them with the certain amendments.[657]

b. Security-Based Swap Customer Reserve Account

Paragraph (e) of Rule 15c3-3, as it existed before today's amendments, requires a carrying broker-dealer to maintain a reserve of cash or qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers, including cash obtained from the use of customer securities. The account must be titled “Special Reserve Bank Account for the Exclusive Benefit of Customers.” The amount of net cash owed to customers is computed pursuant to a formula set forth in Rule 15c3-3a. Under this formula, the carrying broker-dealer adds up customer credit items (e.g., cash in customer securities accounts and cash obtained through the use of customer margin securities) and then subtracts from that amount customer debit items (e.g., margin loans). If credit items exceed debit items, the net amount must be on deposit in the customer reserve account in the form of cash and/or qualified securities. The carrying broker-dealer cannot make a withdrawal from the customer reserve account until the next computation and even then only if the computation shows that the reserve requirement has decreased. The carrying broker-dealer must make a deposit into the customer reserve account if the computation shows an increase in the reserve requirement.

As a component of the omnibus segregation requirements, the Commission proposed reserve account requirements for SBSDs that were modeled on the pre-existing requirements of paragraph (e) of Rule 15c3-3 and Rule 15c3-3a.[658] More specifically, proposed Rule 18a-4 required an SBSD to maintain a special account for the exclusive benefit of security-based swap customers separate from any other bank account of the SBSD. The term “special account for the exclusive benefit of security-based swap customers” (“SBS Customer Reserve Account”) was defined to mean an account at a bank that is not the SBSD or an affiliate of the SBSD and that met certain conditions designed to ensure that cash and qualified securities deposited into the account were isolated from the proprietary assets of the SBSD and identified as property of the security-based swap customers.

The proposed rule provided that the SBSD must at all times maintain in an SBS Customer Reserve Account, through deposits into the account, cash and/or qualified securities in amounts computed daily in accordance with the formula set forth in proposed Rule 18a-4a. This formula required the SBSD to add up credit items and debit items. If, under the formula, the credit items exceeded the debit items, the SBSD would be required to maintain cash and/or qualified securities in that net amount in an SBS Customer Reserve Account. The credit and debit items identified in the proposed formula included the same credit and debit items in the Rule 15c3-3a formula. Further, the proposed formula identified two additional debit items: (1) Margin related to cleared security-based swap transactions in accounts carried for Start Printed Page 43939security-based swap customers required and on deposit in a qualified clearing agency account at a clearing agency; and (2) margin related to non-cleared security-based swap transactions in accounts carried for security-based swap customers held in a qualified registered SBSD account at another SBSD. These items were designed to accommodate the two exclusions from the definition of “excess securities collateral” discussed above pursuant to which an SBSD could deliver a customer's collateral to a clearing agency to meet a margin requirement of the clearing agency or to a second SBSD to meet a regulatory margin requirement of the second SBSD. They also accommodated customer cash collateral delivered for this purpose. In either case, the debit items would offset related credit items in the formula.

As proposed, if the total credits exceeded the total debits, the SBSD needed to maintain that net amount on deposit in a SBS Customer Reserve Account in the form of funds and/or qualified securities. The term “qualified security” as defined in proposed Rule 18a-4 meant: (1) Obligations of the United States; (2) obligations fully guaranteed as to principal and interest by the United States; and (3) general obligations of any State or a subdivision of a State that are not traded flat or are not in default, were part of an initial offering of $500 million or greater, and were issued by an issuer that has published audited financial statements within 120 days of its most recent fiscal year end. The proposed conditions for obligations of a State or subdivision of a State (“municipal securities”) were designed to help ensure that only securities that are likely to have significant issuer information available and that can be valued and liquidated quickly at current market values were used for this purpose.

As discussed above, an SBSD was required to add up credit and debit items pursuant to the formula in proposed Rule 18a-4a. If, under the formula, the credit items exceeded the debit items, the SBSD was required to maintain cash and/or qualified securities in that net amount in the SBS Customer Reserve Account. Under the proposal, an SBSD was required to take certain deductions for purposes of this requirement. The amount of cash and/or qualified securities in the SBS Customer Reserve Account needed to equal or exceed the amount required pursuant to the formula in proposed Rule 18a-4a after applying the deductions.

First, under the proposal, if municipal securities were held in the account, the SBSD was required to apply the standardized haircut specified in Rule 15c3-1 to the value of the municipal securities. Second, if municipal securities were held in the account, the SBSD needed to deduct the aggregate value of the municipal securities of a single issuer to the extent that value exceeded 2% of the amount required to be maintained in the SBS Customer Reserve Account. Third, if municipal securities were held in the account, the SBSD needed to deduct the aggregate value of all municipal securities to the extent that amount exceeded 10% of the amount required to be maintained in the SBS Customer Reserve Account. Fourth, the proposal required that the SBSD deduct the amount of funds held in an SBS Customer Reserve Account at a single bank to the extent that amount exceeded 10% of the equity capital of the bank as reported on its most recent Consolidated Report of Condition and Income (“Call Report”). This proposal was consistent with the proposed 2007 amendments to Rule 15c3-3 that were pending at the time.[659]

The proposed rule also provided that it would be unlawful for an SBSD to accept or use credits identified in the items of the formula in proposed Rule 18a-4a except to establish debits for the specified purposes in the items of the formula. This provision would prohibit the SBSD from using customer cash and cash realized from the use of customer securities for purposes other than those identified in the debit items in the proposed formula. Thus, the SBSD would be prohibited from using customer cash to, for example, pay expenses.

The proposed rule also provided that the computations necessary to determine the amount required to be maintained in the SBS Customer Reserve Account must be made daily as of the close of the previous business day and any deposit required to be made into the account must be made on the next business day following the computation no later than one hour after the opening of the bank that maintains the account. Further, the SBSD could make a withdrawal from the SBS Customer Reserve Account only if the amount remaining in the account after the withdrawal equaled or exceeded the amount required to be maintained in the account.

Finally, the proposed rule required an SBSD to promptly deposit funds or qualified securities into an SBS Customer Reserve Account if the amount of funds and/or qualified securities held in one or more SBS Customer Reserve Accounts falls below the amount required to be maintained by the rule.

Comments and Final Reserve Account Requirements

A commenter argued that a separate calculation for the SBS Customer Reserve Account is not necessary given the common insolvency treatment of securities customers and security-based swap customers.[660] However, similar to the daily possession or control requirement calculation, the Commission believes it is appropriate as an initial matter to require separate reserve computations. First, broker-dealers historically have not engaged in significant amounts of security-based swap activities. Given the customer protection objectives of the reserve account requirements, the Commission believes the prudent approach is to require two reserve account calculations and accounts. Second, the SBS Customer Reserve Account requirements are tailored to security-based swap activities. For example, the SBS Customer Reserve Account formula has debit items relating to margin delivered to security-based swap clearing agencies and other SBSDs. The Commission believes it is appropriate to have separate requirements to help ensure that stand-alone and broker-dealer SBSDs appropriately account for debits and credits in the context of their security-based swap activities and in their traditional securities activities. Third, the definition of qualified securities for purposes of the SBS Customer Reserve Account requirement includes certain municipal securities; whereas the definition of qualified securities for purposes of the traditional securities reserve account requirement is limited to government securities.

A commenter objected to the application of the SBS Customer Reserve Account requirements to bank SBSDs due to the existing customer protection requirements applicable to banks.[661] The commenter argued that the SBS Customer Reserve Account calculation would be operationally intensive. In response, bank SBSDs are exempt from the final omnibus segregation requirements if they meet the conditions of the exemption, including not clearing security-based swap transactions for others.[662] If a bank Start Printed Page 43940SBSD is appropriately operating pursuant to the exemption, it will not be required to perform the SBS Customer Reserve Account calculation. To the extent a bank SBSD does not take advantage of the exemption, the Commission believes that the computation a bank SBSD will be required to perform will be less operationally complex because generally it should only involve cleared security-based swaps. The prudential regulators' margin rules for non-cleared security-based swaps applicable to banks require that initial margin be held at a third-party custodian. Therefore, initial margin arising from non-cleared security-based swaps generally should not be a factor in the SBS Customer Reserve Account formula for these entities.

A commenter requested that the Commission require a weekly SBS Customer Reserve Account computation rather than a daily computation.[663] The commenter stated that calculating the reserve account formula is an onerous process that is operationally intensive and requires a significant commitment of resources. The commenter further stated that the Commission can achieve its objective of decreasing liquidity pressures on SBSDs while limiting operational burdens by requiring weekly computations and permitting daily computations. The Commission acknowledges that a daily reserve calculation will increase operational burdens as compared to a weekly computation. Therefore, in response to comments, the Commission is modifying the final rules to require a weekly SBS Customer Reserve Account computation.[664] The final rules further provide that stand-alone broker-dealers or SBSDs may perform daily computations if they choose to do so.[665] These modifications to the final rules align with the existing reserve account computation requirements in paragraph (e) of Rule 15c3-3.

Another commenter asked the Commission to prohibit an SBSD from using funds in the SBS Customer Reserve Account held for one customer to extend credit to another customer.[666] The SBS Customer Reserve Account deposit will equal or exceed the net monies owed to security-based swap customers as calculated using the formula in Rules 15c3-3b and 18a-4a, as adopted. The logic behind the formula is that credits (monies owed to customers) are offset by debits (monies owed by customers) and, if there is a net amount of credits in excess of debits, that amount is reserved in the form of cash or qualified securities. Consequently, implementing the commenter's suggestion would not be consistent with the omnibus segregation requirements, which are designed to permit the commingling of customer assets in a safe manner.

A commenter requested that the Commission modify the definition of “qualified security” in Rule 18a-4 to include U.S. government money market funds.[667] In the proposal, the Commission sought to align the definition of qualified security in Rule 18a-4 with the existing definition of qualified security in Rule 15c3-3 with one exception: Namely, the Commission proposed that the Rule 18a-4 definition include certain municipal securities because Section 3E(d) of the Exchange Act provides that municipal securities are a “permitted investment” for purposes of the segregation requirements for cleared security-based swaps. There is no corresponding statutory requirement to permit municipal securities to be a “permitted investment” for purposes of the segregation requirements and implementing regulations under Section 15(c)(3) of the Exchange Act applicable to stand-alone broker-dealers. While Section 3E(d) of the Exchange Act authorizes the Commission to expand the list of permitted investments for purposes of the omnibus segregation requirements for security-based swaps, the Commission believes the definitions in the two rules should be consistent and the types of securities permitted to be deposited into the customer reserve accounts required by each rule limited to the safest and most liquid securities.

In addition, the commenter stated that limiting instruments to be utilized by SBSDs under financial responsibility requirements will create pressure on regulated entities in search of those limited instruments to buy and sell on a continuous basis in their reserve accounts.[668] The Commission disagrees. As discussed above, the final rule contains an exemption for stand-alone SBSDs from the omnibus segregation requirements of Rule 18a-4, as adopted, if certain conditions are met.[669] This modification to the final rule will reduce the number of SBSDs subject to the omnibus segregation requirements in the final rules and reduce the amounts that will need to be deposited into these accounts. This modification as well as the availability of municipal securities as qualified securities under Rule 18a-4, as adopted, should mitigate the commenter's concerns regarding the availability of qualified securities. For these reasons, the Commission is not modifying the proposal to permit U.S. government money market funds to serve as qualified securities as suggested by the commenter.

A commenter urged the Commission to reconsider the provision in the proposed rule requiring the SBS Customer Reserve Accounts to be maintained at a bank that is not affiliated with the SBSD.[670] The primary concern with permitting an affiliated bank to carry the SBS Customer Reserve Account is that the SBSD or stand-alone broker-dealer may not exercise due diligence with the same degree of impartiality and care when assessing the financial soundness of an affiliated bank as it would with an unaffiliated bank.[671] The decision of the SBSD or stand-alone broker-dealer to hold cash in a reserve account at an affiliated bank may be driven in part by profit or for reasons based on the affiliation, regardless of any due diligence it may conduct or the overall safety and soundness of the bank.[672] However, this concern largely pertains to cash deposits because they become part of the assets of the bank and can be used by the bank for any of its business activities.[673] As discussed below, the concern about cash deposits is being addressed through a 100% deduction of cash held in an SBS Customer Reserve Account at an affiliated bank.[674] Unlike cash, qualified securities deposited with a bank are held in a custodial capacity and, absent Start Printed Page 43941an agreement between the bank and the depositor, cannot be used by the bank. Consequently, in response to the comment, the Commission is modifying the final rule from the proposal so that it no longer requires the SBS Customer Reserve Account to be maintained at an unaffiliated bank.[675]

The Commission also is modifying the final rules to require an SBSD to deduct 100% of the amount of cash held at an affiliated bank and to increase the deduction threshold for cash held at a non-affiliated bank from 10% to 15% of the bank's equity capital.[676] These modifications more closely align the SBS Customer Reserve Account requirements with the pre-existing customer reserve account requirements for traditional securities.[677] However, the Commission is adding an exception to the 15% deduction to accommodate bank SBSDs that choose to maintain the SBS Customer Reserve Account themselves rather than at an affiliated or non-affiliated bank.[678] Under the exception, they would not need to take the 15% deduction.

One commenter argued that these changes would lead to undue risk for SBSDs and their customers.[679] The Commission does not agree. Increasing the deduction threshold from 10% to 15% aligns the threshold with the threshold in the pre-existing requirements for traditional securities under existing Rule 15c3-3. Further, the exemption from the requirements of Rule 18a-4 likely will appreciably reduce the amounts that will need to be deposited into the SBS Customer Reserve Accounts.[680] For example, the Commission expects that the omnibus segregation requirements largely will apply to cleared security-based swaps transactions where a substantial portion of the initial margin received by the stand-alone broker-dealer or SBSD will be passed on to the clearing agency. Consequently, it will not need to be locked up in SBS Customer Reserve Accounts. Moreover, the Commission does not believe that increasing the threshold from 10% to 15% will unduly undermine the objective of addressing the risk that arises when a bank's deposit base is overly reliant on a single depositor. Finally, permitting a bank SBSD to maintain its own SBS Customer Reserve Account is designed to strike an appropriate balance in terms of achieving the objectives of the segregation rule, while providing the firm with sufficient flexibility in terms of locating its reserve account deposits. This scenario also does not raise the same concerns that arise when an SBSD uses a separate bank to maintain its SBS Customer Reserve Account. Moreover, the Commission expects that most bank SBSDs will operate under the exemption from the omnibus segregation requirements of Rule 18a-4. Therefore, the Commission does not believe these modifications to the final rule will lead to undue risks for SBSDs and their customers.

In addition, the Commission is making a conforming modification to the text of the debit item with respect to margin relating to non-cleared security-based swaps. As discussed above, the definition of “excess securities collateral” has been modified to account for the fact that the prudential regulators require initial margin collected by a bank SBSD to be held at a third-party custodian (rather than being held directly by the bank SBSD).[681] The rule, as proposed, did not account for the possibility that a nonbank SBSD might pledge a customer's initial margin to a third-party custodian pursuant to the margin rules of the prudential regulators. The modification to the definition of “excess securities collateral” discussed above addresses this issue with respect to the possession or control requirement. The modification to the debit item with respect to margin relating to non-cleared security-based swap transactions will address this issue with respect to the SBS Customer Reserve Account requirement. Specifically, the Commission is modifying the debit item to include margin related to non-cleared security-based swap transactions in accounts carried for security-based swap customers required and held at a “third-party custodial account” as that term is defined in the rules.[682] This will allow the SBSD to offset the corresponding credit item that results from using customer collateral to meet the margin requirement of another SBSD when the customer collateral is posted to a third-party custodian (rather than provided directly to the other SBSD).

The Commission originally proposed that it would be unlawful for an SBSD to accept or use credits identified in the items of the formula set forth in Exhibit A to the proposed rule “except to establish debits for the specified purposes in the items of the formula.” [683] This phrase in proposed Rule 18a-4 varied from the phrase in the parallel pre-existing requirement in Rule 15c3-3.[684] The Commission did not intend to establish a different standard for SBSDs and is modifying the phrase as used in Rules 15c3-3, as amended, and 18a-4, as adopted, to align it with the pre-existing text.

For these reasons, the Commission is adopting these provisions relating to the Start Printed Page 43942SBS Customer Reserve Account with the modifications described above.[685]

c. Special Provisions for Non-Cleared Security-Based Swap Counterparties

i. Notice Requirement

Section 3E(f)(1)(A) of the Exchange Act provides that an SBSD and an MSBSP shall be required to notify the counterparty at the “beginning” of a non-cleared security-based swap transaction about the right to require segregation of the funds or other property supplied to margin, guarantee, or secure the obligations of the counterparty.[686] To provide greater clarity as to the meaning of “beginning” as used in the statute, proposed Rule 18a-4 required an SBSD or MSBSP to provide the notice in writing to a counterparty prior to the execution of the first non-cleared security-based swap transaction with the counterparty occurring after the effective date of the rule.[687] Consequently, the notice needed to be given in writing before the counterparty was required to deliver margin to the SBSD or MSBSP. This gave the counterparty an opportunity to determine whether to elect individual segregation, waive segregation, or affirmatively or by default elect omnibus segregation.

A commenter recommended that the Commission clarify that the notice must be sent to the customer (or investment manager authorized to act on behalf of a customer) in accordance with mutually agreed terms by the parties, or absent such terms, to a person reasonably believed to be authorized to accept notices on behalf of a customer.[688] The Commission agrees that the rule should provide more clarity and has modified the requirement to provide that the notice must be sent to a duly authorized individual. This person could be an individual that is mutually agreed to by the parties.

For these reasons, the Commission is adopting the proposed notice requirement with the modification described above.[689] The notification provision in Rule 15c3-3 applies only to a broker-dealer SBSD or MSBSP because the notification requirements in Section 3E(f)(1)(A) of the Exchange Act apply only to SBSDs and MSBSPs (and not to stand-alone broker-dealers).

ii. Subordination Agreements

Proposed Rule 18a-4 required an SBSD to obtain agreements from counterparties that elect either individual segregation or waive segregation with respect to non-cleared security-based swaps under Section 3E(f) of the Exchange Act. In the agreements, the counterparties needed to subordinate all of their claims against the SBSD to the claims of security-based swap customers.[690] By entering into subordination agreements, these counterparties would be excluded from the definition of security-based swap customer in proposed Rule 18a-4.[691] They also would not be entitled to share ratably with security-based swap customers in the fund of customer property held by the SBSD if it was subject to a bankruptcy proceeding.

Under the proposal, an SBSD needed to obtain a conditional subordination agreement from a counterparty that elects individual segregation. The agreement was conditional because the subordination agreement would not be effective in a case where the counterparty's assets were included in the bankruptcy estate of the SBSD, notwithstanding that they had been held by a third-party custodian (rather than the SBSD). Specifically, the proposed rule provided that the counterparty must subordinate claims but only to the extent that funds or other property provided by the counterparty to the independent third-party custodian are not treated as customer property in a formal liquidation proceeding.

An SBSD needed to obtain an unconditional subordination agreement from a counterparty that waives segregation altogether. By waiving individual and omnibus segregation, the counterparty agrees that cash, securities, and money market instruments delivered to the SBSD as initial margin can be used by the SBSD for any business purpose and need not be isolated from the proprietary assets of the SBSD. Therefore, these counterparties are foregoing the protections of segregation. As a consequence, they should not be entitled to a ratable share of the customer property of the SBSD in the event the SBSD is liquidated in a formal proceeding. If they were deemed security-based swap customers, they could have a pro rata priority claim on customer property. This could disadvantage the security-based swap customers that did not waive segregation by diminishing the amount of customer property available to be distributed to them.

A commenter stated that the subordination agreement required of customers that elect individual segregation was not necessary because the initial margin provided by the customer was held at a third-party custodian and therefore would not become “customer property” held by the failed SBSD.[692] The commenter argued that a “legally unnecessary subordination agreement is prone to creating ambiguity, unforeseen consequences and complication . . . and runs contrary to the goal of investor protection . . . .” The Commission disagrees. The subordination agreement is designed to reduce ambiguity, unforeseen consequences, and complications that may arise during an SBSD's liquidation by clarifying that the subordinating customers are not entitled Start Printed Page 43943to a pro rata share of customer property from the liquidation. By entering into the subordination agreements, customers who elect individual segregation are affirmatively waiving their rights to make customer claims with respect to initial margin held by the third-party custodian. Their recourse is to the third-party custodian that is holding the collateral. Therefore, a properly designed and executed subordination agreement affirms the rights of customers that elect individual segregation as compared to the rights of customers whose assets are treated under the omnibus segregation requirements.

The Commission, however, is modifying the final subordination requirements for collateral held at a third-party custodian so that it is no longer are limited to funds or other property that is segregated pursuant to Section 3E(f) of the Exchange Act. As discussed above in section II.A.2.b.ii. of this release, a counterparty's collateral to meet a margin requirement of the nonbank SBSD may be held at a third-party custodian pursuant to other laws. Consequently, the Commission is modifying the rule text to provide that the subordination agreement is required “from a counterparty whose funds or other property to meet a margin requirement of the [nonbank SBSD] are held at a third-party custodian.” [693]

Another commenter stated that customers electing individual segregation should not be required to subordinate claims other than those with respect to such initial margin held by the third-party custodian.[694] The commenter objected to the provision in the proposed rule requiring the customer to subordinate all of its claims against the SBSD to the claims of other security-based swap customers. The Commission agrees that the proposed text of the rule was ambiguous and could be read to mean the customer must subordinate claims to property that is held by the SBSD (as opposed to the third-party custodian). Therefore, the Commission is modifying the final rule from the proposal to clarify that the counterparty electing individual segregation must subordinate its claims against the SBSD only for the funds or other property held at the third-party custodian.[695]

Because a counterparty will not subordinate all of its claims against a stand-alone broker-dealer or broker-dealer SBSD, the Commission is making conforming modifications to the final rule to specifically identify the two classes of carrying broker-dealer customers that must be accounted for in the subordination agreements. In particular, the Commission is adding the phrase “(including PAB customers)” following the term “to the claims of customers” in paragraph (p)(1)(vi) and paragraphs (p)(4)(ii)(A) and (B) of Rule 15c3-3, as amended. PAB customers are other broker-dealers for whom the carrying broker-dealer is holding cash and/or securities.[696] Under amendments to Rule 15c3-3 adopted after the rules in this release were proposed, a carrying broker-dealer must include (and thereby protect) the cash and securities it carries for other customers by including them in a PAB reserve account computation.[697] Broker-dealer customers also have priority claims to cash and securities held at the carrying broker-dealer in a SIPA proceeding. Consequently, their status as a protected class of creditors must be accounted for in the provisions of the rule relating to subordination agreements.

Finally, as discussed above, the Commission is making a conforming amendment to the requirement that the stand-alone broker-dealer or broker-dealer SBSD obtain a subordination agreement from a person who waives segregation with respect to non-cleared security-based swaps to provide that the provision applies to affiliates that waive segregation because persons who are not affiliates cannot waive segregation.[698]

For these reasons, the Commission is adopting the subordination requirements with the modifications discussed above.[699]

D. Alternative Compliance Mechanism

As discussed throughout this release, commenters urged the Commission to harmonize the requirements being adopted today with requirements of the CFTC. Commenters sought harmonization with respect to the Commission's capital requirements,[700] margin requirements,[701] and segregation requirements.[702] One commenter stated that “[i]f the Commission and CFTC do not harmonize their capital rules, they should defer to the capital rules of one another in the case of” an entity that is registered as an SBSD and a swap dealer and “whose swaps or [security-based swaps] represent a de minimis portion of the [entity's] combined swap and [security-based swap] business.” [703] This commenter further stated that “[i]n cases where the firm is predominantly engaged in swap activity, imposing different capital requirements would be inefficient.” Another commenter stated that “[i]f harmonization is not achievable, the rules should be coordinated so that [the Commission] defers to the capital and margin rules of the CFTC for an SBSD that is not a broker-dealer and whose [security-based swaps] constitute a very small proportion of its business (e.g., less than 10% of the notional amount of its outstanding combined swap and SBS positions).” [704]

In response to these comments seeking harmonization, the final capital, margin, and segregation rules being adopted today have been modified from the proposed rules to achieve greater consistency with the requirements of the CFTC. However, as discussed throughout this release, there are differences between the approaches taken by the Commission and the CFTC. Start Printed Page 43944Moreover, the Commission believes that some registered swap dealers (or entities that will register as swap dealers in the future) will need to also register as security-based swap dealers because their security-based swaps business—while not a significant part of their overall business mix—exceeds the de minimis exception to the “security-based swap dealer” definition.[705] In light of the differences between the rules of the Commission and the CFTC, the Commission believes it is appropriate to permit such firms to comply with the capital, margin, and segregation requirements of the CEA and the CFTC's rules, provided the firm's security-based swaps business is not a significant part of the security-based swap market and predominantly involves dealing in swaps as compared to security-based swaps. In this circumstance, the CFTC's regulatory interest in the firm will greatly exceed the Commission's regulatory interest given the relative size of its swaps business as compared to its security-based swaps business.[706]

For these reasons, the Commission is adopting an alternative compliance mechanism in Rule 18a-10 pursuant to which a stand-alone SBSD that is registered as a swap dealer and predominantly engages in a swaps business may elect to comply with the capital, margin and segregation requirements of the CEA and the CFTC's rules in lieu of complying with the capital, margin, and segregation requirements in Rules 18a-1, 18a-3, and 18a-4.[707] This will address the concern raised by the commenters that it would be inefficient to impose differing requirements on a firm that is predominantly a swap dealer.

A firm may elect to operate pursuant to Rule 18a-10 if it meets certain conditions. First, under paragraphs (a)(1) through (3) of Rule 18a-10, the firm must be registered with the Commission as a stand-alone SBSD (i.e., not also registered as a broker-dealer or an OTC derivatives dealer) and registered with the CFTC as a swap dealer. The Commission believes it is appropriate to permit stand-alone SBSDs—which will not be integrated into the traditional securities markets to the same degree as stand-alone broker-dealers and broker-dealer SBSDs—to comply with Rule 18a-10 because their securities activities will be limited to dealing in security-based swaps. The requirement to be registered with the CFTC is designed to ensure that the firm is subject to CFTC oversight given that it will be adhering to the CFTC's rules.

Second, under paragraph (a)(4) of Rule 18a-10, the stand-alone SBSD must be exempt from the segregation requirements of Rule 18a-4. As discussed above in section II.C.2. of this release, the Commission has added a provision to Rule 18a-4 that will exempt a stand-alone or bank SBSD from the rule's omnibus segregation requirements if it meets certain conditions, including that it does not clear security-based swaps for other persons. Section 3E(g) of the Exchange Act applies the customer protection elements of the stockbroker liquidation provisions to cleared security-based swaps and related collateral, and to collateral delivered as initial margin for non-cleared security-based swaps if the collateral is subject to a customer protection requirement under Section 15(c)(3) of the Exchange Act or a segregation requirement. Consequently, a stand-alone SBSD that does not have cleared security-based swap customers and is not subject to a segregation requirement with respect to collateral for non-cleared security-based swaps will not implicate the stockbroker liquidation provisions. Given this result, the Commission believes it would be appropriate to permit the firm to comply with CEA and CFTC segregation requirements to the extent applicable in lieu of Rule 18a-4.

Third, under paragraph (a)(5) of Rule 18a-10, the aggregate gross notional amount of the firm's outstanding security-based swap positions must not exceed the lesser of two thresholds as of the most recently ended quarter of the firm's fiscal year.[708] The thresholds are: (1) The maximum fixed-dollar gross notional amount of open security-based swaps specified in paragraph (f) of the rule (“maximum fixed-dollar threshold”); and (2) 10% of the combined aggregate gross notional amount of the firm's open security-based swap and swap positions (“10% threshold”).

These thresholds are designed to limit the availability of the alternative compliance mechanism to firms whose security-based swaps business is not a significant part of the security-based swap market and that are predominately engaged in a swaps business as compared to a security-based swaps business. In this regard, the capital, margin, and segregation requirements being adopted today are designed to promote the safety and soundness of an SBSD and the ability of the Commission to oversee the firm and, thereby, protect the firm, its counterparties, and the integrity of the security-based swap market. Moreover, the security-based swap market and the broader securities markets (such as the cash markets for equity and fixed-income securities) are interrelated, given that economically similar instruments can be traded in both markets (e.g., an equity security in the cash market and a total return swap referencing that security in the security-based swap market). For these reasons, the Commission has a heightened regulatory interest in stand-alone SBSDs that will be significant participants in the security-based swap market. Therefore, in crafting the alternative compliance mechanism, the Commission sought to calibrate the maximum-fixed-dollar and 10% thresholds to exclude stand-alone SBSDs that will be significant participants in this market.[709]

The amount of the maximum fixed-dollar threshold is $250 billion for a transitional period of 3 years and then will drop to $50 billion (unless the Commission issues an order as discussed below). Based on current information about the security-based swap market and the participants and potential participants in that market, the Commission believes that a stand-alone SBSD with a gross notional amount of outstanding security-based swaps of no more than $50 billion will not be a Start Printed Page 43945significant participant in the security-based swap market. However, as stated above in section I.A. of this release, the Commission recognizes that the firms subject to the capital, margin, and segregation requirements being adopted today are operating in a market that continues to experience significant changes in response to market and regulatory developments. For these reasons, the Commission believes it is appropriate to set a maximum fixed-dollar threshold that is well in excess of $50 billion for a transitional period of 3 years. Therefore, the maximum fixed-dollar threshold will be $250 billion for 3 years, starting on the compliance date for the capital, margin and segregation rules being adopted today. This transitional $250 billion threshold will provide a stand-alone SBSD operating under the alternative compliance mechanism (i.e., firms that are predominantly engaged in a swaps business) with a substantial amount of leeway to develop their security-based swaps business without managing the level of that business to the lower $50 billion threshold. If the security-based swaps business of these firms develops to a degree that the $50 billion threshold would require them to refrain from taking on additional business, the Commission can assess whether the amount of the additional business that causes them to exceed the threshold makes them a significant participant in the security-based swap market.

The transitional period therefore will provide the Commission with the opportunity to evaluate the impact that the $50 billion threshold would have on firms operating pursuant to the alternative compliance mechanism before the threshold drops from $250 billion to $50 billion. Moreover, the final rule establishes a process through which the Commission, by order, can: (1) Maintain the maximum fixed-dollar amount at $250 billion for an additional period of time or indefinitely after the 3-year transition period ends; or (2) lower it to an amount that is less than $250 billion but greater than $50 billion.[710] This process could provide firms operating under the alternative compliance mechanism with additional time to transition from the $250 billion threshold to the $50 billion threshold or another threshold.

The final rules provide that the Commission will issue an order after considering the levels of security-based swap activity of stand-alone SBSDs operating under the alternative compliance mechanism. The Commission intends to analyze how significant these entities are to the security-based swap market and broader securities markets based on their levels of their security-based swap activity. The analysis will consider the firm's individual and collective impact on the security-based swap market. Based on this analysis, the Commission could decide to take no action and let the $250 billion maximum fixed-dollar threshold transition to $50 billion on the 3-year anniversary of the compliance date for the capital, margin, and segregation rules being adopted today. Alternatively, the Commission could decide to reset the maximum fixed-dollar threshold to a level greater than $50 billion (but no more than $250 billion) or provide additional time for firms to transition from a $250 billion threshold to the $50 billion threshold.

The process in the final rule provides that the Commission will publish notice of the potential change to the maximum fixed-dollar threshold (i.e., extending the $250 billion threshold for an additional period of time or indefinitely, or lowering it to a level between $250 billion and $50 billion) and subsequently issue an order regarding the change. The Commission intends to provide such notice in sufficient time for the public to be aware of the potential change.

In summary, the maximum fixed-dollar threshold sets an absolute limit on the availability of the alternative compliance mechanism irrespective of the size of the firm's swaps business as compared to its security-based swaps business. Thus, a firm potentially may not exceed the 10% threshold given the large size of its swaps business but could exceed the maximum fixed-dollar threshold because its security-based swaps business is sufficiently large. This absolute limit is designed to exclude stand-alone SBSDs that are significant participants in the security-based swap market from qualifying for the alternative compliance mechanism.

The 10% threshold establishes a limit on the ratio of the firm's security-based swaps business to its combined security-based swaps and swaps businesses. In crafting this threshold, the Commission sought to limit the availability of the alternative compliance mechanism to firms that are predominantly engaged in a swaps business as compared to a security-based swaps business. Consequently, if the firm's security-based swap business does not exceed the maximum fixed-dollar threshold, it nonetheless may not qualify for the alternative compliance mechanism if its security-based swaps business exceeds the ratio set by the 10% threshold. This is designed to limit the alternative compliance mechanism to firms for which the CFTC (as opposed to the Commission) has a heightened regulatory interest.

Under paragraph (a)(5) of Rule 18a-10, the firm must not exceed the lesser of these thresholds as of the most recently ended quarter of its fiscal year. This point-in-time requirement is designed to simplify the process for determining whether the firm meets the condition by aligning it with when the firm closes its books for financial recordkeeping and reporting purposes. A quarterly test (as opposed to an annual test) also is designed to ensure that a firm using the alternative compliance mechanism consistently limits its security-based swaps business in a manner that aligns with the Commission's objective: To provide this option only to firms that are not a significant part of the security-based swap market and predominantly deal in swaps as compared to security-based swaps. Moreover, a quarterly test (as opposed to a requirement to meet the threshold test at all times) is designed to limit the possibility that a firm operating pursuant to the alternative compliance mechanism inadvertently exceeds one of the thresholds for a brief period of time (particularly by an immaterial amount) and, as a consequence, can no longer use it.

Paragraph (b) of Rule 18a-10 sets forth requirements for a firm that is operating pursuant to the rule. Paragraph (b)(1) provides that the firm must comply with the capital, margin, and segregation requirements of the CEA and the CFTC's rules applicable to swap dealers and treat security-based swaps and related collateral pursuant to those requirements to the extent the requirements do not specifically address security-based swaps and related collateral. Consequently, a firm that is subject to Rule 18a-10 must comply with applicable capital, margin, and segregation requirements of the CEA and the CFTC's rules and a failure to comply with one or more of those rules will constitute a failure to comply with Rule 18a-10. Moreover, the firm must treat security-based swaps and related collateral pursuant to the requirements of the CEA and the CFTC's rules even if the CEA and the CFTC's rules do not specifically address security-based swaps and related collateral. This provision is designed to ensure that security-based swaps and related collateral do not fall into a “regulatory gap” with respect to a nonbank SBSD operating under the alternative compliance mechanism. Thus, if a capital, margin, or segregation Start Printed Page 43946requirement applicable to a swap or collateral related to a swap is silent as to a security-based swap or collateral related to a security-based swap, the nonbank SBSD must treat the security-based swap or collateral related to a security-based swap pursuant to the requirement applicable to the swap or collateral related to the swap.[711]

Paragraph (b)(2) of Rule 18a-10 requires the firm to provide a written disclosure to its counterparties after it begins operating pursuant to the rule. The disclosure must be provided before the first transaction with the counterparty after the firm begins operating pursuant to the rule. The disclosure must notify the counterparty that the firm is complying with the applicable capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of complying with Rules 18a-1, 18a-3, and 18a-4. The disclosure requirement is designed to alert the counterparty that the firm is not complying with these Commission rules notwithstanding the fact that the firm is registered with the Commission as an SBSD. This will provide the counterparty with the opportunity to assess the implications of transacting with the SBSD under these circumstances.

Paragraph (b)(3) of Rule 18a-10 requires the firm to immediately notify the Commission and the CFTC in writing if it fails to meet a condition in paragraph (a) of the rule. This notice—by immediately alerting the Commission and the CFTC of the firm's status—will provide the agencies with the opportunity to promptly evaluate the situation and coordinate any regulatory responses such as increased monitoring of the firm.

Paragraph (c) of Rule 18a-10 addresses when a firm fails to comply with a condition in paragraph (a) of the rule and, therefore, no longer qualifies to operate pursuant to the rule. The paragraph provides that a firm in that circumstance must begin complying with Rules 18a-1, 18a-3, and 18a-4 no later than either: (1) Two months after the end of the month in which the firm failed to meet the condition in paragraph (a); or (2) for a longer period of time as granted by the Commission by order subject to any conditions imposed by the Commission. This period of time to come into compliance with the Commission's rules (“compliance period”) is modeled on the de minimis exception to the “security-based swap dealer” definition.[712] Under paragraph (b) of Rule 3a71-2, an entity that no longer meets the requirements of the de minimis exception will be deemed to not be an SBSD until the earlier of the date on which it submits a complete application to register as an SBSD or two months after the end of the month in which the entity becomes no longer able to take advantage of the exception. The compliance period in Rule 18a-10 is designed to provide an SBSD with time to implement systems, controls, policies, and procedures and take other necessary steps to comply with Rules 18a-1, 18a-3, and 18a-4. The Commission, by order, can grant the SBSD additional time if necessary.

The conditions in paragraphs (a)(1) through (4) of Rule 18a-10 must be met at all times an SBSD is operating pursuant to the rule. Consequently, the compliance period will begin to run on the day of a month that the SBSD fails to meet a condition in paragraphs (a)(1) through (4). As discussed above, whether a firm meets the condition in paragraph (a)(5) of Rule 18a-10 will be determined as of the most recently ended quarter of the firm's fiscal year. Therefore, a firm could fail to meet this condition only on a day that is the end of one of its fiscal year quarters. If the firm fails to meet the condition on one of those days, the compliance period will begin to run on that day.

Paragraph (d) of Rule 18a-10 addresses how a firm would elect to operate pursuant to the rule. Under paragraph (d)(1), a firm can make the election as part of the process of applying to register as an SBSD. In this case, the firm must provide written notice to the Commission and the CFTC during the registration process of its intent to operate pursuant to the rule. Upon being registered as an SBSD, the firm can begin complying with Rule 18a-10, provided it meets the conditions in paragraph (a) of the rule.

Under paragraph (d)(2) of Rule 18a-10, an SBSD can make the election after the firm has been registered as an SBSD. In this case, the firm must provide written notice to the Commission and the CFTC of its intent to operate pursuant to the rule and continue to comply with Rules 18a-1, 18a-3, and 18a-4 for two months after the end of the month in which the firm provides the notice or for a shorter period of time as granted by the Commission by order subject to any conditions imposed by the Commission. The requirement that the firm continue complying with the Commission's rules for a period of time after making the election is designed to provide the Commission and the CFTC with an opportunity to examine the firm before it begins operating pursuant to the alternative compliance mechanism and to prepare for the firm no longer complying with the Commission's rules.

As discussed above, paragraph (b)(3) requires a firm operating pursuant to the rule to immediately notify the Commission and the CFTC in writing if the SBSD fails to meet a condition in paragraph (a). Further, paragraphs (d)(1) and (2) require a firm to provide written notice to the Commission and the CFTC of its intent to operate pursuant to the rule. Paragraph (e) of Rule 18a-10 provides that the notices required by the rule must be sent by facsimile transmission to the principal office of the Commission and the regional office of the Commission for the region in which the security-based swap dealer has its principal place of business or an email address to be specified separately, and to the principal office of the CFTC in a manner consistent with the notification requirements of the CFTC.[713] The paragraph also requires that notices include a brief summary of the reason for the notice and the contact information of an individual who can provide further information about the matter that is the subject of the notice. This will facilitate the ability of the Commission and the CFTC to follow-up with the firm and gather further information about the matter that triggered the notice requirement.

E. Cross-Border Application of Capital, Margin, and Segregation Requirements

1. Capital and Margin Requirements

In 2013, the Commission preliminarily interpreted the Title VII requirements associated with registration to apply generally to the activities of registered entities. In reaching that preliminary conclusion, the Commission did not concur with the views of certain commenters that the Title VII requirements should not apply to the foreign security-based swap activities of registered entities, stating that such a view could be difficult to Start Printed Page 43947reconcile with, among other things, the statutory language describing the requirements applicable to SBSDs.[714]

a. Treatment of Cross-Border Transactions

The Commission further preliminarily identified capital and margin requirements as entity-level requirements, rather than requirements specifically applicable to particular transactions. Entity-level requirements primarily address concerns relating to the entity as a whole, with a particular focus on safety and soundness of the entity to reduce systemic risk in the U.S. financial system. The Commission accordingly proposed to apply the entity-level requirements on a firm-wide basis to address risks to the SBSD as a whole. The Commission did not propose any exception from the application of the entity-level requirements to SBSDs.[715]

Commenters did not address the proposal to treat capital requirements as entity-level requirements. The Commission continues to believe these requirements must apply to the entity as a whole. In reaching this conclusion, the Commission recognizes that the objective of the capital rule for SBSDs is the same as the capital rule for broker-dealers—to ensure that the entity maintains at all times sufficient liquid assets to promptly satisfy its liabilities, and to provide a cushion of liquid assets in excess of liabilities to cover potential market, credit, and other risks.[716] The tangible net worth standard applicable to nonbank MSBSPs is intended to be applied to the entity as a whole to ensure the MSBSP's solvency is based on tangible assets. Therefore, the Commission is also treating the nonbank MSBSP capital requirements as entity-level requirements.

With respect to margin, a commenter pointed out that “the application and enforcement of margin requirements applies on a transaction-by-transaction basis and the calculation of margin depends on the circumstances of a particular [security-based swap].” [717] Another commenter opposed characterizing margin as an entity-level requirement due to a concern that doing so could result in a substituted compliance determination where firms could “comply with only a comparable foreign regime in every circumstance, regardless of who they transact with or where the transactions occur.” [718] The commenter advocated that the Commission “either treat margin as a transaction-level requirement or not permit substituted compliance in these transactions.” A number of commenters requested that margin be treated as a transaction-level requirement for consistency with other domestic and foreign regulators.[719] Some commenters also argued there could be costs and operational complications resulting from subjecting a foreign registrant to both Commission and home country margin requirements.[720]

Margin is designed to protect the nonbank SBSD or MSBSP from the consequences of a counterparty's default.[721] Permitting different margin requirements based on the location of the counterparty is not consistent with this objective. Further, treating margin as a transaction-level requirement could cause those counterparties entering into transactions that constitute the U.S. business of a nonbank registrant to bear a greater burden in ensuring the safety and soundness of the nonbank registrant than counterparties that are part of the nonbank registrant's foreign business.[722] The Commission also concludes that treating margin solely as a transaction-level requirement would not adequately further the objectives of using margin to ensure the safety and soundness of nonbank registrants because it could result in entities with global businesses collecting significantly less collateral than would otherwise be required to the extent that they are not required by local law to collect comparable margin from their counterparties. This potential outcome could increase the registrant's risk of failure if certain counterparties are not required to post margin, especially during a period when the market is already unstable.[723]

In response to the comment that treating margin requirements as entity-level requirements would permit nonbank SBSDs in every circumstance to use foreign requirements to satisfy the margin requirements, the Commission intends to consider certain factors to mitigate this risk prior to making a substituted compliance determination. More specifically, the Commission intends to consider whether the foreign financial regulatory system requires registrants to adequately cover their current and potential future exposure to OTC derivatives counterparties, and ensures registrants' safety and soundness, in a manner comparable to the applicable provisions arising from the Exchange Act and its rules and regulations.[724]

For all of these reasons, the Commission is treating the nonbank SBSD margin requirements as entity-level requirements. The margin requirements applicable to nonbank MSBSPs are intended to be applied to the entity as a whole for the same reasons the margin requirements for nonbank SBSDs are intended to apply to the entity as a whole. Therefore, the Commission is also treating the nonbank Start Printed Page 43948MSBSP margin requirements as entity-level requirements.

The Commission preliminarily identified the SBSD segregation requirements as transaction-level requirements.[725] Consequently, proposed Rule 18a-4 contained provisions to address the application of the segregation requirements to cross-border security-based swap transactions of foreign SBSDs. The applicable segregation requirements are tailored depending on the type of registrant, security-based swap, and customer. The Commission did not receive comments specifically addressing this proposed treatment of segregation requirements. However, one commenter stated that it “support[s] the Commission's overall proposal to distinguish between entity-level and transaction-level requirements” and that it “generally support[s] the Commission's proposed cross-border application of segregation requirements to foreign SBSDs.” [726] The Commission continues to treat segregation requirements as transaction-level requirements.

Amendments to the Substituted Compliance Rule

The Commission proposed to make substituted compliance potentially available in connection with the requirements applicable to foreign SBSDs pursuant to Section 15F of the Exchange Act, other than the registration requirements. Because the capital and margin requirements were grounded in Section 15F, substituted compliance generally would have been available for those requirements under the proposal.[727] Upon a Commission substituted compliance determination, a person would be able to satisfy relevant capital or margin requirements by substituting compliance with corresponding requirements under a foreign regulatory system.

The Commission subsequently adopted Rule 3a71-6, which provides that substituted compliance is available with respect to the Commission's business conduct requirements, and (rather than addressing all requirements under Section 15F of the Exchange Act) reserved the issue as to whether substituted compliance also would be available in connection with other requirements under that statute.[728] Rule 3a71-6 was amended to make substituted compliance available with respect to the Commission's trade acknowledgment and verification requirements.[729] Today the Commission is amending Rule 3a71-6 to make the nonbank SBSD and MSBSP capital and margin requirements available for substituted compliance determinations.

One commenter expressed concerns that there is no adequate legal or policy justification for allowing substituted compliance.[730] In contrast to the implication of that comment, however, substituted compliance does not constitute exemptive relief and does not excuse registered SBSDs and MSBSPs from having to comply with the Commission's capital and margin requirements. Instead, substituted compliance provides an alternative method of satisfying those requirements under Title VII.

i. Basis for Substituted Compliance in Connection With Capital and Margin Requirements

In light of the global nature of the security-based swap market and the prevalence of cross-border transactions within that market, there is the potential that the application of the Title VII capital and margin requirements may duplicate or conflict with applicable foreign requirements, even when the two sets of requirements implement similar goals and lead to similar results. Such duplications or conflicts could disrupt existing business relationships, and, more generally, reduce competition and market efficiency.[731]

To address those effects, the Commission concludes that under certain circumstances it may be appropriate to allow for the possibility of substituted compliance whereby foreign SBSDs and MSBSPs may satisfy Section 15F(e) of the Exchange Act and Rules 18a-1, 18a-2, and 18a-3 thereunder by complying with comparable foreign requirements. Allowing for the possibility of substituted compliance in this manner may help achieve the benefits of these capital and margin requirements in a way that helps avoid regulatory duplication or conflict and hence promotes market efficiency, enhances competition, and facilitates a well-functioning global security-based swap market. Accordingly, Rule 3a71-6 is amended to identify Section 15F(e) of the Exchange Act and Rules 18a-1, 18a-2, and 18a-3 thereunder as being eligible for substituted compliance.[732]

A number of comments addressed substituted compliance as it specifically applies to the Commission's capital and margin requirements. One commenter generally asked the Commission to “recognize local margin requirements” for foreign SBSDs,[733] while other commenters requested that the Commission coordinate with the prudential regulators on substituted compliance determinations for capital and margin.[734] Similarly, another commenter requested that the Commission jointly propose and adopt rules reflecting a harmonized and unified approach to the cross-border application of the security-based swaps and swaps provisions of Title VII of the Dodd-Frank Act.[735] While a joint rulemaking would present logistical challenges due to timing differences in agencies' implementation of cross-border regimes, the Commission staff has consulted and coordinated with the CFTC, the prudential regulators, and foreign regulatory authorities on the cross-border application of its rules, and plans to continue such consultation and coordination during the substituted compliance determination process.[736]

A few commenters sought blanket substituted compliance determinations that would automatically grant substituted compliance without requiring an independent comparability determination with respect to firms subject to foreign capital or margin requirements that are consistent with Start Printed Page 43949certain international standards.[737] In contrast, another commenter recommended that the Commission not consider consistency with the prudential regulators, international standards, and foreign regulators when making substituted compliance determinations.[738] In response to these comments, the Commission believes it is appropriate to analyze directly a foreign jurisdiction's capital and margin requirements. In particular, jurisdictions may customize their capital and margin requirements to local markets and activities. In addition, Rule 3a71-6 provides that the Commission's substituted compliance determination will take into consideration the effectiveness of the supervisory compliance program administered and the enforcement authority exercised by the foreign regulatory authority, which are expected to vary among foreign jurisdictions. Consequently, the analysis of any particular foreign jurisdiction's capital and margin requirements will be fact specific and therefore a “blanket approach” would not be appropriate.

Another commenter sought an exemption for foreign firms with respect to the Commission's margin requirements (among other requirements) pursuant to which they could comply with local requirements that are not comparable to U.S. requirements, provided the aggregate notional value of swaps in the jurisdictions where this exemption is used does not exceed 15% of the firm's total swap activities.[739] The Commission does not believe such an exemption would be appropriate because it could negatively impact the safety and soundness of the firm if the local requirements were less rigorous than the Commission's requirements.

ii. Comparability Criteria, and Consideration of Related Requirements

The Commission will endeavor to take a holistic approach in determining the comparability of foreign requirements for substituted compliance purposes, focusing on regulatory outcomes as a whole rather than on requirement-by-requirement similarity.[740] The Commission's comparability assessments associated with Section 15F(e) of the Exchange Act and Rules 18a-1, 18a-2, and 18a-3 thereunder accordingly will consider whether, in the Commission's view, the foreign regulatory system achieves regulatory outcomes that are comparable to the regulatory outcomes associated with the capital and margin requirements. More specifically, paragraph (a)(2)(i) of Rule 3a71-6 provides that the Commission's substituted compliance determination will take into account factors that the Commission determines appropriate, such as, for example, “the scope and objectives of the relevant foreign regulatory requirements . . . , as well as the effectiveness of the supervisory compliance program administered, and the enforcement authority exercised, by a foreign financial regulatory authority or authorities in such system to support its oversight of such foreign security-based swap entity (or class thereof) or of the activities of such security-based swap entity (or class thereof).”

In reviewing applications, the Commission may determine to conduct its comparability analyses regarding the capital and margin requirements in conjunction with comparability analyses regarding other Exchange Act requirements that promote risk management in connection with SBSDs and MSBSPs. Accordingly, depending on the applicable facts and circumstances, the comparability assessment associated with the capital and margin requirements may constitute part of a broader assessment of the foreign regulatory system's risk mitigation requirements, and the applicable comparability assessments may be conducted at the level of those risk mitigation requirements as a whole. Commenters generally requested additional guidance regarding the criteria the Commission would consider when making a substituted compliance determination.[741] Such criteria have been set forth in the final rule as discussed below.

Comparability Criteria for Nonbank SBSD Capital Requirements

Rule 3a71-6 provides that prior to making a substituted compliance determination regarding SBSD capital requirements, the Commission intends to consider (in addition to any conditions imposed), whether the capital requirements of the foreign financial regulatory system are designed to help ensure the safety and soundness of registrants [742] in a manner that is comparable to the applicable provisions arising under the Exchange Act and its rules and regulations.[743] Under this provision, the Commission would analyze whether the capital and other prudential requirements of the foreign jurisdiction from an outcome perspective help ensure the safety and soundness of the registrants in a manner that is comparable to the applicable provisions arising under the Exchange Act and its rules and regulations.

Comparability Criteria for Nonbank MSBSP Capital Requirements

Nonbank MSBSPs are subject to a tangible net worth standard, rather than a net liquid assets test. This different standard recognizes that the entities required to register as nonbank MSBSPs may engage in a diverse range of business activities different from, and broader than, the securities activities conducted by stand-alone broker-dealers or nonbank SBSDs. In light of these considerations, Rule 3a71-6 provides that prior to making a substituted compliance determination regarding MSBSP capital requirements, the Commission intends to consider (in addition to any conditions imposed), whether the capital requirements of the foreign financial regulatory system are comparable to the applicable provisions arising under the Exchange Act and its rules and regulations.[744]

Comparability Criteria for Nonbank SBSD and MSBSP Margin Requirements

Obtaining collateral is one of the ways OTC derivatives dealers manage their credit risk exposure to OTC derivatives counterparties. Prior to the financial crisis, in certain circumstances, counterparties were able to enter into OTC derivatives transactions without having to deliver collateral. When “trigger events” occurred during the financial crisis, those counterparties faced significant liquidity strains when they were required to deliver collateral.

In light of these considerations, Rule 3a71-6 provides that prior to making a substituted compliance determination regarding SBSD margin requirements, the Commission intends to consider (in addition to any conditions imposed) whether the foreign financial regulatory Start Printed Page 43950system requires registrants to adequately cover their current and future exposure to OTC derivatives counterparties,[745] and ensures registrants' safety and soundness,[746] in a manner comparable to the applicable provisions arising under the Exchange Act and its rules and regulations.[747]

Similarly, Rule 3a71-6 provides that prior to making a substituted compliance determination regarding MSBSP margin requirements, the Commission intends to consider (in addition to any conditions imposed) whether the foreign financial regulatory system requires registrants to adequately cover their current exposure to OTC derivatives counterparties, and ensures registrants' safety and soundness, in a manner comparable to the applicable provisions arising under the Exchange Act and its rules and regulations.[748]

2. Segregation Requirements

a. Treatment of Cross-Border Transactions

As discussed above, the Commission proposed to treat the segregation requirements of Section 3E of the Exchange Act and proposed Rule 18a-4 as transaction-level requirements. Further, these requirements were not available for substituted compliance determinations. However, proposed Rule 18a-4 included provisions that addressed the applicability of these requirements with respect to different types of cross-border transactions.[749] These provisions in proposed Rule 18a-4 applied to foreign SBSDs and MSBSPs that were not dually registered as broker-dealers. Consequently, a broker-dealer SBSD needed to treat cross-border transactions no differently than any other types of transactions for purposes of the segregation requirements in Section 3E of the Exchange Act and proposed Rule 18a-4.

The cross-border provisions in proposed Rule 18a-4 for foreign stand-alone and bank SBSDs and MSBSPs distinguished between entities that were a U.S. branch or agency of a foreign bank, or neither of the above, and between cleared or non-cleared security-based swap transactions. The objective underlying these distinctions was to ensure that U.S. customers of a foreign stand-alone or bank SBSD or MSBSP were protected in the event the firm needed to be liquidated in a formal proceeding. Consequently, the differing treatment of cross-border transactions depending on these distinctions was tied to the applicable bankruptcy or liquidation laws that would apply to a failed foreign stand-alone or bank SBSD or MSBSP.

A commenter expressed general support for the Commission's proposed cross-border treatment of segregation requirements for foreign SBSDs as “consistent with the objective of applying segregation requirements so they work in tandem with applicable insolvency laws.” [750] Another commenter believed the Commission intended to make segregation requirements eligible for substituted compliance, and asked the Commission to clarify this fact.[751] The Commission is adopting the approach as proposed that segregation is a transaction-level (rather than entity-level) requirement, because the Commission believes transaction-based rules are the best mechanism for protecting U.S. customers, given that varying possible liquidation outcomes depending on the type of registrant, security-based swap, and customer involved.

Another commenter generally requested substituted compliance for all transaction-level requirements (which includes segregation requirements) to mitigate the risk of duplicative and/or conflicting regulatory requirements.[752] The transaction-based approach to segregation considers the risk of duplicative and/or conflicting regulatory requirements, but without requiring a substituted compliance application to be submitted. Similarly, another commenter asked for an exemption from the Commission's omnibus segregation requirements for foreign SBSDs (including foreign bank SBSDs) “whose segregation and custody of customer assets are subject to the supervision of a local regulatory authority,” because an insolvent or liquidated foreign SBSD would be subject to banking regulations or home country law, rather than SIPA or the U.S. Bankruptcy Code's stockbroker liquidation provisions.[753] However, the commenter's proposed approach does not consider that the Commission's approach is designed to protect U.S. customers of foreign SBSDs and MSBSPs.

The same commenter requested that the Commission follow the Department of Treasury's approach, which exempts banks from its government securities dealer customer protection requirements if they meet certain conditions and are subject to certain prudential regulator rules. More specifically, the commenter requested a blanket exemption from the Commission's omnibus segregation requirements for foreign SBSDs that are foreign banks with a U.S. branch because they would be liquidated under banking regulations instead of SIPA or the stockbroker liquidation provisions. In response, the Commission recognizes that a foreign SBSD that is not a registered broker-dealer but is a foreign bank may not be eligible to be liquidated pursuant to the stockbroker liquidation provisions, and as such, the foreign SBSD's insolvency proceeding would be administered under U.S. or foreign banking regulations. However, the Commission believes that due to existing ring-fencing laws, imposing segregation requirements on such a foreign SBSD with respect to certain security-based swap customers that are U.S. persons in all circumstances, and with respect to security-based swap customers regardless of U.S. person status when it receives funds or other property arising out of a transaction with a U.S. branch or agency of the foreign SBSD, will reduce the likelihood of U.S. counterparties incurring losses by helping identify customers' assets in an insolvency proceeding and would potentially minimize disruption to the U.S. security-based swap market.

A commenter requested that foreign SBSDs be exempted from transaction-level requirements (including segregation) when transacting with foreign funds managed by U.S. asset managers, because transaction-level requirements primarily focus on protecting counterparties by imposing certain obligations on both U.S. and foreign SBSDs.[754] A second commenter Start Printed Page 43951stated that collateral segregation and disclosure requirements should only apply to transactions with U.S. counterparties, so long as the firm maintains a separate account for collateral collected from U.S. persons as a way to protect U.S. counterparties in case of bankruptcy. The commenter also requested that foreign branches of U.S. banks which are not part of registered broker-dealers not be subject to segregation requirements when transacting with non-U.S. persons, to “mitigate the competitive effects” foreign branches may suffer relative to foreign SBSDs that are subject to segregation requirements in a narrower set of circumstances.

In response to these comments, granting these exemption requests would put U.S. customers' interests at risk in case of a foreign SBSD's bankruptcy. A primary purpose of the Commission's segregation requirements is to facilitate the prompt return of property to U.S. customers and security-based swap customers either before or during a liquidation if a registrant fails. The Commission is able to limit the segregation rules applicable to U.S. branches of foreign banks to a narrower set of transactions, because the applicable insolvency laws enable a ring-fencing mechanism by which regulators may ring fence creditor claims “arising out of transactions had by them with” the U.S. branches or agencies of the foreign bank.[755]

For the foregoing reasons, the Commission—as discussed below—is adopting the substance of the proposed segregation cross-border provisions in paragraph (e) of Rule 18a-4, but—as discussed in the next section—the Commission is modifying the structure of the paragraph by re-organizing it and making other non-substantive modifications.

Final Cross-Border Provisions for Foreign Bank SBSDs

A foreign bank SBSD that has a branch or agency in the United States should not be eligible to be a debtor under the U.S. stockbroker liquidation scheme.[756] Instead, the foreign bank's U.S. branches and agencies would likely be liquidated under federal or state banking law which “ring fences” creditor claims “arising out of transactions had by them with” the U.S. branches or agencies.[757] With respect to a foreign bank SBSD that has no branch or agency in the United States, such entities probably would not be liquidated in the United States for jurisdictional reasons. The treatment of U.S. customers in such a liquidation is unknown because it depends on the laws of the jurisdiction where the foreign SBSD is liquidated. However, many jurisdictions' laws provide for ring fencing similar to U.S. bank liquidation laws.

The proposed cross-border segregation provisions for foreign bank SBSDs were based on the understanding that ring fencing prioritized the claims of U.S. creditors above the claims of foreign creditors (rather than the actuality that both U.S. and foreign creditor claims arising out of a transaction with U.S. branches and agencies receive priority). Therefore, proposed Rule 18a-4 required a foreign bank SBSD with a U.S. branch to comply with the segregation requirements in Section 3E of the Exchange Act, and the rules and regulations thereunder (e.g., proposed Rule 18a-4), with respect to cleared and non-cleared security-based swap transactions only with U.S. persons. The proposed cross-border provisions did not expressly address a foreign bank SBSD that has no branch or agency in the United States.

For the foregoing reasons, Rule 18a-4, as adopted, clarifies that the segregation requirements of Section 3E of the Exchange Act, and the rules and regulations thereunder, apply to a foreign bank SBSD (i.e., a foreign bank, savings bank, cooperative bank, savings and loan association, building and loan association, or credit union): (1) With respect to a security-based swap customer that is a U.S. person (regardless of which branch or agency the customer's transactions arise out of), and (2) with respect to a security-based swap customer that is not a U.S. person if the foreign bank SBSD holds funds or other property arising out of a transaction had by such person with a U.S. branch or agency of the foreign SBSD.[758] Thus, the final cross-border provisions for foreign bank SBSDs expressly account for foreign bank SBSDs that do not have a U.S. branch and for foreign customers who transact with a U.S. branch of a foreign bank SBSD and, therefore, may be protected by U.S. ring fencing laws along with U.S. customers.

The Commission also proposed that the foreign bank SBSD maintain a special account designated for the exclusive benefit of U.S. security-based swap customers.[759] However, this language is removed as extraneous text because Rule 18a-4, as adopted, already requires SBSDs to maintain a special reserve account for the exclusive benefit of security-based swap customers.[760]

Final Cross-Border Provisions for Foreign Stand-Alone SBSDs

A foreign stand-alone SBSD should be subject to the U.S. Bankruptcy Code's stockholder liquidation provisions. In particular, Section 3E(g) of the Exchange Act provides “customer” status under the stockbroker liquidation provisions to all counterparties to cleared security-based swaps, making no distinction between U.S. and non-U.S. customers or counterparties.[761] If the Commission were to apply the segregation requirements only to assets of U.S. customers but not to assets of non-U.S. customers, the amount of assets segregated (i.e., the assets of U.S. person customers) could be insufficient to satisfy the combined priority claims of both U.S. and non-U.S. customers in a stockbroker liquidation proceeding, potentially resulting in losses to U.S. customers. Therefore, proposed Rule 18a-4 required a foreign stand-alone SBSD to comply with the segregation requirements of Section 3E of the Exchange Act, and the rules and regulations thereunder, with respect to assets received from both U.S. and non-U.S. persons if the foreign stand-alone SBSD received collateral from at least one U.S. person to secure cleared security-based swaps.

Section 3E(g) of the Exchange Act also extends customer protection under the stockbroker liquidation provisions to collateral delivered as margin for non-cleared security-based swaps if the collateral is subject to a customer protection requirement under Section 15(c)(3) of the Exchange Act or a segregation requirement. Therefore, proposed Rule 18a-4 required a foreign stand-alone SBSD to comply with the segregation requirements of Section 3E of the Exchange Act, and the rules and regulations thereunder, with respect to non-cleared security-based swap transactions with U.S. persons (but not with non-U.S. persons). Under that approach, the collateral posted by U.S. person counterparties was subject to a segregation requirement and therefore these persons would have “customer” status under the stockbroker liquidation Start Printed Page 43952provisions.[762] Collateral posted by non-U.S. persons was not subject to a segregation requirement and, therefore, these persons would not have “customer” status.

For these reasons, the Commission is adopting the substance of the proposed cross-border provisions for foreign stand-alone SBSDs.[763] However, the Commission is making a clarifying modification to more clearly state that these provisions apply to a foreign SBSD that is not a broker-dealer and is not a foreign bank, savings bank, cooperative bank, savings and loan association, building and loan association, or credit union.[764]

Final Cross-Border Provisions for Foreign MSBSPs

The omnibus segregation requirements in Rule 18a-4 do not apply to MSBSPs. Consequently, if an MSBSP holds collateral for a security-based swap, it will be subject only to: (1) Paragraph (d) of Rule 18a-4, which requires an SBSD or MSBSP to provide notice of the customer's right to require segregation, and (2) Section 3E(f)(1)(B) of the Exchange Act, which provides that, if requested by the security-based swap customer, the MSBSP shall separately segregate the funds or other property for the benefit of the security-based swap customer. Consequently, proposed Rule 18a-4 excepted a foreign MSBSP that is not a broker-dealer from the segregation requirements in Section 3E of the Exchange Act and the disclosure requirements in paragraph (d) of Rule 18a-4 with respect to assets received from a security-based swap customer that is not a U.S. person to secure security-based swaps.[765] The Commission did not receive comment on this proposed exception and is adopting the substance of the proposal.[766]

b. Disclosure Requirements

The Commission proposed disclosure requirements for foreign SBSDs because the treatment of security-swap customers in a liquidation proceeding may vary depending on the foreign SBSD's status and the insolvency laws applicable to the foreign SBSD. In particular, a foreign SBSD was required to disclose to a U.S. security-based swap customer—prior to accepting any assets from the person with respect to a security-based swap—the potential treatment of the assets segregated by the foreign SBSD pursuant to Section 3E of the Exchange Act, and the rules and regulations thereunder, in insolvency proceedings under U.S. bankruptcy law and applicable foreign insolvency laws.[767] The intent was to require that a foreign SBSD disclose whether it could be subject to the stockbroker liquidation provisions in the U.S. Bankruptcy Code, whether the segregated funds or other property could be afforded customer property treatment under the U.S. bankruptcy law, and any other relevant considerations that may affect the treatment of the assets segregated under Section 3E of the Exchange Act in such foreign SBSD's insolvency proceedings. One commenter responded to the Commission's request for comment by opposing applying segregation-related disclosure requirements to transactions with non-U.S. counterparties, because of the Commission's more limited interest in non-U.S. counterparties. The Commission agrees and is adopting its proposal to limit the disclosure requirement to counterparties that are U.S. persons.

In addition, the Commission is modifying the rule text to clarify that the disclosures must be made in writing. As discussed above, the Commission intended that the matters to be disclosed would inform the counterparty about the application of U.S. bankruptcy and foreign insolvency laws to segregated funds or other property the SBSD will hold for the counterparty. The Commission does not believe that an SBSD could provide disclosure on these complex issues in a manner that, in fact, would inform the counterparty about them other than in writing. Therefore, the final rule explicitly provides that the disclosure must be in writing.

For the foregoing reasons, the Commission is adopting the disclosure requirements with the modifications described above.[768]

c. Non-Substantive Modifications

The Commission is making several organizational, clarifying, and non-substantive modifications to the proposed cross-border segregation rule text.

Paragraph (e) of Rule 18a-4 now has a simplified organizational structure compared to paragraphs (e) and (f) of proposed Rule 18a-4. First, the rule text no longer explicitly states that a foreign broker-dealer SBSD is subject to Section 3E of the Exchange Act and the Commission's security-based swap segregation requirements, even though broker-dealers continue to be subject to the segregation requirements.[769] The Commission's security-based swap segregation requirements applicable to stand-alone broker-dealers are located in paragraph (p) of Rule 15c3-3.[770] Thus, all broker-dealers registered with the Commission are subject to Rule 15c3-3, and there are no cross-border exemptions from Rule 15c3-3, even if the broker-dealer is also a foreign SBSD or MSBSP. The proposed rule text was intended to identify exemptions from the Commission's security-based swap segregation rules. As a result, it is not necessary to explicitly state that broker-dealers are subject to Rule 15c3-3 even if they are also foreign SBSDs or MSBSPs.

Second, rather than categorizing the applicable rules by cleared and non-cleared security-based swaps, and then further subdividing them by entity type, the rule paragraphs are now categorized by entity type. In addition, instead of a single paragraph addressing the cross-border non-cleared security-based swap segregation treatment of all foreign SBSDs that are not broker-dealers, there are separate paragraphs addressing foreign SBSDs that are not broker-dealers and are not foreign banks, and foreign SBSDs that are not broker-dealers and are foreign banks. Since a foreign SBSD that is neither a broker-dealer nor a foreign bank is the only entity that must apply a different rule depending on whether the security-based swaps are cleared or non-cleared, this is the only paragraph that requires Start Printed Page 43953subparagraphs for cleared and non-cleared security-based swaps.[771]

Paragraph (e)(2) of Rule 18a-4, which prescribes the segregation requirements applicable to foreign MSBSPs, is now structured in the affirmative instead of the negative by identifying which requirements apply to foreign MSBSPs instead of identifying which requirements “shall not” apply to foreign MSBSPs.[772]

The Commission is also making several changes to simplify and clarify the rule text. Instead of including a cross-reference to the rule defining “foreign security-based swap dealer,” “foreign major security-based swap participant,” and “U.S. person” each time these terms appear, definitions of these terms are added to the “Definitions” section in Rule 18a-4.[773] With respect to SBSDs, “counterparty” is replaced with “security-based swap customer” for consistency with the rest of Rule 18a-4 which uses the defined term “security-based swap customer.” To eliminate ambiguity about the term “registered” SBSD, MSBSP, or broker-dealer, the rule text now clarifies that “registered” refers to an entity registered with the Commission by explicitly cross-referencing the section of the Exchange Act that the entity would register under (i.e., “foreign [SBSD or MSBSP] registered under Section 15 of the Exchange Act (15 U.S.C. 78o-10)” or “broker or dealer registered under Section 15 of the Exchange Act (15 U.S.C. 78o)”).

Several simplifying changes are being made to the cross-border segregation rule text. Throughout the rule text, the phrase “any assets received . . . to margin, guarantee, or secure a [cleared or non-cleared] security-based swap (including money, securities, or property accruing to such [U.S. person or non-U.S. person] counterparty as the result of such a security-based swap transaction)” is simplified to better align with the language used in other rule text. Thus, paragraph (e)(1)(ii) of Rule 18a-4, as adopted, now references “funds or other property for [a or at least one] security-based swap customer that is a U.S. person with respect to a [cleared or non-cleared] security-based swap transaction” to parallel Rule 18a-4's definition of a security-based swap customer. For the same reason, paragraph (e)(3) of Rule 18a-4, as adopted, now references “funds or other property” instead of “assets,” references “funds or other property received, acquired, or held for” instead of “assets collected from,” and references “receiving, acquiring, or holding funds or other property” instead of “accepting any assets.” Finally, paragraph (e)(2) of Rule 18a-4, as adopted, now omits the reference to “assets . . . to margin, guarantee, or secure a security-based swap” as extraneous.[774]

F. Delegation of Authority

The Commission is amending its rules governing delegations of authority to the Director of the Division of Trading and Markets (“Division”). The amendments delegate authority to the Division with respect to requirements in Rules 18a-1 and 18a-4, and are modeled on preexisting delegations of authority with respect to requirements in parallel Rules 15c3-1 and 15c3-3 under 17 CFR 200.30-3 (“Rule 30-3”). The amendments also add additional delegations of authority with respect to Rule 18a-1d (Satisfactory Subordinated Loan Agreements), as well as to Appendix E to Rule 15c3-1 and paragraph (d) to Rule 18a-1 with respect to the approval of the temporary use of a provisional model. These delegations are intended to permit Commission staff to perform functions under Rule 18a-1d for stand-alone SBSDs that are currently performed by a broker-dealer's DEA (i.e., FINRA) under Appendix D to Rule 15c3-1.[775]

The amendments to Rule 30-3 authorize the Director of the Division to: (1) Review amendments to applications of SBSDs filed pursuant to paragraph (d) of Rule 18a-1 and to approve such amendments, unconditionally or subject to specified terms and conditions; [776] (2) impose additional conditions, pursuant to paragraph (d)(9)(iii) of Rule 18a-1 on an SBSD that computes certain of its net capital deductions pursuant to paragraph (d) of Rule 18a-1; [777] (3) require that an SBSD provide information to the Commission pursuant to paragraph (d)(2) of Rule 18a-1; [778] (4) pursuant to Rule 15c3-3 and Rule 18a-4, find and designate as control locations for purposes of paragraph (p)(2)(ii)(E) of Rule 15c3-3, and paragraph (b)(2)(v) of Rule 18a-4, certain broker-dealer and SBSD accounts which are adequate for the protection of customer securities; [779] (5) pursuant to paragraph (b)(6) of Rule 18a-1d, approve prepayment of a subordinated loan; [780] (6) pursuant to paragraph (c)(4) of Rule 18a-1d, approve prepayment of a revolving subordinated loan agreement; [781] (7) pursuant to paragraph (c)(5) of Appendix D to Rule 18a-1, examine any proposed subordinated loan agreement filed by a security-based swap dealer and find the agreement acceptable; [782] (8) determine, pursuant § 240.18a-1(d)(7)(ii), that the notice a security-based swap dealer must provide to the Commission pursuant to § 240.18a-1(d)(7)(i) will become effective for a shorter or longer period of time; [783] and (9) approve, pursuant to § 240.15c3-1e(a)(7)(ii) and § 240.18a-1(d)(5)(ii) of this chapter, the temporary use of a provisional model, in whole or in part, unconditionally or subject to any conditions or limitations.[784] In addition, paragraph (a)(7)(i)'s cross-reference to Rule 15c3-1 is corrected to reference paragraph (a)(6)(iii)(B) instead of paragraph (a)(6)(iii)(E), and paragraph (a)(7)(iv)'s cross-reference to Rule 15c3-1 is corrected to reference paragraph (a)(1)(ii) instead of paragraphs (f)(1)(i) and (ii).

These delegations of authority are intended to preserve Commission resources and increase the effectiveness and efficiency of the Commission's oversight of the financial responsibility rules for SBSDs being adopted today under the authority of the Dodd-Frank Start Printed Page 43954Act. Nevertheless, the Division may submit matters to the Commission for its consideration, as it deems appropriate.

Administrative Law Matters

The Commission finds, in accordance with the Administrative Procedure Act (“APA”),[785] that these amendments relate solely to agency organization, procedure, or practice, and do not relate to a substantive rule. Accordingly, the provisions of the APA regarding notice of rulemaking, opportunity for public comment, and publication of the amendment prior to its effective date are not applicable. For the same reason, and because this amendment does not substantively affect the rights or obligations of non-agency parties, the provisions of the Small Business Regulatory Enforcement Fairness Act,[786] are not applicable. Additionally, the provisions of the Regulatory Flexibility Act, which apply only when notice and comment are required by the APA or other law,[787] are not applicable. Further, because this amendment imposes no new burdens on private persons, the Commission does not believe that the amendment will have any anti-competitive effects for purposes of Section 23(a)(2) of the Exchange Act.[788] Finally, this amendment does not contain any collection of information requirements as defined by the Paperwork Reduction Act of 1980, as amended.

III. Explanation of Dates

A. Effective Date

These final rules will be effective 60 days after the date of this release's publication in the Federal Register.

B. Compliance Dates

In the release establishing the registration process for SBSDs and MSBSPs, the Commission adopted a compliance date for SBSD and MSBSP registration requirements (the “Registration Compliance Date”) that was tied to four then-pending rule sets.[789] Two of those four rule sets have been adopted [790] and the Commission is adopting today in this release one of the remaining two rule sets. The Commission believes it appropriate to set the Registration Compliance Date in this release rather than in final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs.[791] Accordingly, the Registration Compliance Date is 18 months after the later of: (1) The effective date of final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs; or (2) the effective date of final rules addressing the cross-border application of certain security-based swap requirements.[792] Similarly, the compliance date for the rule amendments and new rules being adopted in this release is 18 months after the later of: (1) The effective date of final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs; or (2) the effective date of final rules addressing the cross-border application of certain security-based swap requirements. The Commission believes this extended compliance date addresses commenters' concerns about needing enough time to prepare for and come into compliance with the new requirements.[793] In this regard, the Commission notes that commenters recommended a period of 18 to 24 months following adoption of final rules for firms to come into compliance.[794] With respect to the capital requirements being adopted today, a commenter recommended that SBSD capital requirements take effect at the later of: (1) 2 years after the start of the margin implementation period; and (2) the effective date of the swaps push-out rule, and that, once in effect, SBSD capital standards be determined with reference to the transaction activity of counterparties subject to then-applicable initial margin requirements, taking into account the transition period in the BCBS/IOSCO Paper.[795] The compliance date being adopted today is a reasonable amount of time to come into compliance with the new requirements, given that it is triggered by the adoption of rules that were only recently proposed. Consequently, in practice, the compliance date will be more than 18 months from today's date.

Some commenters recommended that the Commission adopt a compliance date that is shorter than 18 months.[796] The Commission agrees that the Title VII dealer regime should be stood up as expeditiously as possible but must balance that objective with the need to provide firms with a reasonable amount of time to adapt to the new regime. Specifically, firms need time to familiarize themselves with the requirements in the rules being adopted today and how they interact with other security-based swap rules. Firms also need to make and implement informed decisions about business structure and to develop and build compliance systems and controls.

Regarding the Commission's policy statement on the sequencing of final rules governing security-based swaps,[797] commenters recommended establishing phase-in periods for each major new Start Printed Page 43955requirement based on asset class and market participant type.[798] Commenters also suggested imposing requirements on the relatively less complex, more standardized, more liquid products and on interdealer transactions before imposing requirements on more complex, less standardized and less liquid products or transactions involving end users and other smaller market participants.[799] Another commenter suggested grouping rulemakings into two categories in terms of the applicable compliance date.[800] Other commenters requested that the Commission delay the compliance date for the rules being adopted today until after SBSDs and MSBSPs are required to register with the Commission.[801] In contrast, a commenter recommended that there should be a single compliance date with respect to the Commission's margin rules for all relevant market participants after a reasonable compliance period, arguing that a phased-in compliance schedule would create unfairly inconsistent treatment among market participants.[802]

The Commission does not believe it is necessary to phase in the capital, margin, and segregation requirements by asset or market participant type. The compliance date for the rules being adopted today will be more than 18 months from today's date. The Commission believes this will give entities adequate time to take the necessary steps to comply with the new requirements. The Commission also does not believe it would be appropriate to delay the compliance date for the Commission's capital, margin, and segregation rules beyond the date when SBSDs and MSBSPs must register with the Commission, because this would undermine the Commission's ability to effectively regulate and supervise these registrants.

A variety of comments stated that the implementation of the margin rules must be delayed in relation to domestic and foreign regulators, international standard setters, and the development of market infrastructure.[803] Several other jurisdictions and regulators, including the CFTC and the prudential regulators, have finalized margin requirements and certain entities are now subject to these requirements. Given this fact, coupled with a compliance date in excess of 18 months, the Commission believes the industry will have adequate time to come into compliance with the margin rules being adopted today.

Several commenters addressed the timing of the implementation of the Commission's margin rules relative to its clearing rules. A commenter believed that the Commission should not implement the final margin rules until after relevant mandatory central clearing is fully implemented under the Dodd-Frank Act.[804] Other commenters similarly suggested that the non-cleared margin rules should be implemented after clearing rules take effect.[805] A commenter noted that mandatory clearing has not been phased in across market participants and that rules relating to margin for non-cleared transactions should not apply to a particular market participant until the mandatory clearing requirement applies to that participant.[806]

In response to these comments, the Commission does not believe it would be appropriate to link the compliance date for the margin rules to the implementation of mandatory clearing. The margin rule applies to non-cleared security-based swaps and is designed to promote the safety and soundness of nonbank SBSDs and nonbank MSBSPs and to protect their counterparties. Therefore, the Commission believes the better approach is to make the compliance date of the margin rule the same as the Registration Compliance Date for SBSDs and MSBSPs. As discussed above, both of these compliance dates will be 18 months after the later of: (1) The effective date of final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs; or (2) the effective date of final rules addressing the cross-border application of certain security-based swap requirements.

Another commenter suggested that non-cleared security-based swap margin rules should become effective only after operational requirements for non-cleared margin can be met, and submitted models have been reviewed.[807] A commenter recommended that the Commission adopt a compliance date that is at least 2 years from the effective date of a final capital rule to allow for sufficient time for the Commission or FINRA to approve internal models for capital purposes.[808] As discussed above, the compliance date will be in excess of 18 months after these rules are adopted. This should provide sufficient time for the Commission to review the models of entities that will register as nonbank SBSDs and whose models have not already been approved. Moreover, as discussed above, the final capital rules provide that the Commission can approve the temporary use of a provisional model under certain conditions.[809]

C. Effect on Existing Commission Exemptive Relief

Compliance with certain provisions of the Exchange Act and certain rules and regulations thereunder in connection with security-based swap transactions, positions and/or activity is currently subject to temporary exemptive relief granted by the Commission. The rules Start Printed Page 43956the Commission is adopting and amending today relate to temporary exemptive relief for 3 key areas of requirements applicable to SBSDs and MSBSPs: (1) Financial responsibility-related requirements; (2) segregation requirements for non-cleared security-based swaps; and (3) requirements in connection with certain CDS portfolio margin programs.

First, the Commission has provided limited exemptions for registered broker-dealers, subject to certain conditions and limitations, from the application of Sections 7 and 15(c)(3) of the Exchange Act, Rules 15c3-1, 15c3-3,[810] and 15c3-4, and Regulation T in connection with security-based swaps, some of which exemptions were solely to the extent the provisions or rules did not apply to the broker-dealer's security-based swap positions or activities as of July 15, 2011 (collectively, the “Financial Responsibility Rule Exemptions”).[811] In connection with this and other exemptive relief, the Commission also provided that, until such time as the underlying exemptive relief expires, no contract entered into on or after July 16, 2011 shall be void or considered voidable by reason of Section 29(b) of the Exchange Act because any person that is a party to the contract violated a provision of the Exchange Act for which the Commission provided exemptive relief in the Exchange Act Exemptive Order (“Section 29(b) Exemption”).[812] The Financial Responsibility Rule Exemptions are scheduled to expire on the compliance date for any final capital, margin, and segregation rules for SBSDs and MSBSPs.[813] Accordingly, all of the Financial Responsibility Rule Exemptions, together with the portion of the Section 29(b) Exemption that relates to the Exchange Act provisions for which the Commission provided exemptive relief in the Financial Responsibility Rule Exemptions, will expire upon the compliance date set forth in section III.B. of this release.

Second, compliance with Section 3E(f) of the Exchange Act is currently subject to temporary exemptive relief.[814] That relief includes an exemption for SBSDs and MSBSPs from the segregation requirements for non-cleared security-based swaps in Section 3E(f) of the Exchange Act, as well as an exemption (similar but not identical to the Section 29(b) Exemption discussed above) providing that no SBS contract entered into on or after July 16, 2011 shall be void or considered voidable by reason of Section 29(b) of the Exchange Act because any person that is a party to the contract violated Section 3E(f) of the Exchange Act. Both of these exemptions will expire on the Registration Compliance Date set forth in section III.B. of this release.

Finally, on December 14, 2012, the Commission issued an order granting conditional exemptive relief from compliance with certain provisions of the Exchange Act in connection with a program to commingle and portfolio margin customer positions in cleared CDS that include both swaps and security-based swaps in a segregated account established and maintained in accordance with Section 4d(f) of the CEA.[815] This exemptive relief does not contain a sunset date; however, the exemptive relief for dually-registered clearing agency/DCOs is subject to two conditions that will be triggered by the adoption of final rules setting forth margin and segregation requirements applicable to security-based swaps.[816] By their terms, these two conditions will begin to apply by the later of: (1) Six months after adoption of final margin and segregation rules applicable to security-based swaps consistent with Section 3E of the Exchange Act; or (2) the compliance date of such rules. As discussed above in section III.B. of this release, the compliance date for the rules the Commission is adopting today will be 18 months after the later of: (1) The effective date of final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs; or (2) the effective date of final rules addressing the cross-border application of certain security-based swap requirements.[817] Accordingly, each dually registered clearing agency/DCO must comply with these two Start Printed Page 43957conditions no later than that date. Before the compliance date, the Commission intends to continue coordinating with the CFTC to address portfolio margining of security-based swaps and swaps by nonbank SBSDs and swap dealers.

D. Application to Substituted Compliance

For the amendments to Rule 3a71-6, the Commission is adopting an effective date of 60 days following publication in the Federal Register. There will be no separate compliance date in connection with that rule, as the rule does not impose obligations upon entities. As discussed above, SBSDs and MSBSPs will not be required to comply with the capital and margin requirements until they are registered, and the registration requirement for those entities will not be triggered until a number of regulatory benchmarks have been met.

In practice, the Commission recognizes that if the requirements of a foreign regime are comparable to Title VII requirements, and the other prerequisites to substituted compliance also have been satisfied, then it may be appropriate to permit an SBSD or MSBSP to rely on substituted compliance commencing at the time that entity is registered with the Commission. Accordingly, the Commission would consider substituted compliance requests that are submitted prior to the compliance date for its capital and margin requirements. The Commission believes this addresses commenters' concerns that the compliance date could be before substituted compliance determinations are made.[818]

IV. Paperwork Reduction Act

Certain provisions of the new rules and amendments contain “collection of information” requirements within the meaning of the Paperwork Reduction Act of 1995 (“PRA”).[819] The Commission published notice requesting comment on the collection of information requirements [820] and submitted the amendments and the proposed new rules to the Office of Management and Budget (“OMB”) for review in accordance with the PRA.[821] The Commission's earlier PRA assessments have been revised to reflect the modifications to the final rules and amendments from those that were proposed, the adoption of new Rule 18a-10 as a result of comments received,[822] and additional information and data now available to the Commission.[823] An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid OMB control number. The titles for the collections of information are:

RuleRule titleOMB control No.
Rule 18a-1, Rule 18a-1a, Rule 18a-1b, Rule 18a-1c, and Rule 18a-1dNet capital requirements for SBSDs for which there is not a prudential regulator3235-0701
Rule 18a-2Capital requirements for MSBSPs for which there is not a prudential regulator3235-0699
Rule 18a-3 and Rule 18a-10Non-cleared security-based swap margin requirements for SBSDs and MSBSPs for which there is not a prudential regulator; Alternative compliance mechanism for security-based swap dealers that are registered as swap dealers and have limited security-based swap activities3235-0702
Rule 18a-4 and exhibitSegregation requirements for SBSDs and MSBSPs3235-0700
Rule 15c3-1 and appendicesNet capital requirements for brokers or dealers3235-0200
Rule 15c3-3 and exhibitsCustomer protection—reserves and custody of securities824 3235-0078
Rule 3a71-6Substituted compliance for SBSDs and MSBSPs3235-0715

A. Summary of Collections of Information Under the Rules and Rule Amendments

1. Rule 18a-1 and Amendments to Rule 15c3-1

Rule 18a-1 establishes minimum capital requirements for stand-alone SBSDs and the amendments to Rule 15c3-1 augment capital requirements for broker-dealers to accommodate broker-dealer SBSDs and to enhance the provisions applicable to ANC broker-dealers. The new rule and amendments establish new collections of information requirements.

First, under paragraphs (a)(2) and (d) of Rule 18a-1, a stand-alone SBSD must apply to the Commission to be authorized to use internal models to compute net capital. As part of the application process, a stand-alone SBSD is required to provide the Commission staff with information specified in the rule. In addition, a stand-alone SBSD authorized to use internal models will review and update the models it uses to compute market and credit risk, as well as backtest the models.Start Printed Page 43958

Second, under paragraph (f) of Rule 18a-1 and paragraph (a)(10)(ii) of Rule 15c3-1, as amended, nonbank SBSDs, including broker-dealer SBSDs, are required to implement internal risk management controls in compliance with certain requirements of Rule 15c3-4.

Third, under paragraph (c)(1)(vi)(B)(1)(iii)(A) of Rule 18a-1 and paragraph (c)(2)(vi)(P)(1)(iii) of Rule 15c3-1, as amended, broker-dealers, broker-dealer SBSDs, and stand-alone SBSDs not using models are required to use an industry sector classification system, that is documented and reasonable in terms of grouping types of companies with similar business activities and risk characteristics, for the purposes of calculating “haircuts” on non-cleared CDS. These firms could use a third-party classification system or develop their own classification system.

Fourth, under paragraph (h) of Rule 18a-1, stand-alone SBSDs are required to provide the Commission with certain written notices with respect to equity withdrawals.

Fifth, under paragraph (c)(5) of Rule 18a-1d, a stand-alone SBSD is required to file with the Commission two copies of any proposed subordinated loan agreement at least 30 days prior to the proposed execution date of the agreement, as well as a statement setting forth the name and address of the lender, the business relationship of the lender to the SBSD, and whether the SBSD carried an account for the lender effecting transactions in security-based swaps at or about the time the proposed agreement was filed.

Finally, under paragraph (c)(1)(ix)(C)(3) of Rule 18a-1 and paragraph (c)(2)(xv)(C)(3) of Rule 15c3-1, as amended, stand-alone broker-dealers and nonbank SBSDs may treat collateral held by a third-party custodian to meet an initial margin requirement of a security-based swap or swap customer as being held by the stand-alone broker-dealer or nonbank SBSD for purposes of avoiding the capital deduction in lieu of margin or credit risk charge if certain conditions are met.

2. Rule 18a-2

Rule 18a-2 establishes capital requirements for nonbank MSBSPs. In particular, a nonbank MSBSP is required at all times to have and maintain positive tangible net worth, and comply with Rule 15c3-4 with respect to its security-based swap and swap activities.

3. Rule 18a-3

Rule 18a-3 prescribes non-cleared security-based swap margin requirements for nonbank SBSDs and MSBSPs. Paragraph (e) of Rule 18a-3 requires a nonbank SBSD to monitor the risk of each account, and establish, maintain, and document procedures and guidelines for monitoring the risk.

Finally, under paragraph (d) to Rule 18a-3, a nonbank SBSD applying to the Commission for authorization to use and be responsible for a model to calculate the initial margin amount under the rule will be subject to the application process and ongoing conditions in Rule 15c3-1e or paragraph (d) of Rule 18a-1, as applicable, governing the use of internal models to compute net capital.

4. Rule 18a-4 and Amendments to Rule 15c3-3

Rule 18a-4 establishes segregation requirements for cleared and non-cleared security-based swap transactions for bank and stand-alone SBSDs, as well as notification requirements for these entities. Amendments to Rule 15c3-3 establish segregation requirements for stand-alone broker-dealers and broker-dealer SBSDs that are largely parallel to the requirements in Rule 18a-4. Specifically, new paragraph (p) to Rule 15c3-3 establishes segregation requirements for stand-alone broker-dealers and broker-dealer SBSDs with respect to their security-based swap activity. The provisions of Rule 18a-4, as well as the amendments to Rule 15c3-3, are modeled on existing Rule 15c3-3—the broker-dealer segregation rule. Rules 18a-4 and 15c3-3 also contain provisions that are not modeled specifically on Rule 15c3-3 as it exists today. First, paragraph (d) of Rule 18a-4 and paragraph (p)(4) of Rule 15c3-3 require SBSDs and MSBSPs to provide the notice required by Section 3E(f)(1)(A) of the Exchange Act to a counterparty in writing prior to the execution of the first non-cleared security-based swap transaction with the counterparty. Second, SBSDs must obtain subordination agreements from counterparties that elect individual or omnibus segregation.

Additionally, paragraph (a)(5)(iii) of Rule 18a-4 and paragraph (p)(1)(iii) of Rule 15c3-3, as amended, impose documentation requirements with respect to a qualified clearing agency account a broker-dealer or SBSD maintains at a clearing agency that holds funds and other property in order to margin, guarantee, or secure cleared security-based swaps of the firm's security-based swap customers.

Under paragraph (a)(4) of Rule 18a-4 and paragraph (p)(1)(iv) of Rule 15c3-3, as amended, a qualified registered security-based swap dealer account is defined to mean an account at an SBSD registered with the Commission pursuant to Section 15F of the Exchange Act that meets conditions that are largely identical to the conditions for a qualified clearing agency account.

Finally, paragraph (c)(1) of Rule 18a-4 and paragraph (p)(3)(i) of Rule 15c3-3 require an stand-alone broker-dealer and SBSD, among other things, to maintain a special reserve account for the exclusive benefit of security-based swap customers separate from any other bank account of the broker-dealer or SBSD.

Paragraph (c)(1) of Rule 18a-4 and paragraph (p)(3)(i) of Rule 15c3-3, as amended, provide that the stand-alone broker-dealer or SBSD must at all times maintain in a customer reserve account, through deposits into the account, cash and/or qualified securities in amounts computed weekly in accordance with the formula set forth in Exhibit A to Rule 18a-4 or Exhibit B to Rule 15c3-3, which is modeled on the formula in Exhibit A to Rule 15c3-3.

Paragraph (e) of Rule 18a-4 specifies when foreign stand-alone and bank SBSDs and MSBSPs are not required to comply with the segregation requirements in Section 3E of the Exchange Act and Rule 18a-4 thereunder. In addition, a foreign stand-alone or bank SBSD is required to disclose to a U.S. security-based swap customer the potential bankruptcy treatment of property segregated by the SBSD.

Finally, under paragraph (f) of Rule 18a-4, a stand-alone or bank SBSD will be exempt from the requirements of Rule 18a-4 if the SBSD meets certain conditions, including that the SBSD provides notice to the counterparty regarding the right to segregate initial margin at an independent third-party custodian, and provides certain disclosures in writing regarding the collateral received by the SBSD.

5. Rule 18a-10

Rule 18a-10 is an alternative compliance mechanism pursuant to which a stand-alone SBSD that is registered as a swap dealer and predominantly engages in a swaps business may elect to comply with the capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of complying with Rules 18a-1, 18a-3, and 18a-4.Start Printed Page 43959

Paragraph (b) of Rule 18a-10 sets forth certain requirements for a firm that is operating pursuant to the rule. Among other things, paragraph (b)(2) of Rule 18a-10 requires the firm to provide a written disclosure to its counterparties before the first transaction with the counterparty after the firm begins the operating pursuant to the rule notifying the counterparty that the firm is complying with the applicable capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of complying with applicable Commission rules. Paragraph (b)(3) of Rule 18a-10 requires a stand-alone SBSD operating pursuant to the rule to immediately notify the Commission and the CFTC in writing if it fails to meet a condition in paragraph (a) of the rule.

Finally, paragraph (d) of Rule 18a-10 addresses how a firm would elect to operate pursuant to the rule. Under paragraph (d)(1), a firm can make the election as part of the process of applying to register as an SBSD. In this case, the firm must provide written notice to the Commission and the CFTC during the registration process of its intent to operate pursuant to the rule. Under paragraph (d)(2) of Rule 18a-10, an SBSD can make an election to operate under the alternative compliance mechanism after the firm has been registered as an SBSD by providing written notice to the Commission and the CFTC of its intent to operate pursuant to the rule.

6. Amendments to Rule 3a71-6

The Commission is amending Rule 3a71-6 to provide persons with the ability to apply for substituted compliance with respect to the capital and margin requirements of Section 15F(e) of the Exchange Act and Rules 18a-1, 18a-2, and 18a-3 thereunder.

B. Use of Information

The Commission, its staff, and SROs, as applicable, will use the information collected under Rules 18a-1, 18a-2, 18a-3, 18a-4, and 18a-10, as well as the amendments to Rule 15c3-1 and Rule 15c3-3 to evaluate whether an SBSD, MSBSP, or stand-alone broker-dealer is in compliance with each rule that applies to the entity and to help fulfill their oversight responsibilities. The Commission plans to use the information collected pursuant to Rule 3a71-6, as amended, to evaluate requests for substituted compliance with respect to the capital and margin requirements. The collections of information also will help to ensure that SBSDs, MSBSPs, and stand-alone broker-dealers are meeting their obligations under the new rules and rule amendments and have the required policies and procedures in place. In this regard, the collections of information will be used by the Commission as part of its ongoing efforts to monitor and enforce compliance with the federal securities laws through, among other things, examinations and inspections.

Rules 18a-1 and 18a-2, and the amendments to Rule 15c3-1, are integral parts of the Commission's financial responsibility program for nonbank SBSDs and MSBSPs, and stand-alone broker-dealers. Rules 18a-1 and 15c3-1 are designed to ensure that nonbank SBSDs and stand-alone broker-dealers, respectively, have sufficient liquidity to meet all unsubordinated obligations to customers and counterparties and, consequently, if the nonbank SBSD or stand-alone broker-dealer fails, sufficient resources to wind-down in an orderly manner without the need for a formal proceeding. The collections of information in Rule 18a-1, Rule 18a-2 and the amendments to Rule 15c3-1 facilitate the monitoring of the financial condition of nonbank SBSDs and MSBSPs, and stand-alone broker-dealers by the Commission and its staff.

Rule 18a-3 is intended to help ensure the safety and soundness of the nonbank SBSD or MSBSP. Records maintained by these entities relating to the collection of collateral required by Rule 18a-3 will assist examiners in evaluating whether nonbank SBSDs are in compliance with requirements in the rule.

Rule 18a-4 and the amendments to Rule 15c3-3 are integral to the Commission's financial responsibility program as they are designed to protect the rights of security-based swap customers and their ability to promptly obtain their property from an SBSD or stand-alone broker-dealer. The collection of information requirements in the rule and amendments will facilitate the process by which the Commission and its staff monitor how SBSDs and stand-alone broker-dealers are fulfilling their custodial responsibilities to security-based swap customers. Rule 18a-4 and the amendments to Rule 15c3-3 also require that an SBSD to provide certain notices to its counterparties to alert them to the alternatives available to them with respect to segregation of non-cleared security-based swaps. The Commission and its staff will use this new collection of information to confirm registrants are providing the requisite notice to counterparties.

Rule 18a-10 requires a stand-alone SBSD to: (1) Provide certain disclosures to its counterparties to alert them that the firm will be complying with the capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of Rules 18a-1, 18a-3, and 18a-4; (2) to notify the Commission and the CFTC the firm is electing to operate under the conditions of the rule; and (3) provide a notice to the Commission and the CFTC if it fails to meet a condition of the rule. The Commission and its staff will use this new collection of information to confirm which registrants are operating under the conditions of the rule. In addition, the Commission will use the information to confirm that registrants are providing the requisite disclosures to counterparties, and assist examiners in evaluating whether SBSDs are in compliance with requirements in the rule.

Finally, the requests for substituted compliance determinations under Rule 3a71-6 are required when a person seeks a substituted compliance determination with respect to the capital and margin requirements applicable to foreign SBSDs and MSBSPs. Consistent with Exchange Act Rule 0-13(h), the Commission will publish in the Federal Register a notice that a complete application has been submitted, and provide the public the opportunity to submit to the Commission any information that relates to the Commission action requested in the application.

C. Respondents

The Commission estimated the number of respondents in the proposing release.[825] The Commission received no comment on these estimates and continues to believe they are appropriate. However, the number of respondents has been updated to include stand-alone broker-dealers engaged in security-based swap activities as well as the number of foreign SBSDs and MSBSPs. In addition, in response to comments received, the Commission is adopting new Rule 18a-10, which has resulted in the number of respondents being updated in Rules 18a-1, as adopted, and Rule 18a-3, as adopted.

The following charts summarize the Commission's respondent estimates:

Type of respondentNumber of respondents
SBSDs50
Bank SBSDs25
Nonbank SBSDs25
Broker-Dealer SBSDs16
Non-broker-dealer SBSDs34
Stand-Alone SBSDs9
Start Printed Page 43960
ANC Broker-Dealer SBSDs10
Broker-Dealer SBSDs (Not Using Models)6
Stand-Alone SBSDs (Using Models)4
Stand-Alone SBSDs (Not Using Models)2
Stand-Alone Broker-Dealers25
Nonbank MSBSPs5
Nonbank SBSDs subject to Rule 18a-322
Foreign SBSDs and MSBSPs22
Foreign SBSDs and/or foreign MSBSPs submitting substituted compliance applications3
Bank SBSDs exempt from requirements of Rule 18a-425
Stand-Alone SBSDs exempt from requirements of Rule 18a-46
Stand-Alone SBSDs operating under Rule 18a-103

Consistent with prior releases, based on available data regarding the single-name CDS market—which the Commission believes will comprise the majority of security-based swaps—the Commission estimates that the number of nonbank MSBSPs likely will be five or fewer and, in actuality, may be zero.[826] Therefore, to capture the likely number of nonbank MSBSPs that may be subject to the collections of information for purposes of the PRA, the Commission estimates that five entities will register with the Commission as nonbank MSBSPs.[827] The Commission estimates there will be 1 broker-dealer MSBSP for the purposes of calculating paperwork burdens, in recognition that broker-dealer MSBSPs and stand-alone MSBSPs are subject to different burdens under the new and amended rules in certain instances.

Consistent with prior releases, the Commission estimates that 50 or fewer entities ultimately may be required to register with the Commission as SBSDs, and 16 broker-dealers will likely seek to register as SBSDs.[828]

Because many of the dealers that currently engage in OTC derivatives activities are banks, the Commission estimates that approximately 75% of the 34 non-broker-dealer SBSDs will be bank SBSDs (i.e., 25 firms), and the remaining 25% will be stand-alone SBSDs (i.e., 9 firms).[829]

Of the nine stand-alone SBSDs, the Commission estimates, based on its experience with ANC broker-dealers and OTC derivatives dealers, that four firms will apply to use internal models to compute net capital under Rule 18a-1.[830] This estimate has been reduced from six in the proposing release [831] to four to account the adoption of Rule 18a-10, which will enable stand-alone SBSDs to elect an alternative compliance mechanism and comply with capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of Rules 18a-1, 18a-3, and 18a-4. Finally, in the proposing release, the Commission estimated that 3 stand-alone SBSDs would not apply to use models.[832] This estimate has been modified from 3 firms to 2 firms to account for the nonbank SBSDs that will elect the alternative compliance mechanism under Rule 18a-10.

Of the 16 broker-dealer SBSDs, the Commission estimates that 10 firms will operate as ANC broker-dealer SBSDs authorized to use internal models to compute net capital under Rule 15c3-1.[833]

The Commission estimates that 25 registered broker-dealers will be engaged in security-based swap activities but will not be required to register as an SBSD or MSBSP (i.e., will be stand-alone broker-dealers). Other than OTC derivatives dealers, which are subject to significant limitations on their activities, broker-dealers historically have not participated in a significant way in security-based swap trading for at least two reasons.[834] First, because the Exchange Act has not previously defined security-based swaps as securities, security-based swaps have not been required to be traded through registered broker-dealers.[835] Second, a broker-dealer engaging in security-based swap activities is currently subject to existing regulatory requirements with respect to those activities, including capital, margin, segregation, and recordkeeping requirements. The existing financial responsibility requirements make it more costly to conduct these activities in a broker-dealer than in an unregulated entity. As a result, security-based swap activities are mostly concentrated in affiliates of stand-alone broker-dealers.[836]

For purposes of the exemption from the requirements of Rule 18a-4 for stand-alone SBSDs and bank SBSDs, the Commission estimates that 25 bank SBSDs and 6 stand-alone SBSDs will be exempt from the requirements of Rule 18a-4 pursuant to paragraph (f) of the rule.[837] For purposes Rule 18a-10, the Commission estimates that 3 stand-alone SBSDS will operate pursuant to the rule.[838]

For purposes of estimating the number of respondents with respect to the amendments to Rule 3a71-6, applications for substituted compliance may be filed by foreign financial authorities, or by non-U.S. SBSDs or MSBSPs. Consistent with prior estimates, the Commission staff expects that there may be approximately 22 non-Start Printed Page 43961U.S. entities that may potentially register as SBSDs.[839] Potentially, all such non-U.S. SBSDs, or some subset thereof, may seek to rely on substituted compliance in connection with the requirements being adopted today.[840] For purposes of the PRA, however, consistent with prior estimates, the Commission estimates that 3 of these security-based swap entities will submit such applications in connection with the Commission's capital and margin requirements.[841]

D. Total Initial and Annual Recordkeeping and Reporting Burden

1. Rule 18a-1 and Amendments to Rule 15c3-1

The burden estimates for Rule 18a-1 and the amendments to Rule 15c3-1 are based in part on the Commission's experience with burden estimates for similar collections of information requirements, including the current collection of information requirements for Rule 15c3-1.[842]

First, under paragraph (a)(2) of Rule 18a-1, a stand-alone SBSD is required to file an application for authorization to compute net capital using internal models.[843] The requirements for the application are set forth in paragraph (d) of Rule 18a-1, which is modeled on the application requirements of Appendix E to Rule 15c3-1 applicable to ANC broker-dealers.[844]

Based on its experience with ANC broker-dealers and OTC derivatives dealers, the Commission expects that stand-alone SBSDs that apply to use internal models to calculate net capital will already have developed models and internal risk management control systems. Rule 18a-1 also contains additional requirements that stand-alone SBSDs may not yet have incorporated into their models and control systems. Therefore, stand-alone SBSDs will incur one-time hour burdens and start-up costs in order to develop their models in accordance with Rule 18a-1, as well as submit the models along with their application to the Commission for approval. While the Commission's burden estimates are averages, the burdens may vary depending on the size and complexity of each stand-alone SBSD.

The Commission staff estimates that each of the 4 stand-alone SBSDs that apply to use the internal models would spend approximately 1,000 hours to: (1) Develop and submit their models and the description of its their risk management control systems to the Commission; (2) to create and compile the various documents to be included with their applications; and (3) to work with the Commission staff through the application process. The hour burdens include approximately 100 hours for an in-house attorney to complete a review of the application. Consequently, the Commission staff estimates that the total burden associated with the application process for the stand-alone SBSDs will result in an industry-wide one-time hour burden of approximately 4,000 hours.[845] In addition, the Commission staff allocates 75% (3,000 hours) of these one-time burden hours [846] to internal burden and the remaining 25% (1,000 hours) to external burden to hire outside professionals to assist in preparing and reviewing the stand-alone SBSD's application for submission to the Commission.[847] The Commission staff estimates $400 per hour for external costs for retaining outside consultants, resulting in a one-time industry-wide external cost of $400,000.[848]

The Commission staff estimates that a stand-alone SBSD authorized to use internal models will spend approximately 5,600 hours per year to review and update the models and approximately 160 hours each quarter, or approximately 640 hours per year, to backtest the models. Consequently, the Commission staff estimates that the total burden associated with reviewing and back-testing the models for the 4 stand-alone SBSDs will result in an industry-wide annual hour burden of approximately 24,960 hours per year.[849] In addition, the Commission staff allocates 75% (18,720 hours) [850] of these burden hours to internal burden and the remaining 25% (6,240 hours) to external burden to hire outside professionals to assist in reviewing, updating and backtesting the models.[851] The Commission staff estimates $400 per hour for external costs for retaining outside professionals, resulting in an industry-wide external cost of $2.5 million annually.[852]

Stand-alone SBSDs electing to file an application with the Commission to use an internal model will incur start-up costs including information technology costs to comply with Rule 18a-1. Based on the estimates for the ANC broker-dealers,[853] it is expected that a stand-alone SBSD will incur an average of approximately $8.0 million to modify its information technology systems to meet the model requirements of the Rule 18a-Start Printed Page 439621, for a total one-time industry-wide cost of $32 million.[854]

Second, a nonbank SBSD is required to comply with most provisions of Rule 15c3-4, which requires the establishment of a risk management control system as if it were an OTC derivatives dealer.[855] ANC broker-dealers currently are required to comply with Rule 15c3-4.[856] The Commission staff estimates that the requirement to comply with Rule 15c3-4 will result in one-time and annual hour burdens to nonbank SBSDs. The Commission staff estimates that the average amount of time a firm will spend implementing its risk management control system will be 2,000 hours,[857] resulting in an industry-wide one-time hour burden of 24,000 hours across the 12 nonbank SBSDs not already subject to Rule 15c3-4.[858]

In implementing its policies and procedures, a nonbank SBSD is required to document and record its system of internal risk management controls. The Commission staff estimates that each of these 12 nonbank SBSDs will spend approximately 250 hours per year reviewing and updating their risk management control systems to comply with Rule 15c3-4, resulting in an industry-wide annual hour burden of approximately 3,000 hours.[859]

Nonbank SBSDs may incur start-up costs to comply with the provisions of Rules 15c3-1 and 18a-1 that require compliance with Rule 15c3-4, including information technology costs. Based on the estimates for similar collections of information,[860] it is expected that a nonbank SBSD will incur an average of approximately $16,000 for initial hardware and software expenses, while the average ongoing cost will be approximately $20,500 per nonbank SBSD to meet the requirements of the Rule 18a-1 and the amendments to Rule 15c3-1, for a total industry-wide initial cost of $192,000 and an ongoing cost of $246,000 per year.[861]

Third, under paragraph (c)(2)(vi)(P)(1)(iii) of Rule 15c3-1, as amended, and paragraph (c)(1)(vi)(B)(1)(iii)(A) of Rule 18a-1, nonbank SBSDs not authorized to use models are required to use an industry sector classification system that is documented and reasonable in terms of grouping types of companies with similar business activities and risk characteristics used for CDS reference obligors for purposes of calculating “haircuts” on non-cleared security-based swaps under applicable net capital rules.

As discussed above, the Commission staff estimates that 4 broker-dealer SBSDs and 2 nonbank SBSDs not using models will utilize the CDS haircut provisions under the amendments to Rules 15c3-1 and 18a-1, respectively. Consequently, these firms will use an industry sector classification system that is documented for the credit default swap reference obligors. The Commission expects that these firms will utilize external classification systems because of reduced costs and ease of use as a result of the common usage of several of these classification systems in the financial services industry. The Commission staff estimates that nonbank SBSDs not using models will spend approximately 1 hour per year documenting these industry sector classification systems, for a total annual hour burden of 6 hours.[862]

Fourth, under paragraph (h) of Rule 18a-1, a nonbank SBSD is required to file certain notices with the Commission relating to the withdrawal of equity capital. Broker-dealers—which will include broker-dealer SBSDs—currently are required to file these notices under paragraph (e) of Rule 15c3-1. Based on the number of notices currently filed by broker-dealers, the Commission staff estimates that the notice requirements will result in annual hour burdens to stand-alone SBSDs. The Commission staff estimates that each of the 6 stand-alone SBSDs will file approximately 2 notices annually with the Commission. In addition, the Commission staff estimates that it will take a stand-alone SBSD approximately 30 minutes to file these notices, resulting in an industry-wide annual hour burden of 6 hours.[863]

Fifth, under Rule 18a-1d, a nonbank SBSD is required to file a proposed subordinated loan agreement with the Commission (including nonconforming subordinated loan agreements). Broker-dealers currently are subject to such a requirement. Based on staff experience with Rule 15c3-1, the Commission staff estimates that each of the 6 stand-alone SBSDs will spend approximately 20 hours of internal employee resources drafting or updating its subordinated loan agreement template to comply with the requirement, resulting in an industry-wide one-time hour burden of approximately 120 hours.[864] In addition, based on staff experience with Rule 15c3-1, the Commission staff estimates that each stand-alone SBSD will file 1 proposed subordinated loan agreement with the Commission per year and that it will take a firm approximately 10 hours to prepare and file the agreement, resulting in an industry-wide annual hour burden of approximately 60 hours.[865]

Finally, as a result of comments received, Rules 15c3-1 and 18a-1 Start Printed Page 43963permit a stand-alone broker-dealer and a nonbank SBSD to treat collateral held by a third-party custodian to meet an initial margin requirement of a security-based swap or swap customer as being held by the stand-alone broker-dealer or nonbank SBSD for purposes of the capital deduction in lieu of margin provisions of the rule if certain conditions are met. The Commission staff estimates that the 16 broker-dealer SBSDs and 6 stand-alone SBSDs will engage outside counsel to draft and review the account control agreement at a cost of $400 per hour for an average of 20 hours per respondent, resulting in a one-time cost burden of $176,000 for these 22 entities.[866] Based on staff experience with the net capital and customer protection rules, the Commission estimates that the 16 broker-dealer SBSDs and 6 stand-alone SBSDs will enter into approximately 100 account control agreements per year with security-based swap customers and that it will take approximately 2 hours to execute each account control agreement, resulting in an industry-wide annual hour burden of 4,400 hours.[867]

The Commission staff estimates 16 broker-dealer SBSDs and 6 stand-alone SBSDs will need to maintain written documentation of their legal analysis of the account control agreement. Based on staff experience, the Commission estimates that broker-dealers (including broker-dealer SBSDs) and stand-alone SBSDs will meet this requirement split evenly between obtaining a written opinion of outside legal counsel or through the firm's own “in-house” analysis. The Commission estimates that the approximate cost to a broker-dealer (including a broker-dealer SBSD) or a stand-alone SBSD to obtain an opinion of counsel will be $8,000.[868] This figure is based on an estimate of 20 hours per opinion for outside counsel at $400 per hour, resulting in an industry-wide one-time cost of $88,000.[869] In addition, the Commission estimates it will take a broker-dealer (including a broker-dealer SBSD) or a stand-alone SBSD approximately 20 hours to conduct a written “in house” analysis, resulting in an industry-wide one-time hour-burden of 220 hours.[870]

2. Rule 18a-2

Rule 18a-2 requires nonbank MSBSPs to have and maintain positive tangible net worth and implement a system of internal risk management controls under Rule 15c3-4. The Commission staff estimates that the average amount of time a firm will spend implementing its risk management control system will be 2,000 hours,[871] resulting in an industry-wide one-time hour burden of 10,000 hours.[872]

In implementing its policies and procedures, a nonbank MSBSP will be required to document and record its system of internal risk management controls, and prepare and maintain written guidelines regarding its internal control system. The Commission staff estimates that each of the 5 nonbank MSBSPs will spend approximately 250 hours per year reviewing and updating their risk management control systems to comply with Rule 15c3-4, resulting in an industry-wide annual hour burden of approximately 1,250 hours.[873]

Because nonbank MSBSPs may not initially have the systems or expertise internally to meet the risk management requirements of Rule 18a-2, these firms will likely hire an outside risk management consultant to assist them in implementing their risk management systems. The Commission staff estimates that a nonbank MSBSP may hire an outside management consultant for approximately 200 hours to assist the firm for a total start-up cost to the nonbank MSBSP of $80,000 per MSBSP, or a total of $400,000 for all nonbank MSBSPs.[874]

Nonbank MSBSPs may incur start-up costs to comply with Rule 18a-2, including information technology costs. Based on the estimates for similar collections of information,[875] the Commission staff expects that a nonbank MSBSP will incur an average of approximately $16,000 for initial hardware and software expenses, while the average ongoing cost will be approximately $20,500 per nonbank MSBSP to meet the requirements of the Rule 18a-2, for a total industry-wide initial cost of $80,000 and ongoing cost of $102,500.[876]

3. Rule 18a-3

Paragraph (e) of Rule 18a-3 requires a nonbank SBSD to establish and implement risk monitoring procedures with respect to counterparty accounts. Because these firms will be required to comply with Rule 15c3-4, the Commission staff estimates that each of the 22 nonbank SBSDs will spend an average of approximately 210 hours establishing the written risk analysis methodology, resulting in an industry-wide one-time hour burden of approximately 4,620 hours.[877] In Start Printed Page 43964addition, based on staff experience, the Commission staff estimates that a nonbank SBSD will spend an average of approximately 60 hours per year reviewing the written risk analysis methodology and updating it as necessary, resulting in an average industry-wide annual hour burden of approximately 1,500 hours.[878]

Start-up costs may vary depending on the size and complexity of the nonbank SBSD. In addition, the start-up costs may be less for the 16 broker-dealer SBSDs because these firms may already be subject to similar margin requirements.[879] For the remaining 6 nonbank SBSDs, because these written procedures may be novel undertakings for these firms, the Commission staff assumes these nonbank SBSDs will have their written risk analysis methodology reviewed by outside counsel. As a result, the Commission staff estimates that these nonbank SBSDs will likely incur $2,000 in legal costs, or $12,000 in the aggregate initial burden to review and comment on these materials.[880]

Based on comments received, the Commission modified the language in the final rule to provide that a nonbank SBSD may use a model to calculate the initial margin amount under the rule, if the use of the model has been approved by the Commission. Paragraph (d) of Rule 18a-3, as adopted, provides that a nonbank SBSD seeking approval to use a margin model will be subject to an application process and ongoing conditions set forth in Rule 15c3-1e and paragraph (d) of Rule 18a-1 governing the use of internal models to compute net capital.

Based on staff experience, the Commission estimates it will take a nonbank SBSD approximately 50 hours to prepare and submit an application to the Commission to seek authorization to use a model to calculate initial margin. Based on observations regarding market participants' implementation of final swap margin rules adopted by other regulators, the Commission believes it is likely that 22 nonbank SBSDs will seek Commission approval to use a model to calculate initial margin resulting in a total industry-wide one-time hour burden of 1,100 hours.[881] The Commission also estimates that each nonbank SBSD will spend approximately 250 hours per year reviewing, updating, and backtesting their initial margin model, resulting in a total industry-wide annual hour burden of 5,500 hours.[882]

4. Rule 18a-4 and Amendments to Rule 15c3-3

As discussed above in section II.C. of this release, the Commission is amending Rule 15c3-3 to establish security-based swap segregation requirements for stand-alone broker-dealers and broker-dealer SBSDs and adopting Rule 18a-4 to establish largely parallel segregation requirements applicable to stand-alone and bank SBSDs, as well as notification requirements for nonbank SBSDs. The Commission estimates that 41 respondents, consisting of 25 stand-alone broker-dealers and 16 broker-dealer SBSDs, will be subject to the physical possession or control and reserve account requirements for security-based swaps in paragraph (p) of Rule 15c3-3.[883] The Commission estimates that 17 respondents, consisting of 16 broker-dealer SBSDs and 1 broker-dealer MSBSP, will be subject to paragraph (p)(4)(i)'s counterparty notification requirement with respect to non-cleared security-based swap transactions. The Commission estimates that 16 broker-dealer SBSDs will be subject to the requirement to obtain a subordination agreement from counterparties in paragraph (p)(4)(ii) of Rule 15c3-3.

Rule 18a-4, as adopted, will apply to SBSDs and MSBSPs that are not also registered as broker-dealers with the Commission.[884] The Commission estimates that 3 stand-alone SBSDs and 4 MSBSPs will be subject to the collection of information requirements of Rule 18a-4, as adopted (because the Commission estimates that the 25 bank SBSD and 6 stand-alone SBSDs will be exempt from the omnibus segregation requirements).[885]

Under Rule 18a-4 and the amendments to Rule 15c3-3, SBSDs and broker-dealers engaged in security-based swap activities are required to establish special reserve accounts with banks and obtain written acknowledgements from, and enter into written contracts with, the banks. Based on staff experience with Rule 15c3-3, the Commission staff estimates that each of the 44 respondents [886] will establish 6 special reserve accounts at banks (2 for each type of special reserve account). Further, based on staff experience with Rule 15c3-3, the Commission staff estimates that each respondent will spend approximately 30 hours to draft and obtain the written acknowledgement and agreement for each account, resulting in an industry-wide one-time hour burden of approximately 7,920 hours.[887] The Commission staff estimates that 25%[888] of the 44 respondents (approximately 11 respondents) will establish a new special reserve account each year because, for example, they change their banking relationship, for each type of special reserve account. Therefore, the Commission staff estimates an industry-wide annual hour burden of approximately 990 hours.[889]

Paragraph (c)(1) of Rule 18a-4 and paragraph (p)(3)(i) of Rule 15c3-3 Start Printed Page 43965provide that the SBSD or broker-dealer engaged in security-based swap activities must at all times maintain in a special reserve account, through deposits into the account, cash and/or qualified securities in amounts computed in accordance with the formula set forth in Exhibit A to Rule 18a-4 and Exhibit B to Rule 15c3-3. Paragraph (c)(3) of Rule 18a-4 and paragraph (p)(3)(iii) of Rule 15c3-3 provide that the computations necessary to determine the amount required to be maintained in the special bank account must be made on a weekly basis. Based on experience with the Rule 15c3-3 reserve computation paperwork burden hours and with the OTC derivatives industry, the Commission staff estimates that it will take 1-5 hours to compute each reserve computation, and that the average time spent across all the respondents will be approximately 2.5 hours. Accordingly, the Commission staff estimates that the resulting industry-wide annual hour burden is approximately 5,720 hours.[890]

Under paragraph (d)(1) of Rule 18a-4, paragraph (f)(2) of Rule 18a-4, and paragraph (p)(4)(i) of Rule 15c3-3, an SBSD or an MSBSP is required to provide a notice to a counterparty prior to their first non-cleared security-based swap transaction after the compliance date. All 50 SBSDs and 5 MSBSPs are required to provide these notices to their counterparties. The Commission staff estimates that these 55 entities will engage outside counsel to draft and review the notice at a cost of $400 per hour for an average of 10 hours per respondent, resulting in a one-time cost burden of $220,000 for all of these 55 entities.[891]

The number of notices sent in the first year the rule is effective will depend on the number of counterparties with which each SBSD or MSBSP engages in security-based swap transactions. The number of counterparties an SBSD or MSBSP has will vary depending on the size and complexity of the firm and its operations. The Commission staff estimates that each of the 50 SBSDs and 5 MSBSPs will have approximately 1,000 counterparties at any given time.[892] Therefore, the Commission staff estimates that approximately 55,000 notices will be sent in the first year the rule is effective.[893] The Commission staff estimates that each of the 50 SBSDs and 5 MSBSPs will spend approximately 10 minutes sending out the notice, resulting in an industry-wide one-time hour burden of approximately 9,167 hours.[894] The Commission staff further estimates that the 50 SBSDs and 5 MSBSPs will establish account relationships with 200 new counterparties per year. Therefore, the Commission staff estimates that approximately 11,000 notices will be sent annually,[895] resulting in an industry-wide annual hour burden of approximately 1,833 hours.[896]

Under paragraph (d)(2) of Rule 18a-4 and paragraph (p)(4)(ii) of Rule 15c3-3, an SBSD is required to obtain subordination agreements from certain counterparties. The Commission staff estimates that each SBSD will spend, on average, approximately 200 hours to draft and prepare standard subordination agreements, resulting in an industry-wide one-time hour burden of 3,800 hours.[897] Because the SBSD will enter into these agreements with security-based swap customers, after the SBSD prepares a standard subordination agreement in-house, the Commission staff also estimates that an SBSD will have outside counsel review the standard subordination agreements and that the review will take approximately 20 hours at a cost of approximately $400 per hour. As a result, the Commission staff estimates that each SBSD will incur one-time costs of approximately $8,000,[898] resulting in an industry-wide one-time cost of approximately $152,000.[899]

As discussed above, the Commission staff estimates that each of the 19 SBSDs would have approximately 1,000 counterparties at any given time. The Commission staff further estimates that approximately 50% of these counterparties will either elect individual segregation or, if permitted, to waive segregation altogether.[900] The Commission staff estimates that an SBSD will spend 20 hours per counterparty to enter into a written subordination agreement, resulting in an industry-wide one-time hour burden of approximately 190,000 hours.[901] Further, as discussed above, the Commission staff estimates that each of the 19 SBSDs will establish account relationships with 200 new counterparties per year. The Commission staff further estimates that 50% or 100 of these counterparties will either elect individual segregation or, if permitted, to waive segregation altogether. Therefore, the Commission staff estimates an industry-wide annual hour burden of approximately 38,000 hours.[902]

Start Printed Page 43966

Paragraph (e) of Rule 18a-4 establishes exemptions for foreign stand-alone or bank SBSDs and MSBSPs from the segregation requirements in Section 3E of the Exchange Act, and the rules and regulations thereunder, with respect to certain transactions. The Commission previously estimated that there will be 22 foreign SBSDs, but does not have sufficient information to reasonably estimate the number of foreign firms that are dually registered as broker-dealers or are foreign banks, how many U.S. counterparties foreign stand-alone or bank SBSDs will have, and how many eligible firms will opt out of complying with Section 3E of the Exchange Act and the rules and regulations thereunder. Moreover, as discussed above, the Commission estimates that the 25 bank SBSDs and 6 stand-alone SBSDs will be exempt from the omnibus segregation requirements. Therefore, the Commission is making the conservative estimate that 22 foreign SBSDs will be subject to paragraph (e) of Rule 18a-4.

Under paragraph (e)(3) of Rule 18a-4, foreign SBSDs are required to provide disclosures in writing to their U.S. counterparties. The Commission believes that, in most cases, these disclosures will be made through amendments to the foreign SBSD's existing trading documentation.[903] Because these disclosures relate to new regulatory requirements, the Commission anticipates that all foreign SBSDs will need to incorporate new language into their existing trading documentation with U.S. counterparties. Disclosure of the potential treatment of segregated assets in insolvency proceedings under U.S. bankruptcy law and foreign insolvency laws pursuant to paragraph (e)(3) of Rule 18a-4 will likely vary depending on the counterparty's jurisdiction. Accordingly, the Commission expects that these disclosures often may need to be tailored to address the particular circumstances of each trading relationship. However, in some cases, trade associations or industry working groups may be able to develop standard disclosure forms that can be adopted by foreign SBSDs with little or no modification. In either case, the paperwork burden associated with developing new disclosure language and incorporating this language into a registered foreign SBSD's trading documentation will vary depending on: (1) The number of non-U.S. counterparties with whom the registered foreign SBSD trades; (2) the number of jurisdictions represented by the foreign SBSD's counterparties; and (3) the availability of standardized disclosure language. To the extent standardized disclosures become available, the paperwork burden on foreign SBSDs will be limited to amending existing trading documentation to incorporate the standardized disclosures. Conversely, more time will be necessary where a greater degree of customization is required to develop the required disclosures and incorporate this language into existing documentation.

The Commission estimates the maximum total paperwork burden associated with developing new disclosure language will require each of the 22 foreign SBSDs to spend 5 hours of in-house counsel time on 30 jurisdictions.[904] This will create a total one-time industry burden of 3,300 hours.[905] This estimate assumes little or no reliance on standardized disclosure language. In addition, the Commission estimates the total paperwork burden associated with incorporating new disclosure language into each foreign SBSD's trading documentation will be approximately 11,000 hours for all 22 foreign SBSDs.[906]

The Commission expects that the majority of the paperwork burden associated with the new disclosure requirements will be experienced during the first year as language is developed, whether by individual foreign SBSDs or through collaborative efforts, and trading documentation is amended. After the new disclosure language is developed and incorporated into trading documentation, the Commission believes that the ongoing burden associated with paragraph (e) of Rule 18a-4, as adopted, will be limited to periodically updating the disclosures to reflect changes in the applicable law or to incorporate new jurisdictions with security-based swap counterparties. The Commission estimates that this ongoing paperwork burden will not exceed 110 hours per year for all 22 foreign SBSDs (approximately 5 hours per foreign SBSD per year).

Paragraph (f) of Rule 18a-4 provides an exemption from the rule's requirements if certain conditions are met. These conditions include a requirement in paragraph (f)(3) of the rule that the stand-alone or bank SBSD must provide notice to a counterparty regarding the right to segregate initial margin at an independent third-party custodian, and make certain disclosures in writing regarding collateral received by the SBSD.[907]

Paragraph (f)(3) of Rule 18a-4 requires disclosure that margin collateral received and held by the firm will not be subject to a segregation requirement and of how a claim of a counterparty for the collateral would be treated in a bankruptcy or other formal liquidation proceeding of the firm. The Commission estimates the maximum total paperwork burden associated with developing new disclosure language for the purposes of this provision will require each of the 31 SBSDs (25 bank SBSDs and 6 stand-alone SBSDs) to spend 5 hours of in-house counsel time. This will create a total one-time industry burden of 155 hours.[908] This estimate assumes little or no reliance on standardized disclosure language. In addition, the Commission estimates the total paperwork burden associated with incorporating new disclosure language into each SBSD's trading documentation will be approximately 310,000 hours for all 31 SBSDs.[909] The Commission expects that the majority of the paperwork burden associated with the new disclosure requirements under paragraph (f)(3) of Rule 18a-4, as adopted will be experienced during the first year as language is developed. After the new disclosure language is developed and incorporated into trading documentation, the Commission believes that the ongoing burden associated with paragraph (f)(3) of Rule 18a-4, as adopted, will be limited to periodically updating the disclosures. The Commission estimates that this ongoing paperwork burden will not exceed 155 hours per year for all 31 Start Printed Page 43967SBSDs (approximately 5 hours per SBSD per year).[910]

5. Rule 18a-10

In response to comments urging the Commission to harmonize requirements with the CFTC, as well as specific comments requesting that the Commission defer to the CFTC's rules if a nonbank SBSD is registered as a swap dealer and conducts only a limited amount of security-based swaps business, the Commission is adopting new Rule 18a-10. Rule 18a-10 contains an alternative compliance mechanism pursuant to which a stand-alone SBSD that is registered as a swap dealer and predominantly engages in a swaps business may elect to comply with the capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of complying with Rules 18a-1, 18a-3, and 18a-4. As discussed above, the Commission estimates that 3 stand-alone SBSDs will elect to operate under Rule 18a-10. These respondents were included in the proposing release in other collections of information (Rule 18a-1 and Rule 18a-3, as proposed), and have been moved to the information collection for new Rule 18a-10.[911]

The Commission estimates paperwork burden associated with developing new disclosure language under paragraph (b)(2) of Rule 18a-10 will require each of the 3 stand-alone SBSDs to spend 5 hours of in-house counsel time. This would create a total one-time industry burden of 15 hours.[912] This estimate assumes little or no reliance on standardized disclosure language. In addition, the Commission estimates the total paperwork burden associated with incorporating new disclosure language into each stand-alone SBSD's trading documentation will be approximately 30,000 hours for all 3 stand-alone SBSDs.[913] The Commission expects that the majority of the paperwork burden associated with the new disclosure requirements under paragraph (b)(2) of Rule 18a-10, as adopted, will be experienced during the first year as language is developed. After the new disclosure language is developed and incorporated into trading documentation, the Commission believes that the ongoing burden associated with paragraph (b)(2) of Rule 18a-10 will be limited to periodically updating the disclosures. The Commission estimates that this ongoing paperwork burden will not exceed 15 hours per year for all 3 stand-alone SBSDs.[914]

Based on the number of notices currently filed by broker-dealers, the Commission staff estimates that the notice requirement of paragraph (b)(3) of Rule 18a-10 will result in annual hour burdens to stand-alone SBSDs. The Commission staff estimates that 1 stand-alone SBSD will file 1 notice annually with the Commission. In addition, the Commission staff estimates that it will take a stand-alone SBSD approximately 30 minutes to file this notice, resulting in an industry-wide annual hour burden of 30 minutes.[915]

Finally, under paragraphs (d)(1) and (d)(2) of Rule 18a-10, respectively, a stand-alone SBSD can make an election to operate under the alternative compliance mechanism, during the registration process or after the firm registers as an SBSD, by providing written notice to the Commission and the CFTC of its intent to operate pursuant to the rule. The Commission believes that in the first 3 years of the effective date of the rule that the 3 nonbank SBSDs that elect to operate under Rule 18a-10 will file the notice as part of their application process. Therefore, the Commission believes that the time it would take an entity to file a notice as part of the application process would be de minimis and, therefore, would not result in an hour burden for this collection of information or any collection of information associated with registering with the Commission as an SBSD.[916] Finally, since the Commission believes that the 3 nonbank SBSDs will elect to operate under the rule as part of their registration process, the Commission believes that there will be no respondents, and no paperwork hour or cost burden under the PRA associated with paragraph (d)(2) of Rule 18a-10, as adopted.

6. Rule 3a71-6

Rule 3a71-6, as amended, will require submission of certain information to the Commission to the extent person request a substituted compliance determination with respect to the Title VII capital and margin requirements. The Commission expects that foreign SBSDs and MSBSPs will seek to rely on substituted compliance upon registration, and that it is likely that the majority of such requests will be made during the first year following the effective date of this amendment. Requests would not be necessary with regard to applicable rules and regulations of a foreign jurisdiction that have previously been the subject of a substituted compliance determination in connection with the applicable rules.

The Commission expects that the majority of substituted compliance applications will be submitted by foreign authorities, and that very few substituted compliance requests will come from SBSDs or MSBSPs. For purposes of this assessment, the Commission estimates that 3 SBSDs or MSBSPs will submit such applications in connection with the Commission's capital and margin requirements.[917] After consideration of the release adopting Rule 3a71-6, the Commission estimates that the total paperwork burden incurred by such entities associated with preparing and submitting a request for a substituted compliance determination in connection with the capital and margin requirements will be approximately 240 hours, plus $240,000 for the services of outside professionals for all 3 requests.[918]

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E. Collection of Information is Mandatory

The collections of information pursuant to the amendments and new rules are mandatory, as applicable, for ANC broker-dealers, broker-dealers, SBSDs, and MSBSPs. Compliance with the collection of information requirements associated with Rule 3a71-6, regarding the availability of substituted compliance, is mandatory for all foreign financial authorities, foreign SBSDs, or foreign MSBSPs that seek a substituted compliance determination. Compliance with the collection of information requirements associated with Rule 18a-10 regarding the availability of an alternative compliance mechanism is mandatory for all stand-alone SBSDs that elect to operate under the conditions of the rule.

F. Confidentiality

The Commission expects to receive confidential information in connection with the collections of information. To the extent that the Commission receives confidential information pursuant to these collections of information, such information will be kept confidential, subject to the provisions of applicable law.[919]

G. Retention Period for Recordkeeping Requirements

Under Rule 17a-4, ANC broker-dealers are required to preserve for a period of not less than 3 years, the first 2 years in an easily accessible place, certain records required under Rule 15c3-4 and certain records under Rule 15c3-1e. Rule 17a-4 specifies the required retention periods for a broker-dealer. Many of a broker-dealer's records must be retained for 3 years; certain other records must be retained for longer periods.

V. Other Matters

Pursuant to the Congressional Review Act,[920] the Office of Information and Regulatory Affairs has designated these rules as a “major rule,” as defined by 5 U.S.C. 804(2).

VI. Economic Analysis

The Commission is adopting: (1) Rules 18a-1 and 18a-2, and amendments to Rule 15c3-1, to establish capital requirements for nonbank SBSDs and MSBSPs; (2) Rule 18a-3 to establish margin requirements for non-cleared security-based swaps applicable to nonbank SBSDs and MSBSPs; and (3) Rule 18a-4, and amendments to Rule 15c3-3, to establish segregation requirements for SBSDs and notification requirements with respect to segregation for SBSDs and MSBSPs.[921] Some of the amendments to Rules 15c3-1 and 15c3-3 will apply to stand-alone broker-dealers to the extent that they engage in security-based swap or swap activities.[922] The Commission also is amending Rule 15c3-1 to increase the minimum net capital requirements for ANC broker-dealers and amending Rule 3a71-6 to address the potential availability of substituted compliance in connection with the Commission's capital and margin requirements for foreign SBSDs and MSBSPs. Further, the Commission is adopting an alternative compliance mechanism in Rule 18a-10 pursuant to which a stand-alone SBSD that is registered as a swap dealer and predominantly engages in a swaps business may elect to comply with the capital, margin, and segregation requirements of the CEA and the CFTC's rules in lieu of complying with the capital, margin, and segregation requirements being adopted today. Finally, the Commission is adopting a rule that specifies when a foreign non-broker-dealer SBSD or MSBSP need not comply with the segregation requirements of Section 3E of the Exchange Act and the rules thereunder.

The Commission is sensitive to the economic impacts of the rules it is adopting. Some of the costs and benefits stem from statutory mandates, while others are affected by the discretion exercised in implementing the mandates. The following economic analysis seeks to identify and consider the economic effects—including the benefits, costs, and effects on efficiency, competition, and capital formation—that will result from the adoption of Rules 18a-1, 18a-2, 18a-3, 18a-4, and Rule 18a-10, and from the adoption of the amendments to Rules 15c3-1, 15c3-3, and 3a71-6. The economic effects considered in adopting these new rules and amendments are discussed below and have informed the policy choices described throughout this release.

The discussion below provides a baseline against which the rules may be evaluated. For the purposes of this economic analysis, the baseline incorporates the state of the security-based swap and swap markets as they exist today and does not include any of the regulatory provisions that have not yet been adopted. However, to the extent that such provisions have been anticipated by and therefore affected the behavior of market participants those practices will be considered part of the baseline.

The Commission does not currently have comprehensive data on the state of the U.S. security-based swap and swap markets. Consequently, the Commission is using the limited data currently available to develop the baseline and to inform the following analysis of the anticipated costs and benefits resulting from the rules and amendments being adopted today.[923] These rules and amendments have the potential to significantly affect efficiency, competition, and capital formation in the security-based swap and swap markets, with the impact not being limited to the specific entities that fall within the meaning of the terms “security-based swap dealer” and “major security-based swap Start Printed Page 43969participant.” The following analysis will also consider these effects.

A. Baseline

To assess the economic impact of the capital, margin, and segregation rules being adopted today, the Commission is using as its baseline the state of the security-based swap and swap markets as they exist at the time of this release, including applicable rules the Commission has already adopted, but excluding rules the Commission has proposed but not finalized.[924] The analysis includes the statutory provisions that currently govern the security-based swap market pursuant to the Dodd-Frank Act, and rules adopted by the Commission regarding: (1) Entity definitions; [925] (2) cross-border activities; [926] (3) registration of security-based swap data repositories; [927] (4) registration of SBSDs and MSBSPs; [928] (5) reporting and dissemination of security-based swap information; [929] (6) dealing activity of non-U.S. persons with a U.S. connection; [930] (7) business conduct standards; [931] (8) trade acknowledgments; [932] and (9) applications with respect to statutory disqualifications.[933] These statutes and final rules—even if compliance is not yet required—are part of the existing regulatory landscape that market participants expect to govern their security-based swap activity. There are limitations in the degree to which the Commission can quantitatively characterize the current state of the security-based swap market. As described in more detail below, because the available data on security-based swap transactions do not cover the entire market, the Commission has developed its understanding of market activity using a sample that includes only certain portions of the market.

Under the baseline, the security-based swap and swap markets are dominated, both globally and domestically, by a small number of firms, generally entities that are, or are affiliated with, large commercial banks.[934] The economic impacts of the rules and amendments being adopted here are expected to primarily stem from their effect on the relatively small number of entities that act as dealers and major participants in this market. These firms will become subject to the segregation requirements of Rule 15c3-3, as amended, or Rule 18a-4 with respect to security-based swap transactions. These firms—if they are a stand-alone broker-dealer, nonbank SBSD, or nonbank MSBSP—will also become subject to the capital requirements of Rules 15c3-1, 18a-1, and/or 18a-2, as applicable, and—if they are a nonbank SBSD and MSBSP—will also become subject to the margin requirements of Rule 18a-3.[935] Many of the directly affected entities—including nonbank entities—are currently part of a bank holding company. Therefore, certain Federal Reserve regulations applicable to these entities (at the bank-holding company level) enter into the baseline and otherwise impact the analysis of the costs and benefits. Moreover, participants in the security-based swap and swap markets can fall under a number of other regulatory regimes, including those of: the prudential regulators, the CFTC, or numerous international regulatory authorities.[936]

Prior to the Dodd-Frank Act, many participants in the security-based swap and swap markets generally were not directly supervised by the Commission.[937] The Commission does not possess regulatory reports from many of these entities that can be used to determine the nature and extent of their participation in these markets. Consequently, in the Commission's analysis, the nature of an entity's participation in these markets will generally be inferred from transaction data. Market participants meeting the registration thresholds outlined in the Commission's intermediary definitions [938] and cross-border rules are expected to register with the Commission.[939] As discussed elsewhere, the Commission expects that up to 50 entities may register as SBSDs, and that up to an additional five entities may register as MSBSPs.[940] In addition, the Commission estimates that, of the 50 entities expected to register as SBSDs, 16 are registered with the Commission as broker-dealers.[941] Of the 50 entities expected to register as SBSDs, 22 are expected to be non-U.S. persons.[942]

Certain provisions in the amendments and the rules being adopted today affect broker-dealers. Thus, the baseline incorporates the current capital and segregation requirements for broker-dealers under Rules 15c3-1 and 15c3-3 as well as the current state of the Start Printed Page 43970broker-dealer industry.[943] However, because the Exchange Act's definition of “security” did not include security-based swaps until the definition was amended by the Dodd-Frank Act, dealing activity in security-based swaps did not require registration with the Commission as a broker-dealer. Therefore, these entities were not subject to the broker-dealer capital and segregation requirements of the Commission or the margin requirements of the Federal Reserve and the SROs. Moreover, existing broker-dealer capital and segregation requirements made it relatively costly for broker-dealers to trade security-based swaps.[944] As a result, security-based swap transactions have often been effected via entities that are affiliated with broker-dealers, but not via broker-dealers themselves.

The Commission is adopting requirements that apply to MSBSPs. An entity is an MSBSP if it is not an SBSD but nonetheless either: (1) Maintains a “substantial position” in security-based swaps for any of the major security-based swap categories; (2) has outstanding security-based swaps that create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or (3) is a “financial entity” that is “highly leveraged” relative to the amount of capital it holds (and that is not subject to capital requirements established by an appropriate federal banking agency) and maintains a “substantial position” in outstanding swaps or security-based swaps in any major category.[945] As with SBSDs, such entities have previously operated without the Commission's direct supervision (unless separately required to register as a broker-dealer). Based on available transaction data, the Commission has previously estimated that five or fewer entities currently active in the security-based swap market may ultimately register as MSBSPs.[946]

Because many of the entities that may register as SBSDs or MSBSPs are subsidiaries of U.S. and international bank holding companies, the baseline is affected by the relevant Federal Reserve regulations currently applicable at the consolidated bank holding company level,[947] as well as current foreign regulations of security-based swaps.

The amendments and rules being adopted today are primarily focused on security-based swap activities of stand-alone broker-dealers and nonbank SBSDs and MSBSPs. However, certain aspects of the amendments and rules being adopted will also affect the treatment of swaps such as interest rate swaps or CDS on broad-based security indices. For example, entities that are registered with the Commission as nonbank SBSDs but who also participate in the swap market will account for the swap positions in their capital calculations under the requirements being adopted today. Therefore, the Commission's analysis (and the baseline thereto) focuses on security-based swaps, but considers the broader swap market where appropriate.

The Commission's analysis of the state of the current security-based swap market is based on data obtained from the DTCC-TIW, particularly data regarding the activity of market participants in the single-name CDS market during the period from 2008 to 2017.[948] Although the capital, segregation, and margin rules being adopted today apply to all security-based swaps, not just single-name CDS, single-name CDS represent a significant portion of the security-based swap market.[949]

Although the Commission believes the DTCC-TIW data to be sufficient for characterizing the baseline state of the security-based swap market, the complexity of the U.S. regulatory structure presents difficulties in drawing inferences from this baseline. The security-based swap market is dominated by a small number of global financial firms.[950] These firms typically have considerable flexibility in structuring their activities. Such firms may choose to house their security-based swap dealing activities in one of several affiliated entities; the degree to which the rules and amendments being adopted today will apply will depend on these choices. If such activities are placed in a bank SBSD or MSBSP, such as a federally insured depository institution, the capital and margin rules being adopted today will not apply.[951] Conversely, if these activities are instead housed in an affiliated (U.S.) nonbank SBSD, the requirements being adopted today will apply in full. Thus, the requirements' impact will depend on firms' choice of organizational structure, which, in turn, will depend, in part, on the requirements' relative attractiveness compared to those of other regulators.

Available information about the global OTC derivatives market suggests that swap transactions, in contrast to security-based swap transactions, dominate trading activities, notional amounts, and market values.[952] The BIS estimates that the total notional amounts outstanding and gross market value of global OTC derivatives were $532 trillion and $11.0 trillion, respectively, as of the end of 2017. Of these totals, the BIS estimates that foreign exchange contracts, interest rate contracts, and commodity contracts comprised 97% of the total notional amount and 92% of the gross market value. CDS, including index CDS, comprised 1.8% of the total notional amount and 2.9% of the gross market value. Equity-linked contracts, including forwards, swaps and options, comprised an additional 1.2% of the total notional amount and 5.3% of the gross market value. Because the capital, margin, and segregation rules being adopted today for SBSDs and MSBSPs would apply to dealers and participants in the security-based swap market, they are expected to affect a substantially smaller portion of the U.S. OTC derivatives market than the capital, margin, and segregation rules of the CFTC and the prudential regulators for swap dealers and major swap participants.[953] Moreover, many of the Start Printed Page 43971participants in these markets may choose to engage in security-based swap transactions through their banking subsidiaries, further reducing the impact of the Commission's requirements.[954]

1. Market Participants

Transaction data from the DTCC-TIW indicates that security-based swap dealing activity is concentrated among a few dozen entities. In addition to these entities, thousands of other participants appear as counterparties to security-based swaps in the Commission's sample, and include, but are not limited to, investment companies, pension funds, private hedge funds, sovereign entities, and industrial companies. A detailed discussion of security-based swap market participants can be found in the Commission's release regarding applications with respect to statutory disqualifications.[955]

a. Dealing Structures

SBSDs use a variety of business models and legal structures to engage in dealing business for a variety of legal, tax, strategic, and business reasons.[956] Dealers may use a variety of structures in part to reduce risk and enhance credit protection based on the particular characteristics of each entity's business.

Bank and nonbank holding companies may use subsidiaries to deal with counterparties. Further, dealers may rely on multiple sales forces to originate security-based swap transactions. For example, a U.S. bank dealer may use a sales force in its U.S. home office to originate security-based swap transactions in the United States and use separate sales forces spread across foreign branches to originate security-based swap transactions with counterparties in foreign markets.

In some situations, an entity's performance under a security-based swap transaction may be supported by a guarantee provided by an affiliate. More generally, guarantees may take the form of a blanket guarantee of an affiliate's performance on all security-based swap contracts, or a guarantee may apply only to a specific transaction or counterparty. Guarantees may give counterparties to the dealer direct recourse to the holding company or another affiliate for its dealer-affiliate's obligations under security-based swap transactions for which that dealer-affiliate acts as counterparty.

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b. Security-Based Swap Market Participant Domiciles

As depicted in Figure 1, domiciles of new accounts participating in the market have shifted over time. It is unclear whether these shifts represent changes in the types of participants active in this market, changes in reporting, or changes in transaction volumes in particular underliers. For example, the percentage of new entrants that are foreign accounts increased from 24.4% in the first quarter of 2008 to 32.3% in the last quarter of 2017, which may reflect an increase in participation by foreign account holders in the security-based swap market, though the total number of new entrants that are foreign accounts decreased from 112 in the first quarter of 2008 to 48 in the last quarter of 2017.[958] Additionally, the percentage of the subset of new entrants that are foreign accounts managed by U.S. persons increased from 4.6% in the first quarter of 2008 to 16.8% in the last quarter of 2017, and the absolute number rose from 21 to 25, which also may reflect more specifically the flexibility with which market participants can restructure their market participation in response to regulatory intervention, competitive pressures, and other stimuli.[959] At the same time, apparent changes in the percentage of new accounts with foreign domiciles may also reflect improvements in reporting to the DTCC-TIW by market participants, an increase in the percentage of transactions between U.S. and non-U.S. counterparties, and/or increased transactions in single-name CDS on U.S. reference entities by foreign persons.[960]

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c. Security-Based Swap Market: Levels of Security-Based Swap Trading Activity

As noted above, firms that act as dealers play a central role in the security-based swap market. Based on an analysis of 2017 single-name CDS data from the DTCC-TIW, accounts of those firms that are likely to exceed the security-based swap dealer de minimis thresholds and trigger registration requirements intermediated transactions with a gross notional amount of approximately $2.9 trillion, approximately 55% of which was intermediated by the top five dealer accounts.[961] A commenter stated that security-based swap dealing activity is largely concentrated in U.S. and foreign banks, foreign dealers, OTC derivatives dealers, and “stand-alone SBSDs,” and that stand-alone broker-dealers are not significant participants.[962]

These dealers transact with hundreds or thousands of counterparties. Approximately 21% of accounts of firms expected to register as SBSDs and observable in the DTCC-TIW have entered into security-based swaps with over 1,000 unique counterparty accounts as of year-end 2017.[963] Another 25% of these accounts transacted with 500 to 1,000 unique counterparty accounts; 29% transacted with 100 to 500 unique accounts; and 25% of these accounts intermediated security-based swaps with fewer than 100 unique counterparties in 2017. The median dealer account transacted with 495 unique accounts (with an average of approximately 570 unique accounts). Non-dealer counterparties transacted almost exclusively with these dealers. The median non-dealer counterparty transacted with two dealer accounts (with an average of approximately 3 dealer accounts) in 2017.

Figure 2 describes the percentage of global, notional transaction volume in North American corporate single-name CDS reported to the DTCC-TIW from January 2008 through December 2017, separated by whether transactions are between two ISDA-recognized dealers (interdealer transactions) or whether a transaction has at least one non-dealer counterparty.

Figure 2 also shows that the portion of the notional volume of North American corporate single-name CDS represented by interdealer transactions has remained fairly constant through 2015 before falling from approximately 72% in 2015 to approximately 40% in 2017. This fall corresponds to the availability of clearing to non-dealers. Interdealer transactions continue to represent a significant portion of trading activity even as notional volume has declined over the past 10 years,[964] from Start Printed Page 43974more than $6 trillion in 2008 to less than $700 billion in 2017.[965]

Against this backdrop of declining North American corporate single-name CDS activity, about half of the trading activity in North American corporate single-name CDS reflected in the analyzed dataset was between counterparties domiciled in the United States and counterparties domiciled abroad, as shown in Figure 3 below. Using the self-reported registered office location of the DTCC-TIW accounts as a proxy for domicile, Commission staff estimates that only 12% of the global transaction volume by notional volume between 2008 and 2017 was between two U.S.-domiciled counterparties, compared to 49% entered into between one U.S.-domiciled counterparty and a foreign-domiciled counterparty and 39% entered into between two foreign-domiciled counterparties.[966]

If one considers the number of cross-border transactions instead from the perspective of the domicile of the corporate group (e.g., by classifying a foreign bank branch or foreign subsidiary of a U.S. entity as domiciled in the United States), the percentages shift significantly. Under this approach, the fraction of transactions entered into between two U.S.-domiciled counterparties increases to 34%, and to 51% for transactions entered into between a U.S.-domiciled counterparty and a foreign-domiciled counterparty.

By contrast, the proportion of activity between two foreign-domiciled counterparties drops from 39% to 15%. This change in respective shares based on different classifications suggests that the activity of foreign subsidiaries of U.S. firms and foreign branches of U.S. banks accounts for a higher percentage of security-based swap activity than the activity of U.S. subsidiaries of foreign firms and U.S. branches of foreign banks. It also demonstrates that financial groups based in the United States are involved in an overwhelming majority (approximately 85%) of all reported transactions in North American corporate single-name CDS.

Financial groups based in the United States are also involved in a majority of interdealer transactions in North American corporate single-name CDS. Of the 2017 transactions in North American corporate single-name CDS between two ISDA-recognized dealers and their branches or affiliates, 94% of transaction notional volume involved at least one account of an entity with a U.S. parent.

In addition, a majority of North American corporate single-name CDS transactions occur in the interdealer market or between dealers and foreign non-dealers, with the remaining portion of the market consisting of transactions between dealers and U.S.-person non-dealers. Specifically, 60% of North American corporate single-name CDS transactions involved either two ISDA-recognized dealers or an ISDA-recognized dealer and a foreign non-dealer. Approximately 39% of such transactions involved an ISDA-recognized dealer and a U.S.-person non-dealer.

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d. Open Positions

Based on analysis of data from the DTCC-TIW, Table 1 describes the gross notional amount of open positions in non-cleared single-name CDS between different types of market participants (i.e., “accounts”) at the end of 2017. Gross notional amount of open positions between two types of market participants is the sum of the notional amounts in U.S. dollars of all outstanding CDS contracts between the two types of market participants.

At the end of 2017, the gross notional amount of open positions between ISDA-recognized dealers far exceeded the gross notional amount of open positions between all other types of market participants. In particular, the gross notional amount of open positions between ISDA-recognized dealers (“interdealer”) was approximatively $1.25 trillion in non-cleared single-name CDS contracts and $557 billion in non-cleared index CDS contracts. The gross notional amount of open positions other than interdealer was approximatively $525 billion in non-cleared single-name CDS contracts and just over $1 trillion in non-cleared index CDS contracts.

Banks and private funds were among the most active market participants that were not ISDA-recognized dealers. The gross notional amount of open positions between ISDA-recognized dealers and banks was approximatively $184 billion in non-cleared single-name CDS contracts and $113 billion in non-cleared index CDS contracts. Similarly, the gross notional amount of open positions between ISDA-recognized dealers and private funds was approximatively $176 billion in non-cleared single-name CDS contracts and $410 billion in non-cleared index CDS contracts.

Table 1—Gross Notional Amount of Dealer-Intermediated Open Positions in Non-Cleared CDs at the End of 2017

[Billions of U.S. dollars]

Single-name CDSIndex CDS
ISDA-Recognized Dealers1,252557
Banks184113
Insurance Companies2030
Private Funds176410
Registered Investment Companies2462
Non-financial Corporations<1<1
DFA Special Entities44
Foreign Sovereign618
Finance Companies1<1
Others100187
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Others/Unclassified<1188.57

Dealing entities that are likely to register as SBSDs generally have significant open positions in the single-name CDS market. For each dealing entity that is expected to register as an SBSD and for which DTCC-TIW positions data are available as of the end of September 2017, the Commission identifies the cleared and non-cleared single-name CDS positions that the entity holds against its counterparties. The Commission then calculates the aggregate gross notional amount of each entity's open single-name CDS positions. For these 23 dealing entities, the mean, median, maximum, and minimum aggregate gross notional amount are respectively, $219 billion, $115 billion, $902 billion, and $3 billion. The standard deviation in aggregate gross notional amounts is $242 billion.

These entities also engage in dealing activity in the swap market. The aggregate gross notional amounts of their open positions in the swap market have a mean of $11,725 billion, a median of $10,244 billion, a minimum of $72 billion, a maximum of $45,264 billion, and a standard deviation of $10,496 billion.[967] To gauge the relative significance of single-name CDS open positions, the Commission expresses each entity's single-name CDS aggregate gross notional amount as a percentage of its combined swaps and single-name CDS aggregate gross notional amount. The mean, median, maximum, and minimum percentages are respectively 1.34%, 1.23%, 0.03%, and 5.39%. The standard deviation is 1.13%.

e. Cross-Market Participation

The numerous financial markets are integrated, often attracting the same market participants that trade across corporate bond, swap, and security-based swap markets, among others. In a prior release, the Commission discussed the hedging opportunities across the single-name CDS and index CDS markets and how such hedging opportunities in turn influence the extent to which participants that are active in the single-name CDS market are likely to be active in the index CDS market.[968]

2. Counterparty Credit Risk Mitigation

In contrast to the securities markets, counterparty credit risk represents a major source of risk to participants in the OTC security-based swap market.[969] For example, in a CDS transaction, the first party, the protection buyer, agrees to pay the second party, the protection seller, a periodic premium for a set time period in exchange for the protection seller agreeing to pay some amount in the event of the occurrence of a given credit event during the same period. The ongoing reciprocal obligations of the parties in such transactions expose each to ongoing reciprocal counterparty credit risk.

Currently, security-based swap market participants mitigate counterparty credit risk by: (1) Using a central counterparty (“CCP”) such as a clearing agency or DCO to clear a trade; (2) using standardized netting agreements between counterparties; (3) performing portfolio compression to minimize counterparty exposure; and (4) requiring margin (i.e., collateral). Below is a brief discussion of the extent to which market participants make use of each of these practices in the CDS market, which comprises the majority of security-based swap transactions.

a. Clearing

Central clearing through a CCP provides a method for dealing with the counterparty credit risk inherent in security-based swap transactions. Where a clearing agency provides CCP services, clearance and settlement of security-based swap contracts replaces bilateral counterparty exposures with exposures against the clearing agency providing CCP services.[970] Using a CCP to centrally manage credit risk can reduce the monitoring costs and counterparty credit risk of both parties to the original transaction. A centralized clearing structure, when widely adopted, also maximizes the opportunities for netting offsetting contracts thus reducing collateral requirements in centrally-cleared transactions. It can also improve price discovery and financial stability

Although central clearing offers a number of advantages, it is not without limitations. For example, “bespoke” or otherwise illiquid contracts are not amenable to clearing. Widespread adoption of central clearing in security-based swap markets would raise the systemic importance of CCPs.

The ratio of the aggregate notional amount of outstanding CDS contracts cleared through CCPs to the aggregate notional amount of all outstanding CDS contracts has been increasing steadily since 2010.[971] In 2017, this ratio peaked at 27.5%, representing a significant increase over 2016 (21.8%), 2015 (17.1%), 2014 (14.6%), 2013 (13.13%), 2012 (9.75%), 2011 (9.55%), and 2010 (7.36%).[972] Limiting attention to just single-name CDS contracts (i.e., excluding index CDS and multi-name non-index CDS) provides a less consistent picture. While the percentage of single-name CDS contracts that were cleared has increased from 36% in 2010 to 40% in 2017, the upward trend has not been uniform, with a local peak in 2011 (46%) followed by a decline in Start Printed Page 439772012 (45%) and 2013 (37%), an increase in 2014 (43.5%) and 2015 (48%), and then another decline in 2016 (47%) and 2017 (40%).[973]

b. Netting Agreements

Netting agreements between counterparties can mitigate counterparty risk by allowing the positive exposure of counterparty A to counterparty B in a transaction to offset the positive exposure of counterparty B to counterparty A in another transaction. Such offsets are made possible through master netting agreements (“MNAs”).[974]

One way to measure the degree of netting in a set of positions is with the “net-to-gross ratio,” the ratio of the absolute value of the sum of the marked-to-market values of the positions after all product-specific netting agreements (cross-product agreements are excluded) are given effect, to the sum of the positions' absolute marked-to-market values. The more the gains on some positions offset losses on others, the lower the ratio. On an aggregate basis (i.e., across all market participants), the net-to-gross ratio for security-based swaps positions was 27% in 2015. This is a significant increase compared to 2014 (23%) and 2013 (21%), and a marginal increase compared to 2012 (24%) and 2011 (26%).[975]

On a disaggregated basis, there is substantial variation in the degree of netting across different market participants. For instance, in 2015, the ratio of net market value to gross market value was as low as 18% and 20% for CCPs and dealers, respectively, and as high as 78% for insurance companies.[976] These differences in the net-to-gross ratio across different types of market participants reflect differences in their participation in the security-based swap market.

c. Portfolio Compression

Portfolio compression reduces counterparty risk through the termination of early redundant derivatives trades without changing the net exposure of any of the counterparties. The amount of redundant notional amount eliminated through portfolio compression declined steadily over the years, from more than $30 trillion in 2008 [977] and more than $15 trillion in 2009, to $9.8 trillion in 2010, $6.4 trillion in 2011, and $4.1 trillion in 2012.[978]

d. Margin

Participants in the security-based swap market may mitigate counterparty risk by collecting collateral through margin assessment under an active collateral agreement.[979] The Commission lacks regulatory data on the use of collateral by participants in the security-based swap and swap markets.[980] Thus, the Commission's quantitative understanding of margin practices in these markets is largely based on the ISDA's annual margin surveys. These surveys suggest that: (1) The use of collateral has generally increased over the last decade; (2) collateral practices vary by type of market participant and counterparty; (3) segregation of collateral is not widespread; and (4) use of central clearing is increasing.[981]

The statistics in the margin surveys suggest that the use of collateral in security-based swap and swap transactions generally increased in the period from the end of 2002 through the end of 2012.[982] At the end of 2002, 53% of fixed income derivatives transactions and 30% of credit derivatives transactions were subject to a credit support agreement (“CSA”); by 2009, the percentages were 63% and 71%, respectively.[983] By 2012, similar statistics indicated that 79% of fixed income derivative transactions and 83% of credit derivative transactions were subject to CSAs.[984] With respect to non-cleared transactions, the 2012 percentages of fixed income derivative trades and credit derivative trades subject to a CSA were 73% and 79%, respectively.

While the industry margin surveys suggest that the prevalence of CSAs in derivative transactions increased over time, they provide less recent information about collateralization levels and their cross-sectional characteristics. The ISDA reports that, in 2010, an estimated 73% of aggregate OTC derivatives exposures were collateralized.[985] According to the ISDA, collateralization levels in 2010 varied considerably depending on the type of counterparty.[986] Collateralization of exposures to sovereigns was very limited (18%). Collateralization of exposures to hedge funds was much more extensive (160%),[987] reflecting a greater tendency to collect initial margin from those participants. In between these extremes were collateralization levels of current Start Printed Page 43978exposures to mutual funds (100%), banks and broker-dealers (79%), pension funds (71%), insurance companies (68%), energy and/or commodity firms (37.2%), non-financial firms (37%), and special purpose vehicles (19%). The statistics for 2009 reveal a similar pattern.[988] These collateralization level patterns are consistent with the following stylized facts: (1) A counterparty's exposure to a special purpose vehicle is generally not covered to any significant extent; (2) counterparties do not generally require initial margin from dealers, banks, pension funds, and insurance companies, but will collect variation margin in certain cases or on an ad-hoc basis; (3) counterparties require hedge funds to post variation margin and initial margin; (4) counterparties require variation margin from mutual funds, but generally do not require mutual funds to post initial margin; (5) non-financial end-users are generally not required to post margin.[989]

An ISDA margin survey provides some evidence about the asset composition of collateral. According to this survey, in 2014, of the collateral received/(delivered) by survey respondents to cover initial margin, 55.4%/(64.7%) was in cash, 24.2%/(11.1%) was in government securities, and the rest was in other securities. In addition, of the collateral received/(delivered) to cover variation margin, 77.2%/(75.3%) was in cash, 16.3%/(21.4%) was in government securities, and the rest was in other securities. Finally, of the collateral received/(delivered) to cover commingled initial and variation margin, 71.7%/(76.4%) was in cash, 12%/(20.9%) was in government securities, and the rest was in other securities.[990]

The margin surveys also suggest that collateral for non-cleared derivatives is generally not segregated. According to an ISDA margin survey, where initial margin is collected, ISDA members reported that most (72%) was commingled with variation margin and not segregated, and only 5% of the amount received was segregated with a third-party custodian.[991]

Finally, an ISDA margin survey also reports a significant increase in the number of active collateral agreements for client's cleared trades. Specifically, 2014 saw a 67.1% increase in collateral agreements covering client's cleared trades over the previous year.[992] This significant increase is most likely due to the introduction of the clearing mandates in 2013 under the Dodd-Frank Act in the US.[993]

In response to a commenter's suggestion,[994] the Commission has supplemented its analysis of the ISDA margin surveys with an analysis of initial margins estimated for dealer CDS positions. For each dealing entity that is expected to register as an SBSD, the Commission uses DTCC-TIW data as of the end of September 2017 to identify the single-name and index CDS positions that the entity holds against its counterparties. For each dealing entity, the Commission then calculates the initial margin amount [995] from its single-name and index CDS positions with each counterparty by using historical CDS price movements [996] from five one-year samples: 2008, 2011, 2012, 2017, and 2018. The Commission believes the 2008, 2011, and 2012 samples are likely to capture stressed market conditions, while the 2017 and 2018 samples are likely to capture normal market conditions. For each sample and each dealing entity, the Commission then calculates the risk margin amount (i.e., initial margin amounts) of its cleared and non-cleared CDS positions by summing up the initial margins calculated above across all counterparties. Table 2 Panel A below reports a number of statistics, such as minimum, maximum, mean, standard deviation, and the quartiles of the distribution, that summarize the distribution of the dealers' risk margin amounts for each sample.

The Commission can make a number of observations from Table 2 Panel A. The risk margin amounts vary across the five annual samples. Risk margin amounts tend to be larger in 2008 and 2017, but smaller in 2011, 2012, and 2018. For example, the mean risk margin amount in 2008 and 2017 are $768 million and $507 million, respectively, while the mean risk margin amount in 2011, 2012, and 2018 range between $260 and $329 million. The risk margin amounts also vary across dealing entities, suggesting that these entities may hold single-name and index CDS positions with different levels of risk. For example, in the 2008 sample, risk margin amounts range from a minimum of $9.89 million to a maximum of $3,302.12 million. The variation in risk margin amounts across dealing entities, as measured by the standard deviation, also changes across the five annual samples. The standard deviation is higher in 2008 and 2017 and lower in 2011, 2012, and 2018.

The Commission repeats the preceding analysis using only interdealer CDS positions (i.e., calculating risk margin amounts for single-name and index CDS positions held by a dealing entity against another dealing entity). Table 2 Panel B reports statistics summarizing the distribution of these interdealer risk margin amounts for each sample. A key result from Table 2 Panel B is that interdealer risk margin amounts are significantly smaller than risk margin amounts based on single-name and index CDS positions held by a dealer against all its counterparties. For example, in Table 2 Panel A, the mean risk margin amount ranges between $260 million and $768 million, while in Table 2 Panel B, the mean risk margin amount ranges between $8.4 million and $23.1 million. Interdealer risk margin amounts tend to be larger in 2008 and 2017, but smaller in 2011, 2012, and 2018. Interdealer risk margin amounts also vary across different pairs of dealing entities, suggesting that these entities may hold single-name and index CDS positions with different levels of risk. The variation in interdealer risk margin amounts across different pairs of dealing entities, as measured by the standard deviation, also changes across the five annual samples.Start Printed Page 43979

Table 2: Risk Margin Amounts. This table reports summary statistics of risk margin amounts for the single-name and index CDS positions held by dealers against all counterparties (Panel A) and risk margin amounts for the single-name and index CDS positions held by dealers against other dealers (Panel B) as of the end of September 2017. Risk margin amounts are in millions of dollars. The summary statistics are Min (minimum), P25 (first quartile/25th percentile), P50 (second quartile/50th percentile), P75 (third quartile/75th percentile), Max (maximum), Mean, and Std (standard deviation).

Panel A: Risk Margin Amounts for Single-Name and Index CDS Positions Held by Dealers Against All Counterparties

YearMinP25P50P75MaxMeanStd
20089.89255.73488.50673.463302.12767.76817.96
20117.4395.46188.56449.531377.82329.30381.85
20126.6780.60154.86321.101137.43260.05295.31
20171.39138.58385.75600.701487.74507.48472.19
20182.8295.99204.94376.681380.57316.00350.30

Panel B: Risk Margin Amounts for Single-Name and Index CDS Positions Held by Dealers Against Other Dealers

YearMinP25P50P75MaxMeanStd
20080.013.3510.0029.98170.8921.8128.39
20110.001.273.2810.56100.3810.3216.56
20120.000.923.348.9764.828.4512.43
20170.000.503.0817.23528.6123.0760.24
20180.000.753.8311.8467.079.4614.07

3. Global Regulatory Efforts

In 2009, the G20 leaders—whose membership includes the United States, 18 other countries, and the European Union—addressed global improvements in the OTC derivatives market. They expressed their view on a variety of issues relating to OTC derivatives contracts. In subsequent summits, the G20 leaders have returned to OTC derivatives regulatory reform and encouraged international consultation in developing standards for these markets.[997]

Many SBSDs likely will be subject to foreign regulation of their security-based swap activities that is similar to regulations that may apply to them pursuant to Title VII of the Dodd-Frank Act, even if the relevant foreign jurisdictions do not classify certain market participants as “dealers” for regulatory purposes. Some of these regulations may duplicate, and in some cases conflict with, certain elements of the Title VII regulatory framework.

Foreign legislative and regulatory efforts have generally focused on five areas: (1) Moving OTC derivatives onto organized trading platforms; (2) requiring central clearing of OTC derivatives; (3) requiring post-trade reporting of transaction data for regulatory purposes and public dissemination of anonymized versions of such data; (4) establishing or enhancing capital requirements for non-centrally cleared OTC derivatives transactions; and (5) establishing or enhancing margin and other risk mitigation requirements for non-centrally cleared OTC derivatives transactions. Foreign jurisdictions have been actively implementing regulations in connection with each of these categories of requirements. A number of major foreign jurisdictions have initiated the process of implementing margin and other risk mitigation requirements for non-centrally cleared OTC derivatives transactions.[998]

Notably, the European Parliament and the European Council have adopted the European Market Infrastructure Regulation (“EMIR”), which includes provisions aimed at increasing the safety and transparency of the OTC derivatives market. EMIR mandates the European Supervisory Authorities (“ESAs”) to develop regulatory technical standards specifying margin requirements for non-centrally cleared OTC derivative contracts.[999] The ESAs have developed, and in October 2016 the European Commission adopted, these regulatory technical standards.[1000]

Several jurisdictions have also taken steps to implement the Basel III recommendations governing capital requirements for financial entities, which include enhanced capital charges for non-centrally cleared OTC derivatives transactions.[1001] Moreover, as discussed above, subsequent to the publication of the proposing release, the BCBS and IOSCO issued the BCBS/IOSCO Paper. The BCBS/IOSCO Paper recommended (among other things): (1) That all financial entities and systemically important non-financial Start Printed Page 43980entities exchange variation and initial margin appropriate for the counterparty risk posed by such transactions; (2) that initial margin should be exchanged without provisions for “netting” and held in a manner that protects both parties in the event of the other's default; and (3) that the margin regimes of the various regulators should interact so as to be sufficiently consistent and non-duplicative.[1002]

4. Capital Regulation

It is difficult to precisely delineate a baseline for capital requirements and capital levels in the security-based swap market. As discussed in prior sections, the entities that participate in this market may be subject to several overlapping regulatory regimes, including Federal Reserve capital standards at the bank holding company level,[1003] bank capital standards of the OCC and FDIC that apply to bank security-based swap entities,[1004] as well as the net capital requirements applicable to stand-alone broker-dealers. In addition, many entities in this space may be subject to the capital requirements applicable to FCMs, as well to the regimes of foreign regulators.[1005] Finally, certain entities may not be subject to any (direct) capital requirements under the baseline. In the discussion that follows, the relevant aspects of the capital regimes applicable to the various entities operating in the security-based swap market are reviewed, and their relation to the baseline is noted. The discussion focuses on the capital treatment of market risk arising from an entity's proprietary positions in security-based swap transactions specifically, and OTC derivative transactions generally as well as the capital treatment of credit risk arising from exposures to counterparties in OTC derivative transactions.

a. Commission-Registered Broker-Dealers

As described in the prior section, security-based swap dealing activity is concentrated in a small number of large financial firms.[1006] Historically, these firms have not undertaken their security-based swap activities and OTC derivative transactions through Commission-registered broker-dealers. Rather, the dealing activity of these financial firms was housed either in its bank affiliates, its unregistered nonbank affiliates, or in affiliated foreign entities. These arrangements reflected the lack of a legal requirement to house such activities in entities regulated by the Commission, the potential disadvantage in the capital treatment of these activities under Rule 15c3-1,[1007] as well as restrictions on the use of customers' collateral under the Commission's customer protection rule.[1008]

In 1998, the Commission established a program for broker-dealers that operate as OTC derivatives dealers. The program, among other things, permitted OTC derivatives dealers to use internal models to compute capital charges for market and credit risk. In 2004, the Commission extended the use of such models to broker-dealers subject to consolidated supervision with the adoption of alternative net capital requirements for ANC broker-dealers. Today, only a small fraction of broker-dealers are ANC broker-dealers; however, these few ANC broker-dealers are large and account for nearly all of the assets held by Commission-supervised broker-dealers. The capital requirements being adopted today for nonbank SBSDs, including permitting nonbank SBSDs to elect to use models to compute net capital, are modeled on the Commission's net capital rule currently applicable to broker-dealers.

The existing broker-dealer net capital requirements are codified in Rule 15c3-1 and seven appendices to Rule 15c3-1. Specifically, Rule 15c3-1 requires broker-dealers to maintain a minimum level of net capital (meaning highly liquid capital) at all times. Paragraph (a) of the rule requires that a broker-dealer perform two calculations: (1) A computation of the minimum amount of net capital the broker-dealer must maintain; and (2) a computation of the amount of net capital the broker-dealer is maintaining. The minimum net capital requirement is the greater of a fixed-dollar amount specified in the rule and an amount determined by applying 1 of 2 financial ratios: The 15-to-1 ratio or the 2% debit item ratio. Large broker-dealers that dominate the industry use the 2% debit item ratio.

Requirements for computing net capital are set forth in paragraph (c)(2) of Rule 15c3-1, which defines the term “net capital.” The first step in a net capital calculation is to compute the broker-dealer's net worth under GAAP. Next, the broker-dealer must make certain adjustments to its net worth. These adjustments are designed to leave the firm in a position in which each dollar of unsubordinated liabilities is matched by more than a dollar of highly liquid assets. There are fourteen categories of net worth adjustments required by the rule, including the application of haircuts.[1009] Broker-dealers use either standardized haircuts or model-based haircuts that are comprised of market and credit risk charges.

Market Risk Charges

The internal models used by ANC broker-dealers and OTC derivatives dealers to compute market risk charges must meet certain qualitative and quantitative requirements under Appendix E or F that parallel requirements for U.S. banking agencies under Basel II.[1010] The use of internal Start Printed Page 43981models to compute market risk charges can substantially reduce the deductions to the market value of proprietary positions as compared to standardized haircuts. Consequently, large broker-dealers that dominate the industry rely on internal models rather than the standardized haircuts to compute net capital. However, ANC broker-dealers and OTC derivative dealers (i.e., dealers using internal models to compute net capital) are subject to higher fixed-dollar minimum capital requirements than broker-dealers using the standardized haircuts. Under existing paragraph (a)(7) of Rule 15c3-1, ANC broker-dealers are required to maintain tentative net capital of not less than $1 billion and net capital of not less than $500,000,000. In addition, ANC broker-dealers are required to provide notice to the Commission if their tentative net capital falls below $5 billion. For OTC derivative dealers, under existing paragraph (a)(5) of Rule 15c3-1, the corresponding fixed-dollar minimums are $100 million in tentative net capital and $20 million in net capital.

Credit Risk Charges

For ANC broker-dealers, the credit risk charge is the sum of 3 calculated amounts: (1) A counterparty exposure charge; (2) a concentration charge if the current exposure to a single counterparty exceeds certain thresholds; and (3) a portfolio concentration charge if aggregate current exposure to all counterparties exceeds 50% of the firm's tentative net capital.[1011] The OTCDD credit risk model is similar to the ANC credit risk model except that the former does not include a portfolio concentration charge.[1012]

b. Banking Entities

As described in previous sections, the security-based swap market is dominated by a small number of global financial firms. Of the firms expected to register with the Commission as SBSDs, the Commission believes that most will, in the near-term, be subsidiaries of a U.S. bank holding company and therefore be subject to consolidated supervision by the Federal Reserve. Nonbank SBSDs and MSBSPs will be subject not only to the Commission's capital requirements but also indirectly to the capital standards applicable at their parent bank holding companies. For the purposes of satisfying the capital requirements at the bank holding company level, the OTC derivatives positions booked under any consolidated bank subsidiary are accounted for in the capital computation of the holding company. The bank holding companies' consolidated bank subsidiaries also are subject to direct capital requirements of the prudential regulators and indirect capital requirements applicable to their parent bank holding companies. Below is a discussion of the relevant aspects of the capital regime for bank holding companies as it relates to security-based swap positions (and OTC derivative positions in general).

In July 2013, the Federal Reserve and OCC adopted a final rule that implements in the U.S. the Basel III regulatory capital reforms from the BCBS and certain changes to the existing capital standards required by the Dodd-Frank Act.[1013] These rules generally strengthened the capital regime for bank holding companies and banks (collectively, “banks”) by increasing both the quality and the quantity of bank regulatory capital.[1014]