2012-21414
-
Federal Register, Volume 77 Issue 176 (Tuesday, September 11, 2012)[Federal Register Volume 77, Number 176 (Tuesday, September 11, 2012)]
[Rules and Regulations]
[Pages 55903-55966]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-21414]
[[Page 55903]]
Vol. 77
Tuesday,
No. 176
September 11, 2012
Part II
Commodity Futures Trading Commission
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17 CFR Part 23
Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap
Trading Relationship Documentation Requirements for Swap Dealers and
Major Swap Participants; Final Rule
Federal Register / Vol. 77, No. 176 / Tuesday, September 11, 2012 /
Rules and Regulations
[[Page 55904]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 23
RIN 3038-AC96
Confirmation, Portfolio Reconciliation, Portfolio Compression,
and Swap Trading Relationship Documentation Requirements for Swap
Dealers and Major Swap Participants
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is adopting regulations to implement certain provisions of Title VII of
the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act). Section 731 of the Dodd-Frank Act added a new section 4s(i)
to the Commodity Exchange Act (CEA), which requires the Commission to
prescribe standards for swap dealers (SDs) and major swap participants
(MSPs) related to the timely and accurate confirmation, processing,
netting, documentation, and valuation of swaps. These regulations set
forth requirements for swap confirmation, portfolio reconciliation,
portfolio compression, and swap trading relationship documentation for
SDs and MSPs.
DATES: The rules will become effective November 13, 2012. Specific
compliance dates are discussed in the SUPPLEMENTARY INFORMATION.
FOR FURTHER INFORMATION CONTACT: Frank N. Fisanich, Chief Counsel, 202-
418-5949, cftc.gov">ffisanich@cftc.gov, Ward P. Griffin, Associate Chief Counsel,
202-418-5425, cftc.gov">wgriffin@cftc.gov Division of Swap Dealer and
Intermediary Oversight, and Hannah Ropp, Economist, 202-418-5228,
cftc.gov">hropp@cftc.gov, Office of the Chief Economist, Commodity Futures
Trading Commission, Three Lafayette Centre, 1155 21st Street NW.,
Washington, DC 20581.
SUPPLEMENTARY INFORMATION
Table of Contents
I. Background
II. Comments on the Notices of Proposed Rulemaking
A. Regulatory Structure
B. Swap Trading Relationship Documentation
C. End User Exception Documentation
D. Swap Confirmation
E. Portfolio Reconciliation
F. Portfolio Compression
III. Effective Dates and Compliance Dates
A. Comments Regarding Compliance Dates
B. Compliance Dates
IV. Cost Benefit Considerations
A. Statutory Mandate to Consider the Costs and Benefits of the
Commission's Action
B. Background
C. Swap Confirmation
D. Portfolio Reconciliation
E. Portfolio Compression
F. Swap Trading Relationship Documentation
G. Swap Valuation Methodologies
V. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
I. Background
The Commission is hereby adopting Sec. 23.500 through Sec. 23.505
\1\ setting forth standards for the timely and accurate confirmation of
swaps, requiring the reconciliation and compression of swap portfolios,
and setting forth requirements for documenting the swap trading
relationship between SDs, MSPs, and their counterparties. These
regulations are being adopted by the Commission pursuant to the
authority granted under sections 4s(h)(1)(D), 4s(h)(3)(D), 4s(i), and
8a(5) of the CEA. Section 4s(i)(1) of the CEA, requires SDs and MSPs to
``conform with such standards as may be prescribed by the Commission by
rule or regulation that relate to timely and accurate confirmation,
processing, netting, documentation, and valuation of all swaps.''
Documentation of swaps is a critical component of the bilaterally-
traded, over-the-counter (OTC) derivatives market, while confirmation,
portfolio reconciliation, and portfolio compression have been
recognized as important post-trade processing mechanisms for reducing
risk and improving operational efficiency. Each of these processes has
been the focus of significant domestic and international attention in
recent years by both market participants and their regulators.
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\1\ Commission regulations referred to herein are found at 17
CFR Ch. 1.
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II. Comments on the Notices of Proposed Rulemaking
The final rules adopted herein were proposed in three separate
notices of proposed rulemaking.\2\ Each proposed rulemaking was subject
to an initial 60-day public comment period and a re-opened comment
period of 30 days.\3\ The Commission received a total of approximately
62 comment letters directed specifically at the proposed rules.\4\ The
Commission considered each of these comments in formulating the final
regulations.\5\
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\2\ See 75 FR 81519 (Dec. 28, 2010) (Confirmation, Portfolio
Reconciliation, and Portfolio Compression Requirements for Swap
Dealers and Major Swap Participants (Confirmation NPRM)); 76 FR 6715
(Feb. 8, 2011) (Swap Trading Relationship Documentation Requirements
for Swap Dealers and Major Swap Participants (Documentation NPRM));
and 76 FR 6708 (Feb. 8, 2011) (Orderly Liquidation Termination
Provision in Swap Trading Relationship Documentation for Swap
Dealers and Major Swap Participants (Orderly Liquidation NPRM)).
\3\ See 76 FR 25274 (May 4, 2011) (extending or re-opening
comment periods for multiple Dodd-Frank proposed rulemakings).
\4\ Comment files for each proposed rulemaking can be found on
the Commission Web site, www.cftc.gov.
\5\ The Commission also reviewed the proposed rule of the
Securities and Exchange Commission concerning trade acknowledgement
and verification of security-based swap transactions. See 76 FR 3859
(Jan. 21, 2011).
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The Chairman and Commissioners, as well as Commission staff,
participated in numerous meetings with representatives of potential SDs
and MSPs, trade associations, public interest groups, traders, and
other interested parties. In addition, the Commission has consulted
with other U.S. financial regulators including: (i) The Securities and
Exchange Commission (SEC); (ii) the Board of Governors of the Federal
Reserve System; (iii) the Office of the Comptroller of the Currency;
and (iv) the Federal Deposit Insurance Corporation. Staff from each of
these agencies has had the opportunity to provide oral and/or written
comments to this adopting release, and the final regulations
incorporate elements of the comments provided.
The Commission is mindful of the benefits of harmonizing its
regulatory framework with that of its counterparts in foreign
countries. The Commission has therefore monitored global advisory,
legislative, and regulatory proposals, and has consulted with foreign
regulators in developing the final regulations. Specifically,
Commission staff has consulted with the European Securities and Markets
Authority (ESMA), which has recently released a consultation paper for
the regulation of OTC derivatives containing draft technical standards
that are substantially similar to some of the rules adopted by the
Commission in this release, as further noted below.\6\
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\6\ See ESMA Consultation Paper 2012/379, Draft Technical
Standards for the Regulation of OTC Derivatives, CCPs and Trade
Repositories (June 25, 2012) (ESMA Draft Technical Standards).
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A. Regulatory Structure
Several commenters raised general concerns with the legal authority
for or structure of the proposed rules, or their possible effect on
existing transactions.
1. Statutory Authority for the Proposed Rules
The Working Group of Commercial Energy Firms (The Working Group)
[[Page 55905]]
commented that many of the specific provisions in the proposed rules
are not required by section 731 of the Dodd-Frank Act and that such
provisions are not ``reasonably necessary'' to achieve the goals of the
CEA. The Working Group believes that the Commission could meet its
statutory mandate by publishing principle-based rules, rather than the
detailed approach of the proposed rules. Dominion Resources, Inc.
(Dominion) also asserted that the proposed rules would achieve a
regulatory scope beyond what is required by section 4s(i) and may
require end users to change their business practices. Dominion
requested that the proposed rules be further tailored to ensure the
effect of the rules is limited to SDs and MSPs.
The Commission notes that section 731 of the Dodd-Frank Act added a
new section 4s(i) to the CEA that states that each registered SD and
MSP shall conform with such standards as may be prescribed by the
Commission by rule or regulation that relate to timely and accurate
confirmation, processing, netting, documentation, and valuation of all
swaps. Section 4s(i) also states that the Commission shall adopt rules
governing documentation standards for SDs and MSPs.
Swaps and swap trading relationship documentation are contractual
arrangements that necessarily involve more than a single party. The
Commission believes that the statutory requirement that the Commission
adopt rules governing documentation standards relating to confirmation,
processing, netting, documentation, and valuation of all swaps reflects
the intent of Congress to have the Commission adopt rules that
necessarily effect SDs, MSPs, and their swap counterparties. The
Commission also believes the rules establish a set of documentation
standards for prudent risk management for registered SDs and MSPs while
minimizing the burdens on non-SDs and non-MSPs.
2. Application to Existing Swaps and Documentation
In response to a request for comment in the Documentation NPRM
asking how long SDs and MSPs should have to bring existing swap
documentation into compliance with the proposed rules and whether a
safe harbor should be provided for dormant trade documentation, the
International Swaps and Derivatives Association (ISDA) and the
Securities Industry and Financial Markets Association (SIFMA), in a
joint comment letter (ISDA & SIFMA), strongly urged the Commission to
specify that only new transactions entered into after the effective
date of the rules are subject to the rules' requirements, and that it
is not mandatory to amend terms or agreements that apply to
transactions entered into prior to such date. ISDA & SIFMA further
argued that Commission rules relating to business conduct, the
confirmation process, confidentiality and privacy, collateral
segregation requirements, and margin and capital may all directly or
indirectly require registrants to make amendments to existing
relationship documentation, and that it would be extremely inefficient,
time consuming and costly for registrants to engage in separate rounds
of amendments with their trading counterparties for each set of Dodd-
Frank Act rulemakings. ISDA & SIFMA recommended that registrants be
permitted to develop plans to update their agreements in an integrated
manner for the full range of Dodd-Frank Act requirements, and
implementation timelines should reflect the requirements of such an
approach, keeping in mind that those requirements will not be known
until the scope and terms of all of the relevant Commission regulations
(and those of the SEC) are more clearly delineated.
The Working Group and the Financial Services Roundtable (FSR) also
urged the Commission to apply the rules to new swaps only, arguing that
renegotiation of existing documentation would take significantly longer
than six months; may be impossible in some cases; and is not a good use
of limited resources of market participants that will already be taxed
with the necessary changes mandated by the Dodd-Frank Act and the
Commission's other rules. Likewise, the Coalition for Derivatives End-
Users urged the Commission to exempt trades entered into before the
enactment of the Dodd-Frank Act from the requirements of the rules and
the Managed Funds Association (MFA) strongly objected to the Commission
applying any of these requirements to existing contracts. MFA argued
that section 739(5) of the Dodd-Frank Act specifically provides that
the Dodd-Frank Act shall not constitute a ``regulatory change, or
similar event * * * that would permit a party to terminate,
renegotiate, modify, amend, or supplement one or more transactions
under the swap.'' MFA believes that imposing these requirements on
existing agreements would clearly require that existing agreements be
``renegotiated.''
The Federal Home Loan Banks (FHLBs) noted on the other hand that
netting of pre-existing transactions with new transactions is critical
to efficient hedging, and thus documentation for pre-existing swaps
will need to be modified to maintain the benefits of netting.
Having considered these comments, the Commission agrees with
commenters that the rules should not apply retrospectively and will
require compliance with the rules only with respect to swaps entered
after the date on which compliance with the rules is required, as
discussed below. With respect to the comment of the FHLBs, the
Commission notes that the rules would not prohibit parties from
arranging their documentation to maintain the benefits of netting
between pre-existing swaps and swaps entered after the date compliance
with the rules is required if they so choose. In addition, with regard
to ISDA & SIFMA's argument that swap trading documentation would need
to be amended when rules relating to segregation and margin are
finalized, the Commission observes that those rules are likely to
provide for additional time for documentation to be brought into
compliance.
3. Legal Certainty
With respect to the validity of transactions where the parties fail
to comply with the rules, The Working Group argued that for the sake of
legal certainty, a failure to comply with the proposed rules should not
result in invalidation of swaps entered into under deficient swap
trading relationship documentation. The Coalition of Physical Energy
Companies (COPE) recommended that the Commission make clear that
section 739 of the Dodd-Frank Act, regarding legal certainty, applies
to the proposed regulations so that SD or MSP noncompliance with the
rules will not otherwise affect the enforceability of a swap. MFA and
the International Energy Credit Association (IECA) also believe that it
is imperative that the Commission affirmatively clarify that defects in
required regulatory documentation do not render a contract void or
voidable by one of the parties or constitute a breach of the swap
documentation. IECA added that a party should not have a private right
of action with respect to documentation that does not comply with the
rules. IECA further requested that the Commission add specific language
to proposed Sec. 23.504. The FHLBs made the same argument as IECA,
adding that the Commission can enforce the provisions through penalties
for SDs and MSPs.
Upon consideration of these comments, the Commission is clarifying
that it is not the intent of the rules to provide swap counterparties
with a
[[Page 55906]]
basis for voiding or rescinding a swap transaction based solely on the
failure of the parties to document the swap transaction in compliance
with the rules. However, the Commission believes it does not have the
authority to immunize SDs or MSPs from private rights of action for
conduct within the scope of section 22 of the CEA, i.e., for violations
of the CEA. In the interest of legal certainty, to avoid disruptions in
the swaps market, and to reduce compliance costs, the Commission has
determined that it will, in the absence of fraud, consider an SD or MSP
to be in compliance with the rules if it has complied in good faith
with its policies and procedures reasonably designed to comply with the
requirements of each rule.
4. Standing of the ISDA Agreements
Several commenters requested that the Commission clarify the
standing under the rules of the ISDA Master Agreement and Credit
Support Annex (the ISDA Agreements), which are prevalent in the swaps
market. Specifically, ISDA & SIFMA commented that the proposed rules
could create uncertainty as to the level of documentation required
because the proposed rules require that ``all terms'' governing the
swap trading relationship be documented. ISDA & SIFMA thus requested
that the Commission acknowledge the general adequacy of the ISDA
Agreements for purposes of the rule to enhance legal certainty and
market stability. Similarly, COPE argued that many end users have
already negotiated existing documentation under the ISDA architecture
and thus requested that the Commission make clear that: (1) ISDA
Agreements or any substantially similar master agreements satisfy the
documentation requirements of the final rules; (2) in accordance with
the ISDA Agreements and applicable state law, swaps are binding when
made orally; and (3) long-form confirmations that contain all requisite
legal terms to establish a binding agreement also satisfy the
requirements of the rules. IECA also recommended that the Commission
expressly state that the ISDA Agreements satisfy the documentation
requirements of the final rules or state how the ISDA Agreements are
deficient to eliminate any confusion. Finally, the Coalition for
Derivatives End-Users argued that, given that the ISDA Agreements are
used by nearly all end users and that such documentation substantially
complies with the proposed rules, the Commission should expressly state
that the ISDA Agreements satisfy the documentation requirements of the
rules.
On the other hand, the Committee on the Investment of Employee
Benefit Assets (CIEBA) anticipates that ISDA may initiate a uniform
protocol to conform existing ISDA Agreements to the requirements of the
rules. In this regard, CIEBA stated that ISDA protocols, which in the
past have typically been developed by dealer-dominated ISDA committees,
are not form documents that can be revised by the parties. Rather,
CIEBA argues, end users may only adopt these protocols on a ``take it
or leave it'' basis, which may not be in their best interests.
Accordingly, CIEBA recommended that the Commission not, either
explicitly or implicitly, require market participants to consent to
ISDA protocols in order to comply with the Dodd-Frank Act or the
Commission's regulations.
The Commission notes that many comments received with respect to
this and other rulemakings stated that swaps are privately negotiated
bilateral contracts. Although the Commission recognizes that the ISDA
Agreements in their pre-printed form as published by ISDA are capable
of compliance with the rules, such agreements are subject to
customization by counterparties. In addition, the Commission notes that
while the pre-printed form of the ISDA Master Agreement is capable of
addressing the requirements of proposed Sec. 23.504(b)(1), it is not
possible to determine if the pre-printed form of the ISDA Credit
Support Annex will comply with proposed Sec. 23.504(b)(3), because
that section requires that the documentation include credit support
arrangements that comply with the Commission's rules regarding initial
and variation margin and custodial arrangements, which have been
proposed but not yet finalized. Further, the Commission does not
believe that the standard ISDA Agreements address the swap valuation
requirements of Sec. 23.504(b)(4), the orderly liquidation termination
provisions of Sec. 23.504(b)(5), or the clearing records required by
Sec. 23.504(b)(6). Given the foregoing, the Commission declines to
endorse the ISDA Agreements as meeting the requirements of the rules in
all instances.
5. Identical Rules Applicable to SDs and MSPs
The proposed regulations did not differentiate between SDs and
MSPs, but, rather, applied identical rules to both types of entities.
In this regard, BlackRock commented that MSPs are buy-side entities,
yet many of the proposed documentation standards are designed to
regulate dealing activity. BlackRock believes these requirements should
not apply to MSPs because they are unnecessary and will cause both MSPs
and the Commission to use resources inefficiently.
The Commission is not modifying the regulations to differentiate
between SDs and MSPs. The Commission observes that section 4s(i) of the
CEA, as added by the Dodd-Frank Act, does not differentiate between SDs
and MSPs. The Commission thus has determined that the intent of section
4s(i) is to apply the same requirements to MSPs and SDs, and the
Commission is taking the same approach in the final regulations.
B. Swap Trading Relationship Documentation--Sec. 23.504
Section 4s(i)(1) requires swap dealers and major swap participants
to ``conform with such standards as may be prescribed by the Commission
by rule or regulation that relate to timely and accurate confirmation,
processing, netting, documentation, and valuation of all swaps.'' Under
section 4s(i)(2), the Commission is required to adopt rules ``governing
documentation standards for swap dealers and major swap participants.''
OTC derivatives market participants typically have relied on the
use of industry standard legal documentation, including master netting
agreements, definitions, schedules, and confirmations, to document
their swap trading relationships. This industry standard documentation,
such as the widely used ISDA Master Agreement and related definitions,
schedules, and confirmations specific to particular asset classes,
offers a framework for documenting the transactions between
counterparties for OTC derivatives products.\7\ The standard
documentation is designed to set forth the legal, trading, and credit
relationship between the parties and to facilitate netting of
transactions in the event that parties have to close-out their position
with one another or determine credit exposure for margin and collateral
management. Notwithstanding the standardization of such documentation,
some or all of the terms of the master agreement and other documents
are subject to negotiation and modification.
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\7\ The International Swaps and Derivatives Association (ISDA)
is a trade association for the OTC derivatives industry (http://www.isda.org).
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To promote the ``timely and accurate * * * documentation * * * of
all swaps'' under section 4s(i)(1) of the CEA, in the Documentation
NPRM, the Commission proposed Sec. 23.504(a), which required that swap
dealers and major swap participants establish,
[[Page 55907]]
maintain, and enforce written policies and procedures reasonably
designed to ensure that each swap dealer or major swap participant and
its counterparties have agreed in writing to all of the terms governing
their swap trading relationship and have executed all agreements
required by proposed Sec. 23.504. The Commission received
approximately 31 comment letters in response to the Documentation NPRM
and considered each comment in formulating the final rules, as
discussed below.
1. Application to Swaps Executed on a SEF or DCM, or Cleared by a DCO
In response to a request for comment in the Documentation NPRM
regarding whether proposed Sec. 23.504 should include a safe harbor
for swaps entered into on, or subject to the rules of, a board of trade
designated as a contract market, ISDA & SIFMA, as well as the American
Benefits Counsel and the Committee on Investment of Employee Benefit
Assets (jointly, ABC & CIEBA), recommended that the Commission provide
such a safe harbor for swaps executed on a swap execution facility
(SEF) or designated contract market (DCM). ISDA & SIFMA commented that
the safe harbor is especially needed for those transactions where the
SD or MSP will not know the identity of its counterparty until just
before or after execution. ISDA & SIFMA also urged the Commission to
clarify that the term ``swap trading relationship documentation'' is
used to describe only bilateral documentation between parties to
uncleared swaps. MFA also recommended that the Commission clarify that
exchange traded or cleared swaps, which will be subject to standard
contract terms, are not subject to the documentation rules. The Working
Group commented that the swap trading relationship requirement in Sec.
23.504(a) includes a carve-out for swaps cleared with a DCO, but Sec.
23.504(b)(6) includes express requirements for the swap trading
relationship documentation with respect to cleared swaps. Given the
apparent contradiction, The Working Group requested that the Commission
clarify whether the other requirements of Sec. 23.504 apply to swaps
that are intended to be cleared contemporaneously with execution or
that are executed on a SEF or DCM.
In response to The Working Group's comment expressing confusion
about whether Sec. 23.504 applies to swaps that are cleared by a DCO
and to ISDA & SIFMA's comment regarding applicability to cleared swaps,
as well as the applicability to pre-existing swaps per the discussion
above, the Commission is modifying Sec. 23.504 to clarify the overall
applicability of the rule by adding a new paragraph (a)(1) as set forth
in the regulatory text of this rule.
This revision clarifies the circumstances under which the rule
applies. The proviso in Sec. 23.504(a)(1)(ii) would achieve the rule's
goal of avoiding differences between the terms of a swap as carried at
the DCO level and at the clearing member level, which could compromise
the benefits of clearing. Any such differences raise both customer
protection and systemic risk concerns. From a customer protection
standpoint, if the terms of the swap at the customer level differ from
those at the clearing level, then the customer will not receive the
full transparency and liquidity benefits of clearing, and legal and
basis risk will be introduced into the customer position. Similarly,
from a systemic perspective, any differences could diminish overall
price discovery and liquidity and increase uncertainties and
unnecessary costs into the insolvency resolution process. The cross
reference to Sec. 39.12(b)(6) imports the specific requirements that
had been included in proposed Sec. 23.504(b)(6)(v). See below for a
more complete discussion of Sec. 23.504(b)(6).
In response to the comment from ISDA & SIFMA, the Commission
clarifies that swaps executed anonymously on a SEF or traded on a DCM
prior to clearing by a DCO are not subject to the requirements of Sec.
23.504. For those swaps that are not executed anonymously, the swap
trading relationship documentation requirements of Sec. 23.504 would
apply.
2. Viability of Long-Form Confirmations as Swap Trading Relationship
Documentation--Sec. 23.504(a) & (b)
Proposed Sec. 23.504(b) required that all terms governing the
trading relationship between an SD or MSP and its counterparty be
documented in writing. Proposed Sec. 23.504(a) required that SDs and
MSPs establish policies and procedures reasonably designed to ensure
that the required swap trading relationship documentation be executed
prior to or contemporaneously with entering into a swap transaction
with any counterparty. The Commission notes the industry practice
whereby counterparties enter into a ``long-form confirmation'' after
execution of transaction, where the long-form confirmation contains
both the terms of the transaction and many, if not all, terms usually
documented in a master agreement until such time as a complete master
agreement is negotiated and executed.
The Office of the Comptroller of the Currency (OCC) commented that
the proposed rule may require master agreements between all
counterparties even if a ``long-form'' confirmation would sufficiently
address legal risks, creating a significant expense and burden for end
users. Similarly, IECA commented that long form confirmations that
incorporate the terms of a standard master agreement are useful for
certain new transaction relationships. In this respect, IECA recommends
that Sec. 23.504(b)(1) be modified to make clear that terms can be
incorporated by reference.
In response to these comments, the Commission has determined that
so long as a ``long-form'' confirmation includes all terms of the
trading relationship documented in writing prior to or
contemporaneously with the assumption of risk arising from swap
transactions, the ``long-form'' confirmation would comply with the
rules. However, the Commission is not modifying the rule to permit
execution of a long-form confirmation subsequent to the execution of a
swap transaction, which the Commission believes results in some period,
however short, in which the terms of the trading relationship between
the parties are not in written form. In response to the comment of
IECA, the rule does not prohibit incorporation of terms by reference.
Thus, so long as the terms incorporated by reference are in written
form, the documentation would be in compliance with the rule.
3. Confirmation Execution Timing and Swap Trading Relationship
Documentation--Sec. 23.504(a) & (b)(2)
Proposed Sec. 23.504(b)(2) states that swap trading relationship
documentation includes transaction confirmations. Proposed Sec.
23.504(a) requires swap trading relationship documentation to be
executed prior to or contemporaneously with entering into any swap with
a counterparty. However, proposed Sec. 23.501 provides for specific
post-execution time periods for confirming swaps. This apparent
contradiction was identified by a number of commenters.
In order to reconcile the apparent contradiction, ISDA & SIFMA
recommended that confirmations be excluded from swap trading
relationship documentation and be treated solely in Sec. 23.501. MFA
also recommended that confirmations be treated solely in Sec. 23.501,
noting that if forced to choose between quick execution and the
negotiation of all
[[Page 55908]]
terms, the proposed rule's timing requirements might substantially
limit end users' ability to engage in proper risk management using
tailored swaps. MFA also commented that unless modified, the rule might
decrease the number of transactions in the markets, thereby decreasing
liquidity and increasing volatility.
IECA noted that many short term transactions are executed orally
and often documented by recording, ending before a written confirmation
can be completed. IECA also stated that if all confirmations must be in
writing, the additional employee time cost for each market participant
would be substantial and is not included in the annual cost analysis.
The Working Group also commented that in some instances, it may take
longer to negotiate a written confirmation for a swap or complete the
necessary mid- and back-office processes than the planned duration of
the swap at issue. IECA recommended that proposed Sec. 23.504(b)(2) be
modified by adding at the end, ``which confirmations need not be in
writing.''
MetLife commented that the requirement to document ``all'' terms of
a trading relationship is overly burdensome. MetLife believes the
documentation subject to regulation should be clarified to mean two
sets of documents: A master agreement, credit support arrangement and
master confirmation agreement and second, transaction specific
confirmations. The confirmations can include any trade specific terms
including specific valuation methodologies or inputs not already
contained in the master documentation. Differentiation would assist
with clarity for policies and procedures and with the audit
requirements.
The Coalition for Derivatives End-Users and The Working Group
commented that the rule may require pre-trade negotiation and
disadvantage the party that is most sensitive to the timing of the swap
in such negotiations. The Working Group believes such party may have to
accept less than favorable terms in order to execute within its desired
time frame, and that the rule would make it very difficult for parties
to enter into short-term swaps. The Coalition for Derivatives End-Users
point out that end-users often trade by auction and given the low
probability of winning, SDs will not want to incur the expense of
negotiating documents in advance. The Coalition for Derivatives End-
Users also point out that even where established relationships exist,
newly formed affiliates may trade based on existing expectations, but
without the documents fully executed.
On the other hand, CIEBA commended the Commission for including all
terms in swap trading relationship documentation. CIEBA believes this
approach will minimize the potential for disputes over swap terms
during the confirmation process caused by the introduction of new
``standard'' terms after the swap is executed, which CIEBA stated is a
frequent occurrence. CIEBA recommended that the Commission confirm in
its final rules that the requirement that documentation ``shall include
all terms governing the trading relationship between the swap dealer or
major swap participant and its counterparty'' would require all terms
to be in writing prior to or at the time of entering into the swap
transaction, except for terms such as price, quantity and tenor, that
are customarily agreed to contemporaneously with entering into a swap
transaction. CIEBA recommended that the rule require these remaining
terms to be documented in writing contemporaneously with entering into
the swap transaction.
Having considered these comments, the Commission has determined
that proposed Sec. 23.504(a) should be clarified with respect to the
inclusion of swap confirmations in swap trading relationship
documentation. The Commission is therefore modifying the proposed rule
to make clear that the timing of confirmations of swap transactions is
subject to Sec. 23.501, and that swap trading relationship
documentation other than confirmations of swap transactions is required
to be executed prior to or contemporaneously with entering into any
swap transaction.
The Commission does not, however, agree with commenters suggesting
that terms governing a swap or a trading relationship need not be in
writing. The Commission recognizes that binding swap contracts may be
created orally under applicable law and the rule does not affect
parties' ability to enforce such contracts. However, an orderly swap
market and the goal of reducing operational risk require that such oral
contracts be appropriately documented as soon as possible. In response
to the comments of CIEBA, the Commission believes the modifications to
the confirmation time periods in Sec. 23.501 discussed below
adequately address CIEBA's concerns. Given the foregoing, the
Commission is modifying proposed Sec. 23.504(a) to read as set forth
in the regulatory text of this rule
4. Swap Trading Relationship Documentation Among Affiliates
The proposed regulations did not include an exemption or different
rules for documenting swap trading relationships between affiliates.
Shell Energy North America (Shell) commented that an end user trading
with an affiliated SD/MSP does not have valuation, trade, and
documentation risks that nonaffiliated entities may have, that such
transactions only allocate risk within the legal entity, and,
accordingly, affiliate transactions should be exempted from the
documentation rules.
The Commission is not persuaded that the risk of undocumented (and
therefore objectively indiscernible) terms governing swaps is obviated
because the trading relationship is with an affiliate. The Commission
has regulatory interests in knowing or being able to discover the full
extent of a registered SD's or MSP's risk exposure, whether to external
or affiliated counterparties, and is not modifying the rule in response
to this comment. The Commission observes that to the extent certain
risks are not present in affiliate trading relationships, the
documentation of the terms related to such risks should be non-
controversial and easily accomplished. For example, because affiliates
are generally under common control, the documentation of an agreement
on valuation methodologies should not require extensive negotiation as
it may between non-affiliated counterparties.
5. Use of ``Enforce'' in Proposed Sec. 23.504(a)
Proposed Sec. 23.504(a) required that each SD and MSP establish,
maintain, and enforce policies and procedures designed to ensure that
prior to or contemporaneously with entering into a swap transaction, it
executes swap trading relationship documentation that complies with the
rules.
CEIBA questions what is intended by the requirement for SDs and
MSPs to ``enforce policies and procedures'' in Sec. 23.504(a). CEIBA
believes the use of the term ``enforce'' with respect to SDs' and MSPs'
procedures is contrary to the Dodd-Frank Act, because it implies that
such procedures have the force of law and can be imposed on
counterparties absent mutual agreement. CIEBA recommended that the word
``enforce'' should be deleted.
Having considered this comment, the Commission is modifying the
proposed rule by replacing the term ``enforce'' with the term
``follow.'' The intent of the term ``enforce'' in the proposed rule was
to require SDs and MSPs to in fact follow the policies and procedures
established to meet the requirements of the proposed rule, rather than
to enforce
[[Page 55909]]
its internal policies and procedures against third parties.
6. Payment Obligation Terms--Sec. 23.504(b)
In the Documentation NPRM, the Commission asked whether the
proposed rules should specifically delineate the types of payment
obligation terms that must be included in the trading relationship
documentation.
CIEBA commented that the Commission need not dictate every term
that must appear in swap trading relationship documentation, and that
it is important to defined benefit plans to be able to negotiate
payment obligation terms in their documentation.
The Commission agrees with CIEBA on this issue and has not modified
the rule to further define the types of payment obligation terms
required to be specified in swap trading relationship documentation.
7. Additional Requirements for Events of Default and Termination Events
In the Documentation NPRM, the Commission asked whether the
requirement for agreement on events of default or termination events
should be further defined, such as adding provisions related to cross
default.
The Coalition for Derivatives End-Users commented that the ISDA
documentation sufficiently addresses these issues and that parties
should be allowed to negotiate these terms bilaterally so the
Commission need not further define such terms. CIEBA agreed that
parties should be allowed to negotiate these terms bilaterally so the
Commission need not further define such terms.
The Commission agrees with the commenters on this point and has not
modified the rule to further define the types of events of defaults and
termination events required to be specified in swap trading
relationship documentation.
8. Senior Management Approval of Documentation Policies and
Procedures--Sec. 23.504(a)
Proposed Sec. 23.504(a) required SDs' and MSPs' documentation
policies and procedures to be approved in writing by senior management
of the SD or MSP.
The Working Group raised a concern that this requirement will be
used to the negotiating advantage by SDs and MSPs who will claim that
the form of documentation had been approved for regulatory purposes and
cannot be changed without a prohibitively lengthy internal approval
process. In addition, The Working Group argued that rigid documentation
standards that must be approved by senior management could severely
limit the flexibility of SDs, ending the ability of end users to obtain
customized swaps in a timely manner. The Working Group recommended that
the Commission allow current practice to continue where trading
managers can authorize deviations from standard trade documentation so
long as such amendment does not violate the overarching policies and
procedures set by internal management authorized by the governing body.
MFA similarly commented that the senior management approval
requirement, together with the cumulative effect of the proscriptive
documentation rules, may lead to the institutionalization of the terms
favored by SDs and MSPs. As a result, MFA is concerned that SDs and
MSPs will compel their customers to accept unfavorable terms or forego
time-sensitive market opportunities. Accordingly, MFA recommended that
each party should be free to assess requisite approval levels for
various kinds of swap activity based on its unique organizational
structure.
IECA commented that review by senior management is an unnecessary
use of management time. Most SDs and MSPs have risk management policies
that provide a framework for elevating issues through levels of
management as applicable. By requiring senior management to review too
many modifications, many that can be reviewed by lower levels with
appropriate expertise, it is likely that senior management may actually
miss the major issues that should get attention. Also, IECA argued that
the chilling effect of the rule could stifle risk management efforts,
innovation, and increase counterparty risk as review processes become
too rigid in order to comply with regulatory requirements.
The Commission is not modifying the rule based on these comments.
The commenters' concerns are overly broad because the rule requires
senior management of SDs and MSPs to approve the ``policies and
procedures'' governing swap trading documentation practices, not to
approve each agreement, transaction, or modifications thereto. The rule
does not prohibit SDs and MSPs from establishing policies and
procedures instituting a framework for elevating issues through a
hierarchy of management as each sees fit, so long as such framework has
been approved in writing by senior management.
9. Dispute Resolution Procedures--Sec. 23.504(b)(1)
Proposed Sec. 23.504(b)(1) required SDs' and MSP's swap trading
relationship documentation to include dispute resolution procedures. In
the Documentation NPRM preamble, the Commission asked whether the
proposed rules should include specific requirements for dispute
resolution (such as time limits), and if so, what requirements are
appropriate for all swaps.
ISDA & SIFMA objected that the requirement that the parties agree
to dispute resolution procedures is not authorized by the Dodd-Frank
Act and that denying parties to a swap access to the judicial system is
not a measure that should be taken lightly or without Congressional
consideration. Similarly, IECA believes the proposed regulations for
dispute resolution are too specific and could violate separation of
powers under the Constitution.
On the other hand, CIEBA responded that the rules should not
include specific requirements, with the exception of requiring the
availability of independent valuation agents that are agreed upon by
the parties. CIEBA recommended that the Commission propose only a set
of fair and even-handed principles for resolving disputes.
In response to these comments, the Commission is modifying the
proposed rule to delete the term ``procedures'' from the requirement
that swap trading relationship documentation include ``terms addressing
* * * dispute resolution procedures.'' The Commission notes that the
rule as proposed was not intended to require SDs and MSPs to agree with
their counterparties on specific procedures to be followed in the event
of a dispute, but rather to require that dispute resolution be
addressed in a manner agreeable to both parties, whether it be in the
form of specific procedures or a general statement that disputes will
be resolved in accordance with applicable law. The Commission believes
that some form of agreement on the handling of disputes between SDs,
MSPs, and their counterparties will be essential to ensuring the
orderly operation of the swaps market.
10. Documentation of Credit Support Arrangements--Sec. 23.504(b)(3)
Proposed Sec. 23.504(b)(3) required that the swap trading
relationship documentation include certain specified details of the
credit support arrangements of the parties.
Better Markets recommended that the Commission revise the proposed
rule to
[[Page 55910]]
require documentation of the terms under which credit may be extended
to a counterparty by a registrant in the form of forbearance from
funding of margin and the cost of such credit extension, arguing that
such credit extension and the cost thereof, which is embedded in the
price of a swap, seriously impairs the transparency of the market by
concealing the true price of a swap divorced from the cost of credit.
Michael Greenberger commented that leaving terms and rules
regarding credit extension and transactional fees to subjective desires
of market participants will be counterproductive. Mr. Greenberger
supports the comment letter by Better Markets, Inc., which urges the
Commission to propose definitive rules requiring documentation of
credit extension and transactional fees.
COPE asked the Commission to clarify that the rule requires trading
documentation to include any applicable margin provisions and related
haircuts, but does not require margining and haircuts unless agreed by
the parties. IECA echoed the COPE comment, stating that the proposed
rule is unclear whether parties can enter into a swap that requires no
margin, as is contemplated in the Dodd Frank Act.
CIEBA commented that proposed Sec. 23.504(b)(3) should be
clarified by adding the words ``if any'' to the end of each of
subsections (i) through (iv) to make clear that end users are not
required to post initial margin or allow rehypothecation.
Having considered these comments, the Commission is of the view
that the proposed rule was not intended to require margin or related
terms where such are not required pursuant to other Commission
regulations or the applicable regulations adopted by prudential
regulators. The proposed rule was intended to require written
documentation of any credit support arrangement, whether that be a
guarantee, security agreement, a margining agreement, or other
collateral arrangement, but only to require written documentation of
margin terms if margin requirements are imposed by Commission
regulations, the regulations of prudential regulators, or are otherwise
agreed between SDs, MSPs, and their counterparties. Thus, in response
to commenters' requests for clarification, the Commission is modifying
the proposed rule as recommended by CIEBA by adding ``if any'' at the
end of each of subsections (i) through (iv) of Sec. 23.504(b)(3). The
Commission expects that other forms of credit support arrangements will
be documented in accordance with the rule as well.
However, the Commission is not revising the rule to enumerate the
terms of any extension of credit that are required to be included in
the documentation, as recommended by Better Markets. The Commission
believes that the rule, as proposed and as adopted by this release,
already requires documentation of initial and variation margin
requirements, which necessarily will entail documentation of any
extension of credit, i.e., the documentation will reflect whether
margining is subject to any credit extension threshold. Thus, to the
extent applicable, credit support arrangements must include, at a
minimum, the maximum amount of credit to be extended, the method for
determining how much credit has been extended, and any term of the
facility and early call rights. During negotiations regarding credit
support arrangements, counterparties would be well served to address
issues related to the embedded cost of credit. The Commission also
observes that transactional fees are required to be disclosed under
Sec. 23.431 of the Business Conduct Standards for SDs and MSPs Dealing
with Counterparties.\8\
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\8\ See Subpart H of Part 23 of the Commission's Regulations,
Business Conduct Standards for Swap Dealers and Major Swap
Participants with Counterparties, 77 FR 9734, 9824 (Feb. 17, 2012).
In addition, to the extent that any cost of credit may be embedded
in the price of a swap, the Commission believes that the disclosure
of the mid-market mark, which must be disclosed when an SD or MSP
discloses the price of a swap, will facilitate greater transparency
concerning the embedded cost of credit. Id. at 9765-66 (discussing
new Sec. 23.431(a)(3)(i)).
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11. Legal Enforceability of Netting and Collateral Arrangements--Sec.
23.504
The proposed regulations did not require SDs and MSPs to document
the legal enforceability of netting and collateral arrangements in the
swap trading relationship documentation.
In this regard, Volvo Financial Services Europe (Volvo) recommended
that the Commission adopt a rule that states clearly that credit
support arrangements should include legal opinions (updated annually)
verifying the perfection of security interests in collateral supporting
net exposures. Volvo argued that lack of legal certainty contributed to
losses in the 2008 financial crisis where counterparties discovered
that un-perfected security interests resulted in the unenforceability
of pledged collateral. Specifically, Volvo recommended that the
Commission revise the proposed rules to require: (i) Mandatory
collateralization, (ii) robust legal opinions (updated annually) on
enforceability of collateral arrangements, (iii) zero risk weighting if
robust legal opinions are obtained, and (iv) regular collateral audits
by the Commission to ensure that market participants perform the
perfection formalities of security interests.
Although the Commission agrees with the commenter that SDs and MSPs
should support their collateral arrangements with all necessary legal
analysis, the Commission has not made any changes to the proposed rule
based on this comment because the Commission believes (1) Volvo's
concerns regarding margining of uncleared swaps are addressed in the
Commission's proposed margin rules, or the prudential regulators'
proposed margin rules, as applicable, and (2) Volvo's concerns
regarding the legal enforceability of collateral arrangements is
addressed in risk management rules adopted by the Commission in
February, 2012.\9\
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\9\ See 17 CFR 23.600(c)(4)(v)(A) requiring SDs and MSPs to
establish policies and procedures to monitor and manage legal risk,
including policies and procedures that take into account
determinations that transactions and netting arrangements entered
into have a sound legal basis. 77 FR 20128, 20206 (Apr. 3, 2012).
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12. Valuation Methodology Requirement--Sec. 23.504(b)(4)
Proposed Sec. 23.504(b)(4) required that the swap trading
relationship documentation of each SD and MSP with their counterparties
include an agreement in writing on the methods, procedures, rules, and
inputs for determining the value of each swap at any time from
execution to the termination, maturity, or expiration of such swap.
a. Comments Received
Twenty of the comment letters received by the Commission addressed
the proposed valuation requirement in Sec. 23.504(b)(4). Many of those
comments raised similar concerns about the proposal, as summarized
thematically, below:
The Working Group, ISDA & SIFMA, FSR, White & Case, Morgan Stanley,
COPE, MFA, IECA, FHLBs, Hess Energy Trading Company, LLC (Hess),
Riverside Risk Advisors LLC, and Edison Electric Institute (EEI)
commented that valuation disputes provide valuable information to both
market participants and regulators about pricing dislocations and
associated credit risks and a static, rigid valuation methodology
necessarily produces values that become increasingly outdated over time
and could impede
[[Page 55911]]
the transmission of this important risk information.
The Working Group, ISDA & SIFMA, FSR, Markit, Freddie Mac, COPE,
MFA, FHLBs, CIEBA, EEI, and the Coalition of Derivatives End Users
commented that requiring agreement on valuation methodologies and set
alternative methods will materially increase the pre-execution
negotiating burden without an offsetting benefit and agreement on
models for complex swaps would require negotiations that could take
sophisticated professionals months to complete, if such could be
completed at all.
The Working Group, FSR, OCC, and Markit commented that it is
impossible to state valuation methodologies with the required
specificity without disclosing proprietary information about the
parties' internal models.
OCC and Hess commented that requiring agreement on valuation
methodologies may discourage development of more refined, dynamic swap
valuation models, which would lead to use of less sophisticated or
vanilla models that are less accurate than their proprietary
counterparts.
ISDA & SIFMA and IECA commented that agreeing on a methodology that
could survive the loss of any input to the valuation is wholly
unworkable, will diminish standardization as parties negotiate bespoke
approaches to valuation, and will undermine legal certainty if the
valuation methodology is determined not to be adaptable to all
circumstances.
COPE, FHLBs, MFA, EEI, and Markit commented that there is no
business need for swap-by-swap valuation formulas because valuation of
exposures with counterparties is usually conducted on a portfolio basis
and documented in a master agreement, and that agreement on swap-by-
swap valuation formulas also is likely to disrupt trading.
Several commenters also recommended alternative approaches to the
valuation requirement. The Working Group, Morgan Stanley, MFA, IECA,
FHLBs, CIEBA, and MetLife suggested that the focus of the rule should
be on the valuation dispute resolution process rather than valuation
methodologies that include fallback alternatives and other static
terms. MetLife specifically recommended that the Commission establish
``mandatory dispute resolution guidelines'' that include a requirement
for a third party arbiter after a set period of time.
With respect to valuation methodologies, CIEBA and Chris Barnard
recommended that the rule require SDs to value swaps on the basis of
transparent models that can be replicated by their counterparty. The
Working Group requested that the Commission clarify that parties are
permitted to use different valuation methodologies under different
circumstances (i.e., mid-market valuation for collateral purposes and
replacement cost valuation for terminations). Markit and MFA requested
that the Commission clarify that parties may rely on a more general set
of inputs, models, and fallbacks for valuation purposes, rather than
the exhaustive fallbacks required by the rule. White & Case and IECA
recommended that the Commission permit parties to change the valuation
method and inputs as the market changes over time. Freddie Mac
suggested that the rule should provide that the valuation methodology
requirement can be satisfied by executing industry standard
documentation that provides for a commercially reasonable valuation
methodology. The Coalition of Derivatives End Users, IECA, and Chris
Barnard recommended that proprietary inputs be allowed under the rule.
More generally, FSR recommended that the Commission withdraw the
proposed valuation requirement until the Commission has the time to
conduct a thorough study, including a comprehensive cost-benefit
analysis, whereas Markit recommended that the rule be modified to
explicitly allow parties to comply with the rule by agreeing that an
independent third party may provide any or all of the elements required
to agree upon the valuation of swaps. The Coalition of Derivatives End
Users recommended that the Commission change the rule to require SDs
and MSPs to provide commercially reasonable information to substantiate
its valuations upon an end user's request, instead of requiring
extensive pre-trade documentation of valuation methodology.
The Working Group recommended that the Commission modify the rule
to provide that the valuation requirements for cleared swaps or swaps
executed on a trading facility should be satisfied by referencing the
price provided by the relevant DCO or facility, while Markit
recommended that the Commission clarify that neither prices of recently
executed transactions or any other single pricing input should be
regarded as preferable inputs for the valuation of swaps and explicitly
permit parties to use pricing sources other than DCOs, even for cleared
swaps.
A number of commenters supported the rule. Chris Barnard strongly
supported the requirement that the agreed methods, procedures, rules
and inputs constitute a ``complete and independently verifiable
methodology for valuing each swap entered into between the parties,''
and that the methodology must include alternatives ``in the event that
one or more inputs to the methodology become unavailable or fail.'' Mr.
Barnard also supported the requirement for SDs and MSPs to ``resolve a
dispute over the valuation of a swap within one business day.'' Michael
Greenberger generally supported the valuation methodology rule to
promote transparency and financial integrity. MetLife agreed with the
proposal that parties should determine upfront what the valuation
methodologies will be to help mitigate disputes, but believes that
disputes will not be eliminated by the rule.
CIEBA commended the Commission for requiring objective and specific
valuation mechanisms in swaps documentation and believes that this
requirement will limit the potential for valuation disputes. However,
CIEBA believes requiring objective and specific valuation mechanisms is
not enough. In addition to requiring SDs to value swaps using
transparent models that can be replicated by their counterparties,
CIEBA recommended that the Commission require the mechanisms or
procedures by which disputes are resolved to be fair and even-handed
and should not override existing contractual protections negotiated by
the parties.
b. Commission Response
Having considered these comments, the Commission is modifying and
clarifying the proposal in a number of ways. First, in response to
concerns from non-financial entities regarding the cost and the
challenges of pre-execution negotiation, the Commission is modifying
the rule to require valuation documentation only at the request of non-
financial entities. In other words, non-financial entities will have
the ability, but not the obligation, to enter into negotiations on
valuation with their SD or MSP counterparties. As discussed below, the
rule will continue to apply to SDs, MSPs, and financial entities.
While the Commission agrees with commenters regarding the
importance of using transparent models that can be replicated, the
Commission recognizes concerns about protecting proprietary information
used in internal valuation models. Thus, the Commission has modified
the rule to clarify the requirement that the agreement on valuation use
objective criteria, such as recently-executed transactions and
valuations provided by independent third parties. In this regard, the
[[Page 55912]]
Commission agrees with The Working Group that the valuation
requirements for cleared swaps or swaps executed on a trading facility
would be satisfied by referencing the price provided by the relevant
DCO, SEF, or DCM.
Additionally, the Commission confirms commenters' understanding
that proprietary models may be used for purposes of valuation, provided
that both parties agree to the use of one party's confidential,
proprietary model. An agreement by the parties to use one party's
confidential, proprietary model is sufficient to satisfy the
requirements of Sec. 23.504(b)(4)(i), including the requirement that
the parties agree on the methods, procedures, rules and inputs for
determining the value of each swap. On the other end of the spectrum
from simply agreeing to use one party's model, counterparties may, if
they choose, elect to negotiate precisely which model and inputs will
govern the valuation of their swaps. Counterparties would be free to
elect either of these options or many other possibilities under the
terms of Sec. 23.504(b)(4) so long as the resulting valuations are
sufficient to comply with the margin requirements under section 4s(e)
of the CEA and the risk management requirements under section 4s(j) of
the CEA, and there is a dispute resolution process in place or a viable
alternative method for determining the value of the swap. Moreover, the
Commission is modifying proposed Sec. 23.504(b)(4)(iii) to clarify
that confidential, proprietary model information is protected under the
rule.
To address concerns that the use of the phrase ``methods,
procedures, rules, and inputs'' could be interpreted as requiring
agreement on the precise model and all inputs for valuing a swap, the
Commission is modifying the rule text to require that parties agree on
``the process, including methods, procedures, rules, and inputs for
determining the value of each swap.''
Importantly, the Commission is responding to commenters' concerns
about the requirement that the valuation documentation be stated with
sufficient specificity to allow the SD, MSP, the Commission, and any
prudential regulator to value the swap ``independently in a
substantially comparable manner.'' Commenters viewed this standard as
problematic because they read it to require disclosure of proprietary
information or to prevent the updating or revising of models, among
other things. Accordingly, the Commission has determined to remove this
provision from the final rule. So long as the valuation documentation
is stated with sufficient specificity to determine the value of the
swap for purposes of complying with the requirements of the rule--
namely, the margin and risk management requirements under section 4s of
the CEA and Part 23 of Commission regulations--the requirements of
Sec. 23.504(b)(4)(i) would be met.
Under this approach, parties may rely on a general set of methods,
inputs, models, and fallbacks for valuation purposes so long as the
process is sufficient to determine the value of a swap. In response to
concerns that the proposal would require a methodology that would be
static or rigid over time, the Commission is further modifying the rule
to make explicitly clear that the parties may agree on a process,
including methods or procedures for modifying or amending the valuation
process as circumstances require and as the market changes over
time.\10\
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\10\ To the extent that one or both parties foresee that the
valuation method or inputs agreed for a swap or a class or category
of swaps will likely require modification, parties would be well-
served to agree in advance in their swap trading relationship
documentation on an appropriate arrangement for accommodating such
modifications.
---------------------------------------------------------------------------
The Commission does not disagree with commenters that differences
in valuations can provide valuable information to both market
participants and regulators about pricing dislocations and associated
credit risks. Moreover, the objective is not to produce values that
become increasingly outdated over time. Rather, the Commission believes
that by requiring agreement between counterparties on the methods and
inputs for valuation of each swap, Sec. 23.504(b)(4) will assist SDs
and MSPs and their counterparties to arrive at valuations necessary for
margining and internal risk management, and to resolve valuation
disputes in a timely manner, thereby reducing risk.
Agreement between SDs, MSPs, and their financial entity
counterparties on the proper daily valuation of the swaps in their swap
portfolio is an essential component of the Commission's margin
proposal. Under proposed Sec. 23.151, non-bank SDs and MSPs must
document the process by which they will arrive at a valuation for each
swap for the purpose of collecting initial and variation margin in
compliance with the requirements of Sec. 23.504. All non-bank SDs and
MSPs must collect variation margin from their non-bank SD, MSP, and
financial entity counterparties for uncleared swaps on a daily basis.
Variation margin requires a daily valuation for each swap. For swaps
between non-bank SDs and MSPs and non-financial entities, no margin is
required to be exchanged under Commission regulation, but the non-bank
SDs and MSPs must calculate a hypothetical variation margin requirement
for each uncleared swap for risk management purposes under proposed
Sec. 23.154(b)(6).\11\ The daily valuation agreed to by the
counterparties is necessary for compliance with the margin requirements
proposed by the Commission and the prudential regulators under section
4s(e) of the CEA.
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\11\ SDs and MSPs that are banks are subject to the requirements
of section 4s(i). In addition, under the prudential regulators'
margin proposal, SDs and MSPs that are banks would be required to
have documentation in place that specifies the ``(1) [t]he methods,
procedures, rules, and inputs for determining the value of each swap
* * * for purposes of calculating variation margin requirements; and
(2) [t]he procedures by which any disputes concerning the valuation
of swaps * * * or the valuation of assets collected or posted as
initial margin or variation margin, may be resolved.'' Margin and
Capital Requirements for Covered Swap Entities, 76 FR 27564, 27589
(May 11, 2011).
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In addition to the fact that arriving at a daily valuation is one
of the building blocks for the margin rules, timely and accurate
valuations are essential for the risk management of swaps by SDs and
MSPs. Under Sec. 23.600(c)(4)(i), the Commission required that SDs and
MSPs have risk management policies and procedures that take into
account the daily measurement of market exposure, along with timely and
reliable valuation data. The valuation documentation requirements under
Sec. 23.504(b) and the risk management provisions of Sec. 23.600 work
together to ensure that SDs and MSPs have the most accurate and
reliable valuation data available for internal risk management and for
collateralization of risk exposures with counterparties. This is not to
say that valuation disputes can be prevented entirely or that these
disputes do not, at times, offer useful insight into the marketplace.
Indeed, risk management personnel and management within the SD or MSP
should pay particular attention to different valuations for the same
swap originating within their organization or from outside the entity.
For these purposes, the Commission expects that valuation disputes that
are not resolved in accordance with these rules be elevated to senior
management in the firm.\12\ However, the final rule reflects the
recognition that accurate and
[[Page 55913]]
reliable valuations are the foundation of margining and risk
management.
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\12\ Under Sec. 23.600(c)(1)(1)(iii), the risk management
program requires SDs and MSPs to have policies and procedures for
detecting breaches of risk tolerance limits set by an SD or MSP, and
alerting supervisors within the risk management unit and senior
management, as appropriate.
---------------------------------------------------------------------------
The Commission also agrees with commenters that the trading
documentation should be permitted to focus on the valuation dispute
resolution process rather than exclusively on fallback methodologies,
and has further modified the rule to allow for either fallback
methodologies or agreement on a dispute resolution process, but does
not think it necessary or desirable to specify a standard dispute
resolution process at this time, as requested by MetLife.
Lastly, the Commission wishes to distinguish its use of the terms
``valuation'' under section 4s(i) of the CEA and ``daily mark'' under
section 4s(h). In its final rules for Business Conduct Standards for
SDs and MSPs with Counterparties, the Commission explained that the
daily mark for uncleared swaps represented the mid-market mark of a
swap provided by an SD or MSP to its counterparty.\13\ The mid-market
mark of the swap represents an objective value that provides
counterparties with a baseline to assess swap valuations for other
purposes.\14\ By contrast, in Sec. 23.504(b)(4), the Commission is
requiring that SDs, MSPs, and their counterparties agree to a process
for determining the current market value or net present value of a swap
for purposes of collateralizing the risk posed by the swap and internal
risk management. The critical difference being the agreement of both
counterparties to the process for determining the value of a swap,
rather than just the SD's or MSP's calculation of the mid-market value
of the swap.
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\13\ See 77 FR 9734, 9767-68 (Feb. 17, 2012); see also Swap Data
Recordkeeping and Reporting Requirements, 77 FR 2136, (Jan. 13,
2012) (defining ``valuation data'' by reference to section
4s(h)(3)(B)(iii) of the CEA and Sec. 23.431.
\14\ See Sec. 23.431(d). SDs and MSPs must provide a daily mark
for uncleared swaps that is the mid-market mark of the swap which
does not include amounts for profit, credit reserve, hedging,
funding, liquidity, or any other costs or adjustments.
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13. Application to Cleared Swaps--Sec. 23.504(b)(6)
Proposed Sec. 23.504(b)(6) required the swap trading relationship
documentation of SDs and MSPs to include certain items upon acceptance
of a swap for clearing by a DCO, including documentation of each
counterparty's clearing member, the date and time the swap was cleared,
that the swap conforms to the terms of the DCO's templates, and that
the clearing member's books reflect the terms of the swap at the DCO.
The proposed regulation also required the documentation to contain a
statement that the original swap is extinguished and replaced by a swap
subject to the rules of the DCO.
ISDA & SIFMA urged the Commission to clarify that the term ``swap
trading relationship documentation'' is used to describe only bilateral
documentation between parties to uncleared swaps. ISDA & SIFMA
recommend that the Commission not finalize Sec. 23.504(b)(6) because
ISDA & SIFMA (1) Saw no need to record the identity of its
counterparty's clearing member; (2) recommended that the obligation to
provide notice of the date and time of clearing and the identity of the
DCO is deemed satisfied when the counterparty receives a clearing
report from the DCO; (3) objected to notifying the counterparty of the
SD's or MSP's clearing member as that information may be sensitive and
is not material to the counterparty; and (4) saw no need to state facts
about the counterparty's cleared swap in trading relationship
documentation.
CME commented that existing clearing houses use an agency model
with FCMs acting as the agent and guarantor for customers, providing
numerous benefits. To preserve the agency structure, CME requested that
Sec. 23.504(b)(6)(v)(B) be changed to read ``The original swap is
replaced by equal and opposite swaps with the derivatives clearing
organization.''
CME further commented that under the rule the anonymity of the
customer of the clearing member on the other side of the trade to the
clearing member will be lost. CME does not believe the anonymity needs
to be lost to serve the purposes of the documentation rules.
MFA commented that one of the benefits of central clearing is
anonymity, such that once parties submit a swap for central clearing,
it need not retain or know any information about the counterparty. MFA
recommended that the final rule not require any identifying information
about the parties and their firms.
The Commission has considered the commenters' recommendation to
delete the clearing record provisions of Sec. 23.504(b)(6)(iii) and
(iv) and agrees that there is no need to include in the trading
documentation a record of the names of the clearing members for the SD,
MSP, or counterparty. The Commission notes that the new applicability
provision added to Sec. 23.504(a)(1) provides that the swap trading
relationship documentation rule does not apply to swaps executed
anonymously on a DCM or SEF, but believes that anonymity may also be
important in the execution of swaps executed off-facility, such as in
the execution of block trades with asset managers where allocation may
take place following acceptance of the block trade for clearing by a
DCO. Once a swap is accepted for clearing, the identity of a
counterparty's clearing member is no longer relevant and requiring such
a record has the possibility to undermine the anonymity of central
clearing. Therefore, those provisions have been deleted from the final
rule. Similarly, Sec. 23.504(b)(6)(i) and (ii) have been removed
because those records will be captured under the SD and MSP
recordkeeping requirement, Sec. 23.201(a)(3), and the Commission
believes those records are sufficient.
With regard to proposed Sec. 23.504(b)(6)(v), the Commission has
retained but streamlined the provision, as recommended by ISDA & SIFMA
and CME, to include only the text in Sec. 23.504(b)(6) set forth in
the regulatory text of this rule.
The Commission continues to believe that swap trading relationship
documentation should make clear the effects of clearing a trade with a
DCO; i.e., that the original swap is extinguished and replaced with a
swap facing the DCO that conforms to the terms established under the
DCO's rules. The Commission has determined that an orderly swap market
requires this notice to clarify that the terms of the swap under a
DCO's rules are definitive and trump any contradictory terms that may
have been included in the swap as executed between an SD or MSP and its
counterparty.\15\
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\15\ This provision corresponds to Sec. 39.12(b)(6), which
establishes parallel requirements for DCOs clearing swaps. Both
proposals have been modified in a similar manner for the final
rules.
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14. Annual Audit of 5 Percent of Swap Trading Relationship
Documentation--Sec. 23.504(c)
Proposed Sec. 23.504(c) required that SDs and MSPs, at least once
during each calendar year, have an independent internal or external
auditor examine no less than 5 percent of the swap trading relationship
documentation created during the previous twelve month period to ensure
compliance with Commission regulations and the written policies and
procedures established pursuant to Sec. 23.504.
In response to the proposal, ISDA & SIFMA, FSR, and Hess urged the
Commission to adopt a principles-based approach to the audit
requirement and only require SDs and MSPs to conduct periodic audits
sufficient to identify material weaknesses in their documentation
policies and procedures.
[[Page 55914]]
Similarly, IECA recommended that the Commission require an audit of a
random sample, rather than 5 percent, which IECA found too costly.
Commenting on a different aspect of the proposal, Michael Greenberger
thought that allowing internal audits, as opposed to external, could
undermine transparency and accountability.
In response to commenters and as a cost-saving measure, the
Commission is modifying the proposed rule in accordance with the
alternative recommended by ISDA & SIFMA, FSR, and Hess by removing the
5 percent audit requirement and replacing it with a more general
requirement that SDs and MSPs conduct periodic audits sufficient to
identify material weaknesses in their documentation policies and
procedures. With respect to Mr. Greenberger's comment, the Commission
continues to believe that internal auditors are sufficient as a record
of the results of each audit will be retained and can be reviewed by
Commission staff during examinations of the SD or MSP or investigations
by Commission enforcement staff.
15. Dispute Reporting--Sec. 23.504(e)
The proposed regulations required SDs and MSPs to notify the
Commission and any applicable prudential regulator or the SEC of any
swap valuation dispute not resolved within one business day, if the
dispute is with a counterparty that is an SD or MSP, or within five
business days if the dispute is with any other counterparty.
In response to the proposal, ISDA & SIFMA recommended that the
Commission should limit reporting to material disputes at the portfolio
level, urging the Commission to accept the materiality thresholds for
reporting established by the OTC Derivatives Supervisors' Group
process, which require reporting of disputes above a certain dollar
threshold and only after such disputes have had a proper time to
mature. ISDA & SIFMA argued that rule as proposed will be overly
burdensome and the over-reporting will cause substantial informational
``noise.''
MFA strongly agreed that the Commission should adopt rules related
to valuation disputes and their timely resolution, but questioned
whether regulators need notice of every unresolved dispute regardless
of their materiality from a systemic risk or regulatory perspective.
MFA also commented that the proposed dispute resolution period of one
business day for unresolved disputes among SDs and MSPs is too short,
arguing that valuation disputes may require discussion and negotiation
by and among several levels of management and many different
operational teams at an SD or MSP. MFA thus recommended that the
Commission provide for five business days to resolve a valuation
dispute in an account before they must give regulators notice and only
require notice to regulators where the amount in dispute exceeds either
(a) $100 million, or (b) both 10 percent of the higher of the parties'
valuation and $50 million. In addition, MFA strongly believes that any
notices of disputes should be treated confidentially by regulators, and
not be subject to public access.
IECA argued that the proposed rule should be removed because it
creates an unlevel playing field by creating pressure on a party that
wants to avoid reporting to concede in any dispute.
MetLife agreed that the Commission should establish strict
timelines for reporting disputes, but argued that the periods proposed
are too short to allow parties to resolve disputes on their own.
MetLife recommended that disputes between SD/MSPs should be given 3
days before reporting is required and be subject to a materiality
condition of 10 percent of the calculated valuation of the swap in
dispute.
Hess recommended that the Commission limit reporting to material
disputes dependent on the risk the dispute may pose to the financial
system taking into account the size of the dispute relative to the size
of the trade, the collateral involved, and the size of the parties
involved.
For the reasons submitted by these commenters, the Commission has
determined that only material swap valuation disputes should be
reported to the Commission, any applicable prudential regulator, and
the SEC (with regard to swaps defined in section 1a(47)(A)(v) of the
Act). Thus, the Commission is modifying the rule to provide that SDs
and MSPs shall provide notice of any swap valuation dispute in excess
of $20,000,000 (or its equivalent in any other currency).\16\ The
Commission has determined that the $20,000,000 materiality threshold
for reporting is sufficiently high to eliminate unnecessary ``noise''
from over-reporting, but not so high as to eliminate reporting that the
Commission may find of regulatory value, such as a large number of
relatively small disputes that in aggregate could provide the
Commission with information regarding a widespread market disruption.
---------------------------------------------------------------------------
\16\ Compare with ESMA Draft Technical Standards, Article 4 RM,
subsection 2, (stating that ``counterparties shall report to the
competent authority * * * any disputes between counterparties
relating to an OTC derivative contract, its valuation or the
exchange of collateral for an amount or a value higher than EUR 15
million and outstanding for at least 15 business days.'')
---------------------------------------------------------------------------
In addition, the Commission is modifying the requirement for SDs
and MSPs to report unresolved valuation disputes within one business
day if the dispute is with a counterparty that is a SD or MSP. SDs and
MSPs now will be required to report unresolved valuation disputes
within three business days. For disputes with counterparties that are
not SDs or MSPs, the rule is unchanged from the proposal, requiring
that unresolved disputes be reported within five business days.
The Commission has also determined that the reporting requirement
of the rule better fits with the resolution requirement under the
portfolio reconciliation rule at Sec. 23.502 and has renumbered the
rule as Sec. 23.502(c). The Commission notes that the reporting
requirement under the rule as adopted is distinct from the swap
valuation methodology requirement under Sec. 23.504(b)(4), discussed
above, and the time period requirement for SDs and MSPs to resolve swap
valuation disputes in Sec. 23.502, discussed below.
16. Orderly Liquidation Termination--Sec. 23.504(b)(5)
Proposed Sec. 23.504(b)(5) required SDs and MSPs to include in
their swap trading relationship documentation an agreement with their
counterparties that, in the event a counterparty is a covered financial
company (as defined in section 201(a)(8) of the Dodd-Frank Act) or an
insured depository institution (as defined in 12 U.S.C. 1813) for which
the Federal Deposit Insurance Corporation (FDIC) has been appointed as
a receiver (the ``covered party''), the non-covered party is subject to
certain limitations specified by law following the appointment of the
FDIC as receiver of the covered party and the non-covered party
acknowledges that the FDIC may take certain actions with respect to the
transactions governed by such documentation.
In response to the proposal, ISDA & SIFMA and FSR argued that
because the rule language is not identical to section 210 of the Dodd-
Frank Act, the proposed rule requiring an agreement between
counterparties in swap trading relationship documentation could
inadvertently expand FDIC powers beyond limits set by Congress by
creating a discrepancy between the FDIC's actual powers under Title II
of the Dodd-Frank Act and the treatment consented to by the parties.
ISDA & SIFMA believe that any discrepancy could operate to strip
parties of legal
[[Page 55915]]
rights to challenge their treatment under Title II of the Dodd-Frank
Act. This, in turn, could raise questions about whether the rule is a
proper exercise of the Commission's rulemaking authority. ISDA & SIFMA
recommended that the Commission revise the rule to only require a
notice of the relevant provisions of Title II.
CIEBA also noted that the proposed language is similar to, but not
the same as, the statutory text in the Dodd-Frank Act and the FDIA, and
could harm its constituents. By substituting terms and apprising
parties of some, but not all, of their rights, the proposed rule
increases the risk of disputes and creates uncertainty as to what will
be required to comply with both the statute and the regulatory regime.
As an example, CIEBA cited section 210(c)(9)(A)(i) of the Dodd-Frank
Act, which states that, in the context of orderly liquidation, the FDIC
may elect to ``transfer to one financial institution, (i) all qualified
financial contracts * * * or (ii) transfer none of the qualified
financial contracts, claims, property or other credit enhancement
referred to in clause (i) (with respect to such person and any
affiliate of such person).'' In contrast to this statutory language,
the proposed rule uses ``may,'' which suggests that the FDIC has the
discretion to transfer less than all qualified financial contracts in
contrast to its statutory requirement to transfer all or none. CIEBA
also notes that the proposed regulation would remain effective even if
the statutory provision it implements is repealed or amended. This
could result in parties being forced to waive rights that protect their
financial interest in times of market turmoil. In the alternative,
CIEBA recommended that the Commission require the documentation to
include a written statement in which the counterparties agree that they
will comply with the requirements, if any, of section 210(c)(10)(B) of
the Dodd-Frank Act and section 11(e)(10)(B) of the Federal Deposit
Insurance Act, or instead, require an SD or MSP to include a statement
thereof in its risk disclosure documents. At the least, CIEBA requests
that the Commission add an additional section to proposed Sec.
23.504(b)(5) to reflect a counterparty's right to suspend payments to
the covered party for the period of the stay, as provided in section
210(c)(8)(F)(ii) of the Dodd-Frank Act.
EEI & NRECA also objected to the proposed rule, arguing that a
statutory provision intended to encourage cooperation between the FDIC
and the Commission does not provide the Commission with authority to
unilaterally establish new jurisdiction for itself and that the
Commission should allow the FDIC to take the lead as contemplated by
Title II of the Dodd-Frank Act. EEI & NRECA stated that energy end
users would be particularly harmed by the proposed rule because swaps
would be covered by the rule, but not physical transactions, causing
energy end users to separately collateralize swaps and physical
transactions, eliminating their ability to cost-effectively hedge
commercial risks using swaps.
The FHLBs acknowledged the potential applicability of the orderly
liquidation provisions of the Dodd-Frank Act, but also objected to the
inclusion of the provisions in the swap documentation as the provisions
would apply notwithstanding such inclusion and doing so could create
legal uncertainty since other liquidation regimes are not listed in the
documents.
MetLife objected specifically to the requirement to include consent
to FDIC liquidation, arguing that such consent may foreclose a party's
right to appeal or challenge the FDIC's actions. MetLife also raised
concerns that blanket consent could place the remaining party in a
position where it has unwanted excessive credit exposure to the new
counterparty, resulting in violation of state law requirements with
respect to credit ratings and other credit quality requirements.
MetLife requested that the section be removed or that a provision be
added to allow a party to object to any proposed transfer.
Hess argued that the provision is not appropriate because the large
majority of SDs and MSPs will likely not be ``covered financial
companies'' and as of now, the actual application of Title II is
unclear. Hess recommended that the rule only require SDs and MSPs to
provide notice of the possibility of FDIC liquidation.
Chris Barnard commented that the authority of the FDIC is statutory
in nature, and so would automatically apply to the relevant swaps,
overriding any current practice. Given this point, Mr. Barnard believes
the provision is redundant.
In contrast to the foregoing, Better Markets fully supported the
proposed rule, stating that the proposed rule represents a
clarification of a fundamental feature of swaps; the consequences of a
default by an SD or MSP. Better Markets stated that a basic premise of
derivatives in bankruptcy is the exemption from the automatic stay such
that the non-defaulting party may immediately terminate and apply
collateral post insolvency. Better Markets agreed that the proposed
rule documents an important exception to that right newly created in
the Dodd-Frank Act. Better Markets believes that clarity, both at
inception of a swap and at default, is the foundation of the Dodd-Frank
Act, because lack of clarity contributed heavily to the financial
crisis and caused much harm.
The Commission has carefully considered each of the comments
received on the proposal. At the outset, the Commission believes that,
in the context of the proposed rules, it is not possible to track the
statutory language of Title II of the Dodd-Frank Act any more closely.
Given the imperfectability of reproducing such statutory language and
the context in which it appears in the rule, the Commission is
sensitive to commenters' concerns that the rule could have a different
legal effect in application as compared to application of the statutory
language. The Commission is also aware that the statutory provisions
will apply to covered financial companies and insured depository
institutions placed into FDIC receivership even if not included in this
rule. Therefore, the Commission has determined that the best course is
to revise the proposed rule to require that swap trading relationship
documentation contain only a notice as to whether the SD or MSP or its
counterparty is an insured depository institution or financial company
and that the orderly liquidation provisions of the Dodd-Frank Act and
the FDIA may limit the rights of the parties under their trading
relationship documentation in the event either party is deemed a
``covered financial company'' or is otherwise subject to having the
FDIC appointed as a receiver.
C. End User Exception Documentation--Sec. 23.505
1. Overlap With Proposed Sec. 39.6
The proposed regulation required SDs and MSPs, when transacting
with market participants claiming the exception to clearing under
section 2(h)(7) of the CEA, to obtain documentation sufficient to
provide a reasonable basis on which to believe that its counterparty
meets the statutory conditions required for the exception. Various
requirements for the documentation were listed in the proposed rule.
In response to the proposal, The Working Group and Encana Marketing
(USA), Inc. (Encana) argued that because proposed Sec. 39.6 would
require SDs and MSPs to collect and report the information relevant to
the section 2(h)(7) clearing exception, the proposed rule should be
revised to impose no
[[Page 55916]]
documentation obligations with regard to this exception. Encana also
commented that in the alternative, Sec. 23.505 should only require
that SDs and MSPs obtain ``documentation'' that the counterparty
qualifies as an end user in the transaction documents, but did not
specify what form such documentation should take. COPE also commented
that the proposed rule is burdensome and redundant to proposed Sec.
39.6 and believes that the attestation required by proposed Sec. 39.6
should be sufficient.
Michael Greenberger, on the other hand, believes a check-the-box
approach is insufficient, and recommended enhanced reporting
requirements ensuring that the calculation methodology and the
effectiveness of the hedged position are well documented. Better
Markets also recommended enhanced reporting, suggesting that end users
report their hedging transactions to SDRs as provided in proposed Sec.
39.6. Requiring end users to provide information for each transaction
to SDs and MSPs separately is overly burdensome whereas direct
reporting to SDRs would amount to only a slight change from current
prudent practice at many end users.
Having considered these comments, the Commission is adopting the
rule as proposed with one exception. The Commission has permitted
entities that qualify for the exception to the clearing requirement
under section 2(h)(7) of the Act to report information directly to an
SDR regarding how they generally expect to meet their financial
obligations associated with non-cleared swaps on an annual basis in
anticipation of electing the exception for one or more swaps.\17\ Thus,
an electing counterparty could be directly reporting the information
necessary for SD and MSP compliance with proposed Sec. 23.505(a)(3)
through (5). Therefore, the Commission has modified the proposed rule
to clarify that SDs and MSPs need not obtain documentation from any
counterparty that claims an exception from required clearing if that
counterparty is reporting directly to an SDR regarding how it generally
expects to meet its financial obligations associated with its non-
cleared swaps, and the SD or MSP has confirmed that the counterparty
has made its annual submission.
---------------------------------------------------------------------------
\17\ See End-User Exception to the Clearing Requirement for
Swaps, 77 FR 42560, 42590 (July 19, 2012).
---------------------------------------------------------------------------
2. Reasonable Basis--Sec. 23.505(a)
The proposed regulation required that SDs or MSPs have a reasonable
basis to believe its counterparty meets the statutory conditions
required for an exception from a clearing requirement.
In response to the proposal, ISDA & SIFMA requested that the
Commission clarify that the ``reasonable basis to believe'' standard in
the proposed rule may be satisfied by reliance on written
representations from the counterparty, absent facts that reasonably
should have put the swap dealer or major swap participant on notice
that its counterparty may be ineligible for the end user exception.
ISDA & SIFMA argued that registrants should not have to investigate
their counterparty's representations or obtain detailed representations
as to the facts underlying the company's qualifications.
The Coalition for Derivatives End-Users supports the ``check-the-
box'' approach in proposed Sec. 39.6 for end users to use to qualify
for the clearing exception, and is therefore concerned that the
``reasonable basis'' obligation in proposed Sec. 23.505(a) could
undermine the simplicity of the check-the-box approach. The Coalition
for Derivatives End-Users argues that if SDs and MSPs must verify end
user information, they may start to require unnecessary and costly
documentation from end users such as legal opinions or other documents,
rather than serving as passive conduits of information.
After considering these comments, the Commission has determined to
adopt the rule as proposed on this issue. The Commission is of the view
that, contrary to commenters' concerns, the ``reasonable basis''
standard in the proposed rule does not require independent
investigation of information or documentation provided by a
counterparty electing the exception from required clearing. The
Commission believes that so long as an SD or MSP has obtained
information, documentation, or a representation that on its face
provides a reasonable basis to conclude that the counterparty qualifies
for the exception under section 2(h)(7), then, in the absence of facts
that reasonably should have put the SD or MSP on notice that its
counterparty may be ineligible for the exception, no further
investigation would be necessary. The Commission does not believe that
the rule requires legal certainty on the part of SDs or MSPs.
3. Disclosure of Information by End Users
The proposed regulation required SDs and MSPs to obtain
documentation that its counterparty seeking to qualify for the clearing
exception generally meets its financial obligations associated with
non-cleared swaps.
Better Markets argued that the proposed rule should require
documentation in accordance with the Dodd-Frank Act, i.e.,
documentation as to how the counterparty generally meets its
obligations associated with non-cleared swaps, including how it would
meet any obligation to immediately fund margin upon the occurrence of a
credit trigger.
ISDA & SIFMA commented that the Dodd-Frank Act merely requires a
counterparty to notify the Commission as to how it generally meets its
financial obligations. ISDA & SIFMA recommended that Sec. 23.505(a)(5)
be deleted or clarified such that a registrant can satisfy the
requirement by obtaining a representation from its counterparty or by
obtaining the documentation only with respect to swap-related
obligations to the particular SD or MSP.
In the view of COPE, EEI, and CIEBA, the requirement for the SD/MSP
to get information from end users is anti-competitive and inappropriate
as it requires an end user to inform its SD or MSP counterparty, a
potential competitor, of proprietary details about its business,
including its hedging activities. Each recommended that no more than a
representation from the end user should be required. COPE also objects
to the rule placing the SD or MSP in the role of regulator responsible
for determining if the information received is sufficient.
As explained above, the Commission is modifying the proposed rule
to clarify that SDs and MSPs need not obtain documentation from any
counterparty that claims an exception from required clearing if that
counterparty is reporting directly to an SDR under Sec. 39.6(b)
regarding how it generally expects to meet its financial obligations
associated with its non-cleared swaps, and the SD or MSP has confirmed
that the counterparty has made its annual submission. Thus, any entity
seeking to claim the exception from clearing may avoid revealing any
information it considers sensitive to its SD or MSP counterparty by
self-reporting directly to an SDR under Sec. 39.6(b). The Commission
notes that protections against release of reported proprietary
information are addressed in the SDR rules finalized by the Commission.
[[Page 55917]]
D. Swap Confirmation--Sec. 23.501
Confirmation has been recognized as an important post-trade
processing mechanism for reducing risk and improving operational
efficiency by both market participants and their regulators. Prudent
practice requires that, after coming to an agreement on the terms of a
transaction, parties document the transaction in a complete and
definitive written record so there is legal certainty about the terms
of their agreement.
Over the past several years, OTC derivatives market participants
and their regulators have paid particular attention to the timely
confirmation of swaps. The Government Accountability Office (GAO) found
that the rapid expansion of the trading volume of swaps, such as credit
derivatives since 2002, caused stresses on the operational
infrastructure of market participants. These stresses in turn caused
the participants' back office systems to fail to confirm the increased
volume of trades for a period of time.\18\ The GAO found that the lack
of automation in trade processing and the purported assignment of
positions by transferring parties to third parties without notice to
their counterparties were factors contributing to this backlog. If
transactions, whether newly executed or recently transferred to another
party, are left unconfirmed, there is no definitive written record of
the contract terms. Thus, in the event of a dispute, the terms of the
agreement must be reconstructed from other evidence, such as email
trails or recorded trader conversations. This process is cumbersome and
may not be wholly accurate. Moreover, if purported transfers of swaps,
in whole or in part, are made without giving notice to the remaining
parties and obtaining their consent, disputes may arise as to which
parties are entitled to the benefits and subject to the burdens of the
transaction.
---------------------------------------------------------------------------
\18\ U.S. Government Accountability Office, ``Credit
Derivatives: Confirmation Backlogs Increased Dealers' Operational
Risks, But Were Successfully Addressed After Joint Regulatory
Action,'' GAO-07-716 (2007) at pages 3-4.
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The Commission believes the work of the OTC Derivatives Supervisors
Group (ODSG) demonstrates that the industry is capable of swift
movement to contemporaneous execution and confirmation. A large back-
log of unexecuted confirmations in the credit default swap (CDS) market
created by prolonged negotiations and inadequate confirmation
procedures were the subject of the first industry commitments made by
participating dealers to the ODSG.\19\ In October 2005, the
participating dealers committed to reduce by 30 percent the number of
confirmations outstanding more than 30 days within four months. In
March 2006, the dealers committed to reduce the number of outstanding
confirmations by 70 percent by June 30, 2006. By September 2006, the
industry had reduced the number of all outstanding CDS confirmations by
70 percent, and the number of CDS confirmations outstanding more than
30 days by 85 percent. The industry achieved these targets largely by
moving 80 percent of total trade volume in CDS to confirmation on
electronic platforms, eliminating backlogs in new trades.
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\19\ See October 4, 2005 industry commitment letter to the
Federal Reserve Bank of New York, available at http://www.newyorkfed.org/newsevents/news_archive/markets/2005/an050915.html.
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By the end of 2011, the largest dealers were electronically
confirming over 95 percent of OTC credit derivative transactions, and
90 percent were confirmed on the same day as execution (T+0). For the
same period, the largest dealers were electronically confirming over 70
percent of OTC interest rate derivatives (over 90 percent of trades
with each other), and over 80 percent were confirmed T+0. The rate of
electronic confirmation of OTC commodity derivatives was somewhat
lower--just over 50 percent, but over 90 percent for transactions
between the largest dealers.\20\
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\20\ See G15 Industry Confirmation Data dated April 4, 2012
provided by ISDA, available at www.cftc.gov.
---------------------------------------------------------------------------
The Commission further recognizes the ODSG supervisory goal for all
transactions to be confirmed as soon as possible after the time of
execution. Ideally, this would mean that there would be a written or
electronic document executed by the parties to a swap for the purpose
of evidencing all of the terms of the swap, including the terms of any
termination (prior to its scheduled maturity date), assignment,
novation, exchange, or similar transfer or conveyance of, or
extinguishing of rights or obligations.
The Commission believes that timely and accurate confirmation of
swaps is critical for all downstream operational and risk management
processes, including the correct calculation of cash flows, margin
requirements, and discharge of settlement obligations as well as
accurate measurement of counterparty credit exposures. Timely
confirmation also allows any rejections, exceptions, and/or
discrepancies to be identified and resolved more quickly. To this end,
in the Confirmation NPRM, the Commission proposed Sec. 23.501, which
prescribed standards for the timely and accurate confirmation of swap
transactions. The Commission received approximately 27 comment letters
in response to the Confirmation NPRM and considered each in formulating
the final rules, as discussed below.
1. Uniform Application of Proposed Rules to All Asset Classes
In the Confirmation NPRM, the Commission solicited comments on
whether certain provisions of the proposed regulations should be
modified or adjusted to reflect the differences among asset classes.
In response to the request for comments, ISDA noted that the work
done by the industry with the ODSG led to customization of
documentation and confirmation timeframes to account for the
differences between asset classes, and even between products within
asset classes, but the proposed confirmation requirements do not allow
for this same flexibility. However, ISDA did not suggest specific
timeframes for the Commission's rules.
The FHLBs recommended that the Commission exercise caution in
applying rules to all swap asset classes equally as procedures that are
appropriate for interest rate swaps may be insufficient or unnecessary
for other types of swaps.
The Global Foreign Exchange Division of AFME, SIFMA, and ASIFMA
(GFED) commented that the Commission should take into account the high
volume of transactions and wider universe of participants in the
foreign exchange industry when promulgating its final rules.
The Working Group requested that the Commission revise the rules to
permit current practice in the energy swap market where one party sends
an acknowledgement to the other party and the acknowledgement is deemed
a legally binding confirmation if the receiving party does not object
within three business days. The Working Group believes this practice is
efficient because (i) It eliminates the risk of open confirmations,
(ii) dealers need not chase for a physically signed confirmation, and
(iii) counterparties need not respond if terms are acceptable.
BG Americas & Global LNG (BGA) commented that energy commodity
trading companies typically extract trading data in a batched cycle at
the end of the day and generate confirmations the following day. BGA
does not believe it is clear that expedited confirmation would enhance
[[Page 55918]]
transparency or reduce systemic risk and is therefore outweighed by the
enormous cost for registrants that would have to add resources to
perform rolling confirmations and correct errors.
As discussed further below, in section III.B.2, the Commission has
made every effort to tailor the confirmation requirements by asset
class based on data provided by major market participants. The
Commission has achieved such tailoring by modifying the time periods
for confirmation by asset class along with a generous compliance phase-
in period, but has retained an otherwise uniform rule across asset
classes. The Commission believes the uniform standard with appropriate
differences in time periods and compliance periods will lead to
efficient use of limited regulatory resources, while also reducing
implementation costs for affected market participants.
2. Use of ``Enforce'' in Proposed Rules Sec. 23.501(a)(3), Sec.
23.502(b), Sec. 23.502(b)(4), and Sec. 23.503(d)
The proposed regulations require SDs and MSPs to establish,
maintain, and enforce written policies and procedures to accomplish a
number of requirements, including confirmation with financial entities
and non-financial entities; portfolio reconciliation; valuation dispute
resolution; and bilateral and multilateral compression and termination
of fully offsetting swaps.
In regard to the use of ``enforce'' in these provisions, ABC &
CIEBA requested that the Commission delete the term wherever it appears
because SDs and MSPs are not ``registered entities'' under section
1(a)(40) of the CEA and therefore Congress did not intend for SDs and
MSPs to have the self-regulatory authority to enforce compliance with
their internal policies and procedures. Similarly, Freddie Mac
commented that the requirement in the proposed rules that SDs enforce
policies designed to ensure confirmation with non-SD, non-MSP
counterparties within the short deadlines mandated by the proposed
rules could result in SDs exerting undue pressure on such
counterparties to quickly assent to the terms of a trade as framed by
the SD in the form of a condition to execution of a swap, with the risk
that the swap could become void or otherwise fail.
The Commission is sensitive to these concerns, and has accordingly
modified the proposed rules by replacing each instance of the term
``enforce'' with the term ``follow.'' The Commission observes that the
intent of the term ``enforce'' in the proposed rules was to require SDs
and MSPs to in fact follow the policies and procedures established to
meet the requirements of the proposed rules, rather than to require an
SD or MSP to enforce its internal policies and procedures against third
parties.
3. Definition of ``Acknowledgement''--Sec. 23.500(a)
The proposed regulations defined ``acknowledgement'' to mean ``a
written or electronic record of all of the terms of a swap signed and
sent by one counterparty to the other.''
Commenting on this definition, GFED requested that the Commission
clarify whether an ``acknowledgement'' is the same as a ``trade
affirmation'' in the FX market, which is matching of economic fields
only, and MFA recommended that the Commission revise the definition to
provide that an acknowledgement need only specify the primary economic
terms of a swap (rather than all terms).
Despite these comments, the Commission is adopting the definition
of acknowledgement as proposed. The intent of the definition was to
make clear that an SD or MSP must provide its non-SD, non-MSP
counterparties with a complete record of all terms of an executed swap
transaction. The Commission believes that to achieve the timely
confirmation goals of Sec. 23.501, mistaken, misunderstood, or
disputed terms must be identified quickly. To do so, a counterparty
needs to see documentation reflecting all of the terms of the swap
transaction as the SD or MSP understands them. The Commission therefore
does not agree with commenters that an acknowledgement need contain
only the primary economic terms of a swap transaction. In reaching this
conclusion, the Commission recognizes that requiring delivery of an
acknowledgement containing all terms may require the parties to agree
to more terms at execution than are agreed under some current market
practices, but, given the critical role confirmation plays in all
downstream operational and risk management processes, the Commission
believes that any additional pre-execution burden imposed is justified.
4. Definition of ``Confirmation''--Sec. 23.500(c)
The proposed regulations defined ``swap confirmation'' to mean
``the consummation (electronically or otherwise) of legally binding
documentation (electronic or otherwise) that memorializes the agreement
of the parties to all the terms of the swap. A confirmation must be in
writing (whether electronic or otherwise) and must legally supersede
any previous agreement (electronically or otherwise).''
Reacting to this definition, ABC & CIEBA explained that where a
lead fiduciary for a pension fund negotiates ISDA documentation on a
relationship basis, there sometimes will be a provision that the master
agreement's terms legally supersede the confirmation's terms unless the
fiduciary entering the plan into the swap represents that inconsistent
terms in the confirmation are more beneficial to the plan. ABC & CIEBA
therefore requested that the Commission clarify that the phrase
``legally supersede any previous agreement'' is only intended to apply
to prior agreements outside the scope of the package of documentation
that makes up the master agreement between the parties (i.e., master
agreements, credit support agreements, all confirmations, etc.).
Similarly, the Asset Management Group of SIFMA (AMG) explained that
in current practice, some clients to asset managers require that terms
in the confirmation of a swap cannot supersede conflicting terms in a
client's master agreement. AMG therefore also recommended that the
Commission clarify the proposed rule to provide that a confirmation
will not legally supersede the contractual arrangements agreed on by
the parties.
On a different tack, GFED requested clarification as to whether
``confirmation'' means only actual legal confirmation execution or
whether it may also include matching services that do not provide a
legally binding confirmation of all terms, but merely affirmation of
trade economics, and ISDA requested clarification that confirmation may
be accomplished by use of matching services under which some buy-side
firms ``affirm'' trades.
Jason Copping offered an alternative definition of ``confirmation''
under which a swap is confirmed when all parties accept the terms and
no change to the terms would be legally binding until all parties agree
to such changes.
In response to these comments, the Commission reiterates that the
intent of the proposed rule was to require the terms of a confirmation
to include all of the binding terms of the swap. This definition is the
same definition adopted by the Commission in the Swap Data
Recordkeeping and Reporting rules in part 45 of the Commission's
regulations.\21\ In addition, under the Swap Data Recordkeeping and
Reporting rules, all terms agreed in a
[[Page 55919]]
confirmation must be reported to an SDR.\22\ Therefore, in addition to
the need for all terms to be confirmed for purposes of downstream
operational processing and risk management, the Commission has a strong
interest in consistent rules for the swap market. For these reasons,
the Commission is adopting the definition of confirmation as proposed.
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\21\ See 17 CFR 45.1.
\22\ See 17 CFR 45.3.
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With respect to the comments of ABC & CIEBA and AMG, the Commission
understands the practice explained by these commenters to mean that
some confirmations of swaps incorporate by reference certain terms that
are delineated in master agreements and that the parties have agreed
that such terms trump any inconsistent terms that may appear in a
confirmation. The Commission clarifies that the rules adopted herein do
not prohibit the practice of incorporation by reference. Therefore, if
counterparties want to include certain standard provisions in their
master agreements that will control each swap transaction executed,
this approach would be acceptable so long as they ensure that their
books and records and the confirmation data reported to an SDR reflects
the actual terms of each swap transaction. Given the Commission's
interest in ensuring the integrity of data reported to an SDR,
contradictory or conflicting swap transaction terms in an SD's or MSP's
books and records or in data reported to an SDR when reconciled with an
SD's or MSP's books and records could indicate non-compliance with the
both the confirmation rule adopted herein and the swap data reporting
rules under part 45 of the Commission's regulations.
Moreover, the Commission clarifies that any specific agreed-upon
collateral requirements in a confirmation, which may go beyond what
exists in the collateral support arrangements under the swap trading
relationship documentation, would be required to be confirmed according
to the timeframes discussed below.
5. Definition of Financial Entity-Sec. 23.500(e)
The Commission proposed to define ``financial entity'' to have the
same meaning as given to the term in section 2(h)(7)(C) of the Act,
excepting SDs and MSPs. Subsequent to the proposal, the Commission
proposed a number of rules that contained slightly differing
definitions of the term.\23\ The Commission has therefore determined to
revise the definition of ``financial entity'' for purposes of the rules
adopted herein to be consistent with its other rules applicable to SDs
and MSPs. Thus, ``financial entity'' has been defined in the rule
adopted in this release to mean ``a counterparty that is not a swap
dealer or a major swap participant and that is one of the following.
(1) A commodity pool as defined in section 1a(5) of the Act, (2) A
private fund as defined in section 202(a) of the Investment Advisers
Act of 1940, (3) An employee benefit plan as defined in paragraphs (3)
and (32) of section 3 of the Employee Retirement Income and Security
Act of 1974, (4) A person predominantly engaged in activities that are
in the business of banking, or in activities that are financial in
nature as defined in section 4(k) of the Bank Holding Company Act of
1956, and (5) a security-based swap dealer or a major security-based
swap participant.''
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\23\ See e.g., Margin Requirements for Uncleared Swaps for Swap
Dealers and Major Swap Participants, 76 FR 23732, 23744 (Apr. 28,
2011).
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6. Electronic Execution and Processing--Sec. 23.501(a)(1) & (2);
Definition of ``Processed Electronically''--Sec. 23.500(j)
The proposed regulations prescribed trade acknowledgement delivery
and confirmation deadlines for swap transactions that are executed and
processed electronically, and different deadlines for swaps that are
not executed electronically but are processed electronically. The
proposed regulations provided that ``processed electronically'' means
``to be entered into a swap dealer or major swap participant's
computerized processing systems to facilitate clearance and
settlement.'' In addition, the Commission requested comment on whether
the term ``processed electronically'' required more clarification, and,
if so, what definition would be effective and flexible enough to
accommodate future market innovation.
In response to the proposal, ABC & CIEBA urged the Commission to
ensure that the proposed confirmation rule does not indirectly impose
on benefit plans processes that will require third-party service
providers or new technology by expressly stating that a party to an
uncleared swap that is not an SD or MSP has the right to determine
whether the confirmation will occur electronically or manually. AMG
also recommended that a party to an uncleared swap that is not an SD or
MSP should have the right to determine whether the confirmation will
occur electronically or manually.
The Working Group and MFA warned that the Commission should not
mandate confirmation through an electronic matching platform because
electronic matching is unlikely to be able to capture all terms of
customized transactions. Chatham Financial Corp. (Chatham) also argued
that the Commission should not mandate confirmation through an
electronic matching platform, because such a mandate could preclude
end-users from entering into swaps not yet available on matching
platforms and could increase costs for end-users that do not engage in
the volume of swaps necessary to justify the additional costs of
connecting to electronic matching platforms.
ISDA commented that electronic execution and processing standards
should be phased and aspirational because development by the industry
will be required to meet the timelines of the proposed rules. ISDA also
argued that the proposed life cycle confirmation requirement will
undermine the move to electronic execution and processing, because not
all life cycle events are currently supported by electronic platforms
across asset classes.
MarkitSERV supports the Commission's goal of having as many
transactions as possible be executed on electronic platforms, and
recommended that the Commission require all swap transaction
information to be communicated electronically if a registrant has the
ability to do so, and encourage (but not require in all cases) the use
of electronic matching and confirmation platforms.
Many commenters raised questions regarding what would constitute
electronic processing. MFA requested that the Commission clarify if
``processed electronically'' only refers to swaps confirmed through
electronic confirmation or matching services, or whether ``processed
electronically'' could refer to a registrant entering trade information
into its trade capture system, the generation of an acknowledgement
from such system and the forwarding of such acknowledgement to a
counterparty by facsimile, email, or other electronic method, while
GFED requested that the Commission clarify whether a SWIFT confirmation
would meet the definition of ``processed electronically'' under the
proposed rules. The Working Group also questioned whether confirming a
swap via email would constitute electronic processing. The FHLBs
requested that the Commission clarify if ``processed electronically''
only refers to swaps confirmed through electronic confirmation or
matching services, while ISDA recommended that the Commission not
define ``processed electronically'' to include all
[[Page 55920]]
transactions for which some element of the transaction is captured or
processed through electronic means, but define it with reference to a
firm or platform's ``middleware,'' which will actually drive the
process. Finally, MetLife recommended that the Commission more clearly
define the terms ``processed electronically'' and ``executed
electronically'' because MetLife needs more information to determine
whether the proposed time frames for confirmation are realistic within
current market capabilities.
Having considered these comments, the Commission acknowledges the
concerns expressed by market participants regarding the coerced use of
matching platforms and is accordingly modifying the proposed rule to
delete the definition of ``processed electronically'' and delete the
provisions of the rule mandating acknowledgement and confirmation
deadlines for swaps that are executed or processed electronically. In
place of these provisions, the rule has been modified to provide that
swap transactions among SDs and MSPs or between such registrants and
financial entities should be confirmed as soon as technologically
practicable, but in any event by the end of the first business day
following the day of execution (as modified for time zone and business
day differences, discussed in detail below). The Commission believes
this change will eliminate any confusion as to whether a method of swap
execution and confirmation qualifies as ``electronic.'' As explained
further below, the modified rule would provide a single deadline for
confirmation of swap transactions among registrants, a single deadline
for confirmation of swap transactions between registrants and financial
entities, and a single deadline for confirmation of swap transactions
between registrants and all other entities, with appropriate
adjustments of the compliance deadlines by swap asset class for
implementation of the rule.
7. Delivery of Draft Acknowledgement to Non-SD, Non-MSP Counterparties
Sec. 23.501(a)(3)
Proposed Sec. 23.501(a)(3) required SDs and MSPs to establish a
procedure such that, prior to execution of any swap with a non-SD or
non-MSP, the registrant furnish to a prospective counterparty a draft
acknowledgment specifying all terms of the swap transaction other than
the applicable pricing and other relevant terms that are to be
expressly agreed at execution.
Commenting on the proposal, ISDA argued that the requirement to
provide a draft acknowledgement prior to execution may cause loss of
timely execution opportunities, and may require end-users to engage
significant legal resources for review of all proposed transactions,
rather than just executed transactions. ISDA recommended that non-
dealer counterparties be permitted to waive the delivery of draft
acknowledgements. MFA similarly argued that the proposed rule will (i)
Prevent end users from executing promptly when the market is favorable;
(ii) cause end users to concede on terms in order to get timely
execution; (iii) cause a decrease in the number of transactions, which
will decrease liquidity and increase volatility; and (iv) cause wider
bid/ask spreads or less market-making because of an increase in risk
between pricing and execution. Freddie Mac also believes that the
proposed rule would delay prompt execution of hedging transactions
because end users will be required to review draft acknowledgements.
MarkitSERV argued that requiring a draft acknowledgement is
unnecessarily burdensome because (i) multiple SDs competing for a trade
would all be required to furnish a draft acknowledgement, and (ii) many
transactions executed through automated electronic systems can complete
a confirmation promptly after execution. MarkitSERV recommended that
the Commission require draft acknowledgements to contain only terms
necessary to determine price (rather than all terms) and only require
delivery of draft acknowledgements for swaps that cannot be processed
electronically and where confirmation is not reasonably expected to be
completed within 24 hours.
On the other hand, ABC & CIEBA agreed with the Commission's
proposal to require all terms, except terms related to price, be
disclosed in writing prior to the time of execution. AMG also supported
the proposed rule, but recommended that the Commission revise the rule
to provide an exception for swaps where the parties have previously
agreed to non-pricing-related terms.
Finally, MetLife recommended that the Commission revise the
proposed rule to specifically indicate which party is responsible for
delivery of an acknowledgement and which party is responsible for the
return confirmation.
Having considered the commenters' concerns, but cognizant of the
support for the proposed rule by some commenters, the Commission is
modifying the proposed rule to require delivery of a draft
acknowledgement, but only upon request of an SD's or MSPs' non-SD, non-
MSP counterparty prior to execution.
With respect to MetLife's comment, the Commission believes the rule
as proposed clearly states that it is the SD's or MSP's responsibility
to deliver an acknowledgement when trading with a counterparty that is
not an SD or MSP. The SD or MSP is required to have policies and
procedures reasonably designed to ensure that its counterparty returns
a confirmation or otherwise completes the confirmation process. With
respect to trades solely among SDs and MSPs, the Commission does not
believe it is necessary to prescribe responsibility for delivery of an
acknowledgement because both parties would be required to comply with
the confirmation deadline set forth in the rule as adopted herein.
8. Time Period for Confirmation--Sec. 23.501(a)(1) & (3)
Proposed Sec. 23.501 provided time periods for confirmation as set
forth at 75 FR 81519, 81531 (Dec. 28, 2010).
The Commission received 27 comments with respect to the proposed
rule's time periods for confirmation. Below, the comments are described
according to the following categories:
(A) General comments on the proposed time periods;
(B) Comments on proposed time periods for confirmation with non-SDs
and non-MSPs;
(C) Comments on time periods for confirmation with financial
entities;
(D) Comments on confirmation of swaps between parties in different
time zones; and
(E) Comments on confirmation of swaps executed near end of trading
day.
(A) Comments on Time Periods Generally
ISDA stated that the proposed rules place an unnecessary burden
upon the inception of transactions, may increase risk by leading to
needless disputes and operational lapses, and require substantially
more than is necessary to create an initial record of a legally binding
agreement. ISDA also argued that: (i) The time periods proposed are
impractical as certain terms required to be included in a confirmation
may not be known on the same calendar day as execution (e.g., initial
rates may follow trade commitment by days); and (ii) valuation
methodologies required to be agreed prior to execution pursuant to
proposed Sec. 23.504(b)(4), may also slow down the confirmation
process to the extent such methodologies are required to be reflected
in the confirmation. ISDA recommended an alternative framework:
[[Page 55921]]
Execution of a swap on a SEF or DCM or clearing a swap
should be deemed to satisfy any confirmation requirements.
Electronic execution and processing standards should be
phased and aspirational as development by the industry will be
required.
The Commission should conduct a study in order to better
understand the potential barriers to complying with the proposed
timelines for confirmation in each asset class.
The Commission should institute an approach similar to
that utilized by the ODSG; an ongoing dialogue between the Commission
and leaders in the industry to obtain a commitment from the industry to
tighten confirmation timeframes over an extended period, with existing
risk mitigants to address Commission concerns in the interim.
The Working Group also objected to the time periods between
execution and confirmation in the proposed rules because: (i) The time
periods effectively will require all terms of a swap to be negotiated
prior to execution, and that such requirement will disadvantage the
party that is most sensitive to timing of market conditions and may
force that party to accept less optimal economic terms or reduced
negotiating leverage in order to meet the confirmation deadline; and
(ii) the Commission has not articulated any benefit from the
requirement that non-registrants confirm a swap no later than the day
after execution that would outweigh the cost for most non-registrants
to comply with the rule.
MarkitSERV commented that the time periods specified in the
proposed rules for confirmation are not feasible in many cases and
recommended the following alternative:
The time period within which confirmation is required to
be completed should not begin with execution, but only from the point
when all relevant data and information to define the swap has been
obtained (e.g., allocations).
Acknowledgements should be sent within a time period after
all information has been obtained and confirmation should be completed
within a time period after an acknowledgement has been received.
Non-electronically executed and non-electronically
processed transactions should be confirmed within 24 hours of
execution, rather than within the same calendar day.
The confirmation requirement should consist of ``economic
tie-out'' of key economic terms rather than confirmation of all terms.
Electronic processing should be defined to include the
capability for electronic communication.
AMG argued that same calendar day or next business day confirmation
may not be appropriate for complex or customized uncleared swaps,
including swaps entered by asset managers that must allocate block
trades among their clients. AMG also recommended that the Commission
revise the proposed rules to provide for a delay in confirmation for
legitimate disputes between the parties if the parties are seeking to
resolve the dispute in a timely fashion.
BGA commented that the 15 minute and 30 minute deadlines for
confirmation or acknowledgement in the proposed rules are unworkable
and inconsistent with current practice. BGA stated that energy
commodity trading companies typically extract trading data in a batched
cycle at the end of the day and generate confirmations the following
day. BGA does not believe it is clear that expedited confirmation would
enhance transparency or reduce systemic risk and is therefore
outweighed by the enormous cost for registrants that would have to add
resources to perform rolling confirmations and correct errors. BGA also
argued that swaps executed on electronic platforms and through broker/
dealers as clearing agents should not require a confirmation.
Chatham argued that the proposed timeframes for confirmation could
result in decreased accuracy as parties will rush to complete
transaction documentation without thorough review.
The FHLBs stated that currently available electronic swap
processing systems do not support customized terms in swaps used by the
FHLBs and therefore the same business day deadline is not sufficient
for swaps that require manual processing. The FHLBs also stated that
for some swaps (e.g., forward settling interest rate swaps), all terms
may not be known when the swap is executed.
MetLife requested that the Commission extend the timeframe for
delivery and return of confirmations for transactions not executed on a
SEF or DCM as such are often highly structured and customized and it is
unreasonable to expect parties to generate a confirmation within the
timeframe set forth in the proposed rules. MetLife recommended that the
Commission revise the proposed rules to provide three business days
following execution for delivery of an acknowledgement for such
transactions and at least two business days following receipt of an
acknowledgement to review and return a confirmation.
GFED stated that the various deadlines are significantly too short
for many FX swap trades and inappropriately rely on both parties
complying with the proposed rules. GFED recommends that the Commission
revise the proposed rules, as such are applied to FX swap trades,
taking into account: (i) The method of confirmation (electronic/paper);
(ii) the complexity of the underlying transaction (e.g., vanilla
options vs. basket options); and (iii) the counterparty type.
MFA recommended that the Commission specify no timeframe for
confirmation, allowing parties to execute whenever market conditions
are favorable with the expectation that they may negotiate non-economic
terms later.
(B) Comments on Time Periods for Confirmation With Non-SDs and Non-MSPs
With respect to the proposed confirmation time periods for swaps
between an SD or MSP and a non-SD or non-MSP specifically, ISDA
commented that the rule lacks clarity on how non-registrant
counterparties can be required to comply with the confirmation
requirements. The FHLBs echoed ISDA's comment, arguing that the
proposed timeframe may lead SDs and MSPs to put undue pressure on end
users to execute confirmations before such parties have had an
opportunity to fully review such confirmations. To alleviate this
concern, the FHLBs argued that the proposed rules should allow SDs and
MSPs at least 48 hours to provide end users with an acknowledgement, at
least two business days for end users to review acknowledgements and
execute confirmations, and provide for an exception from the
confirmation deadlines for complex or unique swap transactions (as
determined by the parties) upon notice to the Commission detailing the
unique or complex aspects of the swap and the date by which a
confirmation will be executed.
Chatham recommended an alternative confirmation requirement for
swaps with non-SDs and non-MSPs:
For electronically confirmed swaps, an acknowledgement
would be required to be submitted electronically on the same or next
business day after execution, and swap terms would be required to be
affirmed, matched or otherwise confirmed or a notice of discrepancy
provided within three business days; any discrepancy would be required
to be resolved and the swap confirmed within five business days
[[Page 55922]]
after the discrepancy was communicated.
For non-electronically confirmed swaps, an acknowledgement
would be required to be issued within one business day of execution; a
notice of discrepancy provided within five business days; and
confirmation required within 30 days.
Dominion commented that the energy industry standard is to achieve
confirmation of uncleared swaps not executed on an electronic platform
within three business days, and that such standard is often documented
in participants' existing master agreements. Dominion thus argued that
the proposed next business day confirmation requirement may conflict
with end user contractual rights and obligations, and may cause end
users to incur costs even though the Commission has not articulated a
justifiable benefit to end users or the market.
(C) Comments on Time Periods for Confirmation With Financial Entities
Specifically with respect to confirmation of swap transactions
between an SD or MSP and a financial entity, ABC & CIEBA stated that
the ``same business day'' confirmation requirement would impose costly
increases in operational capacity for pension funds, which may
discourage use of swaps or limit trading to earlier parts of the
trading day. ABC & CIEBA recommended that the Commission provide for a
``close of next business day'' time limit for benefit plans and other
non-SD, non-MSP counterparties. AMG also argued that financial entities
should not be subject to shorter time periods for confirmation than
non-financial end-users because many may not have the operational
resources to meet the demands of the proposed rules. Similarly, Freddie
Mac argued that it often takes several business days to correct and
execute confirmations, and the proposed rules would not permit
sufficient time for correction of draft confirmations or resolution of
disputes over trade terms.
While MFA agreed with the proposed longer time period for
confirmation for swap transactions between an SD or MSP and
counterparties that are not SDs or MSPs, but objected to a shorter time
period for financial entity end users as compared to other end users.
MFA argued that designation as a financial entity does not necessarily
correlate with a large swap portfolio or being highly sophisticated
with respect to swaps, and the short time period for confirmation
applicable to financial entities under the proposed rules may cause
unwarranted disadvantages in negotiation of swap terms with SDs and
MSPs.
Finally, the OCC believes that the same calendar day trade
confirmation requirement for financial entities would eliminate or
significantly reduce customized transactions between registrants and
such entities, leading to less effective risk management. The OCC
argued that the short confirmation deadline will require the parties to
negotiate all terms prior to execution, leading to the unnecessary
expenditure of resources for transactions that are never executed. The
OCC further argued that negotiation prior to execution will delay
execution, which itself can create risks in fast moving markets.
(D) Comments on Confirmation of Swaps Between Parties in Different Time
Zones
The Commission received several comments concerned with the
proposed time periods for confirmation as applied to swap transactions
between parties in different time zones.
Commenting on this aspect of the proposed rule, ISDA stated that
cross-border transactions frequently require more than one day to
confirm due to business day and time zone differences; Chatham and GFED
also commented that the proposed timeframes fail to account for
coordination across time zones.
(E) Comments on Confirmation of Swaps Executed at End of Day
The Commission also received several comments concerned with the
proposed same day confirmation requirement for swap transactions among
SDs and MSPs and between an SD or MSP and a financial entity as applied
to swap transactions executed near the end of the trading day.
In this regard, ISDA, Chatham, the FHLBs, AMG, and GFED each
commented that the rules should account for transactions executed
toward the end of the business day that leave little or no time for
same-day confirmation. To account for this issue, AMG recommended that
parties should be given no less than 24 hours to confirm trades, while
the FHLBs recommended that swap transactions executed after 3:00 p.m.
EST should be considered executed on the immediately following business
day.
Commission Response
The Commission has considered the many comments with respect to the
proposed time periods for confirmation and has decided to revise the
proposed rule in a number of ways to better attune the rule to the
intention of the Commission's proposal, the concerns raised by
commenters, and the needs of the market. The Commission has revised the
proposed rule as discussed below.
The proposed time periods for swaps executed or processed
electronically have been replaced in their entirety by a requirement
that, subject to a compliance phase-in schedule, all swaps among SDs
and MSPs or between SDs, MSPs, and financial entities be confirmed ``as
soon as technologically practicable,'' but no later than the end of the
first business day following the day of execution.\24\ The Commission
believes this change still requires electronically executed or
processed trades to be confirmed quickly, but is responsive to
commenters that have provided examples of processing operations that
contain some electronic elements but are not ``straight-through'' in
the sense intended by the proposed rules and therefore are incapable of
meeting the proposed 15 or 30 minute deadlines.
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\24\ Compare with ESMA Draft Technical Standards, Article 1 RM,
subsection 2, (stating that uncleared OTC derivatives ``shall be
confirmed, where available via electronic means, as soon as possible
and at the latest by the end of the same business day.'').
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In revising the rule, the Commission also was persuaded by the
comments of market participants that are concerned with the possibility
of pressure by their dealer counterparties to make costly changes to
their operating systems in order to meet the required confirmation
deadlines. The Commission notes that these changes also make the
confirmation rule consistent with the real-time public reporting rules
and the rules mandating deadlines for the reporting of swap data to
SDRs, both of which use ``as soon as technologically practicable'' as
the applicable standard.\25\
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\25\ See 17 CFR 43.2, Real-Time Public Reporting of Swap
Transaction Data, 77 FR 1182, 1243-44 (Jan. 9, 2012); 17 CFR 45.3,
Swap Data Recordkeeping and Reporting Requirements, 77 FR 2136,
2199-2200 (Jan. 13, 2012).
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With respect to the proposed time periods for swaps executed
between SDs and MSPs and counterparties that are not SDs, MSPs, or
financial entities, the Commission has modified the rule to require,
subject to a compliance phase-in schedule, policies and procedures
reasonably designed to ensure that a confirmation is executed no later
than the end of second business day after execution.\26\ The Commission
believes this change will afford SDs and MSPs an
[[Page 55923]]
extra business day to confirm their swap transactions with non-
financial entities and is more consistent with the time periods
suggested by commenters.
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\26\ Compare with ESMA Draft Technical Standards, Article 1 RM,
subsection 3, (stating that uncleared OTC derivatives ``shall be
confirmed as soon as possible and at the latest by the end of the
second business day following the date of execution.'').
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In response to commenters, as discussed above, the Commission is
revising the proposed rule to state explicitly that swaps executed on a
SEF or DCM, and swaps cleared by a DCO, will be deemed to have met the
confirmation requirements so long as: (i) confirmation of all terms of
the transaction takes place at the same time as execution on a SEF or
DCM; or (ii) the parties submit the swap for clearing no later than the
time that confirmation would otherwise be required and the DCO confirms
the terms of the swap upon acceptance for clearing. To ensure that no
swap transaction goes unconfirmed, the modified rule also contains a
backstop requirement for SDs and MSPs to confirm a swap for which the
registrant receives notice that a SEF, DCM, or DCO has failed to
provide a confirmation on the same day as it receives such notice.
Based on the comments received, the Commission is also modifying
the proposed rule to adjust the confirmation deadline for swaps among
SDs and MSPs and between SDs, MSPs, and financial entities whenever the
parties (i) execute a swap near the end of the trading day (i.e., after
4 p.m.), or (ii) execute a swap with a counterparty located in a
different time zone. The Commission has been persuaded by commenters
that registrants should not be required to maintain back-office
operations 24 hours a day or 7 days a week in order to meet the
proposed confirmation deadlines. The Commission has been particularly
sensitive to comments stating that the proposed confirmation deadlines
may discourage trade execution late in the day. Specifically, the
Commission has made the following changes to the proposed rule:
To account for time-zone issues, the ``day of execution''
has been defined to be the calendar day of the party to the swap that
ends latest, giving the parties the maximum amount of time to confirm
the transaction within the deadlines required by the rule.
To account for end-of-day trading issues, the definition
of ``day of execution'' deems such day to be the next succeeding
business day if execution occurs after 4:00 p.m. in the place of either
counterparty.
To account for non-business day trading, the ``day of
execution'' is also deemed to be the next succeeding business day if
execution occurs on a day that is not a business day.\27\
---------------------------------------------------------------------------
\27\ Compare with ESMA Draft Technical Standards, Article 1 RM,
subsection 3, (stating that where an uncleared OTC derivative
transaction ``is concluded after 16.00 local time, or when the
transaction is concluded with a counterparty that is located in a
different time zone that does not allow for same day confirmation,
the confirmation shall take place as soon as possible and at the
latest by the end of the next business day.'')
---------------------------------------------------------------------------
The Commission notes that this approach is consistent with the
business day definition in the Swap Data Recordkeeping and Reporting
Rules finalized by the Commission in December 2011.\28\
---------------------------------------------------------------------------
\28\ See 71 CFR 45.1, Swap Data Recordkeeping and Reporting, 77
FR 2136, 2197 (Jan. 13, 2012).
---------------------------------------------------------------------------
Despite several commenters' concerns, however, the Commission has
declined to modify the proposed requirement that SDs and MSPs establish
policies and procedures reasonably designed to ensure that swaps with
financial entities meet the same confirmation deadlines as swaps among
SDs and MSPs. While the Commission recognizes that an SD or MSP may not
be able to ensure that a non-registrant financial entity abides by the
confirmation deadline in each and every instance, it believes that
``policies and procedures reasonably designed to ensure'' is not the
same as requiring a guarantee of compliance. Therefore, the Commission
believes that the rule contains sufficient flexibility because it only
requires that the SDs and MSPs make reasonable efforts to confirm swaps
with financial entities by the stated deadline.
As discussed below in section III.B.2, the Commission is phasing in
compliance with each of the time periods required under Sec. 23.501.
This compliance schedule is set forth in the rule text and seeks to
further address concerns from market participants regarding the timing
of compliance.
9. Allocation of Block Trades
The proposed regulations did not address confirmation in the
context of block trades that must be allocated prior to confirmation.
With respect to the allocation of block trades, ISDA argued that
the proposed confirmation rule will be difficult for asset managers to
implement because asset managers often execute block trades and then
allocate the block to two or more clients, a process than can take
significantly longer than the confirmation time periods because the
allocation process hinges on compliance processes or receipt by
investment managers of instructions from their clients. In ISDA's view,
if finalized as proposed, the rule could force investment managers to
execute individual trades for their clients, increasing pricing and
operational costs. AMG echoed this point.
Intercontinental Exchange, Inc. (ICE) also pointed out that the
confirmation deadlines in the proposed rules may make it impossible for
asset managers to make post-execution allocation of trades. ICE stated
that its own trade processing service for CDS requires that trades be
allocated within two hours of execution and recommended that the
Commission adopt a similar standard.
While the Commission acknowledges that allocation of block trades
is required to achieve confirmation, it notes that the modifications to
the rule outlined above replaces the 15 and 30 minute confirmation
deadlines with a requirement that swaps be confirmed ``as soon as
technologically practicable, or in any event by the end of the first
business day following the day of execution.'' The Commission thus
believes that the rule as modified allows registrants and the asset
managers for their counterparties the flexibility to work out an
efficient and timely allocation process within the deadlines for
confirmation as adopted in this release. The Commission also notes that
recent amendments to Commission regulation Sec. 1.35 address the
allocation issue by requiring that account managers must provide
allocation information to the counterparty no later than the end of the
calendar day that the swap was executed.\29\
---------------------------------------------------------------------------
\29\ See Customer Clearing Documentation, Timing of Acceptance
for Clearing, and Clearing Member Risk Management, 77 FR 21278,
21306 (Apr. 9, 2012) (providing that ``Orders eligible for post-
execution allocation must be allocated by an eligible account
manager in accordance with the following: (A) Allocations must be
made as soon as practicable after the entire transaction is
executed, but in any event no later than the following times: For
cleared trades, account managers must provide allocation information
to futures commission merchants no later than a time sufficiently
before the end of the day the order is executed to ensure that
clearing records identify the ultimate customer for each trade. For
uncleared trades, account managers must provide allocation
information to the counterparty no later than the end of the
calendar day that the swap was executed.'').
---------------------------------------------------------------------------
10. Time Period for Delivery of Acknowledgement--Sec. 23.501(a)(2)
Proposed Sec. 23.501(a)(2) set forth at 75 FR 81519, 81531 (Dec.
28, 2010) required SDs and MSPs to send an acknowledgement containing
all of the terms of a swap transaction to each counterparty that is not
an SD or MSP.
In response to the proposal, ISDA asserted that the time periods
proposed are impractical because: (i) Certain terms required to be
included in an acknowledgement may not be known on
[[Page 55924]]
the same calendar day as execution (e.g., initial rates may follow
trade commitment by days); and (ii) valuation methodologies required to
be agreed prior to execution pursuant to proposed Sec. 23.504(b)(4)
may also slow down the acknowledgement process to the extent such
methodologies are required to be reflected in the acknowledgement.
Similarly, MarkitSERV recommended that acknowledgements be sent within
a time period after all information has been obtained (rather than
after execution), while AMG argued that the time periods are
unnecessarily short and do not bear a reasonable relationship to the
systemic risk goals of the Dodd-Frank Act, would be burdensome for
uncleared swaps which merit more individualized treatment, and could
impose excessive costs on swap market participants.
Based on these comments and other considerations discussed above,
the Commission has revised the proposed rule to delete the 15 and 30
minute acknowledgement delivery deadlines and replace them with a
requirement, subject to a compliance phase-in schedule, that an
acknowledgement be provided ``as soon as technologically practicable,
but in any event by the end of the day of execution;'' to state
explicitly that the acknowledgement requirement will be deemed
satisfied by executing a swap on a DCM or SEF, or clearing the swap
through a DCO; and to provide for an adjustment to the ``day of
execution'' to account for time-zone differences and end-of-day trading
issues. The Commission believes these changes are responsive to the
foregoing comments. However, in response to the comments of ISDA and
MarkitSERV regarding terms that may not be known until after the
acknowledgement delivery deadline has passed, the Commission believes
that an acknowledgement could meet the requirement that all terms be
included by describing where and when the ``to be determined'' terms
will be obtained and provide for incorporation by reference once the
terms are known.
As discussed below in section III.B.2, the Commission is phasing in
compliance with each of the time periods required under Sec. 23.501,
including the acknowledgement requirement.
11. Confirmation Through Execution on a SEF or DCM and/or Clearing on a
DCO
The proposed regulations did not contain specific provisions
regarding confirmation through execution on a SEF or DCM, or clearing
on a DCO. However, in the Confirmation NPRM, the Commission stated:
``It is important to note at the outset, that the Commission expects
that swap dealers and major swap participants would be able to comply
with each of the proposed rules by executing a swap on a swap execution
facility (SEF) or on a designated contract market (DCM), or by clearing
the swap through a derivatives clearing organization (DCO). For swaps
executed on a SEF or a DCM, the SEF or DCM will provide the
counterparties with a definitive written record of the terms of their
agreement, which will serve as a confirmation of the swap. Similarly,
if a swap is executed bilaterally, but subsequently submitted to a DCO
for clearing, the DCO will require a definitive written record of all
terms to the counterparties' agreement prior to novation by the DCO;
this too would serve as a confirmation of the swap.'' \30\
---------------------------------------------------------------------------
\30\ See Confirmation NPRM at 81520.
---------------------------------------------------------------------------
Commenting on this aspect of the proposal, Chris Barnard supported
the idea that SDs and MSPs will be able to comply with the proposed
rule by executing a swap on a SEF, a DCM, or by clearing the swap
through a DCO, and supported the greater use of these facilities. Each
of ISDA, CME, ICE, The Working Group, the FHLBs, MetLife, MFA, and
Chatham recommended that the Commission explicitly clarify in the final
rules that the confirmation processes of SEFs, DCMs, and DCOs satisfy
the requirements of the confirmation rules.
MarkitSERV however asserted that the Commission should not presume
that execution on a SEF will automatically result in confirmation of a
swap because the execution and confirmation of a swap are separate and
distinct activities, and it is possible that SEFs and DCMs may offer
execution services without necessarily providing confirmation services.
MarkitSERV recommended that the Commission prescribe standards for any
confirmation service that may be offered to ensure that SEFs and DCMs
produce a complete, legally binding record of each swap based on a
recognized legal framework. MarkitSERV also recommended that SEFs and
DCMs be permitted to allow qualified third parties to perform the
confirmation function after swap execution.
Based on these comments and other considerations discussed above,
the Commission has revised the proposed rules to state explicitly that
swaps executed on a SEF or DCM, and swaps cleared by a DCO, will be
deemed to have met the confirmation requirements so long as: (i)
confirmation of all terms of the transaction takes place at the same
time as execution on a SEF or DCM; or (ii) the parties submit the swap
for clearing no later than the time that confirmation would otherwise
be required and the DCO confirms the terms of the swap upon acceptance
for clearing. Under Sec. 39.12(b)(8), DCOs are required to provide a
confirmation of all the terms of each cleared swap, and this
confirmation is required to take place at the same time the swap is
accepted for clearing.\31\ Under Core Principle 11 for DCMs and Sec.
38.601, DCMs must clear all transactions executed on or through the DCM
through a Commission-registered DCO.\32\ In essence, confirmation for
DCM-executed swaps will occur either at the same time as execution or
upon submission to a DCO. The Commission's rules for SEFs, including
the proposed confirmation rule, Sec. 37.6(b), have yet to be
finalized.\33\ However, to the extent that a SEF offers confirmation
services upon execution or provides for the timely submission of a swap
for clearing, SDs and MSPs would be able to take advantage of the
provisions of Sec. 23.501(a)(4).
---------------------------------------------------------------------------
\31\ See Derivatives Clearing Organization General Provisions
and Core Principles, 76 FR 69334, 69438 (Nov. 8, 2011). Under Sec.
39.12(b)(7), DCOs are required to accept or reject for clearing as
quickly after execution as would be technologically practicable if
fully automated systems were used all contracts that are listed for
clearing by the DCO and are executed on or subject to the rules of a
DCM or a SEF. See Customer Clearing Documentation, Timing of
Acceptance for Clearing, and Clearing Member Risk Management, 77 FR
21278, 21309 (April 9, 2012).
\32\ See Core Principles and Other Requirements for Designated
Contract Markets, 77 FR 36612, 36705 (June 19, 2012).
\33\ See Core Principles and Other Requirements for Swap
Execution Facilities, 76 FR 1214, 1240 (Jan. 7, 2011).
---------------------------------------------------------------------------
With respect to MarkitSERV's comments, the Commission notes that if
a SEF or DCM does not provide confirmation services, the confirmation
deadlines of the rule will control. The standards for confirmation by
SEFs and the ability of a SEF to allow a third party to provide the
confirmation service are outside the scope of this adopting release.
12. Confirmation of Swap Transaction and Ownership Modifications--Sec.
23.500(m)
The proposed regulations required SDs and MSPs to comply with the
confirmation requirements for all ``swap transactions.'' The proposed
regulations defined ``swap transaction'' as any event that results in a
new swap or in a change to the terms of a swap, including execution,
termination, assignment, novation, exchange, transfer, amendment,
conveyance, or
[[Page 55925]]
extinguishing of rights or obligations of a swap.
In response to this requirement, ISDA stated that some ``market''
life cycle events (e.g., option exercise notices, various notices sent
by calculation agent, etc.) captured by the definition of ``swap
transaction'' are already described in the original confirmation and
sees no benefit to confirming those events. ISDA distinguished
``market'' from ``legal'' life cycle events (e.g., novations and
terminations), which currently are confirmed. ISDA stated that industry
methodologies have been developed around the confirmation of legal life
cycle events at great time and expense and recommends that the
Commission defer to industry standards and to allow market participants
to bilaterally agree that certain life cycle events do not require
subsequent confirmation. ISDA believes that the proposed life cycle
confirmation requirement will undermine the move to electronic
execution and processing, because not all life cycle events are
currently supported by electronic platforms across asset classes.
BGA recommended that the Commission revise the proposed definition
of ``swap transaction'' to include only those life-cycle events that
impact the economics or settlement of the trade, as current practice of
energy commodity trading companies is not to send new confirmations for
events like novations.
GFED believes that the Commission should exclude FX swaps from any
life-cycle event confirmation requirement. GFED states that efficient
processes around trade events already exist (e.g., option exercises
confirmed as new trades), and that ISDA has developed a novation
protocol in wide use that is moving the industry toward novation
without confirmation.
While MFA supports confirmation of life-cycle events, it
recommended that the Commission not mandate specific timing
requirements for the confirmation of life-cycle events. MFA states that
once a life-cycle event occurs, parties to a swap may need to
renegotiate certain trade terms and a timing requirement is likely to
disadvantage end users in such negotiation with SDs.
The Working Group recommended that confirmation of changes to
material economic or legal terms of a swap should be confirmed, but the
confirmation should only be required within a reasonable period of
time, rather than the time periods imposed for newly executed swaps.
The Working Group also argued that events related to the underlying
exposure of a swap should not be subject to any confirmation
requirement as they are generally addressed in master trading
agreements or the applicable confirmation.
Having considered these comments, the Commission has determined not
to modify the proposed rule with respect to this issue. In reaching
this conclusion, the Commission observes that the definition of ``swap
transaction'' would require confirmation of changes to the terms of a
swap that have been agreed between the parties or that change the
ownership of a swap. However, the definition does not require
confirmation of events that may impact the economics of the swap. To
the extent that the documented terms of a swap are agreed to in advance
and provide for automatic changes to terms upon the occurrence of a
defined event, the Commission believes that such change would not
require confirmation pursuant to the rule.
13. Legal Uncertainty for Swaps Following Failure to Comply With Swap
Confirmation Rules
The proposal did not address the issue of the legal standing or
enforceability of a swap transaction that is not confirmed within the
time periods mandated by the proposed rules.
In respect of this issue, the FHLBs commented that such failure
should not affect the enforceability of the swaps because such an
outcome would lead to legal uncertainty in the swap market, and The
Working Group recommended that the Commission clearly indicate the
regulatory and legal consequences of one or more parties to a swap
failing to meet the timing requirements for acknowledgement and
confirmation, asserting its view that a swap should not be invalidated
for the failure to meet the timing requirements of the proposed rules.
MFA also argued that legal certainty of trade execution is vital
for all market participants and the proposed rules may lead to
uncertainty as to the enforceability of transactions that fail to be
confirmed in compliance with the requirements of the proposed rules. To
avoid this result, MFA recommended that the rule be revised to require
only that an SD or MSP deliver an acknowledgement specifying the
primary economic terms of a swap (rather than all terms), and specify
no timeframe for confirmation.
Recognizing the concerns raised by commenters with respect to legal
certainty, the Commission notes that it is not the intent of the
confirmation rule to provide swap counterparties with a basis for
voiding or rescinding a swap transaction based solely on the failure of
the parties to confirm the swap transaction in compliance with the
proposed rules. In the absence of fraud, the Commission will consider
an SD or MSP to be in compliance with the confirmation rule if it has
complied in good faith with its policies and procedures reasonably
designed to comply with the requirements. However, the Commission notes
that it does not have the authority to immunize SDs or MSPs from
private rights of action for conduct within the scope of section 22 of
the CEA, i.e., violations of the CEA.
14. Recordkeeping Requirements for Acknowledgements and Confirmation--
Sec. 23.501(b)
Proposed Sec. 23.501(b) required SDs and MSPs to keep a record of
the date and time of transmission of acknowledgements and
confirmations, a record of the length of time between acknowledgement
and confirmation, and a record of the length of time between execution
and confirmation.
Commenting on the proposal, The Working Group recommended that only
a time stamp on acknowledgements and confirmations be required as the
remainder of the required records in the proposed rules could be
determined from the timestamps on these documents. The Working Group
also requested that the Commission clarify how the recordkeeping
requirements in the proposed confirmation rule apply to lifecycle
events because timestamps for some lifecycle events would not make
sense.
MarkitSERV recommended that the Commission clarify that an SD's or
MSP's recordkeeping requirements may be delegated to a third-party
confirmation platform and the conditions under which such delegation
may be done.
BGA argued that energy commodity traders place orders with broker/
dealers and may be unaware of the time at which a trade is actually
executed, and unable to keep accurate records of the length of time
between execution and confirmation of a swap. BGA therefore recommended
that the Commission remove the recordkeeping requirements from the
proposed rules.
GFED commented that the time stamp requirements of the proposed
recordkeeping rules would require significant technology investment as
current systems typically do not time stamp at issuance or receipt.
Having considered these comments, the Commission is modifying the
recordkeeping requirement. First, the Commission is removing the
[[Page 55926]]
requirement that SDs and MSPs keep records of the length of time
between the acknowledgment and confirmation of a swap, as well as the
time between execution and confirmation, as this information can be
readily ascertained by reviewing other records. Second, the cross-
reference to Sec. 1.31 has been changed to refer to the record
retention rule applicable to SDs and MSPs, Sec. 23.203. Apart from
these modifications, the Commission believes the records required to be
made and maintained under Sec. 23.501(b) are the minimum necessary to
monitor compliance with the rule. In addition, the Commission notes
that certain items in the recordkeeping requirement is information that
will be required for compliance with other Commission rules, such as
the time of execution for real-time public reporting of pricing and
transaction data and for reporting to an SDR.
In response to MarkitSERV, the rule does not prohibit SDs and MSPs
from relying on third-party service providers to achieve compliance
with the rule, although the responsibility for compliance cannot be
delegated. Finally, in response to The Working Group's comment, the
Commission is not persuaded that it is impossible to keep time-stamped
records of key changes in ownership including such significant events
as execution, termination, assignment, novation, exchange, transfer,
amendment, conveyance, or extinguishing of rights or obligations. The
Commission believes that its clarification of the ``swap transaction''
definition above alleviates any concern that the rule imposes an
impossible recordkeeping requirement.
E. Portfolio Reconciliation--Sec. 23.502
Portfolio reconciliation is a post-execution processing and risk
management technique that is designed to: (i) Identify and resolve
discrepancies between the counterparties with regard to the terms of a
swap either immediately after execution or during the life of the swap;
(ii) ensure effective confirmation of all the terms of the swap; and
(iii) identify and resolve discrepancies between the counterparties
regarding the valuation of the swap. In some instances, portfolio
reconciliation also may facilitate the identification and resolution of
discrepancies between the counterparties with regard to valuations of
collateral held as margin. Accordingly, in the Confirmation NPRM, the
Commission proposed Sec. 23.502, which required SDs and MSPs to
reconcile their swap portfolios with one another and provide
counterparties who are not registered as SDs or MSPs with regular
opportunities for portfolio reconciliation. In order for the
marketplace to realize the full risk reduction benefits of portfolio
reconciliation, the Commission also proposed to expand portfolio
reconciliation to all transactions, whether collateralized or
uncollateralized. For the swap market to operate efficiently and to
reduce systemic risk, the Commission believed that portfolio
reconciliation should be a proactive process that delivers a
consolidated view of counterparty exposure down to the transaction
level. By identifying and managing mismatches in key economic terms and
valuation for individual transactions across an entire portfolio, the
Commission's proposal sought to require a process in which overall risk
can be identified and reduced. The Commission received numerous
comments to the portfolio reconciliation proposal and considered each
in formulating the final rules, as discussed below.
1. Statutory Basis for Portfolio Reconciliation
The proposed portfolio reconciliation regulations were proposed
pursuant to section 4s(i) of the CEA, as added by section 731 of the
Dodd-Frank Act, which directs the Commission to prescribe regulations
for the timely and accurate confirmation, processing, netting,
documentation, and valuation of all swaps entered into by SDs and MSPs.
The Working Group commented that the Commission should delete the
reconciliation requirements from the proposed rule because section 731
of the Dodd-Frank Act does not require the Commission to issue rules on
portfolio reconciliation and the Commission has not fully analyzed the
potential effect on the market.
In response to The Working Group's comment, the Commission notes
that portfolio reconciliation involves both confirmation and valuation
and serves as a mechanism to ensure accurate documentation. Thus, the
reconciliation requirements finalized herein are within the scope of
section 4s(i) of the CEA. Moreover, the Commission reiterates its
statement in the Confirmation NPRM that disputes related to confirming
the terms of a swap, as well as swap valuation disputes impacting
margin payments, have long been recognized as a significant problem in
the OTC derivatives market, and portfolio reconciliation is considered
an effective means of identifying and resolving these disputes.
2. General Comments to Portfolio Reconciliation--Sec. 23.502
Proposed Sec. 23.502 required SDs and MSPs to engage in periodic
swap portfolio reconciliation with their swap counterparties. Swap
portfolio reconciliation is defined in the proposed rule as a process
by which the two parties to one or more swaps: (i) Exchange the terms
of all swaps in the portfolio between the parties; (ii) exchange each
party's valuation of each swap in a portfolio between the parties as of
the close of business on the immediately preceding business day; and
(iii) resolve any discrepancy in material terms and valuations.
While Chris Barnard supported the proposed reconciliation
requirements, several commenters objected to certain aspects of the
rule.
GFED commented that the portfolio reconciliation requirements are
likely to be onerous, require significant investment in new
infrastructure, and have few benefits for shorter dated FX swaps. GFED
therefore recommended that the rules require only: (i) Reconciliation
of portfolio valuations (as opposed to differences in valuation or
trade specifics at the transaction level) because there is existing
market infrastructure in place for this purpose; and (ii)
reconciliation on a weekly basis with longer timeframes for resolving
discrepancies that reflect the global nature of the FX market.
MFA stated that current market practice is for market participants
to engage in portfolio reconciliation at the transactional level only
if there are portfolio-level discrepancies that result in margin
disputes, and MFA recommended that the Commission only require
portfolio reconciliation upon the occurrence of a material dispute
regarding margin to avoid unnecessary expense. MFA also believes the
Commission should accommodate participants with differing policies,
procedures, business models, structures, and types of swaps by
providing general principles and guidelines as to what constitutes best
practices, but not prescriptive rules.
ISDA stated that current portfolio reconciliation processes in the
industry are a means of identifying the source of a material collateral
dispute at the portfolio level. ISDA believes the draft 2011 Convention
on Portfolio Reconciliation and the Investigation of Disputed Margin
Calls and the draft 2011 Formal Market Polling Procedure, developed
pursuant to industry commitments to the ODSG, which ISDA believes will
be widely adopted by OTC derivatives market participants, should
[[Page 55927]]
play a more significant role in shaping the proposed reconciliation
rules. Specifically, ISDA believes that portfolio reconciliation should
be defined by reference to generally-accepted industry standards, as
instituted through the ODSG process, and reflected in data standards
and best practices as published by ISDA.
While TriOptima supports the regular reconciliation of all
portfolios and believes that this will identify issues that can
minimize counterparty credit exposure and operational risk, TriOptima
also believes that the Commission should not require registrants to
agree on reconciliation procedures, but should encourage the use of
industry-wide practices and protocols.
The Commission has not modified the rule based on these comments,
but certain elements of the rule have been modified based on specific
comments received, as discussed below. The Commission believes that
regular portfolio reconciliation will prevent most disputes from
arising and therefore does not recommend that portfolio reconciliation
be performed only on an ad hoc basis in response to a material margin
dispute at the portfolio level. The Commission notes that portfolio
reconciliation is not required for cleared swaps where the DCO holds
the definitive record of the trade and determines a binding daily
valuation for each swap cleared by the DCO. Therefore the Commission
believes that portfolio reconciliation will become less burdensome as
the bilateral portfolios of SDs and MSPs become significantly smaller
over time as a result of required clearing of swaps. In addition, the
need for portfolio reconciliation may be obviated at such time as all
swaps are reported to SDRs. For example, if an SDR record of a swap is,
by agreement of the parties, the legally operative documentation of the
swap, the parties need only consult the SDR record to reconcile their
portfolios.\34\
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\34\ For example, DTCC's Trade Information Warehouse maintains
the centralized global electronic database for virtually all CDS
contracts outstanding in the marketplace. The repository maintains
the most current credit default swap contract details on the
official legal, or gold record, for both cleared and bilateral CDS
transactions.
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3. Reconciliation of Material Terms--Sec. 23.502(a)(4) & (b)(4)
The proposed regulations required SDs and MSPs to resolve any
discrepancy in material terms of swaps in a swap portfolio discovered
during the process of portfolio reconciliation.
Commenting on this aspect of the proposal, ISDA stated that current
portfolio reconciliation processes in the industry are not meant to
resolve swap terms that do not lead to a material collateral dispute
and that the proposed rule would cause reconciliation to become a
replacement for the confirmation process. Similarly, The Working Group
stated that the Commission should not require reconciliation of terms
other than valuations to avoid imposing substantial costs on market
participants in the absence of any immediate need.
MarkitSERV asserted that the purpose of portfolio reconciliation is
the resolution of disputes that materially impact collateralization at
the portfolio level, and thus it is unnecessarily burdensome to require
any discrepancy in material terms to be resolved. MarkitSERV
recommended that the Commission only require reconciliation of terms
that could have a material impact on the valuation or collateralization
of a swap.
The FHLBs commented that it is not necessary to repeatedly
reconcile all terms of swaps that have been reported to a SDR as most
if not all such terms will not change from day-to-day or even month-to-
month. The FHLBs believe that SDRs will be in the best position to
efficiently and effectively detect and manage discrepancies in the
material terms of a swap transaction. Likewise, MetLife recommended
that the Commission revise the proposed reconciliation rule to require
only the reconciliation of variable economic terms, as the repeated
review of static terms confirmed during the confirmation process would
be an undue burden and expense.
TriOptima, on the other hand, recognized that the Commission's
proposal focuses on reconciliation of material terms in portfolios.
TriOptima believes that this is appropriate because the priority in
reconciliation is on completeness of trade population, rather than
granularity in trade details.
Having considered these comments, the Commission is not making any
change to the proposed requirement that all discrepancies in material
terms be resolved. The Commission is not persuaded by commenters that a
discrepancy in the terms of individual swaps would not be material to
the swap portfolio as a whole unless such discrepancies impact
collateralization at the portfolio level. Rather, the Commission
believes that a discrepancy in the material terms of a swap indicates a
failure in the confirmation process or a failure in a trade input or
processing system. As noted in the preamble to the proposed rules, the
Commission believes that the requirement that all swaps be reported to
an SDR will reduce the burden imposed by the rule by facilitating
efficient, electronic reconciliation for SDs, MSPs, and their
counterparties. Accordingly, the two requirements are consistent and
mutually reinforcing.
4. Frequency of Portfolio Reconciliation--Sec. 23.502(b)
Proposed Sec. 23.502(b) required SDs and MSPs to reconcile swap
portfolios with other SDs or MSPs with the following frequency: Daily
for portfolios consisting of 300 or more swaps, at least weekly for
portfolios consisting of 50 to 300 swaps, and at least quarterly for
portfolios consisting of fewer than 50 swaps. For portfolios with
counterparties other than SDs or MSPs, the proposed regulations
required SDs and MSPs to establish policies and procedures for
reconciling swap portfolios: Daily for swap portfolios consisting of
500 or more swaps, weekly for portfolios consisting of more than 100
but fewer than 500 swaps, and at least quarterly for portfolios
consisting of fewer than 100 swaps.
Several commenters supported the frequency of reconciliation
required by the proposed rule. Chris Barnard supported the frequency of
the proposed reconciliation requirements, while TriOptima stated that a
large number of SDs and MSPs already regularly reconcile their
portfolios with each other and with other entities and that the
increased frequency and inclusion of smaller portfolios as proposed
should prove no obstacle to such entities.
However, several commenters recommended alternatives. ISDA
recommended that the Commission accept the portfolio size/frequency
gradation established by the ODSG process, as that may change over
time, which ISDA believes provides an internationally consistent and
flexible standard. ISDA does not believe the proposed rule should
distinguish between counterparty types for determining frequency of
reconciliation because transaction population is an adequate guide. The
Working Group argued that the frequency of portfolio reconciliation
should be left up to the counterparties because they have the
sophistication necessary to determine whether and with what frequency
reconciliation is required in their own circumstances, which may be
daily, weekly, upon discovery of a dispute, or not at all. In the
alternative, The Working Group recommended that portfolio
reconciliation be required quarterly with any counterparty with which a
registrant has more than 100 swaps, and annually with all other
[[Page 55928]]
counterparties. Finally, Chatham recommended that the Commission revise
the proposed rules to provide that reconciliation with end users is
only required for swaps with maturities greater than one year and at
the following frequency: Weekly for portfolios of 500 or more swaps;
quarterly for portfolios of 100 to 500 swaps; annually for portfolios
of 50 to 100 swaps; and optional reconciliation for portfolios of 50 or
less swaps.
Still other commenters objected more generally to the required
frequency of reconciliation. Dominion argued that the rule should not
override any contractual right that end users may have regarding
reconciliation, including frequency and the process for resolving
disputes, while AMG argued that reconciliation required under the
proposed rules is unnecessarily frequent and imposes excessive costs
that do not bear a reasonable relationship to the systemic risk goals
of the Dodd-Frank Act.
Finally, the OCC stated that many SDs will not be among the G-14
largest OTC derivatives dealers and, given the incremental progression
that was necessary for the G-14 OTC derivatives dealers to develop the
infrastructure necessary to increase reconciliation amongst themselves
from weekly reconciliation for portfolios with 5,000 or more trades in
2008 to the current daily reconciliation for portfolios of 500 or more
trades, the Commission should provide sufficient time for all
registrants to develop required infrastructure.
Having considered these comments, the Commission is modifying the
proposed rule to require daily reconciliation of swap portfolios among
SDs and MSPs only for swap portfolios of 500 or more swaps. The
Commission continues to believe that the requirement that all swaps be
reported to an SDR will lead to efficient, electronic reconciliation
for SDs and MSPs, but, at the urging of commenters, has reduced the
required frequency of reconciliation to match the frequency of
reconciliation currently undertaken by the largest prospective SDs.\35\
In addition, the daily reconciliation requirement for swap portfolios
among SDs and MSPs of 500 or more swaps brings the rule into
conformance with international regulatory efforts.\36\
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\35\ In December 2008, the ODSG's group of 14 major dealers
committed to execute daily portfolio reconciliations for
collateralized portfolios in excess of 500 trades between
participating dealers by June of 2009. See June 2, 2009 summary of
industry commitments, available at http://www.isda.org/c_and_a/pdf/060209table.pdf. As of May 2009, all participating dealers were
satisfying this commitment. The ODSG dealers expanded their
portfolio reconciliation commitment in March 2010 to include monthly
reconciliation of collateralized portfolios in excess of 1,000
trades with any counterparty.
\36\ Compare with ESMA Draft Technical Standards, Article 2 RM,
subsection 4, (stating that ``In order to identify at an early
stage, any discrepancy in a material term of the OTC derivative
contract, including its valuation, the portfolio reconciliation
shall be performed: * * * each business day when the counterparties
have 500 or more OTC derivative contracts outstanding with each
other; * * * once per month for a portfolio of fewer than 300 OTC
derivative contracts outstanding with a counterparty; * * * once per
week for a portfolio between 300 and 499 OTC derivative contracts
outstanding with a counterparty.'')
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For portfolios with counterparties other than SDs or MSPs, the
Commission is adopting the recommendation proposed by The Working
Group--that portfolio reconciliation be required quarterly with any
counterparty with which a registrant has more than 100 swaps, and
annually with all other counterparties. The Commission believes this
approach is largely consistent with that recommended by Chatham, and it
responds, in part, to concerns expressed by AMG. The Commission
believes it also will serve to lower the costs of the rule. Despite
this change in the frequency of reconciliation required for portfolios
with non-SD, non-MSP counterparties, the Commission reiterates its
belief that periodic reconciliation with all counterparties is a best
practice for those using swaps.
In response to Dominion's concern about the rule overriding
contractual rights of market participants, the Commission wishes to
clarify that parties are free to negotiate and elect whatever dispute
resolution mechanisms they so choose. The reconciliation rule merely
sets forth the minimum requirements and timing for reconciliation of
swap portfolios. The rule is not intended to override contractual
rights so long as SDs and MSPs are in compliance with these limited
provisions.
5. Exchange of Swap Data for Portfolio Reconciliation--Sec. 23.500(i)
& Sec. 23.502(b)
The preamble to the proposed regulations stated that portfolio
reconciliation could consist of one party reviewing the trade details
and valuations delivered by the other party and either affirming or
objecting to such details and valuations. MarkitSERV recommended that
the Commission clarify the circumstances in which both parties would be
required to exchange swap data and circumstances in which only one
party would be required to send swap data to its counterparty for
verification. Consistent with its prior statement, the Commission
prefers to permit maximum flexibility and innovation in the process and
thus will leave the circumstances of exchange or verification to the
discretion of SDs, MSPs, and their counterparties.
6. Portfolio Reconciliation With Non-SDs/MSPs--Sec. 23.502
The proposed regulation required SDs and MSPs to establish written
policies and procedures for engaging in portfolio reconciliation with
non-SDs and non-MSPs, which includes the reconciliation of valuations
for each swap in the parties' portfolio.
Commenting on the proposal, MarkitSERV stated that buy-side firms
view valuation data as private information. To allow for
confidentiality, MarkitSERV recommends that the Commission permit non-
SDs and non-MSPs to perform portfolio reconciliation via third parties
in a process that would only disclose valuation data when a discrepancy
exceeds the threshold set forth in the proposed rules.
Dominion asserted that section 4s(i) of the CEA required the
Commission to adopt regulations for netting and valuation for SDs and
MSPs, but not end users, and objects that the proposed rules require
SDs and MSPs to establish policies for reconciliation with end users
and for resolution of valuation disputes with end users in a timely
fashion. Dominion is concerned that an end user will be required to
provide SDs with proprietary market valuations that could be used
against the interests of the end user. Dominion therefore recommended
that the Commission clarify that an SD's or MSP's written procedures
may not require end users to disclose any proprietary market
information for purposes of dispute resolution.
The FHLBs argued that end users should not be subject to the same
reconciliation requirements as SDs and MSPs because the swap portfolios
of end users do not pose a significant risk to the overall financial
system and the reconciliation requirements may increase the costs of
swaps for end users. Chatham similarly argued that non-SDs and non-MSPs
using swaps to hedge risk do not pose systemic risk so daily or weekly
reconciliation is not necessary.
As discussed above, the Commission is modifying the proposed rule
to change the word ``enforce'' to ``follow.'' Based on commenters'
concerns that an SD or MSP cannot force a non-registrant to abide by
the portfolio reconciliation requirements, the Commission is further
modifying the proposed rule to require
[[Page 55929]]
only that SDs and MSPs establish policies and procedures reasonably
designed to ensure that they engage in portfolio reconciliation with
non-registrants with the modified frequency discussed above. The
Commission believes that ``reasonably designed to ensure'' is not the
same as requiring a guarantee of compliance. Therefore, the Commission
believes that the rule, as modified, would require that the SDs and
MSPs make reasonable efforts to engage in portfolio reconciliation with
non-registrants, but would not give SDs or MSPs the authority to
require it of their non-registrant counterparties.
In addition, the Commission is modifying the proposed rule to
clarify that discrepancies in material terms or valuation disputes that
become known to the parties before the quarterly or annual
reconciliation with non-SDs, non-MSPs, should be resolved in a timely
fashion. With this change, the Commission notes that non-SD, non-MSP
counterparties may bring a discrepancy or dispute to an SD's or MSP's
attention and the SD or MSP counterparty must work to resolve those
identified discrepancies and disputes.
7. Portfolio Reconciliation With DCOs for Cleared Swaps--Sec.
23.502(c)
The proposed regulations stated that the portfolio reconciliation
requirements will not apply to swaps cleared by a DCO.
With respect to this provision, MarkitSERV recommended that the
Commission require SDs and MSPs to regularly reconcile their positions
in cleared swaps against SDRs, DCOs, and clearing brokers to correct
discrepancies between the DCO record and a firm's internal records.
The Commission has determined not to follow MarkitSERV's
recommendation on this point. DCOs maintain the definitive record of
the positions of each of their clearing members (both house and
customer) and mark those positions to a settlement price at least once
a day.\37\ Accordingly, the Commission believes that cleared swaps do
not present the same documentation and valuation issues that uncleared
swaps do. The Commission notes that reconciliation of swap data between
DCOs and SDRs is beyond the scope of this rulemaking, which is adopting
regulations with respect to SDs and MSPs only.
---------------------------------------------------------------------------
\37\ Under typical DCO rules, clearing members are bound by the
settlement price of the DCO and the product specifications of
cleared swaps are set by the DCO.
---------------------------------------------------------------------------
8. Portfolio Reconciliation by ``Qualified Third Parties''--Sec.
23.502(b)
The proposed regulations permitted portfolio reconciliation to be
performed on behalf of SDs, MSPs, and their counterparties by a
qualified third party.
Commenting on this proposal, ABC & CIEBA and AMG separately
recommended that the Commission not require use of ``qualified'' third
parties for portfolio reconciliation, but, rather should explicitly
require that use of any third party service provider must be agreed by
both parties and recognize that each party may use a different third
party for reconciliation. Specifically, ABC & CIEBA recommended that
Sec. 23.502(b)(1) and (2) be revised to read as follows:
``(1) Each swap dealer or major swap participant shall agree in
writing with each of its counterparties on the terms of the
portfolio reconciliation, including agreement on the selection of
any third party.
(2) The portfolio reconciliation may be performed on a bilateral
basis by the counterparties or by one or more third parties selected
by the counterparties in accordance with Sec. 23.502(b)(1).''
In response to these comments, the Commission is modifying the
proposed rule to delete the word ``qualified,'' to require that the use
of a third-party service provider be subject to agreement of the
parties, and to provide that each party may use a different third party
so long as the provisions of the rule are met. Further, per AMG's
comments, the Commission expects that parties will determine if the
third-party is qualified based on their own policies.
9. Reconciliation Discrepancy Resolution Procedures--Sec. 23.502(b)(4)
The proposed regulations required that SDs and MSPs establish
procedures reasonably designed to resolve any discrepancies in the
material terms or valuation of each swap identified in the portfolio
reconciliation process.
Commenting on this aspect of the proposal, ABC & CIEBA recommended
that the Commission revise Sec. 23.502(b)(4) in order to ensure that
reconciliation dispute resolution by SDs and MSPs is fair, impartial,
and even-handed.
The Commission agrees that reconciliation dispute resolution should
be fair, impartial, and even-handed as recommended by ABC & CIEBA, but
believes that the commenter's concern will be addressed by deleting the
word ``enforce'' as discussed above. The Commission expects that SDs
and MSPs will cooperate with their counterparties and any applicable
third-party service provider in resolving discrepancies brought to
light through portfolio reconciliation.
10. Time Period for Resolution of Discrepancies in Material Terms--
Sec. 23.502(a)(4) & (b)(4)
With regard to portfolio reconciliation among SDs and MSPs, the
proposed regulations required that any discrepancy in material terms be
resolved immediately.
Freddie Mac stated that in some cases it may be impossible to
resolve a discrepancy in material terms immediately, as required under
Sec. 23.502(a)(4). Freddie Mac recommended that the Commission should
revise the proposed rules to provide that the timely and accurate
processing and valuation requirements of the Dodd-Frank Act will be
deemed satisfied whenever swaps are subject to a master netting
agreement and collateral pledge agreement under which the parties mark
net portfolio value to market and exchange collateral on the basis of
such valuation as promptly as commercially reasonable.
Having considered Freddie Mac's comment, the Commission is adopting
the rule as proposed with respect to immediate resolution of
discrepancies in material terms in swaps among SDs and MSPs. Given the
timely confirmation requirements of all terms of a swap as established
under Sec. 23.501, the Commission believes an immediate resolution of
any material term discrepancy is appropriate. Additionally, the
Commission believes that a longer period is not justified because
resolution of a discrepancy in a material term will likely require an
amendment of the trade record in the relevant SDR, which, for
regulatory oversight purposes, should be as accurate as possible.
11. Resolution of Valuation Disputes in Portfolio Reconciliation--Sec.
23.502(a)(5) & (b)(4)
With regard to portfolio reconciliation among SDs and MSPs, the
proposed regulations required that any discrepancy in the valuation of
a swap be resolved within one business day. With regard to portfolio
reconciliation between SDs or MSPs and non-registrants, the proposed
regulations required that SDs and MSPs have policies and procedures
reasonably designed to resolve any discrepancy in the valuation of a
swap in a timely fashion.
With respect to this aspect of the proposal, ISDA commented that
parties to a good-faith dispute should have a commercially reasonable
timeframe in which to consult in order to find an
[[Page 55930]]
appropriate resolution of the dispute. ISDA believes the draft 2011
Convention on Portfolio Reconciliation and the Investigation of
Disputed Margin Calls and the draft 2011 Formal Market Polling
Procedure, developed pursuant to industry commitments to the ODSG,
which ISDA believes will be widely adopted by OTC derivatives market
participants, should play a more significant role in shaping the
proposed reconciliation rules. The Working Group, the FHLBs, and AMG
also recommended that the Commission support the valuation dispute
resolution methodology sponsored by ISDA.
In addition to its general comments, ISDA made specific
recommendations:
Resolution is labor intensive and to avoid undue costs,
discrepancies in terms and valuations should only require resolution if
such are causing material portfolio-level collateral transfer disputes,
rather than on a transaction by transaction basis, as it allows for the
possibility that material but offsetting differences may exist in a
portfolio.
Again to avoid undue costs, a materiality standard should
apply to any mandated resolution requirement, because, in the absence
of a collateralization requirement or a live dispute as to
collateralization, discrepancies in valuation may be allowed to subsist
as potentially harmless and may disappear through changes in portfolio
composition over time. ISDA recommends that the ODSG resolution
tolerances be adopted by the Commission, as such tolerances may be
amended over time.
Resolution of a valuation dispute should mean that the
discrepancy in a portfolio-level margin dispute is reduced such that it
is within the applicable resolution tolerance, rather than requiring
exact agreement.
Resolution of a valuation dispute should not require
parties to make adjustments to their books and records.
Parties should be free to agree to accept that there is a
difference in opinion as to value, so long as appropriate capital is
held against any potential collateral shortfall.
With respect to the proposal to require valuation disputes to be
resolved within one business day, ISDA stated that a one-day timeframe
for resolution of valuation discrepancies is infeasible, especially
when applied to parties across vastly different global time zones, due
to the need to analyze reconciliation results, escalate for trader-to-
trader discussion or to senior management. Further, ISDA argued that
some disputes prove to be intractable and must be resolved through a
market poll, which requires time to build and populate a valuation
model, which may take hours or even days. AMG also argued that the time
periods are unnecessarily short and do not bear a reasonable
relationship to the systemic risk goals of the Dodd-Frank Act, noting
that the time periods are not consistent with recent ISDA dispute
resolution protocols or other methodologies incorporated in master
agreements, and could impose excessive costs on swap market
participants.
AMG recommended that the Commission clarify the consequences of
failing to resolve a valuation dispute within the mandated timeframe.
Freddie Mac stated that in some cases it may be impossible to resolve a
discrepancy in valuation within one business day, while BGA does not
believe that registrants should be penalized for failing to meet the
one business day resolution deadline. BGA argued that (i) SDs and MSPs
do not have control over their counterparties so resolution may take
more than a day; and (ii) a hard deadline may disadvantage SDs and MSPs
in negotiating a resolution with a counterparty that is not subject to
a deadline. Finally, The Working Group argued that the proposed
requirement that valuation disputes between registrants be resolved
within one business day is not workable due to the complex calculations
required, involvement of multiple functional groups within a
registrant, and possibility that resolution of a dispute may require
modifications to a valuation model that could create further
discrepancies for other swaps that are valued using the same model. The
Working Group believes the Commission should require only that
registrants begin the valuation dispute resolution process upon
discovery of a dispute, but permit counterparties to resolve the
dispute within a reasonable time period.
The FHLBs requested that the Commission specify the meaning of ``in
a timely fashion'' as it relates to discrepancy resolution with end
users.
The Working Group also had a number of recommendations with respect
to the proposed rule:
The Commission should not adopt valuation dispute
resolution rules that may be burdensome for markets where no problem
exists, such as swap markets with underlying physical markets that
provide an objective basis for swap valuations.
The proposed reconciliation rules should apply only to
valuation disputes on a portfolio basis, and not on a transaction
basis, as it would be unnecessarily burdensome to analyze the valuation
of individual swaps unless there is a material dispute as to the
portfolio level exposure between the parties.
Parties should have the right to continue to exchange
collateral without resolving a discrepancy exceeding 10 percent if they
conclude that the discrepancy is not material in their particular
circumstances.
With respect to the proposed 10 percent threshold before a dispute
would require resolution, Chatham argued that a percentage threshold of
10 percent difference is insufficient because it will impose a
significant burden in cases where the absolute value of the swap is
small, such as just after a swap is executed and in the period just
before maturity. MFA also recommended that the Commission revise the
proposed rule to provide that a valuation discrepancy must not only
exceed 10 percent, but must also exceed some reasonable dollar
threshold, and must result in one party being unwilling to satisfy a
collateral call from the other party. On the other hand, MetLife
supported the 10 percent buffer for designation of valuation
discrepancies, but recommended that the Commission extend the deadline
for valuation dispute resolution from 1 to at least 3 business days
with respect to highly structured and customized swaps.
TriOptima provided context with respect to valuation dispute
resolution in the swaps market. TriOptima commented that swaps are
valued using internal models, which use inputs derived from observable
sources or internal calculations and reflect a party's view on the
market; that for many swaps, there is only sparse or episodic liquidity
in similar contracts, which can be used to calibrate internal valuation
models; and that there is valuable information for regulators in a
spectrum of differing valuations of a swap. As an example, TriOptima
hypothesized that regulators could have had an early warning sign in
the run up to the 2008 financial crisis when some market participants
realized earlier than others that the price of credit risk was too low
and raised the price in their internal valuations as opposed to
counterparties that did not recognize the change in credit risk. With
respect to the proposal, TriOptima argued that forcing convergence on
swap valuations between parties could be detrimental to the stability
and resilience of the financial system by creating a disincentive for
firms to use their own judgment in setting market values, removing a
valuable diagnostic tool for regulators. TriOptima further stated that
there is a difference between an internal
[[Page 55931]]
valuation used for regulatory capital purposes and a valuation agreed
with a counterparty for use in calculating margin. If the agreed
valuation is lower than the internal valuation, a party must reserve
capital for the unsecured exposure. Therefore, TriOptima argued that if
the Commission requires the parties to agree on a valuation for
internal purposes, the unsecured exposure disappears and less capital
will be reserved, reducing stability and resilience in the financial
markets. TriOptima recommended that the Commission focus on
establishing principles for how to determine the margining amount on a
portfolio level, rather than forcing parties to agree on valuation of
individual transactions, with a key element in such principles being
consistency. For valuation differences that persist after excluding
errors and inconsistencies, TriOptima believes the parties should be
allowed to agree to disagree and face the credit risk and capital
consequences of having unsecured exposures.
The Commission recognizes the view that there is valuable
information for market participants and regulators in a spectrum of
differing valuations of a swap. The Commission also is cognizant of the
ongoing efforts by industry and ISDA to improve the existing valuation
dispute resolution process. Based on meetings between Commission staff
and ISDA's Collateral Steering Committee, the Commission understands
that ISDA's draft 2011 Convention on Portfolio Reconciliation and the
Investigation of Disputed Margin Calls and the draft 2011 Formal Market
Polling Procedure has reduced valuation dispute resolution to a 30-day
process.
Issues related to swap valuations are woven through a number of
Commission rule proposals. For instance, Sec. 23.504(e), as adopted in
this release, requires SDs and MSPs to report valuation disputes in
excess of $20,000,000 lasting longer than three business days to the
Commission, while under Sec. 23.504(b)(4) SDs and MSPs are required to
agree on valuation methodologies with their counterparties. The
Commission believes that by requiring agreement with each counterparty
on the methods and inputs for valuation of each swap, it is expected
that Sec. 23.504(b)(4) will assist SDs and MSPs to resolve valuation
disputes in a timely manner, thereby reducing risk.
Agreement between SDs, MSPs, and their counterparties on the proper
daily valuation of the swaps in their swap portfolio also is essential
for the Commission's margin proposal. As discussed above, under
proposed rule Sec. 23.151, non-bank SDs and MSPs must document the
process by which they will arrive at a valuation for each swap for the
purpose of collecting initial and variation margin. All non-bank SDs
and MSPs must collect variation margin from their non-bank SD, MSP, and
financial entity counterparties for uncleared swaps on a daily basis.
Variation margin requires a daily valuation for each swap. For swaps
between non-bank SDs and MSPs and non-financial entities, no margin is
required to be exchanged under Commission regulation, but the non-bank
SDs and MSPs must calculate a hypothetical variation margin requirement
for each uncleared swap for risk management purposes under proposed
Sec. 23.154(b)(6).
Given that arriving at a daily valuation is one of the building
blocks for the margin rules and is essential for the mitigation of risk
posed by swaps, the Commission expects that SDs and MSPs as a matter of
best practice will work to resolve valuation disputes for swaps with
other SDs and MSPs within one business day. However, the Commission is
modifying this provision to require that valuation disputes be subject
to policies and procedures reasonably designed to ensure that such
disputes are resolved within five business days, as discussed further
below. The Commission has determined to make no change to the
requirement that valuation disputes between SDs, MSPs, and non-SDs or
non-MSPs be subject to policies and procedures reasonably designed to
ensure that such disputes are resolved ``in a timely fashion.''
The Commission is persuaded by commenters that some valuation
disputes may be difficult to resolve within the one-day timeframe and
is therefore modifying the rule such that it no longer requires
resolution, but instead requires that SDs and MSPs establish procedures
reasonably designed to ensure that swap valuation disputes are resolved
within five business days.\38\ Thus SDs and MSPs will not violate the
rule if they fail to resolve a particular dispute within five business
days, so long as they have followed their reasonably designed
procedures. In addition, the rule will require SDs and MSPs to have
policies and procedures identifying how they will comply with any
variation margin requirements pending resolution of a valuation
dispute. The rule already requires SDs and MSPs to establish procedures
to resolve valuation disputes with non-SD/MSP counterparties in a
timely fashion.
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\38\ Compare with ESMA Draft Technical Standards, Article 4 RM,
subsection 2, (stating that ``counterparties shall, when concluding
OTC derivative contracts with each other have agreed detailed
procedures and processes in relation to * * * resolution of disputes
in a timely manner; * * * resolution of disputes that are not
resolved within five business days, including third party
arbitration or a market polling mechanism.'')
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Regarding the safe harbor for valuation differences of less than 10
percent, the Commission believes the 10 percent threshold is
appropriate as it provides certainty as to which disputes must be
resolved. The Commission believes the efficiency of a bright line rule,
as opposed to the formulas and discretion in the alternatives presented
by commenters, will better serve the operational processes of SDs and
MSPs and the regulatory oversight of the Commission.
12. Reporting of Valuation Disputes to the Commission
The proposed regulations required SDs and MSPs to keep records of
valuation disputes and the time to resolution of such disputes, but did
not require SDs or MSPs to report such disputes to the Commission.
However, as noted by the New York City Bar Committee on Futures and
Derivatives (NYCB), proposed Sec. 23.504(e) required valuation
disputes among SDs and MSPs outstanding for more than one business day,
or five business days for disputes between an SD or MSP and a non-SD,
non-MSP counterparty to be reported to the Commission.
In this regard, ISDA recommended that the Commission require
monthly reporting of margin disputes outstanding more than 15 days that
exceed the applicable tolerances, which is consistent with current ODSG
commitments. MetLife recommended a period of 90 days before reporting
is required.
As discussed above, the Commission is modifying this provision to
require reporting within three business days, and it has added a
$20,000,000 threshold for reporting of disputes. The Commission
believes the less frequent reporting provided by the threshold will
alleviate the concerns of the commenters.\39\
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\39\ Compare with ESMA Draft Technical Standards, Article 4 RM,
subsection 2, (stating that ``counterparties shall report to the
competent authority * * * any disputes between counterparties
relating to an OTC derivative contract, its valuation or the
exchange of collateral for an amount or a value higher than EUR 15
million and outstanding for at least 15 business days.'')
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[[Page 55932]]
13. Recordkeeping Requirement for Portfolio Reconciliation--Sec.
23.502(d)
The proposed regulations required SDs and MSPs to make and retain a
record of each portfolio reconciliation, including a record of each
discrepancy and the time to resolution of each discrepancy.
ISDA objected to the recordkeeping requirement for portfolio
reconciliation, arguing that it should consist only of disputes, and
not of the entire process. Specifically, ISDA recommended that records
be kept of the date of the initial dispute, the resolution of the
dispute, the date of resolution, and the net portfolio valuations of
the two parties. Further, ISDA requested an explicit statement that
access to third party reconciliation services' records will satisfy the
obligation to permit inspection of the records by supervisors.
Similarly, The Working Group requested that the Commission clarify that
the records required to be kept in relation to valuation dispute
resolution pertain only to discrepancies that exceed the 10 percent
buffer.
The Commission notes that its recordkeeping rule for SDs and MSPs
includes a recordkeeping requirement that SDs and MSPs make and keep a
record of each portfolio reconciliation, including the number of
portfolio reconciliation discrepancies and the number of swap valuation
disputes (including the time-to-resolution of each valuation dispute
and the age of outstanding valuation disputes, categorized by
transaction and counterparty).\40\ In the interests of streamlining
regulatory requirements, the Commission is modifying Sec. 23.502(d) to
cross reference Sec. 23.202 and delete the substantive requirements.
The Commission has also revised the cross-reference to Sec. 1.31 to a
cross-reference to the SD and MSP record retention rule, Sec. 23.203.
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\40\ See 17 CFR 23.202(a)(3)(iii), Reporting, Recordkeeping, and
Daily Trading Records Requirements for Swap Dealers and Major Swap
Participants, 77 FR 20128, 20201 (April 3, 2012).
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In response to comments of ISDA and The Working Group, the
Commission believes that the level of detail included in portfolio
reconciliation records is left to the reasonable discretion of SDs and
MSPs so long as the basic requirements of the rule are met.
F. Portfolio Compression--Sec. 23.503
Section 4s(i) of the CEA directs the Commission to prescribe
regulations for the timely and accurate processing and netting of all
swaps entered into by swap dealers and major swap participants.
Portfolio compression is an important, post-trade processing and
netting mechanism that can be an effective and efficient tool for the
timely and accurate processing and netting of swaps by market
participants. Portfolio compression is a mechanism whereby
substantially similar transactions among two or more counterparties are
terminated and replaced with a smaller number of transactions of
decreased notional value in an effort to reduce the risk, cost, and
inefficiency of maintaining unnecessary transactions on the
counterparties' books. Because portfolio compression participants are
permitted to establish their own credit, market, and cash payment risk
tolerances and to establish their own mark-to-market values for the
transactions to be compressed, the process does not alter the risk
profiles of the individual participants beyond a level acceptable to
the participant. The usefulness of portfolio compression as a risk
management tool has been acknowledged widely.
In 2008, the PWG identified frequent portfolio compression of
outstanding trades as a key policy objective in the effort to
strengthen the OTC derivatives market infrastructure.\41\ Similarly,
the 2010 staff report outlining policy perspectives on OTC derivatives
infrastructure issued by the FRBNY identified trade compression as an
element of strong risk management and recommended that market
participants engage in regular, market-wide portfolio compression
exercises.\42\
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\41\ See ``Policy Objectives for the OTC Derivatives Markets,''
President's Working Group on Financial Markets (Nov. 14, 2008).
\42\ See Federal Reserve Bank of New York Staff Report No. 424:
``Policy Perspectives on OTC Derivatives Market Infrastructure,''
Jan. 2010 (revised Mar. 2010).
---------------------------------------------------------------------------
Based upon these considerations, the Commission proposed Sec.
23.503, which imposed certain portfolio compression requirements upon
SDs and MSPs. The Commission received numerous comments to the
portfolio compression proposal and considered each in formulating the
final rules, as discussed below.
1. Statutory Basis for Portfolio Compression
The proposed portfolio compression regulations were proposed
pursuant to section 4s(i) of the CEA, which directs the Commission to
prescribe regulations for the timely and accurate confirmation,
processing, netting, documentation, and valuation of all swaps entered
into by SDs and MSPs.
Commenting on the proposal, ISDA stated that the portfolio
compression requirements lack an explicit statutory basis in the Dodd-
Frank Act, and should be left to the judgment of market participants.
Likewise, The Working Group stated that section 731 of the Dodd-Frank
Act does not require the Commission to issue rules on portfolio
compression and believes the final rules should not include portfolio
compression requirements.
In response to these comments, section 4s(i) of the CEA clearly
authorizes the Commission to prescribe standards for the netting of
swaps. As explained in the Confirmation NPRM, portfolio compression is
a post-trade processing and netting mechanism whereby substantially
similar transactions among two or more counterparties are terminated
and replaced with a smaller number of transactions of decreased
notional value.
2. Definition of ``Multilateral Portfolio Compression Exercise''--Sec.
23.500(h)
The proposed regulations defined ``multilateral portfolio
compression exercise'' as an exercise in which multiple swap
counterparties wholly or partially terminate some or all of the swaps
outstanding among those counterparties and replace the swaps with a
smaller number of swaps whose combined notional value is less than the
combined notional value of the original swaps included in the exercise.
The replacement swaps may be with the same or different counterparties.
With respect to this definition, TriOptima commented that the
proposed definition of ``multilateral portfolio compression exercise''
is too narrow and recommends that the Commission revise the definition
to read: ``an exercise in which multiple swap counterparties wholly
terminate or change the notional value of some or all of the swaps
submitted by the counterparties for inclusion in the portfolio
compression and, depending on the methodology employed, replace the
terminated swaps with other swaps whose combined notional value (or
some other measures of risk) is less than the combined notional value
(or some other measure of risk) of the terminated swaps in the
compression exercise.'' ISDA recommended the same changes as those
recommended by TriOptima for the same reasons.
Based on the explanations of commenters, the Commission is
persuaded that the proposed definition was unnecessarily narrow and the
Commission has accordingly modified the definition of ``multilateral
portfolio compression exercise'' in the manner recommended by
commenters. In addition, for the sake of consistency, the
[[Page 55933]]
definition of ``bilateral portfolio compression exercise'' has also
been modified in a consistent manner.
3. Mandatory Portfolio Compression--Sec. 23.503
The proposed regulations required SDs and MSPs to engage in
bilateral and multilateral portfolio compression exercises with respect
to all swaps in which their counterparty is also an SD or MSP. In
contrast, the proposed regulations required SDs and MSPs to establish
policies and procedures for engaging in portfolio compression with swap
counterparties that are not SDs or MSPs.
On this issue, The Working Group argued that portfolio compression
is only beneficial in markets where there is a high degree of
transaction standardization and a high volume of redundant trades, and
therefore recommended that the Commission only impose mandatory
compression exercises on markets where the ratio of gross market value
to notional size (which is a rough estimation of the level of redundant
trades) shows that the benefits of compression outweigh the substantial
cost of engaging in the exercise. The Working Group also recommended
that the Commission not impose mandatory compression in markets where
compression platforms have not yet been designed, tested, and approved
by the Commission.
Markit pointed out that portfolio compression was recently
attempted in the commodities and foreign exchange asset classes, but
was not pursued further because the trial cycles had limited success,
and is concerned that mandatory participation under the proposed rules
might lead to compression for a range of uncleared swaps where the
potential benefits do not justify the cost of the exercise,
particularly for the large number of potential SDs and MSPs that
currently do not participate in compression cycles. Costs identified by
Markit include changes to participant's risk systems and connectivity
enhancements that would allow for the booking and processing of a large
volume of swaps (thousands) in as short a period as a single day.
Markit recommended an alternative to the proposal in which the
Commission would establish thresholds for determining whether a
category of non-cleared swaps should be subject to any mandatory
compression exercise and the frequency of such exercises. Markit
believes such thresholds should be related to the minimum number of
swaps, number of participants, number of swaps per participant, amount
of ongoing trading activity, degree of standardization in the product,
and the notional amount of transactions that must be compressed.
With respect to compression between SDs and MSPs and non-SDs, non-
MSPs, Markit believes that there will be no noteworthy benefit from
requiring non-dealer counterparties to participate in portfolio
compression exercises for uncleared swaps, as such entities have
portfolios with a very small number of offsetting transactions and
often have complicated arrangements with prime brokers making
compression more difficult and costly.
Freddie Mac commented that mandatory portfolio compression should
be limited to swaps that match and offset cash flows exactly, and that
any compression requirement allow for exceptions for end users relying
on swaps for hedging purposes or that otherwise believe the termination
of an existing swap would have an adverse effect on remaining trades.
Providing the view of a portfolio compression vendor, TriOptima
stated that for many smaller institutions and for larger institutions
trading illiquid swaps, the net to gross ratio of a portfolio is
sometimes close to 100 percent, meaning that all swaps in the portfolio
are in the same market-risk direction. TriOptima argued that it would
not be productive for such institutions to take part in multilateral
compression as many transactions designated as hedges for accounting
purposes must be excluded from compression, and either no transactions
could be compressed or the resulting notional reduction would be
minimal. TriOptima therefore recommended that the Commission remove any
mandatory compression requirement from the proposed rule and instead
focus on creating incentives for institutions to take part in portfolio
compression. TriOptima noted that most capital requirements are based
on net risk positions and therefore recommended that the Commission
create capital or other incentives to reduce gross risk positions.
Based on the comments received, the Commission has concluded that
it may be premature to require SDs and MSPs to engage in mandatory
bilateral and multilateral compression exercises for all asset classes
at this time. Although the Commission agrees with Markit's comment that
compression opportunities should be based on an analysis of the market,
including the number of swaps, number of participants, number of swaps
per participant, amount of ongoing trading activity, degree of
standardization in the product, and the notional amount of transactions
that could be compressed, it does not foresee that it will have the
resources to make such a determination or to set thresholds for
mandatory compression. In addition, as discussed more fully below, the
Commission is modifying the bilateral offset requirement for swaps
between SDs and MSPs that are ``fully offsetting.''
Accordingly, the Commission has modified the proposed rules to
remove the mandatory bilateral and multilateral compression
requirements and has replaced them with a requirement that SDs and MSPs
establish policies and procedures for periodically engaging in
portfolio compression exercises with counterparties that are also SDs
or MSPs and for engaging in portfolio compression with all other
counterparties upon request.\43\ In this regard, the Commission
anticipates that in order to be in compliance with the rule, an SD's or
MSP's policies and procedures would include procedures for engaging in
periodic evaluation of compression opportunities, written policies
establishing when the SD or MSP would consider a compression
opportunity to be materially beneficial, and procedures for engaging in
those opportunities when such arise. These policies and procedures
would also be required to address how the SD and MSP would determine
which swaps to include and exclude from compression exercises and what
risk tolerances it would accept.
---------------------------------------------------------------------------
\43\ Compare with ESMA Draft Technical Standards, Article 3 RM,
subsection 2, (stating that ``counterparties with 500 or more OTC
derivative contracts outstanding which are not centrally cleared
shall have procedures to regularly, and at least twice a year,
analyse the possibility to conduct a portfolio compression exercise
in order to reduce their counterparty credit risk and engage in such
portfolio compression exercise.'')
---------------------------------------------------------------------------
The Commission has also modified the rule to clarify that (1) non-
SDs/MSPs are not required to engage in portfolio compression exercises
with SDs and MSPs, but (2) that SDs and MSPs must engage in portfolio
compression exercises with non-SDs/MSPs upon request.
As further support for the modifications, the Commission notes that
in the proposed DCO rules, the Commission proposed that DCOs must offer
multilateral compression, but the final DCO rule provided that
participation in compression exercises by clearing members and their
customers would be voluntary.\44\
---------------------------------------------------------------------------
\44\ See 17 CFR 39.13(h)(4), Derivatives Clearing Organization
General Provisions and Core Principles, 76 FR 69334, 69383 (Nov. 8,
2011).
---------------------------------------------------------------------------
[[Page 55934]]
4. Swaps Eligible for Compression--Sec. 23.503
Proposed Sec. 23.503 required SDs and MSPs to include all swaps in
their compression exercises with other SDs and MSPs and swaps with
other counterparties to the extent that the swaps are able to be
terminated through a portfolio compression exercise.
With respect to this aspect of the proposal, BlackRock recommended
that the Commission revise the proposed compression rules to more fully
promote the compression of substantially similar, but not fully
offsetting, swaps.
The Commission believes that the concerns underlying BlackRock's
comment is addressed by the changes to the proposed rule as discussed
above, specifically the modification requiring SDs and MSPs to engage
in compression with non-SDs and non-MSPs at the request of such
parties. The Commission believes it is prudent to permit the parties to
agree on the method and venue of compression, rather than having the
Commission prescribe the method and venue.
5. Application of Portfolio Compression to Non-SD/MSPs
In the Confirmation NPRM, the Commission requested comment on
whether it should require SDs and MSPs to engage in compression
exercises with counterparties that are not SDs or MSPs. The Commission
also requested comment on whether financial entities as defined in
proposed Sec. 23.500 should be subject to the same compression
requirements as SDs and MSPs.
In response to this request for comments, Markit stated that there
will be no noteworthy benefit from requiring non-dealer counterparties
to participate in portfolio compression exercises for uncleared swaps
because such entities have portfolios with a very small number of
offsetting transactions and often have complicated arrangements with
prime brokers making compression more difficult and costly.
ISDA also identified several issues with the proposal to apply
compression requirements to non-SDs:
Current portfolio compression exercises only achieve
successful results by limiting exercises to a single asset-class and a
relatively small and homogeneous group of participants (i.e., the G14
dealers), which limits the difficulty and range of attendant risks.
Multilateral compression cycles are typically managed with
automated tools to support tear up and new trade creation that end-
users usually do not possess, and the costs of obtaining such tools
cannot be justified by the benefits.
The requirement for bilateral netting of swaps not covered
by multilateral or cleared compression processes will impose onerous
tasks with only limited benefit for end-users who engage in trades that
are typically more bespoke.
ABC & CIEBA commented that benefit plans should not be subject to
the proposed portfolio compression rule because every swap of a benefit
plan serves a business purpose and benefit plan swap portfolios contain
no redundant positions. ABC & CIEBA also argued that benefit plans may
have multiple investment advisers with individual mandates and
portfolio compression could result in losses if market movements that
had been previously hedged are undone by compression. ABC & CIEBA thus
urged the Commission to require SDs and MSPs to obtain explicit consent
of end user counterparties prior to compression of any swap.
AMG, Dominion, the FHLBs, and Chatham echoed the concerns of ABC &
CIEBA, commenting that non-SDs and non-MSPs (including financial
entities) should not be subject to mandatory or involuntary portfolio
compression due to legitimate reasons for offsetting, but beneficial
swap positions, such as hedging specific assets. Thus, AMG, Dominion,
and the FHLBs recommended that the Commission revise the proposed rules
to require SDs and MSPs to obtain the explicit consent of its end user
counterparties prior to compression of any swap. BlackRock recommended
that the Commission require SDs and MSPs to engage in bilateral and
multilateral compression exercises with counterparties that are not SDs
or MSPs, if such parties chose to do so.
MFA similarly recommended that portfolio compression be an option
for end users, but not an obligation as portfolio compression is only
appropriate for entities with portfolios large enough to yield
meaningful benefits that outweigh the expense of a compression
exercise. MFA further stated that end users should not be required to
engage in multilateral portfolio compression for cleared swaps. GFED
believes that portfolio compression is unnecessary for non-dealer end
users as volumes are too small.
With respect to compression with financial entities, the FHLBs
commented that financial entities should not be subject to the same
compression requirements as SDs and MSPs as the swap portfolios of such
entities do not, by definition, pose a significant risk to the overall
financial system, such requirements could have adverse effects for such
entities because their tax and accounting treatment may differ
significantly from those of SDs, and such requirements may discourage
financial entities from using swaps for hedging or risk mitigation.
Freddie Mac believes that mandatory portfolio compression should be
limited to swaps that match and offset cash flows exactly, and that any
compression requirement allow for exceptions for end users relying on
swaps for hedging purposes or that otherwise believe the termination of
an existing swap would have an adverse effect on remaining trades.
With respect to insurers, NAIC stated that state insurance laws
require insurers to ``tag'' each swap position to specific hedging,
replication, or income generation transactions, giving insurance
regulators complete transparency into the swap position carried by
insurers. NAIC is concerned that the proposed compression requirements,
despite the exception in Sec. 23.503(c)(3)(i), may require SDs and
MSPs to terminate fully offsetting swaps that include swaps held by
insurers for hedging of specific assets and liabilities, hindering
state regulators' ability to regulate insurers. NAIC requested that the
Commission modify the rule so that any swap position of an insurer that
is specifically designated as a hedge as required by state insurance
statutory accounting rules be allowed to remain outstanding and not be
subject to portfolio compression rules.
MetLife also strongly opposed any mandated compression of
offsetting swap positions. MetLife believes that the safe harbor in the
proposed rules for exclusion of swaps ``likely to increase
significantly the risk exposure'' of a party is not sufficiently broad
to protect a party's essential hedging transactions. MetLife
recommended that MSPs and other end users be permitted to opt out of
compression for transactions that are bona fide hedges. Specifically,
MetLife stated that the compression requirements may conflict with
state insurance laws governing allocation of hedging transactions to
specific assets and liabilities. MetLife concurred with other
commenters in urging the Commission to exclude insurance companies from
any mandatory portfolio compression requirement.
On the other hand, Eris Exchange stated that it has clearly heard
that the swap trading community welcomes the Commission's proposed
compression rule. Eris Exchange believes the end user community is
optimistic that financial reform will lead to greater position netting
and the ability to more
[[Page 55935]]
freely unwind aged swap trades without having to go through a
cumbersome novation process involving substantial operational burden
and negotiated up-front payments.
Having considered these comments, the Commission notes that, as
discussed above, the rule has been modified to require SDs and MSPs to
establish policies and procedures for engaging in portfolio compression
with non-SDs and non-MSPs when requested by such counterparties. The
Commission believes this change addresses the comments of non-SDs and
non-MSPs discussed above.
6. Application of Portfolio Compression by Asset Class
Proposed Sec. 23.503 applied uniformly to all swaps, regardless of
asset class. The Commission requested comment regarding whether the
compression requirement should be restricted to particular asset
classes.
ISDA commented that compression in asset classes other than credit
and interest rates would be extremely costly and the benefits would be
limited. ISDA stated that the industry will need to develop practices
for each additional asset class because methods used in one asset class
are not portable to other asset classes with distinct characteristics.
ISDA specifically recommended that the following asset classes be
excluded from any compression requirements:
Foreign exchange swaps, which achieve compression through
daily trade aggregation in CLS and have short tenors;
Equity derivatives, because they are broadly positional in
nature, there is a lack of standardization, and they are broadly
hedged; and
Commodity derivatives, because notional amounts are low
and compression may only be worthwhile for oil and precious metals.
GFED also recommended that the Commission exclude foreign exchange
swaps from the portfolio compression requirements as most foreign
exchange swaps are short dated (i.e., three to six months average, one
month for options) and the costs of implementation likely outweigh the
limited benefits.
As noted above, Markit stated that portfolio compression was
recently attempted in the commodities and foreign exchange asset
classes, but was not pursued further because the trial cycles had
limited success.
As discussed above, the Commission has modified the rule to remove
the mandatory compression requirement and replace it with a requirement
that SDs and MSPs establish policies and procedures for the regular
evaluation of compression opportunities with other SDs and MSPs, when
appropriate, and for engaging in compression with non-SDs and non-MSPs
upon request. The Commission believes this change addresses commenters'
concerns regarding the inappropriate or inefficient application of
portfolio compression to certain asset classes.
7. Bilateral Uncleared Swap Portfolio Compression--Sec. 23.503(b)
Proposed Sec. 23.503(b) required SDs and MSPs to engage in
bilateral portfolio compression exercises at least once every calendar
year with their swap counterparties that were also SDs or MSPs, unless
the SD or MSP participated in a multilateral compression exercise in
which such counterparties also participated.
With respect to this proposal, ISDA commented that the move to
clearing will reduce the need for bilateral/uncleared trade compression
because most fungible, liquid products in the credit and rates markets
will be in DCOs.
The Commission believes that the changes to the proposed rule
discussed above will address commenters' concerns regarding the
inefficient application of portfolio compression to uncleared swaps.
Specifically, the rule as adopted will not require SDs and MSPs to
engage in bilateral compression, but only require that registrants
establish policies and procedures for periodically engaging in such
compression where appropriate.
8. Termination of Fully-Offsetting Bilateral Swaps--Sec. 23.503(a)
Proposed Sec. 23.503(a) required SDs and MSPs to terminate fully
offsetting swaps with other SDs or MSPs no later than the close of
business on the business day following the day the fully offsetting
swap was executed.
Commenting on this proposal, The Working Group stated that an SD or
MSP with a regulatory requirement for functional separation may have
legitimate reasons for maintaining offsetting long and short positions,
thus the Commission should not mandate termination of fully-offsetting
swaps, but only require that registrants have policies and procedures
for termination of such swaps in appropriate circumstances. The Working
Group also argued that requiring registrants to run and monitor daily
systems for the detection of completely offsetting swaps where there
are likely to be none is unnecessarily burdensome. Finally, The Working
Group believes that the one business day time period for terminating
fully-offsetting swaps is unnecessarily burdensome and should be
revised to allow for one week.
ISDA believes the requirement for registrants to terminate fully-
offsetting swaps between registrants to be unnecessary because such
swaps are not sources of material risk. ISDA believes compliance with
the rule would be extremely difficult and expensive to implement as
compliance will require new processes to identify single offsetting
trades. In addition, ISDA stated that perfectly offsetting swaps are
not common and recommends the Commission clarify whether only perfect
offsets are required to be terminated.
The Commission finds these comments persuasive and is modifying the
rule to require only that SDs and MSPs establish policies and
procedures to terminate fully offsetting swaps with other SDs and MSPs
in a timely fashion, where appropriate. The Commission believes this
modification allows SDs and MSPs to design policies and procedures that
permit the maintenance of offsetting long and short positions for
legitimate business reasons.\45\ The Commission has also determined to
remove the one-day termination requirement as a cost-saving measure and
to replace it with the phrase ``in a timely fashion.''
---------------------------------------------------------------------------
\45\ Compare with ESMA Draft Technical Standards, Article 3 RM,
subsection 3, (stating that ``counterparties shall terminate each of
the fully offset OTC derivative contracts not later than when the
compression exercise is finalized.'')
---------------------------------------------------------------------------
9. Compression of Cleared Swaps
The proposed regulation did not differentiate between cleared swaps
and uncleared swaps.
In this respect, ISDA believes that no compression requirement
should attach to cleared trades, but, in the alternative, ISDA
recommended the Commission clarify that complying with a DCOs
compression requirements will satisfy the compression requirements of
the proposed rule. Likewise, MFA stated that end users should not be
required to engage in multilateral portfolio compression for cleared
swaps.
Having considered these comments, and in light of the portfolio
compression requirements under the Commission's regulations for
DCOs,\46\ the Commission has concluded that it is unnecessary to apply
the requirements of this rule to swaps that are cleared by a DCO and
has modified the rule accordingly. The Commission notes that this
change is parallel to the portfolio reconciliation
[[Page 55936]]
rule, which also does not apply to swaps cleared by a DCO.
---------------------------------------------------------------------------
\46\ See 17 CFR 39.13(h)(4), Derivatives Clearing Organization
General Provisions and Core Principles, 76 FR 69334, 69383 (Nov. 8,
2011).
---------------------------------------------------------------------------
10. Mandatory Multilateral Compression Offered by a DCO or SRO--Sec.
23.503(c)(2)
Proposed Sec. 23.503(c)(2) required SDs and MSPs to participate in
all multilateral portfolio compression exercises offered by a DCO of
which the SD or MSP is a member or an SRO of which the SD or MSP is a
member.
Commenting on this aspect of the proposal, both ISDA and TriOptima
stated that mandating compression offered by a DCO or SRO will inhibit
competition among providers of compression services. ISDA is concerned
that members of DCOs and SROs may become bound to compression services
with inadequate transparency, insufficient testing and lack of price
competition. ISDA recommends that the Commission permit registrants to
select the compression service provider, including for DCO or SRO-
mandated compression exercises.
As discussed above, the Commission has removed the mandatory
compression requirements from the rule as adopted. Nonetheless, in
response to these comments, the Commission agrees that the rule should
not demonstrate a preference for any type of compression services
provider and has accordingly modified the rule to require SDs and MSPs
to evaluate multilateral compression exercises initiated, offered, or
sponsored by any third party. This change also comports with the
decision to change the final DCO rules to provide for voluntary
participation in compression exercises.
11. Risk Tolerances in Multilateral Portfolio Compression--Sec.
23.503(c)(3)(ii)
Proposed Sec. 23.503(c)(3)(ii) permitted SDs and MSPs to establish
counterparty, market, cash payment, and other risk tolerances, and to
exclude specific potential counterparties for the purposes of
multilateral compression exercises.
Commenting on this aspect of the proposal, The Working Group
recommended that the Commission grant market participants broad
discretion when setting ``risk tolerances'' for multilateral
compression exercises, including:
A broad array of risks for which swaps may be excluded
from the exercise (e.g., regulatory risk, financial statement risk);
The ability to express preference for preserving swaps
with one counterparty over another for credit risk management purposes;
and
The ability to require that only identical swaps and not
substantially similar swaps can be compressed.
Having removed the mandatory multilateral compression requirement
from the rule, the Commission has also removed the portions of the rule
related to setting risk tolerances. However, under the revised rule,
SDs and MSPs must establish policies and procedures for engaging in
multilateral compression exercises, and the Commission expects that
these policies and procedures will address how the SD and MSP would
determine which swaps to include and exclude from compression exercises
and what risk tolerances it would accept. The Commission believes that
this change addresses commenters' concerns regarding the discretion to
determine risk tolerances in multilateral compression exercises.
12. Portfolio Compression Service Provider Standards
The proposed regulations did not prescribe standards for portfolio
compression service providers, and Markit recommended that, due to the
complexity of multilateral compression exercises, the Commission
establish standards for compression service providers to ensure
competency, timely service, and sufficient resources. The process for
choosing compression service providers should be fair and open. Freddie
Mac urged the Commission to closely scrutinize the necessity and
propriety of the terms of business demanded by prospective service
providers (including SDRs, SEFs and DCOs) and disapprove overreaching
terms such as open-ended indemnification, disclaimer of liability,
assertions of ownership over transactional data, and other intellectual
property of service users.
Given that the rule as adopted no longer contains a mandatory
compression requirement, the Commission believes that these comments
regarding standards for service providers and overreaching terms are
best addressed by competition in the market for providers of
compression services.
13. Recordkeeping Requirement for Portfolio Compression--Sec.
23.503(e)
Propose Sec. 23.503(e) required SDs and MSPs to maintain records
of each bilateral and multilateral compression exercise, including
dates, the swaps included in the exercise, the eligible swaps excluded
from the exercise and the reason for such exclusion, the counterparty
and risk tolerances specified for the exercise, and the results of the
exercise. ISDA commented that the recordkeeping requirement for
portfolio compression is too prescriptive in its detail. The Commission
is modifying the rule to require simply that SDs and MSPs maintain
complete and accurate records of all compression exercises. As a matter
of good practice, the Commission anticipates that market participants
will make and maintain all necessary records of any swaps that are
netted down, new swaps entered into, and any swaps that are submitted
for compression but not compressed. In addition, the Commission
observes that the rule does not prohibit SDs and MSPs from relying on
third-party service providers to achieve compliance with the rule,
although the responsibility for compliance cannot be delegated.
III. Effective Dates and Compliance Dates
In the Documentation NPRM and Confirmation NPRM, the Commission
requested comment on the length of time necessary for registrants to
come into compliance with the proposed rules. As discussed further
below, the Commission also proposed a compliance schedule, Sec.
23.575, for swap trading relationship documentation, Sec. 23.504, in a
separate release in September 2011.
A. Comments Regarding Compliance Dates
1. Documentation NPRM
With respect to Sec. 23.504, The Working Group recommended that
the Commission delay promulgating rules on swap documentation until it
has finalized all required rules to be issued under the Dodd-Frank Act
and can fully analyze the potential effect of documentation rules on
the swap markets, or, in the alternative, adopt a general framework
with an extended period of time for implementation to allow market
participants to design appropriate documentation standards. Further, if
the Commission should decide to make the proposed rules applicable to
existing transactions, then The Working Group recommended that the
Commission provide a short term safe-harbor for existing transactions
and give the market 36 months to come into compliance. If the
Commission should decide not to make the proposed rules applicable to
existing transactions, then The Working Group recommended that the
Commission give the market 12 months to come into compliance.
ISDA & SIFMA requested that the Commission defer proposing an
implementation timeline until the
[[Page 55937]]
Commission's rules and the SEC's rules relating to trading
documentation are fully developed and the industry has been given the
opportunity to address implementation issues with the Commission at
that time.
FSR believes that the renegotiation of existing documentation would
take significantly longer than six months and urged the Commission to
recognize that negotiation of new credit support arrangements,
including third-party custody arrangements, will be particularly time-
consuming and thus requested that the Commission provide an
appropriately long implementation timeframe. The Coalition of
Derivatives End-Users proposed a period of not less than two years for
implementation for end users because it is unclear how each SD and MSP
would seek to implement changes to comply with swap documentation rules
for both existing and new swaps. The Coalition believes this period of
time will allow for discussions and negotiations across all swap
counterparty relationships.
IECA recommended that a long implementation period be provided.
Otherwise, SDs will have an advantage because they have more resources
to apply than end users and it is likely that any standard amendment
would come from industry groups such as ISDA, which primarily
represents the interests of SDs. CIEBA is also concerned that a
deadline for SDs and MSPs to bring their documentation into compliance
would allow SDs and MSPs to present buy-side participants with a newly
standardized set of documentation, and would result in buy-side
participants having insufficient input into the substance of the
documentation. CIEBA also noted that a number of its members reported
that it is not uncommon for SDs to take up to a year to finalize an
ISDA agreement with a pension plan fiduciary. If SDs were required to
revise all their swap agreements, CIEBA believes that it could take
years.
In contrast to the foregoing comments, Michael Greenberger
commented that since many dealers already use documentation that will
comply with the regulations, allowing a maximum of thirty days to
comply with the rules following adoption should suffice.
In addition to the foregoing comments, the Commission received
comments with respect to proposed compliance schedules for a number of
proposed rules, including Sec. 23.504.\47\ In September 2011, the
Commission proposed four compliance schedules for four separate
provisions of the Dodd-Frank Act, including: (i) The clearing
requirement; (ii) the trade execution requirement; (iii) trading
documentation under section 4s; and (iv) margining requirements for
uncleared swaps.\48\ In its proposal, Swap Transaction Compliance and
Implementation Schedule: Trading Documentation and Margining
Requirements under Section 4s of the CEA, (Implementation Schedule
NPRM), the Commission stated that the proposed compliance schedule for
Sec. 23.504 was designed to afford affected market participants a
reasonable amount of time to bring their transactions into compliance
with the requirements of the rule and to provide relief in the form of
additional time for compliance. The schedule was intended to facilitate
the transition to the new regulatory regime established by the Dodd-
Frank Act in an orderly manner that does not unduly disrupt markets and
transactions. To this end, the Commission proposed Sec. 23.575, under
which an SD or MSP would be afforded ninety (90), one hundred eighty
(180), or two hundred and seventy (270) days to bring its swap trading
relationship documentation with its various counterparties into
compliance with the requirements of Sec. 23.504, depending on the
identity of each such counterparty. In the proposal, market
participants that are financial entities, as defined in section
2(h)(7)(C) of the CEA, were grouped into the following four categories:
---------------------------------------------------------------------------
\47\ See Swap Transaction Compliance and Implementation
Schedule: Trading Documentation and Margining Requirements under
Section 4s of the CEA, 76 FR 58176 (Sept. 20, 2011) (Implementation
Schedule NPRM).
\48\ The trading documentation and margining requirements
compliance schedules were proposed in one release. See id. The
clearing requirement and trade execution requirement were proposed
in another release, Swap Transaction Compliance and Implementation
Schedule: Clearing and Trade Execution Requirements under Section
2(h) of the CEA, 76 FR 58186 (Sept. 20, 2011). The Commission
finalized the compliance schedule for the clearing requirement on
July 24, 2012. See Swap Transaction Compliance and Implementation
Schedule: Clearing Requirement Under Section 2(h) of the CEA, 77 FR
44441 (July 30, 2012). The compliance schedules for margin for
uncleared swaps and the trade execution requirement will be
finalized separately.
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Category 1 Entities included SDs, security-based swap
dealers, MSPs, major security-based swap participants, and active funds
(defined as any private fund as defined in section 202(a) of the
Investment Advisers Act of 1940), that is not a third-party subaccount
and that executes 20 or more swaps per month based on a monthly average
over the 12 months preceding this adopting release.
Category 2 Entities included commodity pools; private
funds as defined in section 202(a) of the Investment Advisers Act of
1940 other than active funds; employee benefit plans identified in
paragraphs (3) and (32) of section 3 of the Employee Retirement Income
and Security Act of 1974; or persons predominantly engaged in
activities that are in the business of banking, or in activities that
are financial in nature as defined in section 4(k) of the Bank Holding
Company Act of 1956, provided that the entity is not a third-party
subaccount.
Category 3 Entities include Category 2 Entities whose
positions are held as third-party subaccounts.
Category 4 Entities includes any person not included in
Categories 1, 2, or 3.
Proposed Sec. 23.575 required SDs and MSPs to be in compliance
with Sec. 23.504 no later than 90 days after publication of the final
rule in the Federal Register for swap transactions with a Category 1
Entity, no later than 180 days after publication for swap transactions
with a Category 2 Entity, and no later than 270 days after publication
for swap transactions with a Category 3 Entity or Category 4 Entity.
The Commission received approximately 19 comments with respect to
the compliance phasing proposal, each of which it considered in
finalizing the compliance dates for the rule, as discussed below.
a. Definition of ``Active Fund''
The proposal defined ``active fund'' as ``any private fund as
defined in section 202(a) of the Investment Advisers Act of 1940, that
is a not a third party subaccount and that executes 20 or more swaps
per month based on a monthly average over the 12 months preceding * *
*.''
Commenting on this definition, the Association of Institutional
Investors (AII) stated that basing the definition on an average of 20
swap transactions per month is arbitrary. AII believes that the
Commission should collect data under swap transaction reporting rules
and then make a determination, but, in the alternative, AII recommended
that the threshold be higher and that the definition specify the type
of swaps that count towards the threshold. FIA/ISDA/SIFMA and Vanguard
also commented that the average monthly threshold should be raised, and
recommended that the threshold be raised to include only those funds
averaging more than 200 transactions per month.
MFA recommended that the definition be eliminated because it is
over-inclusive, difficult to administer, and unnecessarily divides the
class of buy-side market participants. Under MFA's view, all private
funds should be Category 2 Entities. If the Commission does not delete
the definition, MFA
[[Page 55938]]
requested clarification regarding those swaps that are to be included
in the calculation, e.g., novations, amendments, partial tear-ups, etc.
On a different tack, FSR stated that the definition of ``active
fund'' is unclear and needs further clarification to distinguish
between active fund and ``third-party subaccount.'' FSR represented
that its fund manager members believe that most (if not all) entities
that would fall into the term ``active fund'' would also constitute
``third-party subaccounts.''
The American Council of Life Insurers (ACLI) commented that the
frequency of trading is not an appropriate indicator of experience or
available resources for determining which entities can comply most
quickly. Similarly CDE recommended a minimum notional amount monthly
average threshold to avoid capturing smaller end-users and excluding
hedges and inter-affiliate swaps from the monthly average threshold.
On the other hand, Better Markets and Chris Barnard supported the
proposal, stating that average monthly trading volume is the
appropriate proxy for determining an entity's ability to comply with
the proposed implementation schedule and is better than notional
volume.
The Alternative Investment Management Association (AIMA) also
believes that the average number of swaps executed during the previous
12 months is a good proxy for determining what is an active fund, but
recommended that the definition should include private funds regardless
of whether they are a third party subaccount or not. Otherwise, private
funds that are not subaccounts will be disadvantaged relative to those
that are, in terms of the cost of entering into swaps during the course
of the implementation schedule. AIMA considered alternatives to the
definition but believes that instituting an ``assets under management''
threshold for the definition of active fund may be problematic, as
notwithstanding such a threshold, a manager may invest in other types
of financial instruments such that they do not in fact have the
experience or resources to more quickly comply with the regulations.
AIMA also believes that commodity pools that are not private funds, but
that execute 20 or more swaps on average per month, should be included
in the definition.
Having considered the comments received, the Commission believes
that the definition of ``active fund'' appropriately uses a
transaction-based trigger to distinguish between funds more active in
the swaps market and those that are less so. However, in response to
comments that an average of 20 transactions per month may be overly
inclusive and may cause some smaller entities, less well-positioned for
compliance with shorter implementation timeframes, to fall within the
definition. Accordingly, the Commission has determined to raise the
threshold to 200 swap transactions on average per month so as to ensure
only more active participants in the market are included within the
definition. The Commission also agrees with commenters that
establishing an appropriate minimum notional amount applicable to all
participants in the swap market, or assets under management standard,
to be impracticable.
However, the Commission does not believe it is appropriate to
create exclusions for the types of swap transactions within the
definition given the administrative burdens of monitoring such
distinctions for purposes of the proposed implementation schedule. In
response to commenters seeking clarification of what types of swap
transactions are to be included in the monthly calculation, the
Commission notes that the proposed implementation schedule, and the
compliance dates adopted in this release, both refer to ``swaps'' and
not ``swap transactions.'' ``Swap transaction'' is defined in Sec.
23.500 to include assignments, novations, amendments, and other events
that Sec. 23.501 requires to be documented by confirmation. Therefore,
in response to commenter's concerns, the Commission confirms that the
active fund threshold of 200 swaps per month refers to ``swaps'' as
defined in section 1a(47) of the CEA and Commission regulations, but
would not include assignments, novations, amendments, or like events
that occur with respect to existing swaps.
b. Definition of ``Third-party Subaccount''
The Implementation Schedule NPRM defined ``third-party subaccount''
to mean ``a managed account that requires the specific approval by the
beneficial owner of the account to execute documentation necessary for
executing, confirming, margining or clearing swaps.'' Third-party
subaccounts were designated as Category 3 Entities, whereas other funds
were designated Category 1 or Category 2 Entities.
With respect to this definition, AII commented that the definition
is too narrow given the administrative work required in managing an
account, regardless of the execution authority. Further, AII stated
that execution authority is not an industry standard, and thus divides
the universe of separate accounts inappropriately. Similarly, the
Investment Company Institute (ICI) stated that third party subaccounts,
whether subject to the specific execution authority of the beneficiary
or not, require managers to work closely with clients when entering
into trading agreements on the customer's behalf. As such, no
distinction should be made based on specific execution authority or
lack thereof, and that all third party accounts should be uniformly
classified as Category 3 Entities, allowing for a 270 day compliance
period.
FIA/ISDA/SIFMA also recommended that all accounts managed for third
parties, regardless of the execution authority, should be in the
Category 3 Entity implementation phase. FIA/ISDA/SIFMA recommended that
the Commission adopt a definition of ``third-party fund'' that is any
fund that is not a private fund and is sub-advised by a subadvisor that
is independent of and unaffiliated with the fund sponsor. A ``third-
party subaccount'' would be defined as any account that is not a fund
and is managed by an asset manager, irrespective of the level of
delegation granted by the account owner by the account owner to the
asset manager.
Based on the comments received, the Commission is revising the
definition of Third-Party Subaccount to mean an account that is managed
by an investment manager that (1) is independent of and unaffiliated
with the account's beneficial owner or sponsor, and (2) is responsible
for the documentation necessary for the account's beneficial owner to
document swaps as required under section 4s(i) of the CEA. In modifying
this definition, the Commission is taking into account the point made
by AII, FIA/ISDA/SIFMA, and ICI that all investment managers will need
additional time to comply with the trading documentation requirements
regardless of whether they have explicit execution authority. However,
the definition retains the nexus between the investment manager and the
documentation needed for swaps under section 4s(i) of the CEA. In other
words, if the investment manager has no responsibility for documenting
the swap trading relationships, then that account would be required to
come into compliance with the documentation requirements within 180
days. For those accounts under the revised definition, however, the
Commission believes that the 270-day deadline is more appropriate.
Given the general notice that investment managers have had
[[Page 55939]]
about the Dodd-Frank Act's documentation requirements for SDs and MSPs
since the enactment of the statute in July, 2010, managers should have
been able to consider and plan the infrastructure and resources that
are necessary for all of their accounts, including Third-Party
Subaccounts, to comply with the documentation requirements. Thus, the
180- and 270-day deadlines should provide adequate time to accommodate
all managed accounts.
c. Definitions of Categories of Entities
The Commission received several comments with respect to the
definitions of the categories of entities to which the proposed
implementation schedules applied.
Encana and EEI, National Rural Electric Cooperative Association,
and Electric Power Supply Association (Joint Associations) believe that
the definition of Category 4 Entity under the proposed implementation
schedules should expressly include non-financial end users.
The Coalition for Derivatives End-Users argued that financial end-
users should be treated identically to non-financial end-users because
they do not pose systemic risk, and therefore, should be given the most
time to comply with the requirements.
ICI requested clarification that a market participant can determine
whether it is an MSP for purposes of the proposed implementation
schedules at the same time that it is required to review its status as
an MSP under other Commission and SEC rules.
CIEBA requested that in-house ERISA funds should be in the group
with the longest compliance time, and not Category 2 Entities, arguing
that these funds are not systemically risky, and they typically rely
upon third-party managers for some portion of their fund management.
Splitting in-house and external accounts (i.e., those accounts meeting
the Implementation Schedule NPRM's definition of third-party subaccount
and which are therefore Category 3 Entities) of the same ERISA plan
will impact risk management given different implementation schedules.
The distinction will also cause pension funds to bear the costs of
compliance because they will need to comply prior to their third party
managers who would be better positioned to provide insight and services
in this regard.
The Commission considered the foregoing comments, and has
determined to modify the category definitions in certain respects. In
response to Encana and the Joint Associations, non-financial entities
are clearly included amongst Category 4 Entities and SDs and MSPs are
given 270 days to comply with the documentation requirement with
respect to such entities.
With respect to issues raised by the Coalition for Derivatives End-
Users regarding those financial entities included in Category 2, the
Commission believes that those entities have been correctly categorized
based upon the distinction between financial and non-financial entities
under section 2(h)(7) of the CEA. The Commission believes that, just as
Congress has required financial entities to be subject to required
clearing due to their importance to the financial system, SDs and MSPs
should be required to meet the documentation requirements of Sec.
23.504 with such entities prior to being required to meet such
documentation requirements with non-financial entities. However, the
definition of Category 2 Entity is modified by removing the reference
to ERISA plans. The Commission recognizes the concerns raised by CIEBA
regarding splitting in-house and external accounts (i.e., those
accounts meeting the definition of Third-Party Subaccount and permitted
270 days) of the same ERISA plan. In response to these concerns, the
Commission is removing the reference to employee benefit plans as
defined in paragraphs (3) and (32) of section 3 of the Employee
Retirement Income and Security Act of 1974. As a result, these ERISA
plans will be afforded the longest compliance period (270 days).
In response to the comment from ICI, the Commission confirms that a
potential MSP may be able to review its obligation to register as an
MSP at the same time it is reviewing where it fits under the compliance
dates adopted in this release depending on the nature and scope of an
MSP's swaps activities. The Commission notes that its rule further
defining MSP was published on May 23, 2012, and its rule further
defining ``swap'' was published on August 13, 2012, so potential MSPs
will necessarily have to review their registration obligations ahead of
complying with the compliance dates adopted herein. However, if an
entity discovers that it has crossed the threshold established under
the MSP rules and is required to register during the 90-day period for
Category 1 Entities, the Commission would permit that entity to
petition for additional time to come into compliance with the Sec.
23.504.\49\
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\49\ Similarly, the Commission would consider allowing entities
to petition for additional time to comply to the extent that they
discover that they have exceeded the de minimis threshold under the
swap dealer definition and are required to register during the 90-
day period for Category 1.
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d. Proposed Implementation Schedule
As outlined above, proposed Sec. 23.575 required SDs and MSPs to
be in compliance with Sec. 23.504 no later than 90 days after
publication of the final rule in the Federal Register for swap
transactions with a Category 1 Entity, no later than 180 days after
publication for swap transactions with a Category 2 Entity, and no
later than 270 days after publication for swap transactions with a
Category 3 Entity or Category 4 Entity.
With respect to the proposed schedule, FIA/ISDA/SIFMA believes that
the proposed implementation schedule should be lengthened because of
the significant burden associated with the documentation requirements.
FIA/ISDA/SIFMA argued that it would be impossible to begin complying
with all of the documentation requirements of Sec. 23.504 at the same
time.
AII stated that the proposed implementation schedule does not
provide enough time for institutional investment advisors to comply
given the volume of document negotiations that will need to occur
concurrently, as well as operational changes required by the Commission
and other regulators under the Dodd-Frank Act. AII argued that
institutional investment advisers also will face special challenges
trying to allocate block trades across multiple categories of
counterparty, and managing multiple implementation schedules. AII
believes that tight timeframes will create an imbalance in negotiations
with smaller counterparties at risk of being ``shut out of the market''
if they do not accept terms of the dealer community. AII therefore
recommended that all market participants should have 18 months to come
into compliance after the rules have been finalized.
Encana believes non-financial end users should get more time to
comply with the regulations given less familiarity with Commission
regulations and the need to develop and implement policies and
procedures.
CDE stated that it is unlikely that end-users and other entities
relied on by end-users will be able to meet the requirements Sec.
23.504 if the requirements are imposed on all swaps at the same time.
Chris Bernard generally agreed with the proposed implementation
schedule, though he believes that documentation relating to the swap
valuation provisions of Sec. 23.504(b)(4) should be prioritized within
the compliance schedule.
[[Page 55940]]
The California Public Employees' Retirement System, the Colorado
PERA, the Missouri State Employees' Retirement System, the Teacher
Retirement System of Texas, and the State of Wisconsin Investment Board
recommended a one year phase-in for pension funds because the strict
procedures that exist to protect their participants may hamper their
ability to more quickly make the required changes to documents and
procedures.
FSR commented that compliance periods should be substantially
longer, with Category 2 lasting at least a year, and not starting until
a significantly longer Category 1 has completed. As smaller market
participants face the risk of accepting unsuitable terms or being shut
out of the market given the tight timeframes and lack of resources,
additional time should be granted to entities hedging in the ordinary
course of business.
ICI stated that implementation should be longer, such as 18-24
months to accommodate all of the changes that are necessary in the
market, arguing that too short a deadline will disadvantage smaller
market participants who may be shut out of the market. ICI also
recommended that the proposed implementation schedules should only
begin after all related rules are finalized.
ACLI stated that 180 days for Category 2 Entities is insufficient
for insurance companies that will need to work with state regulators on
changes to operations, to negotiate documents of first impression,
especially given the scope of the documentation to be negotiated or
changed.
The Commission acknowledges the concerns of commenters regarding
negotiation imbalances if the scope of documentation to be changed is
large, but believes that, with the modifications to the rules outlined
above, most market participants will have documentation already in
place that either meets the requirements of the rule or could meet such
requirements with relatively modest amendments. Thus, the Commission
believes that these changes plus the staggered timeframes of the
compliance dates adopted in this release adequately address the
concerns of commenters regarding the time and effort necessary to
complete the necessary documentation.
2. Confirmation NPRM
With respect to Sec. Sec. 23.501, 23.502, and 23.503 generally,
GFED argued that the Commission should not implement the proposed rules
prior to Treasury determining which foreign exchange products are
subject to the proposed rules to avoid unnecessary costs and burdens,
while MFA believes that the Commission should evaluate the notable
differences in experience and resources of market participants related
to post-trade processes prior to publishing final rules. MFA believes
that the Commission's goals would be best served, and market disruption
avoided, by providing market participants with additional time to
design, test, and implement processes required to comply with the
proposed rules.
Specifically with respect to Sec. 23.501, MarkitSERV believes that
the rules should be phased in based on a product-by-product analysis of
complexity and average time to confirm similar transactions, while
Chatham believes the confirmation requirements should be phased-in over
6 to 12 months and that non-SDs and non-MSPs should be the last
participants required to comply with the rules. In addition, ISDA
provided the Commission with details of the current percentage of
transactions electronically traded and confirmed, voice traded and
electronically confirmed, voice traded and manually confirmed, and
electronically traded and manually confirmed by eight large dealers in
the five major swap asset classes (credit, rates, commodities, foreign
exchange, and equity derivatives). ISDA provided the Commission with a
break-down of this data showing time to confirmation by asset class,
and the differences between electronic confirmation in dealer-to-dealer
transactions versus transactions with other counterparty types.
Specifically with respect to Sec. 23.502, Chatham recommended that
the Commission provide end-users with at least six months to one year
to comply with the proposed reconciliation rules, while the OCC stated
that many SDs will not be among the G-14 largest OTC derivatives
dealers and, given the incremental progression that was necessary for
the G-14 OTC derivatives dealers to develop the infrastructure
necessary to increase reconciliation amongst themselves from weekly
reconciliation for portfolios with 5,000 or more trades in 2008 to the
current daily reconciliation for portfolios of 500 or more trades, the
Commission must provide sufficient time for all registrants to develop
the required infrastructure.
With respect to Sec. 23.503, ISDA urged the Commission to consider
a long phase-in period for any compression requirement due to
significant administrative and logistical issues.
B. Compliance Dates
Having considered the comments received, the Commission is adopting
the effective and compliance dates as set forth below.
1. Swap Trading Relationship Documentation--Sec. 23.504
The effective date of Sec. 23.504 will be the date that is 60 days
after publication of the final rules in the Federal Register.
The Commission proposed a compliance schedule, Sec. 23.575, but
has determined not to finalize its schedule in the form of a rule.
Rather, compliance periods are outlined below. With respect to swap
transactions with SDs, security-based swap dealers, MSPs, major
security-based swap participants, or any private fund, as defined in
section 202(a) of the Investment Advisers Act of 1940, that is not a
third-party subaccount (defined below) and that executes 200 or more
swaps per month based on a monthly average over the 12 months preceding
this adopting release (active funds), SDs and MSPs must comply with
Sec. 23.504 by January 1, 2013.
With respect to swap transactions with commodity pools; private
funds as defined in section 202(a) of the Investment Advisers Act of
1940 other than active funds; or persons predominantly engaged in
activities that are in the business of banking, or in activities that
are financial in nature as defined in section 4(k) of the Bank Holding
Company Act of 1956, provided that the entity is not an account that is
managed by an investment manager that (1) is independent of and
unaffiliated with the account's beneficial owner or sponsor, and (2) is
responsible for the documentation necessary for the account's
beneficial owner to document swaps as required under section 4s(i) of
the CEA (third-party subaccounts), SDs and MSPs must comply with Sec.
23.504 by April 1, 2013.
With respect to swap transactions with any other counterparty, SDs
and MSPs must comply with Sec. 23.504 by July 1, 2013.
2. Swap Confirmation--Sec. 23.501
The effective date of Sec. Sec. 23.500 and 23.501 will be the date
that is 60 days after publication of the final rules in the Federal
Register.
With respect to confirmation, the Commission is establishing an
implementation schedule in the rule, differentiated by swap asset
class. For credit swaps and interest rate swaps (including cross-
currency swaps), SDs and MSPs will be required to confirm swap
transactions with other SDs and MSPs as soon as technologically
practicable, but in any event by the end of the second day after the
day of execution until February 28, 2014. After
[[Page 55941]]
February 28, 2014, SDs and MSPs must comply with the requirements of
paragraph (a)(1).
For equity swaps, foreign exchange swaps, and other commodity
swaps, SDs and MSPs will be required to confirm swap transactions with
other SDs and MSPs as soon as technologically practicable, but in any
event by the end of the third day after the day of execution until
August 31, 2013. For the period between September 1, 2013 and August
31, 2014, SDs and MSPs will be required to confirm equity, foreign
exchange, and other commodity swap transactions with other SDs and MSPs
as soon as technologically practicable, but in any event by the end of
the second day after the day of execution. After August 31, 2014, SDs
and MSPs must comply with the requirements of paragraph (a)(1).
For credit and interest rate swap transactions (including cross-
currency swaps) with counterparties that are not SDs or MSPs, SDs and
MSPs will be required to send an acknowledgement of swap transactions
as soon as technologically practicable, but in any event by the end of
the first day after the day of execution until February 28, 2014. After
February 28, 2014, SDs and MSPs must comply with the requirements of
paragraph (a)(2).
For equity, foreign exchange, and other commodity swap transactions
with counterparties that are not SDs or MSPs, SDs and MSPs will be
required to send an acknowledgement of swap transactions as soon as
technologically practicable, but in any event by the end of the second
day after the day of execution until August 31, 2013. For the period
between September 1, 2013 and August 31, 2014, SDs and MSPs will be
required to send an acknowledgement of equity, foreign exchange, and
other commodity swap transactions with counterparties that are not SDs
or MSPs as soon as technologically practicable, but in any event by the
end of the first day after the day of execution. After August 31, 2014,
SDs and MSPs must comply with the requirements of paragraph (a)(2).
For credit and interest rate swap transactions (including cross-
currency swaps) with financial entities, SDs and MSPs will be required
to establish policies and procedures reasonably designed to ensure that
they confirm swap transactions as soon as technologically practicable,
but in any event by the end of the second day after the day of
execution until February 28, 2014. After February 28, 2014, SDs and
MSPs must comply with the requirements of paragraph (a)(3)(i).
For equity, foreign exchange, and other commodity swap transactions
with financial entities, SDs and MSPs will be required to establish
policies and procedures reasonably designed to ensure that they confirm
swap transactions as soon as technologically practicable, but in any
event by the end of the third day after the day of execution until
August 31, 2013. For the period between September 1, 2013 and August
31, 2014, SDs and MSPs will be required to establish policies and
procedures reasonably designed to ensure that they confirm equity,
foreign exchange, and other commodity swap transactions with financial
entities as soon as technologically practicable, but in any event by
the end of the second day after the day of execution. After August 31,
2014, SDs and MSPs must comply with the requirements of paragraph
(a)(3)(i).
For credit and interest rate swap transactions (including cross-
currency swaps) with counterparties that are not SDs, MSPs, or
financial entities, SDs and MSPs will be required to establish policies
and procedures reasonably designed to ensure that they confirm swap
transactions as soon as technologically practicable, but in any event
by the end of the fifth day after the day of execution until August 31,
2013. For the period between September 1, 2013 and August 31, 2014, SDs
and MSPs will be required to establish policies and procedures
reasonably designed to ensure that they confirm credit and interest
rate swap transactions with counterparties that are not SDs, MSPs, or
financial entities as soon as technologically practicable, but in any
event by the end of the third day after the day of execution. After
August 31, 2014, SDs and MSPs must comply with the requirements of
paragraph (a)(3)(ii).
For equity, foreign exchange, and other commodity swap transactions
with counterparties that are not SDs, MSPs, or financial entities, SDs
and MSPs will be required to establish policies and procedures
reasonably designed to ensure that they confirm swap transactions as
soon as technologically practicable, but in any event by the end of the
seventh day after the day of execution until August 31, 2013. For the
period between September 1, 2013 and August 31, 2014, SDs and MSPs will
be required to establish policies and procedures reasonably designed to
ensure that they confirm equity, foreign exchange, and other commodity
swap transactions with counterparties that are not SDs, MSPs, or
financial entities as soon as technologically practicable, but in any
event by the end of the fourth day after the day of execution. After
August 31, 2014, SDs and MSPs must comply with the requirements of
paragraph (a)(3)(ii).
Solely for purposes of the implementation schedule applicable to
Sec. 23.501, swaps are divided into the following asset classes:
Credit swap means any swap that is primarily based on instruments
of indebtedness, including, without limitation: Any swap primarily
based on one or more broad-based indices related to instruments of
indebtedness; and any swap that is an index credit swap or total return
swap on one or more indices of debt instruments.
Equity swap means any swap that is primarily based on equity
securities, including, without limitation: Any swap primarily based on
one or more broad-based indices of equity securities; and any total
return swap on one or more equity indices.
Foreign exchange swap has the meaning set forth in section 1a(25)
of the CEA. It does not include swaps primarily based on rates of
exchange between different currencies, changes in such rates, or other
aspects of such rates (sometimes known as ``cross-currency swaps'').
Interest rate swap means any swap which is primarily based on one
or more interest rates, such as swaps of payments determined by fixed
and floating interest rates; or any swap which is primarily based on
rates of exchange between different currencies, changes in such rates,
or other aspects of such rates (sometimes known as ``cross-currency
swaps'').
Other commodity swap means any swap not included in the credit,
equity, foreign exchange, or interest rate asset classes, including,
without limitation, any swap for which the primary underlying item is a
physical commodity or the price or any other aspect of a physical
commodity.
3. Portfolio Reconciliation & Portfolio Compression
The effective date of Sec. Sec. 23.502 and 23.503 will be the date
that is 60 days after publication of the final rules in the Federal
Register.
With respect to Sec. 23.502 (Portfolio Reconciliation) and Sec.
23.503 (Portfolio Compression), SDs and MSPs that are currently
regulated by a U.S. prudential regulator or are registrants of the SEC
must comply with Sec. Sec. 23.502 and 23.503 by the date that is 90
days after publication of this final rule in the Federal Register. SDs
and MSPs that are not currently regulated by a U.S. prudential
regulator and are not registrants of the SEC must comply with
[[Page 55942]]
Sec. Sec. 23.502 and 23.503 by the date that is 180 days after
publication of this final rule in the Federal Register.
C. Compliance Date Extension for Certain Business Conduct Standards
With Counterparties
ISDA members have requested that the Commission align the
compliance dates for the provisions of subpart H of part 23 that
involve documentation \50\ with the trading relationship documentation
rules in this release. ISDA members have represented that industry-led
efforts are underway to facilitate compliance with new Dodd-Frank Act
documentation requirements and an alignment of compliance dates would
allow the most efficient transition to compliance with part 23's
documentation requirements.\51\
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\50\ Subpart H of Part 23 of the Commission's Regulations,
Business Conduct Standards for Swap Dealers and Major Swap
Participants with Counterparties, 77 FR 9734, 9824 (Feb. 17, 2012).
\51\ ISDA is partnering with Markit to launch a technology-based
solution enabling counterparties to amend their OTC derivatives
documentation quickly and efficiently to comply with Dodd-Frank
regulatory requirements. See http://www2.isda.org/dodd-frank-documentation-initiative/.
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The Commission has decided to defer the compliance dates for
certain provisions of subpart H until January 1, 2013. Compliance with
the following provisions will be deferred until January 1, 2013:
Sec. Sec. 23.402; 23.410(c); 23.430; 23.431(a)-(c); 23.432;
23.434(a)(2), (b), and (c); 23.440; and 23.450.\52\ Compliance with all
other provisions will continue to be required by October 15, 2012.
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\52\ The Commission's decision to defer compliance does not
reflect an endorsement of the industry-led effort, nor does it imply
that the Commission has reviewed the documentation protocol for
compliance with Commission rules. All market participants are
subject to the new compliance dates regardless of whether they
participate in the protocol.
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IV. Cost Benefit Considerations
Section 15(a) of the CEA \53\ requires the Commission to consider
the costs and benefits of its actions before promulgating a regulation
under the CEA or issuing certain orders. Section 15(a) further
specifies that the costs and benefits shall be evaluated in light of
five broad areas of market and public concern: (1) Protection of market
participants and the public; (2) efficiency, competitiveness, and
financial integrity of futures markets; \54\ (3) price discovery; (4)
sound risk management practices; and (5) other public interest
considerations. The Commission considers the costs and benefits
resulting from its discretionary determinations with respect to the
Section 15(a) factors.
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\53\ 7 U.S.C. 19(a).
\54\ Although by its terms section 15(a)(2)(B) of the CEA
applies to futures markets only, the Commission finds this factor
useful in analyzing regulations pertaining to swap markets as well.
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Under section 731 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act), Congress directed the Commission to
``adopt rules governing documentation standards for swap dealers and
major swap participants.'' The statutory provision in question, section
4(s)(i)(1) of the CEA, laid out a broad and general directive relating
to ``timely and accurate confirmation, processing, netting,
documentation, and valuation of all swaps.'' In promulgating the final
rules subject to this release, the Commission has taken its direction
from the statutory text, but is exercising its discretion with regard
to the specific requirements set forth in the rules--namely, to require
SDs and MSPs to meet certain confirmation deadlines for their swap
transactions with other SDs and MSPs, to have policies and procedures
for confirming swap transactions with financial entities and non-
financial entities within certain time periods, to engage in regular
portfolio reconciliation and portfolio compression, and to ensure that
their swaps are governed by appropriate trading relationship
documentation.
In exercising its discretion, the Commission has taken into account
a series of voluntary industry initiatives, including efforts to
improve the confirmation, reconciliation, compression, documentation,
and valuation of swaps, as well as the overarching goals of the Dodd-
Frank Act: reducing systemic risk, increasing transparency, and
promoting integrity within the financial system. As discussed below,
these industry efforts provide a useful reference point for considering
the Commission's action.
In the context of the relevant statutory provision and ongoing
industry initiatives, in the sections that follow, the Commission
discusses each requirement individually in light of cost-benefit issues
raised by commenters and suggested alternatives. The Commission also
summarizes and considers costs and benefits collectively for the set of
confirmation, portfolio reconciliation, and portfolio compression
rules, and separately for the swap trading relationship documentation
rules.
A. Background
In the fall of 2008, an economic crisis threatened to freeze U.S.
and global credit markets. The federal government intervened to
buttress the stability of the U.S. financial system.\55\ The crisis
revealed the vulnerability of the U.S. financial system and economy to
wide-spread systemic risk resulting from, among other things, poor risk
management practices of financial firms and the lack of supervisory
oversight for certain financial institutions as a whole.\56\ More
specifically, the crisis and the attendant failure of a series of large
financial institutions demonstrated the need for direct regulation of
the OTC derivatives markets.\57\
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\55\ On October 3, 2008, President Bush signed the Emergency
Economic Stabilization Act of 2008, which was principally designed
to allow the U.S. Treasury and other government agencies to take
action to restore liquidity and stability to the U.S. financial
system (e.g., the Troubled Asset Relief Program--also known as
TARP--under which the U.S. Treasury was authorized to purchase up to
$700 billion of troubled assets that weighed down the balance sheets
of U.S. financial institutions). See Pub. L. 110-343, 122 Stat. 3765
(2008).
\56\ See Financial Crisis Inquiry Commission, ``The Financial
Crisis Inquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United
States,'' Jan. 2011, at xxvii, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf [hereinafter the FCIC Report].
\57\ See id. at 25 (concluding that ``enactment of * * * [the
Commodity Futures Modernization Act of 2000 (``CFMA'')] to ban the
regulation by both the federal and state governments of over-the-
counter (OTC) derivatives was a key turning point in the march
toward the financial crisis.''). See also id. at 343 (``Lehman, like
other large OTC derivatives dealers, experienced runs on its
derivatives operations that played a role in its failure. Its
massive derivatives positions greatly complicated its bankruptcy,
and the impact of its bankruptcy through interconnections with
derivatives counterparties and other financial institutions
contributed significantly to the severity and depth of the financial
crisis.'') and id. at 353 (``AIG's failure was possible because of
the sweeping deregulation of [OTC] derivatives, [* * *] including
capital and margin requirements that would have lessened the
likelihood of AIG's failure. The OTC derivatives market's lack of
transparency and of effective price discovery exacerbated the
collateral disputes of AIG and Goldman Sachs and similar disputes
between other derivatives counterparties.'').
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American International Group (AIG) is an example of how the
stability of a large financial institution could be undermined by
certain failures in risk management, internal controls with respect to
trading positions, documentation, and valuation, AIG was a regulated
U.S. insurance company nearly undone by its collateral posting
obligations under swaps entered into by its subsidiary, AIG Financial
Products (AIGFP). AIGFP suffered enormous losses from credit default
swaps that it issued on certain underlying securities, which, because
AIGFP's performance on such credit default swaps had been guaranteed by
its parent, caused credit agencies to downgrade the credit rating of
the entire AIG corporation. The downgrade triggered collateral calls
and induced a liquidity crisis at AIG, which
[[Page 55943]]
resulted in over $85 billion of indirect assistance from the Federal
Reserve Bank of New York to prevent AIG's default.\58\
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\58\ The Federal Reserve Bank of New York explained its
intervention as a means of preventing contagion concerns resulting
from an AIG default from spreading financial losses to other firms.
The FCIC argued and Gretchen Morgenson reported that the entire U.S.
financial system might have been threatened by such a large default.
See FCIC Report at 200-02 and 344-52 and Gretchen Morgenson,
``Behind Insurer's Crisis, Blind Eye to a Web of Risk,'' N.Y. Times,
Sept. 27, 2008 [hereinafter Morgenson Article]. Corrected version
published Sept. 30, 2008, available at http://www.nytimes.com/2008/09/28/business/28melt.html?pagewanted=all.
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The inability to value its portfolio accurately and agree on
valuations with its counterparties posed a serious problem for AIG
during the financial crisis.\59\ Swap valuation disputes were common,
because, among other things, there was widespread market opacity for
many of the inputs needed to properly value many swaps.\60\ As reported
during the fall of 2008, ``the methods that A.I.G. used to value its
derivatives portfolio began to come under fire from trading partners.''
\61\ As explained by a Congressional panel, ``the threats within
[AIG's] businesses emanated from outsized exposure to the deteriorating
mortgage markets, owing to grossly inadequate valuation and risk
controls, including insufficient capital buffers as losses and
collateral calls mounted'' (emphasis added).\62\
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\59\ See Testimony Before the Financial Crisis Inquiry
Commission, including AIG/Goldman Sachs Collateral Call Timeline,
available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0701-AIG-Goldman-supporting-docs.pdf (timeline
documenting valuation disputes and collateral calls); Testimony of
Joseph Cassano, available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-Cassano.pdf; and AIG Statement
Summary, available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-AIG-Statement-Summary.pdf.
\60\ The failure of the market to set a price for mortgage-
backed securities led to wide disparities in the valuation of CDS
referencing mortgage-backed securities (especially collateralized
debt obligations). ``The illiquid market for some structured credit
products, auction rate securities, and other products backed by
opaque portfolios led to major write-downs across the industry in
2008. The resulting depletion of capital led to credit downgrades,
which in turn drove counterparty collateral calls and sales of
illiquid assets. This further depleted capital balances. Widening
CDS spreads have become widely viewed as a leading indicator of a
bank's financial health and viability.'' PriceWaterhouseCoopers,
``Lehman Brothers' Bankruptcy: Lessons learned for the survivors,''
Informational presentation for clients, August 2009, at 12,
available at http://www.pwc.com/en_JG/jg/events/Lessons-learned-for-the-survivors.pdf. In addition, such wide disparities led to
large collateral calls from dealers on AIG, hastening its downfall.
See CBS News, ``Calling AIG? Internal Docs Reveal Company Silent
About Dozens Of Collateral Calls,'' Jun. 23, 2009, available at:
http://www.cbsnews.com/stories/2009/06/23/cbsnews_investigates/main5106672.shtml.
\61\ See Morgenson Article.
\62\ Congressional Oversight Panel, June Oversight Report: The
AIG Rescue, Its Impact on Markets, and the Government's Exit
Strategy, June 10, 2010, at 24, available at http://cybercemetery.unt.edu/archive/cop/20110402010341/cop.senate.gov/documents/cop-061010-report.pdf.
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The financial crisis also highlighted the significance of
substandard or missing legal documentation. For example, the Lehman
Brothers Holding Inc. (LBHI) bankruptcy offers another stark lesson on
how failures in risk management, documentation, and valuation can
contribute to the ultimate collapse of an entire financial institution.
During the days leading up the LBHI's bankruptcy, potential buyers were
stymied by the state of Lehman's books.\63\ As recognized by
PriceWaterhouseCoopers in a lessons learned document put together after
the Lehman bankruptcy, effective risk management requires the existence
of sound documentation, daily reconciliation of portfolios, rigorously
tested valuation methodologies, and sound collateralization
practices.\64\
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\63\ See In re Lehman Brothers Holdings Inc., 08-13555, and
Giddens v. Barclays Capital Inc., 09-01732, U.S. Bankruptcy Court,
Southern District of New York; see also Linda Sandler, ``Lehman
Derivatives Records a `Mess,' Barclays Executive Says,'' Bloomberg,
Aug. 30, 2010, available at http://www.bloomberg.com/news/2010-08-30/lehman-derivatives-records-a-mess-barclays-executive-says.html
(reporting on testimony provided in previously cited Lehman
bankruptcy proceeding).
\64\ See PriceWaterhouseCoopers, ``Lehman Brothers' Bankruptcy:
Lessons learned for the survivors,'' Informational presentation for
clients, August 2009, at 12-24, available at http://www.pwc.com/en_JG/jg/events/Lessons-learned-for-the-survivors.pdf.
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More broadly, the President's Working Group (PWG) on Financial
Policy noted shortcomings in the OTC derivative markets as a whole
during the crisis. The PWG identified the need for an improved
integrated operational structure supporting OTC derivatives,
specifically highlighting the need for an enhanced ability to manage
counterparty risk through ``netting and collateral agreements by
promoting portfolio reconciliation and accurate valuation of trades.''
\65\
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\65\ The President's Working Group on Financial Markets,
``Policy Statements on Financial Market Developments,'' Mar. 2008,
available at http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.
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Congress sought to address the deficiencies in the regulatory
system that contributed to the financial crisis through the enactment
of the Dodd-Frank Act, which was signed by President Obama on July 21,
2010.\66\ Title VII of the Dodd-Frank Act amended the CEA \67\ to
overhaul the structure and oversight of the OTC market that previously
had been subject to little or no oversight.\68\ One of the cornerstones
of this legislation is the establishment of a new statutory framework
for comprehensive regulation of financial institutions that participate
in the swaps market as SDs or MSPs, which must register and are subject
to greater oversight and regulation.\69\ This new framework for SDs and
MSPs seeks to reduce the potential for the recurrence of the type of
financial and operational stresses that contributed to the 2008 crisis.
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\66\ Pub. L. 111-203, 124 Stat. 1376 (2010). The text of the
Dodd-Frank Act is available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/hr4173_enrolledbill.pdf.
\67\ 7 U.S.C. 1, et seq.
\68\ Prior to the adoption of Title VII, swaps and security-
based swaps were by and large unregulated. The CFMA excluded
financial OTC swaps from regulation under the CEA, provided that
trading occurred only among ``eligible contract participants.''
Swaps based on exempt commodities--including energy and metals--
could be traded among eligible contract participants without CFTC
regulation, but certain CEA provisions against fraud and
manipulation continued to apply to these markets. No statutory
exclusions were provided for swaps on agricultural commodities by
the CFMA, although they could be traded under certain regulatory
exemptions provided by the CFTC prior to its enactment. Swaps based
on securities were subject to certain SEC enforcement authorities,
but the SEC was prohibited from prophylactic regulation of such
swaps.
\69\ The provisions of the CEA relating to swaps that were
enacted by Title VII of the Dodd-Frank Act are also referred to
herein as ``the Dodd-Frank requirements.''
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Efforts to regulate the swaps market are underway not only in the
United States but also abroad in the wake of the 2008 financial crisis.
In 2009, leaders of the Group of 20 (G-20)--whose membership includes
the European Union (EU), the United States, and 18 other countries--
agreed that: (i) OTC derivatives contracts should be reported to trade
repositories; (ii) all standardized OTC derivatives contracts should be
cleared through central counterparties and traded on exchanges or
electronic trading platforms, where appropriate, by the end of 2012;
and (iii) non-centrally cleared contracts should be subject to higher
capital requirements. In line with the G-20 commitment, much progress
has been made to coordinate and harmonize international reform efforts,
but the pace of reform varies among jurisdictions and disparities in
regulations remain due to differences in cultures, legal and political
traditions, and financial systems.\70\
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\70\ Legislatures and regulators in a number of foreign
jurisdictions are undertaking significant regulatory reforms over
the swaps market and its participants. See CFTC and SEC, Joint
Report on International Swap Regulation Required by Section 719(c)
of the Dodd-Frank Wall Street Reform and Consumer Protection Act,
Jan. 31, 2012, at 23, available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/dfstudy_isr_013112.pdf. For example,
the European Parliament adopted the substance of the European Market
Infrastructure Regulation (``EMIR'') on March 29, 2012. As discussed
below, ESMA has proposed regulations that are very similar to those
being adopted by the Commission in this release.
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[[Page 55944]]
Even before the passage of the Dodd-Frank Act, market participants
and regulators had been paying particular attention to the post-trade
processing of swaps. For example, operational issues associated with
the OTC derivatives market have been the focus of reports and
recommendations by the PWG.\71\ In response to the financial crisis in
2008, the PWG called on the industry to improve trade matching and
confirmation and to promote portfolio reconciliation.
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\71\ See, e.g., Press Release, ``President's Working Group on
Financial Markets, Progress Summary on OTC Derivatives Operational
Improvements'' (Nov. 2008).
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Significantly, beginning in 2005, the Federal Reserve Bank of New
York (FRBNY) undertook a targeted, supervisory effort to enhance
operational efficiency and performance in the OTC derivatives market,
by increasing automation in processing and by promoting the timely
confirmation of trades. Known as the OTC Derivatives Supervisors' Group
(ODSG), the FRBNY led an effort with OTC derivatives dealers' primary
supervisors, trade associations, industry utilities, and private
vendors, through which market participants (including buy-side
participants) regularly set goals and commitments to bring
infrastructure, market design, and risk management improvements to all
OTC derivatives asset classes. Over the years, the ODSG expanded its
focus from credit derivatives to include interest rate derivatives,
equity derivatives, foreign exchange derivatives, and commodity
derivatives. Along with this expanded focus came increased engagement
with market participants on cross-asset class issues. Specifically, the
ODSG encouraged the industry to commit itself to a number of reforms,
including improved operational performance with respect to the OTC
derivatives confirmation process, portfolio reconciliation, and
portfolio compression. The regulations being adopted by the Commission
in this adopting release build upon the ODSG's work.\72\ The specific
operational performance enhancements upon which each of the
Commission's rules included in this adopting release expressly build,
the comments to the rule proposals related to the costs and benefits of
such rules, and the Commission's consideration of the costs and
benefits of such rules are discussed below.
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\72\ ``No more Fed letter commitments expected, says Dudley,''
Risk Magazine, May 16, 2012, available at http://www.risk.net/risk-magazine/news/2174981/fed-letter-commitments-expected-dudley
(William Dudley, president of the Federal Reserve Bank of New York,
stated ``Now we're moving to a new regime, where the OTC derivatives
market is being regulated for the first time. As we do that, and the
SEC and CFTC stand up in terms of regulation, it's completely
appropriate for us to stand down.'').
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This final rule implements Dodd-Frank Act section 731, which is an
important component of the comprehensive set of reforms passed by
Congress to protect the American public and ``promote the financial
stability of the United States'' in the wake of a financial crisis and
the resulting recession that was caused in part by the lack of adequate
regulation of financial markets.\73\ The damage to the American public
has been tremendous. According to the U.S. Department of the Treasury,
over $19 trillion in household wealth and over 8.8 million jobs were
lost during the recession that began in late 2008.\74\ Between
September 2008 and May 2012 there have been approximately 3.6 million
completed home foreclosures across the country.\75\ The U.S. Census
Bureau estimates that the number of households living below the poverty
level rose 2.6 percent from 2007 to 2010.\76\ The overarching purpose
and benefit of this final rule, together with the other rules the
Commission is implementing under Title VII of the Dodd-Frank Act is to
identify and fix the structural weaknesses that contributed to the
financial crisis in an effort to avoid a repeat of the same.
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\73\ Dodd-Frank Act, Preamble.
\74\ See U.S. Department of the Treasury, ``The Financial Crisis
Response--In Charts,'' April 2012, available at http://www.treasury.gov/resource-center/data-chart-center/Documents/20120413_FinancialCrisisResponse.pdf. See also Congressional Budget
Office, The Budge and Economic Outlook: Fiscal Years 2012-2022, at
26 (Jan. 2012) (explaining gross domestic product (GDP) has fallen
dramatically and it is not expected to return to normal levels until
at least 2018. At that time, the cumulative shortfall in GDP
relative to potential GDP is expected to reach $5.7 trillion).
\75\ See CoreLogic, ``CoreLogic Reports 66,000 Completed
Foreclosures Nationally,'' May 2012, available at http://www.corelogic.com/about-us/news/corelogic-reports-66,000-completed-foreclosures-nationally-in-april.aspx.
\76\ See U.S. Census Bureau, ``Income, Poverty, and Health
Insurance Coverage in the United States: 2010,'' at 14 (Sept. 2010),
available at http://www.census.gov/prod/2011pubs/p60-239.pdf.
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B. Swap Confirmation
The Government Accountability Office (GAO) found that the rapid
expansion of the trading volume of swaps, such as credit derivatives,
since 2002, caused stresses on the operational infrastructure of market
participants. These stresses, in turn, caused the participants' back
office systems to fail to confirm the increased volume of trades for a
period of time.\77\ The GAO found that the lack of automation in trade
processing and the purported assignment of positions by transferring
parties to third parties without notice to their counterparties were
factors contributing to this backlog. If transactions, whether newly
executed or recently transferred to another party, are left
unconfirmed, there is no definitive written record of the contract
terms. Thus, in the event of a dispute, the terms of the agreement must
be reconstructed from other evidence, such as email trails or recorded
trader conversations. This process is cumbersome and may not be wholly
accurate. Moreover, if purported transfers of swaps, in whole or in
part, are made without giving notice to the remaining parties and
obtaining their consent, disputes may arise as to which parties are
entitled to the benefits and subject to the burdens of the transaction.
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\77\ U.S. Government Accountability Office, ``Credit
Derivatives: Confirmation Backlogs Increased Dealers' Operational
Risks, But Were Successfully Addressed After Joint Regulatory
Action,'' GAO-07-716 (2007) at 3-4.
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As the work of the ODSG demonstrates, the industry is capable of
swift movement to contemporaneous execution and confirmation. A large
back-log of unexecuted confirmations in the CDS market created by
prolonged negotiations and inadequate confirmation procedures were the
subject of the first industry commitments made by participating dealers
to ODSG.\78\ In October 2005, the participating dealers committed to
reduce by 30 percent the number of confirmations outstanding more than
30 days within four months. In March 2006, the dealers committed to
reduce the number of outstanding confirmations by 70 percent by June
30, 2006. By September 2006, the industry had reduced the number of all
outstanding CDS confirmations by 70 percent, and the number of CDS
confirmations outstanding more than 30 days by 85 percent. The industry
achieved these targets largely by moving 80 percent of total trade
volume in CDS to confirmation on electronic platforms, eliminating
backlogs in new trades.
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\78\ See October 4, 2005 industry commitment letter to the
Federal Reserve Bank of New York, available at http://www.newyorkfed.org/newsevents/news_archive/markets/2005/an050915.html.
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By the end of 2011, the largest dealers were electronically
confirming over 95
[[Page 55945]]
percent of OTC credit derivative transactions, and 90 percent were
confirmed on the same day as execution (T+0). For the same period, the
largest dealers were electronically confirming over 70 percent of OTC
interest rate derivatives (over 90 percent of trades with each other),
and over 80 percent were confirmed T+0. The rate of electronic
confirmation of OTC commodity derivatives was somewhat lower--just over
50 percent, but over 90 percent for transactions between the largest
dealers.\79\ These statistics provide some confidence that, over time,
timely confirmation rates will continue to improve.
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\79\ See G15 Industry Confirmation Data dated April 4, 2012
provided by ISDA, available at www.cftc.gov.
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The primary benefit of timely and accurate confirmation is that the
parties to a swap know what their deal is. In other words, a
confirmation definitively memorializes all of the terms of the swap
transaction, which is critical for all downstream operational and risk
management processes. If transactions, whether newly executed or
recently transferred to another party, are left unconfirmed, there is
no definitive written record of the contract terms. Risk management
processes dependent on the trade terms (such as collateral management,
and payment and settlement systems) may be inaccurate, and, in the
event of a dispute, the terms of the agreement must be reconstructed
from other evidence, such as email trails or recorded trader
conversations.
Recognizing the laudable gains in electronic confirmation
processing by the industry and the risk reduction in the shortening of
time periods between execution and confirmation, the Commission
proposed a confirmation rule that would have required SDs and MSPs
trading with each other to confirm their swap transactions within 15
minutes if the swap transaction was executed and processed
electronically, within 30 minutes if the swap transaction was only
processed electronically, and within the same calendar day if the swap
transaction could not be processed electronically. Similarly, the
Commission proposed that SDs and MSPs have policies and procedures for
confirming swap transactions with financial entities within the same
calendar day, and with counterparties that are not SDs, MSPs, or
financial entities not later than the next business day.
Several commenters recognized the benefits of the Commission's
confirmation proposal and wrote in support of the approach. Chris
Barnard wrote that the proposal would increase transparency and promote
legal certainty for swaps. CME stated that it supported the goals of
improving the post-trade processing of swaps and ensuring timely and
accurate confirmation of such data among counterparties. CME agreed
with the overall approach taken by the Commission on this subject and
with the goal of promulgating confirmation requirements that are
effective, not duplicative and cost and time efficient to the industry.
CME noted the cost-savings to market participants of confirming their
swaps through DCOs, which is explicitly permitted under the swap
confirmation rule.
On the other hand, multiple commenters objected to the Commission's
proposal on cost grounds. Some read the proposal as detrimentally
mandating electronic confirmation.\80\ Other commenters argued that the
short time periods permitted for confirmation would effectively require
all terms of a swap to be negotiated prior to execution, increasing
costs for the party that is most sensitive to timing of market
conditions and increasing risk by leading to needless disputes and
operational lapses.\81\ Still others argued that financial entities
should not be subject to shorter confirmation deadlines than non-
financial entities.\82\ Finally, some commenters stated that the rule
would require changes in current market practice and it was unclear
that the cost of additional resources to meet the requirements of the
rule was outweighed by any enhanced transparency or reduction in
systemic risk.\83\ No commenter provided quantitative data on the
comprehensive compliance costs of the rule as proposed, but ISDA and
The Working Group enumerated costs related to adopting electronic
confirmation procedures. ISDA stated that each asset class uses
different electronic confirmation platforms, so a trader conducting
trades in multiple asset classes would need to build the infrastructure
necessary to integrate multiple platforms. Such expenditures are
routine for dealers, says ISDA, but for smaller entities, the
operational costs may impede their ability to hedge risk. The Working
Group estimated that electronic confirmation could cost an SD or MSP in
excess of $1,000,000 annually, citing that one third-party confirmation
service charges $6.00 per trade. However, The Working Group cited no
source for the proposition that potential SDs or MSPs currently execute
the more than 166,000 trades annually that would be required to reach a
$1,000,000 annual confirmation cost at $6.00 per trade.
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\80\ Chatham argued that the Commission should not mandate
confirmation through an electronic matching platform, because such a
mandate could preclude end-users from entering into swaps not yet
available on matching platforms and could increase costs for end-
users that do not engage in the volume of swaps necessary to justify
the additional costs of connecting to electronic matching platforms.
ABC & CIEBA also argued that the proposed rule could impose
processes that require third-party service providers or new
technology.
\81\ The Working Group; ISDA; Chatham.
\82\ CIEBA stated that the rule would impose costly increases in
operational capacity for pension funds and recommended that the
Commission provide for a ``close of next business day'' time limit
for benefit plans, along with a requirement that SDs and MSPs
provide an acknowledgement at the time of execution as well as a
draft acknowledgement prior to execution. AMG argued that financial
entities should not be subject to shorter time periods for
confirmation because many may not have the operational resources to
meet the deadlines. MFA stated that designation as a financial
entity does not necessarily correlate with a large swap portfolio or
being highly sophisticated, and thus the short time period for
confirmation in the proposed rules may cause unwarranted economic
disadvantages.
\83\ BGA; MetLife; MFA; GFED; the FHLBs; AMG.
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The Commission carefully considered each of these comments in
formulating the final rule and has responded to the cost concerns of
commenters where doing so was in keeping with the benefit of timely and
accurate memorialization of all the terms of a swap transaction between
an SD or MSP and its counterparties. First, the final rule does not
apply to swap transactions that are executed on a SEF or DCM or that
are submitted for clearing to a DCO by the required confirmation
deadline, so market participants that mostly transact in standardized
swaps may not be affected by the rule, or will have their costs greatly
reduced. This fact was highlighted by both CME and ICE in their
comments to the proposed rule.
Second, the Commission notes that the final rule affirmatively does
not mandate electronic confirmation. Instead, the final rule sets an
ultimate deadline for confirmation of swap transactions among SDs and
MSPs, while also requiring that if technologically practicable, such
swap transactions be confirmed sooner. The deadline of ``the end of the
first business day following the day of execution'' is modified to
allow for more time if registrants are trading near the end of the
trading day or if such registrants are in different time zones. With
respect to swap transactions with non-SDs and non-MSPs, SDs and MSPs
are only required to have policies and procedures in place that are
reasonably designed to ensure confirmation by the end of the first
business day following the day of execution (modified for end of day
trading and time zone differences) for financial entities, or by
[[Page 55946]]
the end of the second business day following the day of execution for
non-financial entities, rather than the next business day as proposed.
The Commission would expect an SD's or MSP's policies and procedures to
require sufficient pre-trade agreement on repetitive terms such that
non-SD, non-MSP counterparties are able to execute in a timely manner
without protracted pre-trade negotiations that may prove costly for
market participants sensitive to execution timing. The requirement for
policies and procedures (as opposed to hard deadlines) recognizes that
SDs and MSPs cannot force their non-SD, non-MSP counterparties to adopt
particular electronic confirmation processes, but must accommodate the
needs of their counterparties while ensuring, to the extent possible,
that confirmation is achieved within the rule's time periods.
In addition, to further reduce the burden of the rule on those
market participants that are least able to quickly adapt to the rule's
requirements, the Commission notes that compliance with the rule is
implemented on a staggered basis. As discussed above under section
III.B.2, compliance is required first for swaps in the credit and
interest rate asset class, and, within that asset class, first for
swaps among SDs, MSPs, and financial entities with a longer compliance
period for swaps between SDs or MSPs and non-financial entities.
Compliance is staggered similarly with respect to all other swaps, but
with longer compliance periods.
The Commission understands that, for certain asset classes, the low
number of transactions does not seem to justify increased expenditure
on faster confirmations; however, the Commission is committed to
decreasing the length of time between execution and confirmation in
order to improve the efficiency of bilateral markets and decrease
overall systemic risk resulting from outstanding unconfirmed trades
among many participants. The Commission maintains that such benefits
are significant and important regardless of asset class. Thus, the
Commission has applied the same general timeframes to all asset
classes, but has extended the compliance deadlines for commodity,
equity, and foreign exchange asset classes in order to allow
participants in those asset classes sufficient time to integrate faster
confirmations without an immediate and potentially overwhelming burden.
Finally, the Commission notes that ESMA has proposed confirmation
requirements that are substantially similar to those adopted by the
Commission in this release.\84\ By closely aligning confirmation
requirements through consultation with ESMA, the Commission believes
that SDs and MSPs will benefit from a largely unitary regulatory regime
that does not require separate compliance and operational policies and
procedures.
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\84\ See ESMA Draft Technical Standards, Article 1 RM,
subsection 2 (stating that uncleared OTC derivatives ``shall be
confirmed, where available via electronic means, as soon as possible
and at the latest by the end of the same business day.''), and ESMA
Draft Technical Standards, Article 1 RM, subsection 3 (stating that
uncleared OTC derivatives ``shall be confirmed as soon as possible
and at the latest by the end of the second business day following
the date of execution'').
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C. Portfolio Reconciliation
Disputes related to confirming the terms of a swap, as well as swap
valuation disputes, have long been recognized as a significant problem
in the OTC derivatives market.\85\ Portfolio reconciliation is
considered an effective means of identifying and resolving these
disputes. The Commission recognizes that the industry has made
significant progress in adopting the use of portfolio reconciliation to
decrease the number of swap disputes.\86\ In December 2008, the ODSG's
group of 14 major dealers committed to execute daily portfolio
reconciliations for collateralized portfolios in excess of 500 trades
between participating dealers by June of 2009.\87\ As of May 2009, all
participating dealers were satisfying this commitment. In October 2009,
the ODSG committed to publishing a feasibility study on market-wide
portfolio reconciliation that would set forth how regular portfolio
reconciliation could be extend beyond the ODSG dealers to include
smaller banks, buy-side participants, and derivative end users.
Consistent with this publication, the ODSG dealers expanded their
portfolio reconciliation commitment in March 2010 to include monthly
reconciliation of collateralized portfolios in excess of 1,000 trades
with any counterparty. Most recently, the industry has been preparing a
new ``Convention on the Investigation of Disputed Margin Calls'' and a
new ``Formal Market Polling Procedure'' that are intended to ``create a
consistent and predictable process * * * that eliminates present
uncertainties and delays.'' \88\
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\85\ See ISDA Collateral Committee, ``Commentary to the Outline
of the 2009 ISDA Protocol for Resolution of Disputed Collateral
Calls,'' June 2, 2009 (stating ``Disputed margin calls have
increased significantly since late 2007, and especially during 2008
have been the driver of large (sometimes > $1 billion) un-
collateralized exposures between professional firms.'').
\86\ The Commission also recognizes and encourages the industry
practice of immediately transferring undisputed collateral amounts.
\87\ See June 2, 2009 summary of industry commitments, available
at http://www.isda.org/c_and_a/pdf/060209table.pdf.
\88\ See ``ISDA 2010 Convention on the Investigation of Disputed
Margin Calls'' and ``ISDA 2010 Formal Market Polling Procedure.''
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In light of these efforts the Commission proposed Sec. 23.502,
which required SDs and MSPs to reconcile their swap portfolios with one
another and provide counterparties that are not registered as SDs or
MSPs with regular opportunities for portfolio reconciliation.
Specifically, proposed Sec. 23.502 required SDs and MSPs to reconcile
swap portfolios with other SDs or MSPs with the following frequency:
daily for portfolios consisting of 300 or more swaps, at least weekly
for portfolios consisting of 50 to 300 swaps, and at least quarterly
for portfolios consisting of fewer than 50 swaps. For portfolios with
counterparties other than SDs or MSPs, the proposed regulations
required SDs and MSPs to establish policies and procedures for
reconciling swap portfolios: daily for swap portfolios consisting of
500 or more swaps, weekly for portfolios consisting of more than 100
but fewer than 500 swaps, and at least quarterly for portfolios
consisting of fewer than 100 swaps. In order for the marketplace to
realize the full risk reduction benefits of portfolio reconciliation,
the Commission also proposed to expand portfolio reconciliation to all
transactions, whether collateralized or uncollateralized. For the swap
market to operate efficiently and to reduce systemic risk, the
Commission believes that portfolio reconciliation should be a proactive
process that delivers a consolidated view of counterparty exposure down
to the transaction level. By identifying and managing mismatches in key
economic terms and valuation for individual transactions across an
entire portfolio, the Commission proposal sought to require a process
in which overall risk can be identified and reduced.
Agreement between SDs, MSPs, and their counterparties on the proper
daily valuation of the swaps in their swap portfolio also is essential
for the Commission's margin proposal. Under proposed rule Sec. 23.151,
non-bank SDs and MSPs must document the process by which they will
arrive at a valuation for each swap for the purpose of collecting
initial and variation margin.\89\
[[Page 55947]]
All non-bank SDs and MSPs must collect variation margin from their non-
bank SD, MSP, and financial entity counterparties for uncleared swaps
on a daily basis. Variation margin requires a daily valuation for each
swap. For swaps between non-bank SDs and MSPs and non-financial
entities, no margin is required to be exchanged under Commission
regulation, but the non-bank SDs and MSPs must calculate a hypothetical
variation margin requirement for each uncleared swap for risk
management purposes under proposed Sec. 23.154(b)(6).
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\89\ See Margin Requirements for Uncleared Swaps for Swap
Dealers and Major Swap Participants, 76 FR 23732, 23744 (April 28,
2011). Bank SDs and MSPs will also be required to document the
process by which they will arrive at a valuation for each swap for
the purpose of collecting margin under the margin rules proposed by
the OCC, the Federal Reserve Board, and the FDIC. See Margin and
Capital Requirements for Covered Swap Entities, 76 FR 27564, 27589
(May 11, 2011).
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Several commenters articulated the benefits of portfolio
reconciliation and supported the Commission's proposal. TriOptima
supported the regular reconciliation of all portfolios as a process
that will identify issues that can minimize counterparty credit
exposure and operational risk. Chris Barnard also supported the rule,
stating that the rule should increase transparency, promote market
integrity and reduce risk by establishing procedures that will promote
legal certainty concerning swap transactions, assist with the early
resolution of valuation disputes, reduce operational risk, and increase
operational efficiency.
Conversely, multiple commenters objected to proposed Sec. 23.502
on cost grounds. Some commenters argued that the rule would require
significant investment in new infrastructure and some argued that the
rule would have few benefits for SDs and MSPs that trade in shorter
dated swaps.\90\ Others asserted that portfolio reconciliation at the
transactional level was only necessary if there are portfolio level
discrepancies that result in margin disputes, and argued that routine
reconciliation at the proposed frequency was unnecessarily costly.\91\
Some argued that the swap portfolios of non-SDs, non-MSPs do not pose
significant risk to the financial system and the rule may increase the
costs of swaps for such entities.\92\ Still others argued that the
Commission must provide sufficient time for all registrants to develop
the infrastructure required to meet the frequency of reconciliation
required by the rule.
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\90\ GFED.
\91\ MFA; ISDA; The Working Group; MarkitSERV; AMG.
\92\ Dominion; FHLBs; Chatham.
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In relation to the one business day valuation dispute resolution
requirement, many commenters stated that parties to a good-faith
dispute should have a commercially reasonable timeframe in which to
consult in order to find an appropriate resolution of the dispute.
These commenters supported ISDA's 2011 Convention on Portfolio
Reconciliation and the Investigation of Disputed Margin Calls and the
2011 Formal Market Polling Procedure, developed pursuant to industry
commitments to the ODSG, which ISDA believes will be widely adopted by
OTC derivatives market participants, and believed these industry
efforts should play a more significant role in shaping the proposed
reconciliation rules.\93\ Other commenters argued that SDs and MSPs
should not have to expend resources to resolve valuation disputes
exceeding the proposed 10 percent threshold if they conclude that the
discrepancy is not material in their particular circumstances.\94\
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\93\ ISDA; The Working Group; FHLBs; AMG.
\94\ Chatham; The Working Group; MFA; ISDA.
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The Commission carefully considered each of the foregoing comments
in formulating the final rule.
It should be noted that the Confirmation NPRM stated that the
Commission anticipated that SDs and MSPs will be able to efficiently
reconcile their internal records with their counterparties by reference
to data in SDRs. The Commission received no comments disputing this
assertion, and one commenter noted that SDRs would be in the best
position to detect and manage discrepancies in the material terms of a
swap transaction both efficiently and effectively.\95\ The Commission
has thus determined to adopt the portion of the rule that requires SDs
and MSPs to reconcile the material terms of each swap in their swap
portfolios in addition to reconciling the valuation of each swap but,
at the urging of commenters, has reduced the required frequency of
reconciliation to match the frequency of reconciliation currently
undertaken by the largest prospective SDs.\96\ The final rules require
SDs and MSPs to reconcile portfolios with other SDs and MSPs at the
following frequencies: daily for portfolios comprising 500 or more
swaps; weekly for portfolios comprising 51 to 499 swaps; and quarterly
for portfolios comprising one to 50 swaps. The Commission believes that
the frequency of reconciliation of material terms and valuations of
each swap required by the rule as modified will ensure the risk-
reducing benefits of reconciliation by presenting a consolidated view
of counterparty exposure down to the transaction level, and that these
benefits are especially noteworthy when considered in light of the
efficiencies possible through use of SDR data in the reconciliation
process.
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\95\ FHLBs.
\96\ In December 2008, the ODSG's group of 14 major dealers
committed to execute daily portfolio reconciliations for
collateralized portfolios in excess of 500 trades between
participating dealers by June of 2009. See June 2, 2009 summary of
industry commitments, available at http://www.isda.org/c_and_a/pdf/060209table.pdf. As of May 2009, all participating dealers were
satisfying this commitment. The ODSG dealers expanded their
portfolio reconciliation commitment in March 2010 to include monthly
reconciliation of collateralized portfolios in excess of 1,000
trades with any counterparty.
---------------------------------------------------------------------------
Having considered comments that the frequency of reconciliation
with non-SD, non-MSP counterparties required by the rule was
unnecessary to achieve the benefits of portfolio reconciliation
outlined above, the Commission is also reducing the frequency of
reconciliation required for non-registrant counterparties and is
modifying the final rule to require reconciliation with such
counterparties quarterly for swap portfolios of more than 100 swaps,
and annually for all other swap portfolios. This level was recommended
by commenters, including The Working Group.
With respect to the proposed rule's one business day deadline for
valuation dispute resolution among SDs and MSPs, the Commission
observes that daily valuation is critical for the appropriate operation
of the Commission's proposed rules on margin, which is itself essential
for the mitigation of risk posed by swaps. Issues related to swap
valuations are woven through a number of Commission rule proposals. For
instance, Sec. 23.504(e), as adopted in this release, requires SDs and
MSPs to report valuation disputes with SD or MSP counterparties in
excess of $20,000,000 and lasting longer than three business days to
the Commission, while under Sec. 23.504(b)(4) SDs and MSPs are
required to agree on valuation methodologies with their counterparties.
However, the Commission recognizes that valuation dispute
resolution may be labor intensive and therefore costly. For this
reason, the Commission modified the rule to provide for a five-day
resolution process. In addition to this change, the Commission notes
that, the costs of valuation dispute resolution are mitigated by the
operation of several other parts of the new regulatory regime for
swaps. First, the reconciliation requirements, and thus the valuation
dispute resolution requirement, does not apply to cleared swaps,
because DCOs establish settlement prices for each cleared swap every
business day. It is likely that a large part of the swap
[[Page 55948]]
portfolios of SDs and MSPs will consist of cleared swaps \97\ to which
the reconciliation requirements will not apply; valuation disputes will
therefore only arise in bilateral, uncleared portfolios. Second, the
reconciliation requirements of Sec. 23.503 are expected to avoid
disputes from arising in the first instance through the regular
comparison of material terms and valuations. Third, the Commission
expects that Sec. 23.504(b)(4), by requiring agreement with each
counterparty on the methods and inputs for valuation of each swap, will
assist SDs and MSPs to resolve valuation disputes within five business
days.
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\97\ ``It is expected that the standardized, plain vanilla, high
volume swaps contracts--which according to the Treasury Department
are about 90 percent of the $600 trillion swaps market--will be
subject to mandatory clearing.'' 156 Cong. Rec. S5921 (daily ed.
Jul. 15, 2010) (statement of Sen. Lincoln). The Tabb group estimates
that 60-80 percent of the swaps market measured by notional amount
will be cleared within five years of the time that the Dodd-Frank
Act is implemented. See Tabb Group, ``Technology and Financial
Reform: Data, Derivatives and Decision Making.''
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SDs and MSPs need not resolve every valuation dispute, but only
those where the difference in valuation is 10 percent or more. The
Commission believes the 10 percent threshold is appropriate as it
provides certainty as to which disputes must be resolved. The
Commission believes the efficiency of a bright line rule, as opposed to
the formulas and discretion in the alternatives suggested by
commenters, will better serve the operational processes of SDs and MSPs
and the regulatory oversight of the Commission. Thus, to maintain the
risk mitigation benefits of the rule outlined above, the Commission has
determined to retain the requirement that swap valuation disputes among
SDs and MSPs be resolved within five business days.
As a further cost reduction measure, the Commission notes that it
has extended the compliance dates for those SDs and MSPs that have not
been previously regulated by a prudential regulator, and thus are least
likely to have the infrastructure in place to begin regular
reconciliation with their counterparties. As stated in section III.B.3
above, SDs and MSPs that have been previously regulated need not comply
with the rule for three months after publication of the final rule in
the Federal Register. SDs and MSPs that have not been previously
regulated need not comply for six months after publication.
Finally, the Commission notes that ESMA has proposed portfolio
reconciliation requirements that are substantially similar to those
adopted by the Commission in this release.\98\ By closely aligning
portfolio reconciliation requirements through consultation with ESMA,
the Commission believes that SDs and MSPs will benefit from a largely
unitary regulatory regime that does not require separate compliance and
operational policies and procedures.
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\98\ See ESMA Draft Technical Standards, Article 2 RM,
subsection 4, (stating that ``In order to identify at an early
stage, any discrepancy in a material term of the OTC derivative
contract, including its valuation, the portfolio reconciliation
shall be performed: * * * each business day when the counterparties
have 500 or more OTC derivative contracts outstanding with each
other; * * * once per month for a portfolio of fewer than 300 OTC
derivative contracts outstanding with a counterparty; * * * once per
week for a portfolio between 300 and 499 OTC derivative contracts
outstanding with a counterparty.'').
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D. Portfolio Compression
Portfolio compression is a mechanism whereby substantially similar
transactions among two or more counterparties are terminated and
replaced with a smaller number of transactions of decreased notional
value in an effort to reduce the risk, cost, and inefficiency of
maintaining unnecessary transactions on the counterparties' books. In
many cases, these redundant or economically-equivalent positions serve
no useful business purpose, but can create unnecessary risk,\99\ as
well as operational and capital inefficiencies.
---------------------------------------------------------------------------
\99\ Federal Reserve Bank of New York Staff Report No. 424:
``Policy Perspectives on OTC Derivatives Market Infrastructure,''
Jan. 2010 (revised Mar. 2010).
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The usefulness of portfolio compression as a risk management tool
has been acknowledged widely. In 2008, the PWG identified frequent
portfolio compression of outstanding trades as a key policy objective
in the effort to strengthen the OTC derivatives market
infrastructure.\100\ Similarly, the 2010 staff report outlining policy
perspectives on OTC derivatives infrastructure issued by the FRBNY
identified trade compression as an element of strong risk management
and recommended that market participants engage in regular, market-wide
portfolio compression exercises.\101\
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\100\ ``Policy Objectives for the OTC Derivatives Markets,''
President's Working Group on Financial Markets (Nov. 14, 2008).
\101\ Federal Reserve Bank of New York Staff Report No. 424:
``Policy Perspectives on OTC Derivatives Market Infrastructure,''
Jan. 2010 (revised Mar. 2010).
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The value of portfolio compression also is illustrated by existing
market participation in compression exercises. In March 2010, the
Depository Trust and Clearing Corporation (DTCC) explicitly attributed
the reduction in the gross notional value of the credit derivatives in
its warehouse to industry supported portfolio compression.\102\
TriOptima, which offers the TriReduce portfolio compression service,
estimates that it terminated $106.3 trillion gross notional of interest
rate swaps and $66.9 trillion gross notional of credit swaps between
2003 and 2010.\103\ Similarly, Creditex and Markit, which offer
portfolio compression exercises in single name credit default swaps,
enabled participating institutions to eliminate $4.5 trillion in
notional between late 2008 through 2009.\104\
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\102\ DTCC Press Release, ``DTCC Trade Information Warehouse
Completes Record Year Processing OTC Credit Derivatives'' (Mar. 11,
2010). Notably, beginning in August 2008, ISDA encouraged
compression exercises for credit default swaps by selecting the
service provider and defining the terms of service.
\103\ See www.trioptima.com. Between 2007 and 2008, TriOptima
reduced $54.7 trillion gross notional of interest rate swaps and
$49.1 trillion gross notional of credit swaps. In March of 2010, the
staff of the Federal Reserve Bank of New York estimated that since
2008 nearly $50 trillion gross notional of credit default swap
positions has been eliminated through portfolio compression. Federal
Reserve Bank of New York Staff Report No. 424: ``Policy Perspectives
on OTC Derivatives Market Infrastructure,'' Jan. 2010 (revised Mar.
2010).
\104\ See www.isdacdsmarketplace.com.
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In light of the recognized benefits of portfolio compression in
reducing the risk, cost, and inefficiency of maintaining unnecessary
transactions, the Commission proposed Sec. 23.503, which required SDs
and MSPs to participate in multilateral compression exercises that are
offered by those DCOs or self-regulatory organizations of which the SD
or MSP is a member, or as required by Commission regulation or order.
The Commission also proposed that SDs and MSPs be required to terminate
bilaterally all fully offsetting swaps between them by the close of
business on the business day following the day the parties entered into
the offsetting swap transaction and to engage annually in bilateral
portfolio compression exercises with counterparties that are also SDs
and MSPs to the extent that they have not participated in a
multilateral compression exercise. Proposed Sec. 23.503 did not
require portfolio compression exercises for swaps outstanding between
an SD or MSP and counterparties that are neither SDs nor MSPs. Instead,
SDs and MSPs were required to establish written policies and procedures
for periodically terminating all fully offsetting swaps and
periodically engaging in compression exercises with such
counterparties.
Several commenters supported the Commission's proposal and outlined
the benefits of the approach. For instance,
[[Page 55949]]
Blackrock wrote in support of the Commission's proposal and encouraged
the Commission to expand the proposal in order to achieve what
Blackrock believes to be the essential benefits of compression. In
addition, Eris Exchange wrote in support of compression and noted that
it should lead to greater position netting and the ability to more
freely unwind aged swap trades without having to go through a
cumbersome novation process involving substantial operational burden
and negotiated up-front payments.
On the other hand, multiple commenters objected to proposed Sec.
23.503 on cost grounds. Some commenters argued that resource-intensive
compression exercises should not be required in asset classes where
there is not a high degree of transaction standardization and a high
volume of redundant trades because the benefits would not outweigh the
costs.\105\ Similarly, many commenters argued that non-SD
counterparties should not be included in any mandatory compression
because such entities have portfolios with a very small number of
offsetting transactions (i.e., almost all swaps are in the same market
direction) and the cost of the exercise is not justified by the small
benefit derived.\106\ Other commenters noted that it is not cost
effective to establish and run daily systems to monitor for fully
offsetting swaps where there are likely to be none.\107\ On another
tack, some commenters argued against requiring participation in
compression exercises offered by DCOs and SROs to avoid lack of
competition and higher costs.
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\105\ ISDA; The Working Group; Markit.
\106\ TriOptima; Markit; ISDA; ABC & CIEBA; AMG; Chatham;
Dominion; FHLBs; Freddie Mac; MetLife; MFA; NAIC; GFED.
\107\ The Working Group.
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The Commission carefully reviewed the comments received with
respect to proposed Sec. 23.503 and considered each in formulating the
final rule. Partly in response to the comments received regarding the
costs imposed by the proposed rule, the Commission has revised the rule
to reduce the cost burden on market participants. First, the Commission
has determined to exclude swaps cleared by a DCO from the rule. As
noted above, each DCO is required to establish portfolio compression
procedures, but participation in such compression exercises by clearing
members is voluntary. Accordingly, the revisions to Sec. 23.503 are
consistent with the revised DCO final rules with respect to cleared
swaps. Second, the Commission was persuaded that the benefits of the
rule could be maintained without requiring SDs and MSPs to incur the
costs of mandatory compression. Thus, as discussed in more detail
above, the Commission is electing to adopt the alternative suggested by
commenters and is modifying the rule to replace the mandatory
compression requirement with a requirement that SDs and MSPs establish
policies and procedures for periodically engaging in portfolio
compression exercises with counterparties that are also SDs or MSPs and
for engaging in portfolio compression with all other counterparties
upon request. The Commission is qualifying the requirement that SDs and
MSPs terminate fully offsetting swaps by requiring instead that SDs and
MSPs establish policies and procedures for terminating fully offsetting
swaps in a timely fashion, but allowing SDs and MSPs to determine where
it is appropriate to do so. The Commission believes that these
modifications retain the benefits of portfolio compression while
reducing the compliance costs to SDs and MSPs and costs that otherwise
may have been incurred by other market participants.
Finally, the Commission notes that ESMA has proposed portfolio
compression requirements that are substantially similar to those
adopted by the Commission in this release.\108\ By closely aligning
portfolio compression requirements through consultation with ESMA, the
Commission believes that SDs and MSPs will benefit from a largely
unitary regulatory regime that does not require separate compliance and
operational policies and procedures.
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\108\ See ESMA Draft Technical Standards, Article 3 RM,
subsection 2, (stating that ``counterparties with 500 or more OTC
derivative contracts outstanding which are not centrally cleared
shall have procedures to regularly, and at least twice a year,
analyse the possibility to conduct a portfolio compression exercise
in order to reduce their counterparty credit risk and engage in such
portfolio compression exercise.'').
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E. Swap Trading Relationship Documentation
The OTC derivatives markets traditionally have been characterized
by privately negotiated transactions entered into by two
counterparties, in which each party assumes and manages the credit risk
of the other. While OTC derivatives are traded by a diverse set of
market participants, such as banks, hedge funds, pension funds, and
other institutional investors, as well as corporate, governmental, and
other end-users, a relatively few number of dealers are, by far, the
most significantly active participants. As such, the default of a
dealer may result in significant losses for the counterparties of that
dealer, either from the counterparty exposure to the defaulting dealer
or from the cost of replacing the defaulted trades in times of market
stress.\109\
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\109\ See Financial Stability Board, ``Implementing OTC
Derivatives Market Reforms: Report of the OTC Derivatives Working
Group,'' (Oct. 10, 2010), available at http://www.financialstabilityboard.org/publications/r_101025.pdf.
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OTC derivatives market participants typically have relied on the
use of industry standard legal documentation, including master netting
agreements, definitions, schedules, and confirmations, to document
their swap trading relationships. This industry standard documentation,
such as the widely used ISDA Master Agreement and related definitions,
schedules, and confirmations specific to particular asset classes,
offers a framework for documenting the transactions between
counterparties for OTC derivatives products.\110\ The standard
documentation is designed to set forth the legal, trading, and credit
relationship between the parties and to facilitate cross-product
netting of transactions in the event that parties have to close-out
their position with one another.
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\110\ The International Swaps and Derivatives Association (ISDA)
is a trade association for the OTC derivatives industry (http://www.isda.org).
---------------------------------------------------------------------------
One important method of addressing the credit risk that arises from
OTC derivatives transactions is the use of bilateral close-out netting.
Parties seek to achieve enforceable bilateral netting by documenting
all of their transactions under master netting agreements.\111\
Following the occurrence of a default by one of the counterparties
(such as bankruptcy or insolvency), the exposures from individual
transactions between the two parties are netted and consolidated into a
single net ``lump sum'' obligation. A party's overall exposure is
therefore limited to this net sum. That exposure then may be offset by
the available collateral previously provided being applied against the
net exposure. As such, it is critical that the netting provisions
between the parties are documented and legally enforceable and that the
collateral may be used to meet the net exposure. In recognition of the
risk-reducing benefits of close-out netting, many jurisdictions provide
favorable treatment of netting
[[Page 55950]]
arrangements in bankruptcy,\112\ and favorable capital and accounting
treatment to parties that have enforceable netting agreements in
place.\113\
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\111\ Enforceable bilateral netting arrangements are a common
commercial practice and are an important part of risk management and
minimization of capital costs.
\112\ See e.g., 11 U.S.C. 561 (protecting contractual right to
terminate, liquidate, accelerate, or offset under a master netting
agreement and across contracts).
\113\ See 12 CFR part 3, Appendix C; 12 CFR part 208, Appendix
F; 12 CFR part 225, Appendix G; and 12 CFR part 325, Appendix D
(banking regulations regarding qualifying master netting
agreements).
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There is also a risk that inadequate documentation of open swap
transactions could result in collateral and legal disputes, thereby
exposing counterparties to significant counterparty credit risk. By way
of contrast, adequate documentation between counterparties offers a
framework for establishing the trading relationship between the
parties.
To ensure the risk-reducing benefits of adequate swap trading
relationship documentation, the Commission proposed Sec. 23.504.
Proposed Sec. 23.504 required SDs and MSPs to establish, maintain, and
enforce written policies and procedures reasonably designed to ensure
that each SD and MSP and its counterparties have agreed in writing to
all of the terms governing their swap trading relationship and have
executed all agreements required by proposed Sec. 23.504. These
included agreement on terms related to payment obligations, netting of
payments, events of default or other termination events, netting of
obligations upon termination, transfer of rights and obligations,
governing law, valuation, and dispute resolution procedures, as well as
credit support arrangements, including margin and segregation.
Agreement on valuation methodologies pursuant to Sec. 23.504(b)(4) is
discussed separately below. In addition, proposed Sec. 23.504 required
each SD and MSP to have an independent internal or external auditor
examine annually at least 5 percent of the swap trading relationship
documentation created during the year to ensure compliance with
Commission regulations and the SD's or MSP's policies and procedures
established pursuant to Sec. 23.504.
Several commenters supported the rule. One stated that clear and
thorough standards for documentation are essential to avoid the
situation that became apparent when AIG and Lehman Brothers failed: A
hopelessly tangled web of poorly documented transactions, with the
effort to sort it all out emerging as a separate threat to the
financial system.\114\ Others supported the goal of the rule to ensure
that the parties to a trade have in fact agreed on its economic and
legal terms prior to or contemporaneously with entering into a swap,
and are communicating and maintaining appropriate records memorializing
that agreement.\115\ However, many commenters also objected to the
proposed rule on cost grounds.
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\114\ Better Markets.
\115\ ISDA & SIFMA.
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Several commenters strongly urged the Commission not to make Sec.
23.504 retroactively applicable to existing swaps because the need to
make amendments to existing documentation would be time consuming and
costly.\116\ Having considered these comments, the Commission is
adopting the alternative presented by commenters and is modifying Sec.
23.504 to make clear that the rule does not apply to swaps executed
prior to the date on which SDs and MSPs are required to be in
compliance with Sec. 23.504. The Commission notes, however, that the
rule does not prohibit SDs and MSPs from agreeing with their
counterparties to amend existing swap trading relationship
documentation to bring such documentation into compliance with Sec.
23.504 (or any other Commission regulation) and ensure that netting
arrangements will apply to swaps executed prior to and after
promulgation of Sec. 23.504. The ability to combine netting sets in
this manner may reduce costs of collateralization for many SDs and
MSPs.
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\116\ The Working Group; ISDA & SIFMA; FSR; MFA; FHLBs; The
Coalition for Derivative End-Users.
---------------------------------------------------------------------------
Several commenters were concerned that proposed Sec. 23.504 may
require market participants to incur the burden and expense of
negotiating master agreements even if a stand-alone agreement or
``long-form'' confirmation that incorporates terms of a standard master
agreement by reference would sufficiently address legal risks.\117\ The
Commission notes, however, that nothing in the rule prohibits
incorporation by reference so long as the terms so incorporated are in
written form, and therefore confirms that so long as a ``long-form''
confirmation includes all terms of the trading relationship and is
executed prior to or contemporaneously with entering into a swap
transaction, such would be in compliance with Sec. 23.504.
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\117\ OCC; IECA.
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A number of comments reflected a concern regarding the requirement
that SDs and MSPs audit no less than 5 percent of their trading
relationship documentation annually, arguing that the requirement is
burdensome and recommending that the Commission adopt an alternative,
principles-based approach requiring SDs and MSPs to conduct audits
sufficient to identify material weaknesses in their documentation
policies and procedures. The Commission was persuaded that the audit
requirement need not prescribe the percentage of agreements to be
audited to maintain the benefits of the rule, and has modified the rule
in accordance with the recommendations of commenters.
In addition, several commenters recommended that valuation dispute
reporting under Sec. 23.504(e) should be subject to a materiality
standard to avoid an overly-burdensome reporting requirement that will
result in substantial informational noise. The Commission agreed with
these commenters and reduced the burden of the reporting requirement by
revising the proposed rule to add a $20,000,000 threshold on the
reporting of valuation disputes.
Finally, the Commission recognizes that requiring implementation of
the documentation requirements of Sec. 23.504 immediately or within a
very compressed timeframe creates certain costs for industry
participants. Consequently, reducing these costs--enumerated below--by
extending the compliance schedule represents a benefit.
First, to meet timelines some firms will need to contract
additional staff or hire vendors to handle some necessary tasks or
projects. Additional staff hired or vendors contracted in order to meet
more pressing timelines represent an additional cost for market
participants. Moreover, as pointed out by commenters, a tightly
compressed timeframe raises the likelihood that more firms will be
competing to procure services at the same time; this could put firms
that conduct fewer swaps at a competitive disadvantage in obtaining
those services, making it more difficult for them to meet required
timelines.\118\ In addition, it could enable service providers to
command a pricing premium when compared to times of ``normal'' or
lesser competition for similar services. That premium represents an
additional cost when compared to a longer compliance timeline.
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\118\ See letter from CIEBA.
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Second, if entities are not able to comply with the documentation
requirements by a certain date, they may avoid transacting swaps
requiring compliance until such a time as they are able to comply. In
this event, liquidity
[[Page 55951]]
that otherwise would result from those foregone swaps would be reduced,
making the swaps more expensive for market participants taking the
other side. Moreover, firms compelled to withdraw from the market
pending compliance with required documentation measures will either
leave certain positions un-hedged--potentially increasing the firm's
own default risk, and therefore the risk to their counterparties and
the public. Alternatively, firms compelled to withdraw from the market
for a period of time could attempt to approximate their foregone swap
hedges using other, likely more expensive, instruments. Further, to the
extent the withdrawing entities are market makers, they will forsake
the revenue potential that otherwise would exist for the period of
their market absence.
Third, firms may have to implement technological solutions, sign
contracts, and establish new operational procedures before industry
standards have emerged that address new problems effectively. To the
extent that this occurs, it is likely to create costs. Firms may have
to incur additional costs later to modify their technology platforms
and operational procedures further, and to renegotiate contracts--
direct costs that a more protracted implementation schedule would have
avoided.\119\ Moreover, costs created by the adoption of standards that
fail to address certain problems, or attributable to undesired
competitive dynamics resulting from such standards, may be
longstanding.
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\119\ See e.g., ACLI letter.
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The Commission, informed by its consideration of comments and
alternatives, discussed in the sections above and below, believes that
the approach contained in this adopting release is reasonable and
appropriate in light of the tradeoffs described above. The compliance
dates discussed above give the Commission the opportunity to provide
additional time to entities in ways that generally align with: (1)
Their resources and expertise, and therefore their ability to comply
more quickly; and (2) their level of activity in the swap markets, and
therefore the possible impact of their swap activities on the stability
of the financial system. Entities with the most expertise in, and
systems capable to transact, swaps also are likely to be those whose
transactions represent a significant portion of all transactions in the
swap markets. They are more likely to be able to comply quickly, and
the benefits of requiring them to do so are greater than would be the
case for less active entities. On the other hand, entities with less
system capability and in-house swap expertise may need more time to
comply with documentation requirements, but it is also likely that
their activities represent a smaller proportion of the overall market,
and therefore are less likely to create or exacerbate shocks to the
financial system.\120\ The Commission believes that SDs, security-based
swap dealers, MSPs, major security-based swap participants, and active
funds (as defined above) are entities likely possessing more advanced
systems and expertise, and whose swap activities constitute a
significant portion of overall swap market transactions. On the other
hand, other market participants may be less likely to have highly
developed infrastructure and likely have swap activities that
constitute a less significant proportion of the market. Therefore, the
Commission has determined to stagger the compliance dates for Sec.
23.504, providing 90, 180, or 270 days for SDs and MSPs to bring their
swap trading relationship documentation into compliance with the rules,
depending on the identity of the counterparty as discussed more fully
in section III.B.1 above.
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\120\ OCC data demonstrates that among insured US commercial
banks, ``the five banks with the most derivatives activity hold 96
percent of all derivatives, while the largest 25 banks account for
nearly 100 percent of all contracts.'' The report is limited to
insured US commercial banks, and also includes derivatives that are
not swaps. However, swap contracts are included among the
derivatives in the report, constituting approximately 63 percent of
the total notional value of all derivatives. These statistics
suggest that a relatively small number of banks hold the majority of
swap positions that could create or contribute to distress in the
financial system. Data is insufficient, however, to generalize the
conclusions to non-banking institutions. See ``OCC's Quarterly
Report on Bank Trading and Derivatives Activities: Fourth Quarter
2011'' p. 11. http://www.occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq411.pdf.
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F. Swap Valuation Methodologies
Swap valuation disputes have long been recognized as a significant
problem in the OTC derivatives market.\121\ The ability to determine
definitively the value of a swap at any given time lies at the center
of many of the OTC derivatives market reforms contained in the Dodd-
Frank Act and is a cornerstone of risk management. Swap valuation is
also crucial for determining capital and margin requirements applicable
to SDs and MSPs and therefore plays a primary role in risk mitigation
for uncleared swaps.
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\121\ See ISDA Collateral Committee, ``Commentary to the Outline
of the 2009 ISDA Protocol for Resolution of Disputed Collateral
Calls,'' June 2, 2009 (stating ``Disputed margin calls have
increased significantly since late 2007, and especially during 2008
have been the driver of large (sometimes > $1 billion) un-
collateralized exposures between professional firms.'').
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The Commission recognizes that swap valuation is not always an easy
task. In some instances, there is widespread agreement on valuation
methodologies and the source of formula inputs for frequently traded
swaps. Many of these swaps have been accepted for clearing for a number
of years (i.e., commonly traded interest rate swaps and CDS). However,
parties often dispute valuations of thinly traded swaps where there is
not widespread agreement on valuation methodologies or the source for
formula inputs. Many of these swaps are thinly traded either because of
their limited use as risk management tools or because they are simply
too customized to have comparable counterparts in the market. As many
of these swaps are valued by dealers internally by ``marking-to-
model,'' their counterparties may dispute the inputs and methodologies
used in the model. As uncleared swaps are bilateral, privately
negotiated contracts, on-going swap valuation for purposes of initial
and variation margin calculation and swap terminations or novations,
has also been largely a process of on-going negotiation between the
parties. The inability to agree on the value of a swap became
especially acute during the 2007-2009 financial crisis when there was
widespread failure of the market inputs needed to value many
swaps.\122\
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\122\ The failure of the market to set a price for mortgage-
backed securities led to wide disparities in the valuation of CDS
referencing mortgage-backed securities (especially collateralized
debt obligations). Such wide disparities led to large collateral
calls from dealers on AIG, hastening its downfall. See CBS News,
``Calling AIG? Internal Docs Reveal Company Silent About Dozens Of
Collateral Calls,'' Jun. 23, 2009, available at: http://www.cbsnews.com/stories/2009/06/23/cbsnews_investigates/main5106672.shtml.
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In light of these concerns, the Commission proposed Sec.
23.504(b)(4), which required SDs and MSPs to include in their swap
trading relationship documentation an agreement with their
counterparties on the methods, procedures, rules, and inputs for
determining the value of each swap at any time from execution to the
termination, maturity, or expiration of such swap. The Commission
believes that by requiring agreement between counterparties on the
methods and inputs for valuation of each swap, Sec. 23.504(b)(4) will
assist SDs and MSPs and their counterparties to arrive at valuations
necessary for margining and internal risk management, and to resolve
valuation disputes in a timely manner, thereby reducing risk.
[[Page 55952]]
Commenters supported the valuation proposal in light of the
benefits to risk management and adequate collateralization.\123\
Indeed, some commenters argued that the Commission should have been
more prescriptive in its approach to valuation.
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\123\ Better Markets; Michael Greenberger; Chris Barnard.
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Multiple commenters, however, objected to Sec. 23.504(b)(4) on
cost grounds. Specifically, commenters stated that the rule will
significantly increase the pre-execution swap negotiation burden on
SDs, MSPs, and their counterparties without an offsetting benefit.\124\
Some commenters also objected that the rule may discourage the
development of more refined, dynamic swap valuation models that are
more accurate, and therefore more efficient, than less sophisticated or
vanilla models.\125\
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\124\ The Working Group; ISDA & SIFMA; FSR; Markit; Freddie Mac;
COPE; MFA; FHLBs; CIEBA; EEI; Coalition of Derivatives End-Users.
Several of these commenters stated that such pre-execution
negotiations could take months to complete, if possible at all.
\125\ OCC; Hess.
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Other commenters offered alternatives to requiring SDs and MSPs to
agree on valuation methodologies with their counterparties. Many
recommended that the Commission focus its rules on the valuation
dispute resolution process, rather than valuation methodologies.\126\
One recommended that the rule include an explicit authorization for
parties to use the services of independent third parties to provide any
or all of the elements required to agree upon the valuation of swaps,
and not include any preferable inputs or pricing sources for the
valuation of swaps.\127\ Another recommended that the rule be deleted
and replaced with a requirement that SDs and MSPs provide information
to substantiate their valuations upon the request of a
counterparty.\128\
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\126\ The Working Group; Morgan Stanley; MFA; IECA; FHLBs;
CIEBA; MetLife.
\127\ Markit.
\128\ Coalition of Derivatives End-Users.
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As discussed above, the Commission is substantially modifying the
rule in response to concerns raised and alternatives suggested by
commenters. Many of the changes being made in the rule adopted by this
release address the cost concerns and alternatives outlined above.
First, the rule has been focused on the valuation needed to meet the
margin requirements under section 4s(e) of the CEA and the Commission's
regulations under part 23, and to meet the risk management requirements
under section 4s(j) of the Act and the Commission's regulations under
part 23. The Commission believes that this change, by focusing the use
of the agreed-upon valuation methodologies, will ease pre-execution
negotiation and improve internal risk management processes. In
addition, the Commission responded to concerns from market participants
who feared they would have to agree on precise models, by clarifying
that they had to agree on a process, which includes things such as
methods, procedures, rules and inputs. Parties are free to agree on a
model, agree to use one party's confidential proprietary model, rely on
third-party vendors, or a host of other possibilities.
Second, the rule has been modified such that SDs and MSPs need not
agree on swap valuation methodologies with counterparties that are not
SDs, MSPs, or financial entities, unless such counterparties request
such agreements. The Commission believes that this change will
alleviate the pre-execution negotiation burden on SDs, MSPs, and their
non-financial entity counterparties by limiting such negotiations to
counterparties that are more likely to use sophisticated valuation
methodologies akin to those in use by the SD or MSP itself.
Third, in response to commenters that objected that the rule may
discourage the development of more refined, dynamic swap valuation
models that are more accurate, and therefore more efficient, than less
sophisticated or vanilla models, the Commission is modifying the rule
to explicitly permit parties to agree on changes or procedures to
modify their valuation agreements at any time. This change allows
counterparties to determine an efficient means of changing the
agreement for each contract to allow for evolution of valuation
methodologies while maintaining the benefits of agreed-upon valuation
methodologies.
Fourth, in response to commenters' concerns regarding the
protection of proprietary information used in valuation, the Commission
is modifying the rules to make explicit that SDs and MSPs are not
required to disclose to the counterparty confidential, proprietary
information about any model it may use to value a swap. The Commission
believes this clarification will alleviate concerns that proprietary
information would have to be disclosed as a result of the valuation
agreement process.
Finally, the rule has been modified to allow for use of a valuation
dispute resolution process in place of the proposed requirement that
the documentation include alternative methods for determining the value
of a swap in the event of the unavailability or failure of any input
required to value the swap. The Commission believes this change lessens
the negotiation and operational burden on SDs and MSPs.
The Commission believes that the changes outlined above
substantially reduce the burden of the rule on SDs, MSPs, and their
counterparties without sacrificing the benefits of the rule. The rule
will serve to assist SDs and MSPs and their counterparties in arriving
at valuations necessary for margining and internal risk management, and
in resolving valuation disputes in a timely manner, thereby reducing
risk.
G. Summary of Cost and Benefit Considerations: Confirmation, Portfolio
Reconciliation, and Portfolio Compression
In the Confirmation NPRM, the Commission specifically requested
comment on its consideration of costs and benefits. The Commission
received a number of comments in addition to those discussed above.
ISDA commented that registrants will incur substantial initial one-
time costs to develop, test, and implement new procedures and
technology that are required in order to be compliant with the proposed
rules. With regard to confirmation costs, ISDA asserted that market
participants will have to invest in electronic platforms for
confirmation for each asset class in order to meet the expedited
timeframes for confirmation, which may be prohibitively expensive,
particularly for non-SDs and non-MSPs. However, ISDA did not provide
any quantitative data in support of this assertion despite multiple
requests from Commission staff.\129\
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\129\ See cftc.gov for information regarding staff meetings with
ISDA pertaining to these final rules.
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ISDA also argued that given the marked improvement in post-trade
processing, as well as continued industry efforts and commitments to
enhance post-trade processing in a targeted, efficient and safe manner,
it is unclear whether the incremental benefits of the Commission's
proposed standards applicable to all swap confirmations will outweigh
the significant compliance costs that the confirmation requirements
will entail.
To comply with the portfolio reconciliation requirement promptly,
ISDA believes firms that do not currently use an electronic platform or
vendor service will need to expend significant time and resources, and
even those firms that do use electronic platforms or vendor services to
reconcile their portfolios will need to make significant adjustments to
comply with the reconciliation requirement. ISDA believes that initial
compliance
[[Page 55953]]
with the proposed rules will cost each entity approximately $5-10
million and annual portfolio reconciliation expenses for a party with a
large portfolio may rival and perhaps even exceed this upfront cost.
The Working Group requested that the Commission address any
requirement for electronic matching of all or certain types of swaps in
a separate rulemaking that includes a careful study of the potential
costs imposed by such a rule. The Working Group estimated, based on the
$6.00 per trade fee of the ICE eConfirm service, that implementation of
an electronic matching requirement would cost each registrant in excess
of $1,000,000 annually. In addition, The Working Group asserted that
there would be additional opportunity costs associated with no longer
being able to enter into customized transactions.
The Working Group requested that the Commission evaluate the
proposed rules in light of its various recordkeeping and reporting
proposals, as such may cause firms to incur tremendous administrative
obligations to record changes to their swap portfolios, their
accounting records, treasury arrangements and capital allocations, as
well as incurring reporting obligations to SDRs on a swap-by-swap
basis. The Working Group also presented a report prepared by NERA
estimating that compliance with the proposed rules for some entities in
this category would entail annual incremental costs of $1,400,000.\130\
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\130\ NERA, Cost-Benefit Analysis of the CFTC's Proposed Swap
Dealer Definition Prepared for the Working Group of Commercial
Energy Firms, December 20, 2011. In the late-filed comment
supplement, NERA estimates these costs for entities ``engaged in
production, physical distribution or marketing of natural gas,
power, or oil that also engage in active trading of energy
derivatives''--termed ``nonfinancial energy companies'' in the
report. The figure cited includes costs to comply with the proposed
confirmation, portfolio reconciliation, and portfolio compression
requirements and is based on the survey response of only one member
of The Working Group. Elsewhere in the same report, NERA estimates
the costs of compliance with the confirmation requirements alone at
$235,000 for initial set-up and annual operating costs of $307,000.
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The FHLBs cautioned that SD compliance with the proposed rules
could adversely impact end users in a number of ways, including (i) SD
unwillingness to offer swaps important to end user risk management if
the SD cannot comply with the rules in an economic manner; (ii) passing
on of SD compliance costs to end user counterparties, discouraging some
end users from using cost-effective risk management tools and raising
overall system risk; and (iii) introduction of legal uncertainty as to
the enforceability of swaps that fail to meet the confirmation
deadlines of the proposed rules. The FHLBs also argued that certain
swap documentation requires review by legal staff and the short
deadline for confirmation would require pre-execution review by legal
staff, even for swaps that are discussed but never actually executed,
entailing costly and unnecessary legal expenditures.
As discussed in the above sections, the Commission has modified
many aspects of the proposed rules in order to mitigate the burden
placed on market participants as identified by commenters while still
achieving the important policy goals outlined above. The Commission
has:
Provided for a phased implementation plan, providing
longer periods for compliance with the rule for those entities for
which the rules will be most burdensome, with particularly long phasing
of confirmation deadlines; \131\
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\131\ This alternative was suggested by both ISDA and The
Working Group, and the Commission has adopted it for these final
rules.
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Expanded the definition of ``multilateral portfolio
compression exercise'' which increases flexibility of the rule;
Removed the 15 and 30 minute acknowledgement and
confirmation deadlines for swap transactions that are ``processed
electronically'';
Required draft trade acknowledgements only to be delivered
upon request of a counterparty prior to execution;
Adjusted confirmation deadlines for time zone differences
and end of day trading, providing relief from more stringent deadlines;
Provided a safe harbor from confirmation requirements for
swaps executed on a SEF or DCM, or cleared by a DCO;
Clarified which swap transactions require confirmation;
Reduced the frequency of required portfolio reconciliation
with non-SDs and MSPs;
Changed the valuation dispute resolution requirement from
``one business day'' to ``policies and procedures reasonably designed
to ensure that valuation disputes are resolved within five business
days;''
Required portfolio compression with non-SDs and non-MSPs
only upon request of the non-SD or non-MSP counterparty;
Changed the mandatory portfolio compression requirement
among SDs and MSPs to a requirement for policies and procedures for
engaging in regular portfolio compression, where appropriate;
Required fully-offsetting swaps to be terminated in a
timely fashion (rather than within one business day) and only where
appropriate; and
Clarified that the compression rule does not apply to
cleared swaps; compression of cleared swaps will be in accordance with
the rules of the DCO.
Through these changes, the Commission anticipates that many of the
concerns raised by commenters regarding the costs of the rules will be
mitigated.
Confirmation. The Commission anticipates that there will be a
significant adjustment for market participants to move to the faster
timeframes required by the confirmation rules, particularly in those
asset classes where the majority of transactions are manually
confirmed. SDs and MSPs will have to design, compose, and implement
policies and procedures reasonably designed to meet the confirmation
timeframes; SDs and MSPs must also compile and maintain any applicable
records. Participants may invest in electronic platforms for
confirmation for each asset class in order to meet the expedited
timeframes for confirmation. The Commission notes, however, that such
investment is not necessarily required by the rules as market
participants are able to confirm in any manner that meets the rule's
deadline of the first business day after the day of execution (or two-
business day timeframe, for swap transactions with non-financial non-
registrants).
With regard to confirmation, the historical context reveals that
market participants, including all major swap dealers, have been
working on achieving timely confirmation across all asset classes for
the past 5-7 years. Consequently, additional costs related to
confirmation technology for these entities would be minimal for those
SDs and MSPs already achieving timely confirmation of their swap
transactions. In addition, costs will be further minimized through a
significant phase-in period. For example, SDs and MSPs will have up to
two years to achieve compliance with the rules.
Moreover, the Commission has sought to gather additional
information about the costs of confirmation services from both ISDA and
major third party service providers of confirmation services.
Commission staff meetings with third party service providers have
revealed that per trade or event confirmations can cost anywhere from
$3 to $10 per transaction. It should be noted, however, that
confirmation fee schedules can be complex and dependent on a host of
idiosyncratic factors.
[[Page 55954]]
The Commission notes The Working Group's estimate of approximately
$1,000,000 per entity to implement an electronic matching requirement,
but observes that the deletion of the phrase ``processed
electronically'' from the rules should make clear to market
participants that there is no requirement to confirm electronically.
However, this estimate may be useful for individual entities to use as
a reference figure for investment in electronic platforms.\132\
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\132\ The Commission also notes the estimates provided by NERA,
but observes that NERA did not provide sufficient information for
the Commission to determine which portion of such estimates assumed
implementation of an electronic matching requirement. Thus the
Commission could not independently verify the estimates.
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The Commission is unable to provide more specific quantification of
the costs of confirmation given the unique characteristics of the swap
portfolios of SDs, MSPs, and their counterparties, as well as the
parties' discretion in choosing how to comply with the confirmation
timeframe.
As noted above, the Commission does not believe the rules requiring
SDs and MSPs to have policies and procedures to achieve confirmation
with their non-registrant counterparties should pose an unreasonable
burden on end users. The Commission extended the confirmation deadline
for non-financial, non-registrant counterparties to two business days
after execution, lessening the rush to review and approve
acknowledgements and/or confirmations while maintaining a relatively
quick turn-around for these market participants. In addition, the
Commission anticipates that the changed provisions regarding draft
acknowledgements and compression--which give the non-SD or MSP
counterparty the option as opposed to obligation--should ensure that
such entities are protected from unfair practices without overburdening
the operations of these entities.
The benefits associated with quicker confirmation, as noted in
sections III.C and IV.B of this release, include improvement of post-
execution operational and risk management processes, including the
correct calculation of cash flows and discharge of settlement
obligations as well as accurate measurement of counterparty credit
exposure. Timely confirmation also allows any discrepancies,
exceptions, and/or rejections of terms to be identified and resolved
more quickly, lessening the risk of a dispute that could disrupt
orderly market operations. In general, the rules regarding expedited
confirmation should improve the efficient and orderly operations of
bilateral markets through more effective risk management and dispute
resolution. The extended compliance timeframes should allow for a
smooth transition to the new rules as market participants prepare not
only to meet these standards, but others imposed by new regulations
under the Dodd-Frank Act.
Reconciliation. In response to ISDA's concern that the
reconciliation rules would require significant investment in electronic
platforms for reconciliation, especially for those entities with large
portfolios, the Commission reiterates its view that the advent of SDRs
will eventually ease some of those costs by providing a central data
location for most (if not all) the material terms that are required to
be reconciled.
Importantly, the Commission has not determined which processes for
reconciliation are the most appropriate, which means that each market
participant can choose the method for reconciliation that best fits its
own internal structure and cost-benefit analysis, provided such method
comports with the Commission's requirements. In addition, the changes
listed above--including the reduced frequency of reconciliation for
portfolios between SDs or MSPs and their non-SD or non-MSP
counterparties--should ease the burden of reconciling portfolios. While
the Commission has been unable to independently verify the $5-10
million estimate for portfolio reconciliation provided by ISDA, the
Commission expects that the changes herein as well as the increased use
of SDRs will lessen the estimated cost considerably.
In the Confirmation NPRM, the Commission asserted that the costs of
the proposed rules would be minimized by the fact that most SDs and
MSPs reconcile their swap portfolios as part of a prudent operational
processing regime that many, if not most, SDs and MSPs already
undertake as part of their ordinary course of business. In response to
these assertions, at least one commenter agreed that a large number of
SDs and MSPs already regularly reconcile their portfolios with each
other and with other entities and that the increased frequency and
inclusion of smaller portfolios as proposed should prove no obstacle to
such entities.\133\ Consequently, additional costs of the Commission's
final rule would be minimal for those SDs and MSPs already engaged in
regular portfolio reconciliation. In addition, the Commission's
decision to extend the valuation dispute resolution requirement from
one day responds to concerns from market participants about cost.
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\133\ TriOptima letter.
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Given the widespread benefits of portfolio reconciliation,
including increased risk management and fewer disputes to resolve, the
Commission believes its final rules regarding reconciliation are
appropriate notwithstanding the increased costs for some participants.
The Commission recognizes that certain costs will still arise despite
the changes the Commission has made. Such costs include (i) Increased
costs to include all material terms rather than some subset of terms;
(ii) the additional resources to design, compose, and implement the
required policies and procedures; (iii) the additional resources needed
to comply with the dispute resolution timeframes; and (iv) the
compilation and maintenance of applicable records. These costs,
however, are by nature specific to each entity's internal operations;
absent specific cost estimates from commenters (which were not
provided), the Commission cannot accurately provide estimations
regarding the resources needed to comply. As stated above and in the
NPRM, portfolio reconciliation is widely recognized as an effective
means of identifying and resolving disputes regarding terms, valuation,
and collateral. Reconciliation is beneficial not only to the parties
involved but also to the markets as a whole. By identifying and
managing disputed key economic terms or valuation for each transaction
across a portfolio, overall risk can be diminished. Registrants will be
able to identify and correct problems in their post-execution processes
(including confirmation) in order to reduce the number of disputes and
improve the integrity and efficiency of their internal processes.
Expanding the universe of participants subject to reconciliation,
therefore, can help to reduce the risk bilateral markets may pose to
the broader financial system.
Compression. Finally, the Commission believes its final rules
regarding portfolio compression dramatically reduce costs as compared
to the proposed rule; however, the Commission recognizes that costs
will necessarily increase from the current state of the market.
Participants will necessarily have to design, compose, and implement
policies and procedures to regularly evaluate compression opportunities
with their counterparties as well as those opportunities offered by
third parties. However, given the large risk management benefits
available from the regular compression of offsetting trades--benefits
including reduced risk
[[Page 55955]]
and enhanced operational efficiency--the Commission believes the final
rules are appropriate to ensure the fair and orderly operation of
bilateral derivatives markets.
In terms of quantification of the costs of compression, the
Commission notes that in its Confirmation NPRM, it stated that there
are a number of third-party vendors that provide compression, and some
of these providers charge fees based on results achieved (such as
number of swaps compressed). No commenter refuted this statement or
provided alternative information regarding quantification.
H. Section 15(a) Considerations: Confirmation, Portfolio
Reconciliation, and Portfolio Compression
1. Protection of Market Participants and the Public
The final rules relating to confirmation, portfolio reconciliation,
and portfolio compression protect market participants by improving
operational efficiency and mitigating legal risk. In turn, the
reduction of risk in bilateral markets can reduce risk across the
interconnected financial system, protecting the public from costly
market disruptions.
Timely confirmation protects market participants by providing
certainty as to obligations between SDs, MSPs, and their counterparties
while allowing a more efficient processing of disputed terms that may
become apparent during the confirmation process. Disputes regarding
terms and conditions, when left unresolved, can expose market
participants to significant counterparty credit risk. By diminishing
the number of these disputes that occur and by decreasing the length of
time in which they are resolved, the Commission believes these rules
protect participants from such unnecessary risk.
2. Efficiency, Competitiveness, and Financial Integrity of Derivatives
Markets
The final rules improve the efficiency of the market by decreasing
the amount of time trades remain outstanding, improving the processes
by which trades are confirmed, and requiring participants to eliminate
unnecessary trades. Trades that remain unconfirmed for extended periods
of time create inefficient backlogs that inhibit the orderliness of the
market. Proper confirmation, compression, and reconciliation policies
improve transparency in the market and increase efficiency by promoting
the exchange of important market information. Requirements regarding
confirmations and draft acknowledgements, as discussed above, provide
non-financial entities with information necessary for confirming
promptly. In addition, such draft acknowledgements may serve
counterparties insofar as they might compare and assess counterparties,
which should improve competition among SDs and MSPs.
3. Price Discovery
The timeliness of confirmations, as required under these rules,
should ensure that all terms including prices of transactions are
agreed upon quickly and efficiently. This linking of price terms with
all other swap terms should improve the information provided to the
public and regulators through SDRs and other means, thereby improving
the overall price discovery process. Periodic reconciliation and
compression also aid in ensuring that unnecessary and/or offsetting
trades are netted and that, should disputes arise, those disputes are
promptly and effectively resolved. In this way, the pricing information
communicated regarding trades conducted under these rules should be
accurate and timely, improving the price discovery function of
bilateral derivatives markets.
4. Sound Risk Management
As described throughout this release, the rules promulgated herein
are designed to mitigate the risk in bilateral derivatives markets by
ensuring the timely and accurate confirmation of trades, reconciliation
of portfolios, and compression of portfolios. The final rules require
actions, policies, and procedures on the part of SDs and MSPs to
diminish operational risk, legal risk, and counterparty credit risk.
The Commission believes these requirements will encourage sound risk
management on the part of SDs and MSPs; given the systemically
important nature of these entities, sound risk management by SDs and
MSPs should improve the risk management of the financial system as a
whole, lessening the risks associated with a major market crisis.
5. Other Public Interest Considerations
The Commission has not identified other public interest
considerations as a result of these rules.
I. Summary of Cost and Benefit Considerations: Swap Trading
Relationship Documentation
The Commission requested comment on its consideration of costs and
benefits under section 15(a) of the CEA. The Commission received a
number of responsive comments in addition to those discussed above.
The Working Group stated that the Commission should articulate the
public policy benefit of the proposed rule and present analysis that
demonstrates such benefit exceeds the cost imposed on market
participants and the Commission. IECA stated that the proposed
regulations would impose administrative and regulatory costs in excess
of any benefit gained. The Coalition for Derivatives End Users was
concerned that the valuation provision will increase costs without a
proportionate benefit. Markit stated that the proposed rule will make
the process of transaction documentation very expensive and time
consuming, and will lead to extremely technical and verbose swap
documentation, noting that the need to negotiate such terms may impede
effective trading. Markit thus believes the costs outweigh the
benefits, and urges the Commission to impose more realistic
requirements regarding valuation methodologies.
IECA believes the Commission's cost-benefit analysis did not
consider the legal review and management time expense for end users,
which could be significant for small entities. IECA focuses on the
Commission's estimates under the Paperwork Reduction Act, and
challenges the Commission's use of $125 per hour for legal fees. IECA
believes that $500 an hour is more appropriate for legal fees. IECA
also believes that the Commission's estimate of an average of 10 hours
per counterparty to negotiate the new documentation under Sec.
23.504(b) is low, as the time needed must include not only negotiation,
but also time for determining price points and inputs, decision-making
time, and senior management time.
The Working Group believes the Commission's implementation costs
substantially underestimate the potential impact because: (i) Margin
requirements have yet to be proposed and negotiation of credit support
arrangements currently can take months; (ii) market participants are
unlikely to agree to standardized valuation methodologies; (iii) the
Commission does not specifically discuss the potentially substantial
costs associated with the audit requirement under Sec. 23.504(e);
\134\ and (iv) the
[[Page 55956]]
proposed rules would significantly alter the process by which parties
enter into swaps, and such costs have not been considered.
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\134\ The Working Group presented a report prepared by NERA
estimating that compliance with the audit requirements in these and
other proposed rules for some nonfinancial energy companies would
entail annual incremental costs of $224,000. NERA, Cost-Benefit
Analysis of the CFTC's Proposed Swap Dealer Definition Prepared for
the Working Group of Commercial Energy Firms, December 20, 2011. In
the late-filed comment supplement, NERA estimates these costs for
entities ``engaged in production, physical distribution or marketing
of natural gas, power, or oil that also engage in active trading of
energy derivatives''--termed ``nonfinancial energy companies'' in
the report. The figure cited includes costs to maintain a risk
management program, quarterly audits of the program, and annual
audits of swap trading relationship documentation, the first two of
which are required under a separate rulemaking previously adopted by
the Commission.
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As discussed in the above sections, the Commission has modified
many provisions of the final rules in response to comments received and
in order to mitigate the burden imposed on market participants while
accomplishing the goals as laid out in the NPRM. The Commission has:
Provided for a phased implementation plan, providing
longer periods for compliance with the rule for those entities for
which the rules will be most burdensome;
Clarified that the rules will be applicable only to swaps
that are entered into after the rules become effective, and therefore
not requiring retroactive application to existing swaps;
Clarified that the rules do not apply to swaps executed on
a SEF or DCM and cleared by a DCO, subject to certain minimum
requirements;
Imposed no additional requirements regarding documentation
of events of default, termination events, or payment obligations;
Permitted parties to agree on either alternative methods
for determining the value of a swap or a valuation dispute resolution
process;
Reduced recordkeeping requirements under Sec.
23.504(b)(6);
Removed the 5 percent annual documentation audit
requirement in favor of a more general audit standard; and
Modified the swap valuation dispute reporting requirement
to reduce the number of disputes that must be reported to the
Commission, the SEC, and any applicable prudential regulator, and
replaced the one-day reporting requirement with a three-day requirement
for SDs and MSPs.
The Commission believes that these changes will reduce or eliminate
many of the burden concerns raised by commenters.
Still, the Commission anticipates that significant costs will be
incurred as a result of these documentation rules. Although the rules
do not apply retroactively--that is, concerns regarding the need to re-
negotiate already agreed-upon contracts are null--there will be costs
going forward for market participants. Registrants will have to (i)
Negotiate and document all terms of each trading relationship; (ii)
design, compose, and implement policies and procedures reasonably
designed to ensure the execution of swap trading relationship
documentation, including valuation documentation; (iii) obtain
documentation from counterparties who are claiming the end user
exception to clearing; (iv) periodically audit documentation; and (v)
keep records and/or make reports as required under Sec. Sec.
23.504(d)-(e) and 23.505(b).
In its Documentation NPRM, the Commission considered the costs of
its proposal and noted that memorializing the specific terms of the
swap trading relationship and swap transactions between counterparties
is prudent business practice and, in fact, many market participants
already use standardized documentation. Accordingly, it is believed
that many, if not most, SDs and MSPs currently execute and maintain
trading relationship documentation of the type required by proposed
Sec. 23.504 in the ordinary course of their businesses, including
documentation that contains several of the terms that would be required
by the proposed rules. Thus, the hour and dollar burdens associated
with the swap trading relationship documentation requirements may be
limited to amending existing documentation to expressly include any
additional terms required by the proposed rules.
The Commission also explained its belief that, to the extent any
substantial amendments or additions to existing documentation would be
needed, such revisions would likely apply to multiple counterparties,
thereby reducing the per counterparty burden imposed upon SDs and MSPs.
In addition, in its proposal, the Commission anticipated that
standardized swap trading relationship documentation will develop
quickly and progressively within the industry, dramatically reducing
the cost to individual participants.
Indeed, the Commission is aware of industry-led efforts already
underway to bring trading relationship documentation into compliance
with new Dodd-Frank Act requirements.\135\ These types of initiatives
are likely to lower overall costs to market participants.
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\135\ ISDA is partnering with Markit to launch a technology-
based solution enabling counterparties to amend their OTC
derivatives documentation quickly and efficiently to comply with
Dodd-Frank regulatory requirements. See http://www2.isda.org/dodd-frank-documentation-initiative/.
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The Commission further expects the per hour and dollar burdens to
be incurred predominantly in the first year or two after the effective
date of the final regulations. Once an SD or MSP has changed its pre-
existing documentation with each of its counterparties to comply with
the proposed rules, there likely will be little need to further modify
such documentation on an ongoing basis.
In terms of quantification, the Commission recognizes IECA's
comments indicating that the primary costs of the documentation and
valuation rules will be legal costs. In terms of a per hour fee, the
Commission has previously cited Bureau of Labor Statistics findings
that the mean hourly wage of an employee under occupation code 23-1011,
``Lawyers,'' that is employed by the ``Securities and Commodity
Contracts Intermediation and Brokerage Industry'' is $82.22.\136\ The
Commission has adjusted this amount upward to $100 per hour because SDs
and MSPs include large financial institutions whose employees' salaries
may exceed the mean wage provided. To account for the possibility that
the services of outside counsel may be required to satisfy the
requirements associated with negotiating, drafting, and maintaining the
required trading relationship documentation, the Commission used an
average salary of $125 per hour. In response to comments that the
hourly rate should be increased further, the Commission notes that any
determination to use outside counsel is at the discretion of the
registrant. Accordingly, the per-hour estimate for legal costs
associated with these rules is $125-500 per hour. In terms of the
number of hours required to amend documentation, whether the
requirement be ten hours or substantially more, the Commission notes
that industry-wide efforts could reduce this amount significantly.
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\136\ http.www.bls.gov/oes/2099/mayowe23.1011.htm.
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The Commission also notes the NERA report regarding the costs of an
annual audit. Given the alternative audit requirement finalized in
these rules, the Commission expects that the audit costs would be
reduced, perhaps significantly.
In conclusion, the Commission believes the final rules for
documentation of swap trading relationships are appropriate to ensure
the efficient and orderly operation of bilateral derivatives markets
and to
[[Page 55957]]
reduce the legal, operational, counterparty credit, and market risk
that can arise from undocumented terms. The final rules promote an
appropriate level of standardization; while the Commission does not
believe the rules prohibit customized terms, the manner in which they
are documented (i.e. written, pre-arranged terms that must include
certain types of agreements as applicable) will become standardized.
SDs, MSPs, and their counterparties alike will have certainty regarding
what their documentation must include, though the actual terms are
still readily negotiable. The Commission agrees with the Financial
Stability Oversight Board OTC Derivatives Working Group that increased
documentation standardization should improve the market in a number of
ways, including (i) Facilitating automated processing of transactions;
(ii) increasing the fungibility of contracts, which enables greater
market liquidity; (iii) improving valuation and risk management; (iv)
increasing the reliability of price information; (v) reducing the
number of problems in matching trades; and (vi) facilitating reporting
to SDRs.
J. Section 15(a) Considerations: Swap Trading Relationship
Documentation
1. Protection of Market Participants and the Public
The final documentation rules will protect market participants by
ensuring that every trading relationship and every transaction is
properly documented. Full and transparent documentation diminishes the
risk of unfair practices like valuing a swap to advantage one party at
the expense of the other. As such, documentation protects particularly
those parties most susceptible to being taken advantage of, such as
non-financial entities. In addition, the legal and credit certainty
provided by proper documentation provides protection to both sides of a
relationship by ensuring a clear understanding of options and
obligations, particularly in case of dispute or market crisis.
The provisions in the final rules related to valuation also provide
protection to market participants from costly disputes over the
collateralization of a swap; such disputes exacerbated the financial
crisis as proper collateralization for risk management purposes could
not be determined.
2. Efficiency, Competitiveness, and Financial Integrity of Derivatives
Markets
As proper documentation encourages orderly operations and
diminishes risk, the Commission believes the final rules improve the
efficiency of markets. Increased standardization should allow for
increased competition among SDs and MSPs, whose counterparties will be
better able to compare between swap trading relationships to determine
which relationships with which dealers best suit their needs. The
transparency and certainty provided by proper documentation, in
addition to the diminished risk of predatory trading practices, should
improve the integrity of bilateral derivatives markets. Overall, then,
the Commission considers the final rules to have a net positive impact
on the efficiency, competitiveness, and financial integrity of
derivatives markets.
3. Price Discovery
To the extent the final rules improve the process of valuing swap
transactions between counterparties, they should also increase the
reliability of pricing information; this increase in pricing
reliability should improve the price discovery function of bilateral
markets.
4. Sound Risk Management
Proper documentation of trading relationships and transactions is
essential to sound risk management; simply put, if a dealer is unaware
or unsure of agreed-upon terms and policies, it cannot be managing risk
as efficiently as possible. The final rules, because they require full
documentation of all facets of the relationship between counterparties,
mitigate (i) The legal risk inherent in poorly documented or oral
contracts; (ii) the counterparty credit risk that stems from improper
documentation of credit terms and the counterparty credit risk that
could occur based on false or misleading representations by either
counterparty; and (iii) the operational risk that arises when internal
operations personnel and systems do not have full or identical
information regarding a particular transaction or counterparty.
The final valuation rules also provide support for sound risk
management practices because they strive to ensure that two
counterparties are not disputing the value of a transaction where
margin or other cash flows are being exchanged. Limiting the risk that
unresolved disputes can create in the marketplace as a whole--again
considering the role valuation disputes played in the 2008 financial
crisis--should allow systemic risk management as well as improving the
risk management processes of individual market participants.
5. Other Public Interest Considerations
The Commission has not identified other public interest
considerations as a result of these rules.
V. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) \137\ requires that agencies
consider whether the rules they propose will have a significant
economic impact on a substantial number of small entities and, if so,
provide a regulatory flexibility analysis respecting the impact. The
Commission has already established certain definitions of ``small
entities'' to be used in evaluating the impact of its rules on such
small entities in accordance with the RFA.\138\ SDs and MSPs are new
categories of registrant. Accordingly, the Commission noted in the
proposals that it had not previously addressed the question of whether
such persons were, in fact, small entities for purposes of the RFA.
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\137\ 5 U.S.C. 601 et seq.
\138\ 47 FR 18618 (Apr. 30, 1982).
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In this regard, the Commission explained that it previously had
determined that FCMs should not be considered to be small entities for
purposes of the RFA, based, in part, upon FCMs' obligation to meet the
minimum financial requirements established by the Commission to enhance
the protection of customers' segregated funds and protect the financial
condition of FCMs generally. Like FCMs, SDs will be subject to minimum
capital and margin requirements, and are expected to comprise the
largest global financial firms--and the Commission is required to
exempt from designation as an SD entities that engage in a de minimis
level of swaps dealing in connection with transactions with or on
behalf of customers. Accordingly, for purposes of the RFA for the
proposals and future rulemakings, the Commission proposed that SDs not
be considered ``small entities'' for essentially the same reasons that
it had previously determined FCMs not to be small entities.
The Commission further explained that it had also previously
determined that large traders are not ``small entities'' for RFA
purposes, with the Commission considering the size of a trader's
position to be the only appropriate test for the purpose of large
trader reporting. The Commission then noted that MSPs maintain
substantial positions in swaps, creating substantial counterparty
exposure that could have serious adverse effects on the financial
[[Page 55958]]
stability of the United States banking system or financial markets.
Accordingly, for purposes of the RFA for the proposals and future
rulemakings, the Commission proposed that MSPs not be considered
``small entities'' for essentially the same reasons that it previously
had determined large traders not to be small entities.
The Commission concluded its RFA analysis applicable to SDs and
MSPs as follows: ``The Commission is carrying out Congressional
mandates by proposing these rules. The Commission is incorporating
registration of SDs and MSPs into the existing registration structure
applicable to other registrants. In so doing, the Commission has
attempted to accomplish registration of SDs and MSPs in the manner that
is least disruptive to ongoing business and most efficient and
expeditious, consistent with the public interest, and accordingly
believes that these registration rules will not present a significant
economic burden on any entity subject thereto.''
The Commission did not receive any comments on its analysis of the
application of the RFA to SDs and MSPs. Moreover, during the time
period since the rule proposals were published in the Federal Register,
the Commission has issued final rules in which it determined that the
registration and regulation of SDs and MSPs would not have a
significant economic impact on a substantial number of small
entities.\139\ Accordingly, pursuant to Section 605(b) of the RFA, 5
U.S.C. 605(b), the Chairman, on behalf of the Commission, certifies
that these rules will not have a significant economic impact on a
substantial number of small entities.
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\139\ See, e.g., Registration of Swap Dealers and Major Swap
Participants, 77 FR 2613 (Jan. 19, 2012); Swap Dealer and Major Swap
Participant Recordkeeping, Reporting, and Duties Rules; Futures
Commission Merchant and Introducing Broker Conflicts of Interest
Rules; and Chief Compliance Officer Rules for Swap Dealers, Major
Swap Participants, and Futures Commission Merchants, 77 FR 20128
(Apr. 3, 2012).
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B. Paperwork Reduction Act
The Commission may not conduct or sponsor, and a registrant is not
required to respond to, a collection of information unless it displays
a currently valid Office of Management and Budget (OMB) control number.
The Commission's adoption of Sec. Sec. 23.500 through 23.505 (Swap
Confirmation, Portfolio Reconciliation, Portfolio Compression, Swap
Trading Relationship Documentation, and End User Exception
Documentation) imposes new information collection requirements on
registrants within the meaning of the Paperwork Reduction Act.\140\
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\140\ 44 U.S.C. 3501 et seq.
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Accordingly, the Commission requested and OMB assigned control
numbers for the required collections of information. The Commission has
submitted this notice of final rulemaking along with supporting
documentation for OMB's review in accordance with 44 U.S.C. 3507(d) and
5 CFR 1320.11. The title for these collections of information are
``Swap Trading Relationship Documentation Requirements for Swap Dealers
and Major Swap Participants, OMB control number 3038-0088,''
``Confirmation, Portfolio Reconciliation, and Portfolio Compression
Requirements for Swap Dealers and Major Swap Participants, OMB control
number 3038-0068,'' and ``Orderly Liquidation Termination Provision in
Swap Trading Relationship Documentation for Swap Dealers and Major Swap
Participants, OMB control number 3038-0083.'' \141\ Many of the
responses to this new collection of information are mandatory.
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\141\ These collections include certain collections required
under the Business Conduct Standards with Counterparties rulemaking,
as stated in that rulemaking. See Business Conduct Standards for
Swap Dealers and Major Swap Participants with Counterparties, 77 FR
9734 (Feb. 17, 2012).
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The Commission protects proprietary information according to the
Freedom of Information Act and 17 CFR part 145, ``Commission Records
and Information.'' In addition, Section 8(a)(1) of the CEA strictly
prohibits the Commission, unless specifically authorized by the Act,
from making public ``data and information that would separately
disclose the business transactions or market positions of any person
and trade secrets or names of customers.'' The Commission also is
required to protect certain information contained in a government
system of records according to the Privacy Act of 1974, 5 U.S.C. 552a.
The regulations require each respondent to furnish certain
information to the Commission and to maintain certain records. The
Commission invited the public and other Federal agencies to comment on
any aspect of the information collection requirements discussed in the
Documentation NPRM, the Confirmation NPRM, and the Orderly Liquidation
NPRM. Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicited
comments in order to: (i) Evaluate whether the proposed collections of
information were necessary for the proper performance of the functions
of the Commission, including whether the information will have
practical utility; (ii) evaluate the accuracy of the Commission's
estimates of the burden of the proposed collections of information;
(iii) determine whether there are ways to enhance the quality, utility,
and clarity of the information to be collected; and (iv) minimize the
burden of the collections of information on those who are to respond,
including through the use of automated collection techniques or other
forms of information technology.
It is not currently known how many SDs and MSPs will become subject
to these rules, and this will not be known to the Commission until the
registration requirements for these entities become effective. In its
rule proposals, the Commission took ``a conservative approach'' to
calculating the burden hours of this information collection by
estimating that as many as 300 SDs and MSPs would register.\142\ Since
publication of the proposals in late 2010 and early 2011, the
Commission has met with industry participants and trade groups,
discussed extensively the universe of potential registrants with NFA,
and reviewed public information about SDs active in the market and
certain trade groups. Over time, and as the Commission has gathered
more information on the swaps market and its participants, the estimate
of the number of SDs and MSPs has decreased. In its FY 2012 budget
drafted in February 2011, the Commission estimated that 140 SDs might
register with the Commission.\143\ After recently receiving additional
specific information from NFA on the regulatory program it is
developing for SDs and MSPs,\144\ however, the Commission believes that
approximately 125 SDs and MSPs, including only a handful of MSPs, will
register. While the Commission originally estimated there might be
approximately 300 SDs and MSPs, based on new estimates provided by NFA,
the Commission now estimates
[[Page 55959]]
that there will be a combined number of 125 SDs and MSPs that will be
subject to new information collection requirements under these
rules.\145\
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\142\ See 75 FR at 81528; 76 FR at 6713; 76 FR at 6723.
\143\ CFTC, President's Budget and Performance Plan Fiscal Year
2010, p. 13-14 (Feb. 2011), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcbudget2012.pdf. The
estimated 140 SDs includes ``[a]pproximately 80 global and regional
banks currently known to offer swaps in the United States;''
``[a]pproximately 40 non-bank swap dealers currently offering
commodity and other swaps;'' and ``[a]pproximately 20 new potential
market makers that wish to become swap dealers.'' Id.
\144\ Letter from Thomas W. Sexton, Senior Vice President and
General Counsel, NFA to Gary Barnett, Director, Division of Swap
Dealer and Intermediary Oversight, CFTC (Oct. 20, 2011) (NFA Cost
Estimates Letter).
\145\ NFA Letter (Oct. 20, 2011) (estimating that there will be
125 SDs and MSPs required to register with NFA).
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For purposes of the PRA, the term ``burden'' means the ``time,
effort, or financial resources expended by persons to generate,
maintain, or provide information to or for a Federal Agency.''
For most of the provisions set forth in the NPRMs, the Commission
estimated the cost burden of the proposed regulations based upon an
average salary for Financial Managers of $100 per hour. In addition,
for certain provisions in the Documentation NPRM, the Commission
estimated the cost burden of the proposed regulations based upon an
average salary for Lawyers of $125 per hour. In response to these
estimates, The Working Group commented that, inclusive of benefit costs
and allocated overhead, the per-hour average salary estimate for
compliance and risk management personnel should be significantly higher
than $120. FIA and SIFMA stated that some of the compliance policies
required by the proposed regulations will be drafted by both in-house
lawyers and outside counsel, so the blended hourly rate should be
roughly $400.
The Commission notes that its wage estimates were based on recent
Bureau of Labor Statistics findings, including the mean hourly wage of
an employee under occupation code 23-1011, ``Lawyers,'' that is
employed by the ``Securities and Commodity Contracts Intermediation and
Brokerage Industry,'' which is $82.22. The mean hourly wage of an
employee under occupation code 11-3031, ``Financial Managers,'' (which
includes operations managers) in the same industry is $74.41.\146\
Taking these data, the Commission then increased its hourly wage
estimates in recognition of the fact that some registrants may be large
financial institutions whose employees' salaries may exceed the mean
wage. The Commission also observes that SIFMA's ``Report on Management
& Professional Earnings in the Securities Industry--2010'' estimates
the average wage of a compliance attorney and a compliance staffer in
the U.S. at only $46.31 per hour.
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\146\ See http://www.bls.gov/oes/2099/mayowe23.1011.htm and
http://www.bls.gov/oes/current/oes113031.htm.
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The Commission recognizes that some registrants may hire outside
counsel with expertise in the various regulatory areas covered by the
regulations discussed herein. While the Commission is uncertain about
the billing rates that registrants may pay for outside counsel, the
Commission believes that such counsel may bill at a rate of several
hundred dollars per hour. Outside counsel may be able to leverage its
expertise to reduce substantially the number of hours needed to fulfill
a requested assignment, but a registrant that uses outside counsel may
incur higher costs than a registrant that does not use outside counsel.
Any determination to use outside counsel is at the discretion of the
registrant. Having considered the comments received and having reviewed
the available data, the Commission has determined that $100 per hour
for Financial Managers, and $125 for Lawyers, remain reasonable
estimates of the per-hour average salary for purposes of its PRA
analysis. The Commission also notes that this determination is
consistent with the Commission's estimate for the hourly wage for CCOs
under the recently adopted final rules establishing certain internal
business conduct standards for SDs and MSPs.\147\
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\147\ See Swap Dealer and Major Swap Participant Recordkeeping,
Reporting, and Duties Rules; Futures Commission Merchant and
Introducing Broker Conflicts of Interest Rules; and Chief Compliance
Officer Rules for Swap Dealers, Major Swap Participants, and Futures
Commission Merchants, 77 FR 20128, 20196 (Apr. 3, 2012).
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The Commission received comments related to the PRA in response to
its notices of proposed rulemaking. Notably, none of these commenters
suggested specific revised calculations with regard to the Commission's
burden estimate.
IECA commented that if all confirmations must be in writing, the
additional employee time cost for each market participant would be
substantial and is not included in the annual cost analysis. IECA also
commented that the estimate of 10 hours per counterparty to negotiate
new documentation is too low. Because the rule requires transaction-by-
transaction valuation methodologies that will need to be newly
negotiated for many transactions, IECA believes the Commission should
calculate an aggregate amount based on the number of transactions.
Also, the time needed must include not only negotiation, but also time
for determining pricing points and inputs, executive decision-maker
time, and also senior management and board time for reviewing forms and
material modifications. Time will also be needed to reevaluate the ISDA
documentation if the Commission does not state that such are
acceptable.
The Working Group requested that the Commission evaluate the
proposed rules in light of its various recordkeeping and reporting
proposals, as such may cause firms to incur tremendous administrative
obligations to record changes to its swap portfolio, its accounting
records, treasury arrangements and capital allocations (including loss
of cash flow hedging treatment under hedge accounting rules), as well
as incurring reporting obligations to swap data repositories on a swap-
by-swap basis.
The Commission has considered the comments received concerning the
PRA-related burden estimates set forth in the notices of proposed
rulemaking. However, because none of the commenters suggested specific
revised calculations on the estimates, the only change that the
Commission is making to its estimation of annual burdens associated
with the rules is the change to reflect the new estimate of the number
of SDs and MSPs.
With respect to the rules proposed in the Documentation NPRM, the
Commission now estimates the initial burden to be 6,168 hours per year,
at an initial annual cost of $684,300, for each SD and MSP, and the
initial aggregate burden cost for all registrants is $85,537,500.\148\
With respect to the rules proposed in the Confirmation NPRM, the
Commission now estimates the burden to be 1,282.5 hours, at an annual
cost of $128,250 for each SD and MSP, and the aggregate burden cost for
all registrants is 160,312.5 burden hours and $16,031,250. With respect
to the rules set forth in the Orderly Liquidation NPRM, the Commission
now estimates the initial burden to be 270 hours per year, at an
initial annual cost of $27,000 for each SD and MSP, and the initial
aggregate burden cost for all registrants is 33,750 burden hours and
$3,375,000.\149\
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\148\ As noted in the Documentation NPRM, the Commission has
characterized the annual costs as initial annual costs, since the
Commission anticipates that the cost burdens will be reduced
dramatically over time as the agreements and other records required
by the proposed regulations become increasingly standardized within
the industry. 76 FR at 6722.
\149\ See id. (discussing the characterization of the annual
costs as initial annual costs). The Commission notes that the
substantive requirements under the Orderly Liquidation rule have
been reduced significantly. While the proposal required the parties
to negotiate and agree on documentation provisions, the final rules
requires only a simple notice. The Commission has elected not to
alter its PRA burden estimate, but observes that such estimates are
likely to overstate the actual burden significantly.
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In total, the Commission estimates that the rules set forth in this
Adopting Release will impose a burden of 7,720.5 hours per year, at an
initial annual cost of $839,550, for each SD and MSP, and
[[Page 55960]]
the aggregate burden cost for all registrants is $104,943,750.
In addition to the burden hours discussed above, the Commission
anticipates that SDs and MSPs may incur certain start-up costs in
connection with the proposed recordkeeping obligations. Such costs
would include the expenditures related to developing and installing new
technology and systems, or reprogramming or updating existing
recordkeeping technology and systems, to enable the SD or MSP to
collect, capture, process, maintain, and re-produce any newly required
records. The Commission received no comments with respect to the
estimated number of burden hours for these start-up costs, or with
respect to the programming wage estimate of $60 per hour. Accordingly,
the Commission estimates that the start-up costs would require 40
burden hours for the rules proposed in the Documentation NPRM and 40
hours for the rules proposed in the Confirmation NPRM.\150\ Thus, the
estimated start-up burden associated with the required technological
improvements would be $4,800 [$60 x 80 hours per affected registrant]
or $600,000 in the aggregate.\151\
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\150\ The Commission does not anticipate that SDs and MSPs will
incur any start-up costs in connection with the proposed
recordkeeping obligations in the rules proposed in the Orderly
Liquidation NPRM, other than those previously noted and accounted
for in the Documentation NPRM and Confirmation NPRM.
\151\ According to recent Bureau of Labor Statistics findings,
the mean hourly wages of computer programmers under occupation code
15-1021 and computer software engineers under program codes 15-1031
and 1032 are between $34.10 and $44.94. See http://www.bls.gov/oes/current/oes113031.htm. Because SDs and MSPs generally will be large
entities that may engage employees with wages above the mean, the
Commission has conservatively chosen to use a mean hourly
programming wage of $60 per hour.
---------------------------------------------------------------------------
List of Subjects in 17 CFR Part 23
Antitrust, Commodity futures, Conduct standards, Conflict of
Interests, Major swap participants, Reporting and recordkeeping, Swap
dealers, Swaps.
For the reasons stated in this release, the Commission amends 17
CFR part 23 as follows:
PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS
0
1. The authority citation for part 23 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6b-1, 6c, 6p, 6r, 6s, 6t,
9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21.
0
2. Subpart I (consisting of Sec. Sec. 23.500, 23.501, 23.502, 23.503,
23.504, and 23.505) is added to read as follows:
Subpart I--Swap Documentation
Sec.
23.500 Definitions.
23.501 Swap confirmation.
23.502 Portfolio reconciliation.
23.503 Portfolio compression.
23.504 Swap trading relationship documentation.
23.505 End user exception documentation.
Subpart I--Swap Documentation
Sec. 23.500 Definitions.
For purposes of this subpart I, the following terms shall be
defined as provided.
(a) Acknowledgment means a written or electronic record of all of
the terms of a swap signed and sent by one counterparty to the other.
(b) Bilateral portfolio compression exercise means an exercise in
which two swap counterparties wholly terminate or change the notional
value of some or all of the swaps submitted by the counterparties for
inclusion in the portfolio compression exercise and, depending on the
methodology employed, replace the terminated swaps with other swaps
whose combined notional value (or some other measure of risk) is less
than the combined notional value (or some other measure of risk) of the
terminated swaps in the exercise.
(c) Confirmation means the consummation (electronically or
otherwise) of legally binding documentation (electronic or otherwise)
that memorializes the agreement of the counterparties to all of the
terms of a swap transaction. A confirmation must be in writing (whether
electronic or otherwise) and must legally supersede any previous
agreement (electronically or otherwise). A confirmation is created when
an acknowledgment is manually, electronically, or by some other legally
equivalent means, signed by the receiving counterparty.
(d) Execution means, with respect to a swap transaction, an
agreement by the counterparties (whether orally, in writing,
electronically, or otherwise) to the terms of the swap transaction that
legally binds the counterparties to such terms under applicable law.
(e) Financial entity means a counterparty that is not a swap dealer
or a major swap participant and that is one of the following:
(1) A commodity pool as defined in Section 1a(5) of the Act;
(2) A private fund as defined in Section 202(a) of the Investment
Advisors Act of 1940;
(3) An employee benefit plan as defined in paragraphs (3) and (32)
of section 3 of the Employee Retirement Income and Security Act of
1974;
(4) A person predominantly engaged in activities that are in the
business of banking, or in activities that are financial in nature as
defined in Section 4(k) of the Bank Holding Company Act of 1956; and
(5) A security-based swap dealer or a major security-based swap
participant.
(f) Fully offsetting swaps means swaps of equivalent terms where no
net cash flow would be owed to either counterparty after the offset of
payment obligations thereunder.
(g) Material terms means all terms of a swap required to be
reported in accordance with part 45 of this chapter.
(h) Multilateral portfolio compression exercise means an exercise
in which multiple swap counterparties wholly terminate or change the
notional value of some or all of the swaps submitted by the
counterparties for inclusion in the portfolio compression exercise and,
depending on the methodology employed, replace the terminated swaps
with other swaps whose combined notional value (or some other measure
of risk) is less than the combined notional value (or some other
measure of risk) of the terminated swaps in the compression exercise.
(i) Portfolio reconciliation means any process by which the two
parties to one or more swaps:
(1) Exchange the terms of all swaps in the swap portfolio between
the counterparties;
(2) Exchange each counterparty's valuation of each swap in the swap
portfolio between the counterparties as of the close of business on the
immediately preceding business day; and
(3) Resolve any discrepancy in material terms and valuations.
(j) Prudential regulator has the meaning given to the term in
section 1a(39) of the Commodity Exchange Act and includes the Board of
Governors of the Federal Reserve System, the Office of the Comptroller
of the Currency, the Federal Deposit Insurance Corporation, the Farm
Credit Association, and the Federal Housing Finance Agency, as
applicable to the swap dealer or major swap participant.
(k) Swap portfolio means all swaps currently in effect between a
particular swap dealer or major swap participant and a particular
counterparty.
(l) Swap transaction means any event that results in a new swap or
in a change to the terms of a swap, including execution, termination,
assignment, novation, exchange, transfer, amendment, conveyance, or
extinguishing of rights or obligations of a swap.
[[Page 55961]]
(m) Valuation means the current market value or net present value
of a swap.
Sec. 23.501 Swap confirmation.
(a) Confirmation. Subject to the compliance schedule in paragraph
(c) of this section:
(1) Each swap dealer and major swap participant entering into a
swap transaction with a counterparty that is a swap dealer or major
swap participant shall execute a confirmation for the swap transaction
as soon as technologically practicable, but in any event by the end of
first business day following the day of execution.
(2) Each swap dealer and major swap participant entering into a
swap transaction with a counterparty that is not a swap dealer or a
major swap participant shall send an acknowledgment of such swap
transaction as soon as technologically practicable, but in any event by
the end of the first business day following the day of execution.
(3) (i) Each swap dealer and major swap participant shall
establish, maintain, and follow written policies and procedures
reasonably designed to ensure that it executes a confirmation for each
swap transaction that it enters into with a counterparty that is a
financial entity as soon as technologically practicable, but in any
event by the end of the first business day following the day of
execution.
(ii) Each swap dealer and major swap participant shall establish,
maintain, and follow written policies and procedures reasonably
designed to ensure that it executes a confirmation for each swap
transaction that it enters into with a counterparty that is not a swap
dealer, major swap participant, or a financial entity not later than
the end of the second business day following the day of execution.
(iii) Such procedures shall include a requirement that, upon a
request by a prospective counterparty prior to execution of any such
swap, the swap dealer or major swap participant furnish to the
prospective counterparty prior to execution a draft acknowledgment
specifying all terms of the swap transaction other than the applicable
pricing and other relevant terms that are to be expressly agreed at
execution.
(4) Swaps executed on a swap execution facility, designated
contract market, or submitted for clearing by a derivatives clearing
organization.
(i) Any swap transaction executed on a swap execution facility or
designated contract market shall be deemed to satisfy the requirements
of this section, provided that the rules of the swap execution facility
or designated contract market establish that confirmation of all terms
of the transaction shall take place at the same time as execution.
(ii) Any swap transaction submitted for clearing by a derivatives
clearing organization shall be deemed to satisfy the requirements of
this section, provided that:
(A) The swap transaction is submitted for clearing as soon as
technologically practicable, but in any event no later than the times
established for confirmation under paragraphs (a)(1) or (3) of this
section, and
(B) Confirmation of all terms of the transaction takes place at the
same time as the swap transaction is accepted for clearing pursuant to
the rules of the derivatives clearing organization.
(iii) If a swap dealer or major swap participant receives notice
that a swap transaction has not been confirmed by a swap execution
facility or a designated contract market, or accepted for clearing by a
derivatives clearing organization, the swap dealer or major swap
participant shall execute a confirmation for such swap transaction as
soon as technologically practicable, but in any event no later than the
times established for confirmation under paragraphs (a)(1) or (3) of
this section as if such swap transaction were executed at the time the
swap dealer or major swap participant receives such notice.
(5) For purposes of this section:
(i) ``Day of execution'' means the calendar day of the party to the
swap transaction that ends latest, provided that if a swap transaction
is--
(A) Entered into after 4:00 p.m. in the place of a party; or
(B) Entered into on a day that is not a business day in the place
of a party, then such swap transaction shall be deemed to have been
entered into by that party on the immediately succeeding business day
of that party, and the day of execution shall be determined with
reference to such business day; and
(ii) ``Business day'' means any day other than a Saturday, Sunday,
or legal holiday.
(b) Recordkeeping. (1) Each swap dealer and major swap participant
shall make and retain a record of:
(i) The date and time of transmission to, or receipt from, a
counterparty of any acknowledgment; and
(ii) The date and time of transmission to, or receipt from, a
counterparty of any confirmation.
(2) All records required to be maintained pursuant to this section
shall be maintained in accordance with Sec. 23.203 and shall be made
available promptly upon request to any representative of the Commission
or any applicable prudential regulator, or with regard to swaps defined
in section 1a(47)(A)(v), to any representative of the Commission, the
Securities and Exchange Commission, or any applicable prudential
regulator.
(c) Compliance schedule. The requirements of paragraph (a) of this
section are subject to the following compliance schedule:
(1) For purposes of paragraph (a)(1) of this section, each swap
dealer and major swap participant entering into a swap transaction that
is or involves a credit swap or interest rate swap with a counterparty
that is a swap dealer or major swap participant shall execute a
confirmation for the swap transaction as soon as technologically
practicable, but in any event by:
(i) The end of the second business day following the day of
execution for the period from the effective date of this section to
February 28, 2014; and
(ii) The end of the first business day following the day of
execution from and after March 1, 2014.
(2) For purposes of paragraph (a)(1) of this section, each swap
dealer and major swap participant entering into a swap transaction that
is or involves an equity swap, foreign exchange swap, or other
commodity swap with a counterparty that is a swap dealer or major swap
participant shall execute a confirmation for the swap transaction as
soon as technologically practicable, but in any event by:
(i) The end of the third business day following the day of
execution for the period from the effective date of this section to
August 31, 2013;
(ii) The end of the second business day following the day of
execution for the period from September 1, 2013 to August 31, 2014; and
(iii) The end of the first business day following the day of
execution from and after September 1, 2014.
(3) For purposes of paragraph (a)(2) of this section, each swap
dealer and major swap participant entering into a swap transaction that
is or involves a credit swap or interest rate swap with a counterparty
that is not a swap dealer or a major swap participant shall send an
acknowledgment of such swap transaction as soon as technologically
practicable, but in any event by:
(i) The end of the second business day following the day of
execution for the period from the effective date of this section to
February 28, 2014; and
(ii) The end of the first business day following the day of
execution from and after March 1, 2014.
(4) For purposes of paragraph (a)(2) of this section, each swap
dealer and major
[[Page 55962]]
swap participant entering into a swap transaction that is or involves
an equity swap, foreign exchange swap, or other commodity swap with a
counterparty that is not a swap dealer or a major swap participant
shall send an acknowledgment of such swap transaction as soon as
technologically practicable, but in any event by:
(i) The end of the third business day following the day of
execution for the period from the effective date of this section to
August 31, 2013;
(ii) The end of the second business day following the day of
execution for the period from September 1, 2013 to August 31, 2014; and
(iii) The end of the first business day following the day of
execution from and after September 1, 2014.
(5) For purposes of paragraph (a)(3)(i) of this section, each swap
dealer and major swap participant shall establish, maintain, and follow
written policies and procedures reasonably designed to ensure that it
executes a confirmation for each swap transaction that is or involves a
credit swap or interest rate swap that it enters into with a
counterparty that is a financial entity as soon as technologically
practicable, but in any event by:
(i) The end of the second business day following the day of
execution for the period from the effective date of this section to
February 28, 2014; and
(ii) The end of the first business day following the day of
execution from and after March 1, 2014.
(6) For purposes of paragraph (a)(3)(i) of this section, each swap
dealer and major swap participant shall establish, maintain, and follow
written policies and procedures reasonably designed to ensure that it
executes a confirmation for each swap transaction that is or involves
an equity swap, foreign exchange swap, or other commodity swap that it
enters into with a counterparty that is a financial entity as soon as
technologically practicable, but in any event by:
(i) The end of the third business day following the day of
execution for the period from the effective date of this section to
August 31, 2013;
(ii) The end of the second business day following the day of
execution for the period from September 1, 2013 to August 31, 2014; and
(iii) The end of the first business day following the day of
execution from and after September 1, 2014.
(7) For purposes of paragraph (a)(3)(ii) of this section, each swap
dealer and major swap participant shall establish, maintain, and follow
written policies and procedures reasonably designed to ensure that it
executes a confirmation for each swap transaction that is or involves a
credit swap or interest rate swap that it enters into with a
counterparty that is not a swap dealer, major swap participant, or a
financial entity not later than:
(i) The end of the fifth business day following the day of
execution for the period from the effective date of this section to
August 31, 2013;
(ii) The end of the third business day following the day of
execution for the period from September 1, 2013 to August 31, 2014; and
(iii) The end of the second business day following the day of
execution from and after September 1, 2014.
(8) For purposes of paragraph (a)(3)(ii) of this section, each swap
dealer and major swap participant shall establish, maintain, and follow
written policies and procedures reasonably designed to ensure that it
executes a confirmation for each swap transaction that is or involves
an equity swap, foreign exchange swap, or other commodity swap that it
enters into with a counterparty that is not a swap dealer, major swap
participant, or a financial entity not later than:
(i) The end of the seventh business day following the day of
execution for the period from the effective date of this section to
August 31, 2013;
(ii) The end of the fourth business day following the day of
execution for the period from September 1, 2013 to August 31, 2014; and
(iii) The end of the second business following the day of execution
from and after September 1, 2014.
(9) For purposes of paragraph (c) of this section:
(i) ``Credit swap'' means any swap that is primarily based on
instruments of indebtedness, including, without limitation: Any swap
primarily based on one or more broad-based indices related to
instruments of indebtedness; and any swap that is an index credit swap
or total return swap on one or more indices of debt instruments;
(ii) ``Equity swap'' means any swap that is primarily based on
equity securities, including, without limitation: Any swap primarily
based on one or more broad-based indices of equity securities; and any
total return swap on one or more equity indices;
(iii) ``Foreign exchange swap'' has the meaning set forth in
section 1a(25) of the CEA. It does not include swaps primarily based on
rates of exchange between different currencies, changes in such rates,
or other aspects of such rates (sometimes known as ``cross-currency
swaps'');
(iv) ``Interest rate swap'' means any swap which is primarily based
on one or more interest rates, such as swaps of payments determined by
fixed and floating interest rates; or any swap which is primarily based
on rates of exchange between different currencies, changes in such
rates, or other aspects of such rates (sometimes known as ``cross-
currency swaps''); and
(v) ``Other commodity swap'' means any swap not included in the
credit, equity, foreign exchange, or interest rate asset classes,
including, without limitation, any swap for which the primary
underlying item is a physical commodity or the price or any other
aspect of a physical commodity.
Sec. 23.502 Portfolio reconciliation.
(a) Swaps with swap dealers or major swap participants. Each swap
dealer and major swap participant shall engage in portfolio
reconciliation as follows for all swaps in which its counterparty is
also a swap dealer or major swap participant.
(1) Each swap dealer or major swap participant shall agree in
writing with each of its counterparties on the terms of the portfolio
reconciliation.
(2) The portfolio reconciliation may be performed on a bilateral
basis by the counterparties or by a qualified third party.
(3) The portfolio reconciliation shall be performed no less
frequently than:
(i) Once each business day for each swap portfolio that includes
500 or more swaps;
(ii) Once each week for each swap portfolio that includes more than
50 but fewer than 500 swaps on any business day during any week; and
(iii) Once each calendar quarter for each swap portfolio that
includes no more than 50 swaps at any time during the calendar quarter.
(4) Each swap dealer and major swap participant shall resolve
immediately any discrepancy in a material term of a swap identified as
part of a portfolio reconciliation or otherwise.
(5) Each swap dealer and major swap participant shall establish,
maintain, and follow written policies and procedures reasonably
designed to resolve any discrepancy in a valuation identified as part
of a portfolio reconciliation or otherwise as soon as possible, but in
any event within five business days, provided that the swap dealer and
major swap participant establishes, maintains, and follows written
policies and procedures reasonably designed to identify how the swap
dealer or major swap participant will comply with any variation margin
requirements under section 4s(e) of the Act and regulations under this
part pending resolution of the discrepancy in
[[Page 55963]]
valuation. A difference between the lower valuation and the higher
valuation of less than 10 percent of the higher valuation need not be
deemed a discrepancy.
(b) Swaps with entities other than swap dealers or major swap
participants. Each swap dealer and major swap participant shall
establish, maintain, and follow written policies and procedures
reasonably designed to ensure that it engages in portfolio
reconciliation as follows for all swaps in which its counterparty is
neither a swap dealer nor a major swap participant.
(1) Each swap dealer or major swap participant shall agree in
writing with each of its counterparties on the terms of the portfolio
reconciliation, including agreement on the selection of any third-party
service provider.
(2) The portfolio reconciliation may be performed on a bilateral
basis by the counterparties or by one or more third parties selected by
the counterparties in accordance with paragraph (b)(1) of this section.
(3) The required policies and procedures shall provide that
portfolio reconciliation will be performed no less frequently than:
(i) Once each calendar quarter for each swap portfolio that
includes more than 100 swaps at any time during the calendar quarter;
and
(ii) Once annually for each swap portfolio that includes no more
than 100 swaps at any time during the calendar year.
(4) Each swap dealer or major swap participant shall establish,
maintain, and follow written procedures reasonably designed to resolve
any discrepancies in the material terms or valuation of each swap
identified as part of a portfolio reconciliation or otherwise with a
counterparty that is neither a swap dealer nor major swap participant
in a timely fashion. A difference between the lower valuation and the
higher valuation of less than 10 percent of the higher valuation need
not be deemed a discrepancy.
(c) Reporting. Each swap dealer and major swap participant shall
promptly notify the Commission and any applicable prudential regulator,
or with regard to swaps defined in section 1a(47)(A)(v) of the Act, the
Commission, the Securities and Exchange Commission, and any applicable
prudential regulator, of any swap valuation dispute in excess of
$20,000,000 (or its equivalent in any other currency) if not resolved
within:
(1) Three (3) business days, if the dispute is with a counterparty
that is a swap dealer or major swap participant; or
(2) Five (5) business days, if the dispute is with a counterparty
that is not a swap dealer or major swap participant.
(d) Reconciliation of cleared swaps. Nothing in this section shall
apply to a swap that is cleared by a derivatives clearing organization.
(e) Recordkeeping. A record of each swap portfolio reconciliation
consistent with Sec. 23.202(a)(3)(iii) shall be maintained in
accordance with Sec. 23.203.
Sec. 23.503 Portfolio compression.
(a) Portfolio compression with swap dealers and major swap
participants.
(1) Bilateral offset. Each swap dealer and major swap participant
shall establish, maintain, and follow written policies and procedures
for terminating each fully offsetting swap between a swap dealer or
major swap participant and another swap dealer or major swap
participant in a timely fashion, when appropriate.
(2) Bilateral compression. Each swap dealer and major swap
participant shall establish, maintain, and follow written policies and
procedures for periodically engaging in bilateral portfolio compression
exercises, when appropriate, with each counterparty that is also a swap
dealer or major swap participant.
(3) Multilateral compression. Each swap dealer and major swap
participant shall establish, maintain, and follow written policies and
procedures for periodically engaging in multilateral portfolio
compression exercises, when appropriate, with each counterparty that is
also a swap dealer or major swap participant. Such policies and
procedures shall include:
(i) Policies and procedures for participation in all multilateral
portfolio compression exercises required by Commission regulation or
order; and
(ii) Evaluation of multilateral portfolio compression exercises
that are initiated, offered, or sponsored by any third party.
(b) Portfolio compression with counterparties other than swap
dealers and major swap participants. Each swap dealer and major swap
participant shall establish, maintain, and follow written policies and
procedures for periodically terminating fully offsetting swaps and for
engaging in portfolio compression exercises with respect to swaps in
which its counterparty is an entity other than a swap dealer or major
swap participant, to the extent requested by any such counterparty.
(c) Portfolio compression of cleared swaps. Nothing in this section
shall apply to a swap that is cleared by a derivatives clearing
organization.
(d) Recordkeeping. (1) Each swap dealer and major swap participant
shall make and maintain a complete and accurate record of each
bilateral offset and each bilateral or multilateral portfolio
compression exercise in which it participates.
(2) All records required to be maintained pursuant to this section
shall be maintained in accordance with Sec. 23.203 and shall be made
available promptly upon request to any representative of the Commission
or any applicable prudential regulator, or with regard to swaps defined
in section 1a(47)(A)(v) of the Act, to any representative of the
Commission, the Securities and Exchange Commission, or any applicable
prudential regulator.
Sec. 23.504 Swap trading relationship documentation.
(a) (1) Applicability. The requirements of this section shall not
apply to:
(i) Swaps executed prior to the date on which a swap dealer or
major swap participant is required to be in compliance with this
section;
(ii) Swaps executed on a board of trade designated as a contract
market under section 5 of the Act or to swaps executed anonymously on a
swap execution facility under section 5h of the Act, provided that such
swaps are cleared by a derivatives clearing organization and all terms
of the swaps conform to the rules of the derivatives clearing
organization and Sec. 39.12(b)(6) of this chapter; and
(iii) Swaps cleared by a derivatives clearing organization.
(2) Policies and procedures. Each swap dealer and major swap
participant shall establish, maintain, and follow written policies and
procedures reasonably designed to ensure that the swap dealer or major
swap participant executes written swap trading relationship
documentation with its counterparty that complies with the requirements
of this section. The policies and procedures shall be approved in
writing by senior management of the swap dealer and major swap
participant, and a record of the approval shall be retained. Other than
confirmations of swap transactions under Sec. 23.501, the swap trading
relationship documentation shall be executed prior to or
contemporaneously with entering into a swap transaction with any
counterparty.
(b) Swap trading relationship documentation. (1) The swap trading
relationship documentation shall be in writing and shall include all
terms governing the trading relationship between the swap dealer or
major swap participant and its counterparty,
[[Page 55964]]
including, without limitation, terms addressing payment obligations,
netting of payments, events of default or other termination events,
calculation and netting of obligations upon termination, transfer of
rights and obligations, governing law, valuation, and dispute
resolution.
(2) The swap trading relationship documentation shall include all
confirmations of swap transactions under Sec. 23.501.
(3) The swap trading relationship documentation shall include
credit support arrangements, which shall contain, in accordance with
applicable requirements under Commission regulations or regulations
adopted by prudential regulators and without limitation, the following:
(i) Initial and variation margin requirements, if any;
(ii) Types of assets that may be used as margin and asset valuation
haircuts, if any;
(iii) Investment and rehypothecation terms for assets used as
margin for uncleared swaps, if any; and
(iv) Custodial arrangements for margin assets, including whether
margin assets are to be segregated with an independent third party, in
accordance with Sec. 23.701(e), if any.
(4) (i) The swap trading relationship documentation between swap
dealers, between major swap participants, between a swap dealer and
major swap participant, between a swap dealer or major swap participant
and a financial entity, and, if requested by any other counterparty,
between a swap dealer or major swap participant and such counterparty,
shall include written documentation in which the parties agree on the
process, which may include any agreed upon methods, procedures, rules,
and inputs, for determining the value of each swap at any time from
execution to the termination, maturity, or expiration of such swap for
the purposes of complying with the margin requirements under section
4s(e) of the Act and regulations under this part, and the risk
management requirements under section 4s(j) of the Act and regulations
under this part. To the maximum extent practicable, the valuation of
each swap shall be based on recently-executed transactions, valuations
provided by independent third parties, or other objective criteria.
(ii) Such documentation shall include either:
(A) Alternative methods for determining the value of the swap for
the purposes of complying with this paragraph in the event of the
unavailability or other failure of any input required to value the swap
for such purposes; or
(B) A valuation dispute resolution process by which the value of
the swap shall be determined for the purposes of complying with this
paragraph (b)(4).
(iii) A swap dealer or major swap participant is not required to
disclose to the counterparty confidential, proprietary information
about any model it may use to value a swap.
(iv) The parties may agree on changes or procedures for modifying
or amending the documentation required by this paragraph at any time.
(5) The swap trading relationship documentation of a swap dealer or
major swap participant shall include the following:
(i) A statement of whether the swap dealer or major swap
participant is an insured depository institution (as defined in 12
U.S.C. 1813) or a financial company (as defined in section 201(a)(11)
of the Dodd-Frank Act, 12 U.S.C. 5381(a)(11));
(ii) A statement of whether the counterparty is an insured
depository institution or financial company;
(iii) A statement that in the event either the swap dealer or major
swap participant or its counterparty is a covered financial company (as
defined in section 201(a)(8) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, 12 U.S.C. 5381(a)(8)) or an insured depository
institution for which the Federal Deposit Insurance Corporation (FDIC)
has been appointed as a receiver (the ``covered party''), certain
limitations under Title II of the Dodd-Frank Act or the Federal Deposit
Insurance Act may apply to the right of the non-covered party to
terminate, liquidate, or net any swap by reason of the appointment of
the FDIC as receiver, notwithstanding the agreement of the parties in
the swap trading relationship documentation, and that the FDIC may have
certain rights to transfer swaps of the covered party under section
210(c)(9)(A) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act, 12 U.S.C. 5390(c)(9)(A), or 12 U.S.C. 1821(e)(9)(A);
and
(iv) An agreement between the swap dealer or major swap participant
and its counterparty to provide notice if either it or its counterparty
becomes or ceases to be an insured depository institution or a
financial company.
(6) The swap trading relationship documentation of each swap dealer
and major swap participant shall contain a notice that, upon acceptance
of a swap by a derivatives clearing organization:
(i) The original swap is extinguished;
(ii) The original swap is replaced by equal and opposite swaps with
the derivatives clearing organization; and
(iii) All terms of the swap shall conform to the product
specifications of the cleared swap established under the derivatives
clearing organization's rules.
(c) Audit of swap trading relationship documentation. Each swap
dealer and major swap participant shall have an independent internal or
external auditor conduct periodic audits sufficient to identify any
material weakness in its documentation policies and procedures required
by this section and Commission regulations. A record of the results of
each audit shall be retained.
(d) Recordkeeping. Each swap dealer and major swap participant
shall maintain all documents required to be created pursuant to this
section in accordance with Sec. 23.203 and shall make them available
promptly upon request to any representative of the Commission or any
applicable prudential regulator, or with regard to swaps defined in
section 1a(47)(A)(v) of the Act, to any representative of the
Commission, the Securities and Exchange Commission, or any applicable
prudential regulator.
Sec. 23.505 End user exception documentation.
(a) For swaps excepted from a mandatory clearing requirement. Each
swap dealer and major swap participant shall obtain documentation
sufficient to provide a reasonable basis on which to believe that its
counterparty meets the statutory conditions required for an exception
from a mandatory clearing requirement, as defined in section 2h(7) of
the Act and Sec. 39.6 of this chapter. Such documentation shall
include:
(1) The identity of the counterparty;
(2) That the counterparty has elected not to clear a particular
swap under section 2h(7) of the Act and Sec. 39.6 of this chapter;
(3) That the counterparty is a non-financial entity, as defined in
section 2h(7)(C) of the Act;
(4) That the counterparty is hedging or mitigating a commercial
risk; and
(5) That the counterparty generally meets its financial obligations
associated with non-cleared swaps. Provided, that a swap dealer or
major swap participant need not obtain documentation of paragraphs
(a)(3), (4), or (5) of this section if it obtains documentation that
its counterparty has reported the information listed in Sec.
39.6(b)(3) in accordance with Sec. 39.6(b)(4) of this chapter.
(b) Recordkeeping. Each swap dealer and major swap participant
shall maintain all documents required to be
[[Page 55965]]
obtained pursuant to this section in accordance with Sec. 23.203 and
shall make them available promptly upon request to any representative
of the Commission or any applicable prudential regulator, or with
regard to swaps defined in section 1a(47)(A)(v) of the Act, to any
representative of the Commission, the Securities and Exchange
Commission, or any applicable prudential regulator.
Issued in Washington, DC, on August 24, 2012, by the Commission.
Sauntia S. Warfield,
Assistant Secretary of the Commission.
Appendices to Confirmation, Portfolio Reconciliation, Portfolio
Compression, and Swap Trading Relationship Documentation Requirements
for Swap Dealers and Major Swap Participants--Commission Voting Summary
and Statements of Commissioners
NOTE: The following appendices will not appear in the Code of
Federal Regulations.
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Sommers,
Chilton, O'Malia and Wetjen voted in the affirmative; no
Commissioner voted in the negative.
Appendix 2--Statement of Chairman Gary Gensler
I support the final rule implementing Congress' direction that
the Commission adopt rules for ``timely and accurate confirmation,
processing, netting, documentation, and valuation of all swaps.''
This direction was included in the swaps market reform provisions of
the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act).
Each of these requirements promotes crucial back office
standards that will reduce risk and increase efficiency in the swaps
market. These final rules are critical to the risk management of
swap dealers and major swap participants and lowering their risk to
the public.
The rules establish procedures to promote legal certainty by
requiring timely confirmation of all swap transactions, setting
forth documentation requirements for bilateral swap transactions,
and requiring timely resolutions of valuation disputes. In addition,
the rules enhance understanding of one counterparty's risk exposure
to another, and promote sound risk management through regular
reconciliation and compression of swap portfolios.
The 2008 financial crisis brought to light how large financial
institutions, including AIG, had valuation disputes and other
problems regarding documentation standards. These rules will
directly address many of those issues, highlighting issues for
senior management and regulators at an earlier stage.
The final rule builds upon extensive work by the Federal Reserve
Bank of New York (FRBNY) to improve standards in the back offices of
large financial institutions dealing in swaps. Beginning in 2005,
the FRBNY, along with U.S. and global prudential authorities,
undertook a supervisory effort to enhance operational efficiency and
lower risk in the swaps market by increasing automation in swaps
processing, improving documentation, and promoting the timely
confirmation of trades.
CFTC staff also consulted with other U.S. and foreign financial
regulators, and participated in numerous meetings with market
participants. CFTC staff worked to address the more than 60 public
comment letters responding to the three proposed rules comprising
this final rule.
Appendix 3--Statement of Commissioner Bart Chilton
I support this second package of internal business conduct
standard final rules. These rules establish a set of prudent
documentation standards for registered swap dealers (SDs) and major
swap participants (MSPs) while aiming to minimize the burdens on
non-SDs and non-MSPs. Vibrant and liquid financial markets are
necessary for economic prosperity. As shown by the 2007-2009
financial crisis, that prosperity itself is gravely threatened when
the rules governing financial markets fail to curb the build-up of
systemic risk. I am pleased that the preamble introducing these
rules appropriately refers to the tremendous cost of the financial
crisis; it is obvious that not implementing strong regulations
effectuating the intent of the Dodd-Frank Act, including these final
rules, would result in social costs to the American taxpayer and
consumer.\152\ In addition, I note that there are enormous and
ongoing social costs that taxed our economy as a result of the
reckless practices that became prevalent in the years before the
financial crisis.
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\152\ See infra above.
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The documentation and conduct standards set forth in this
release are designed to, most importantly in my opinion, reduce
valuation disputes: Disputes between parties about the value of a
swap or portfolio of swaps. Valuation disputes can delay the
exchange of collateral. The failure to exchange collateral in a
timely manner can have disastrous impacts on a firm's ability to
manage its risk and allocate capital efficiently. A large,
interconnected firm's inability to manage its risk and to properly
allocate capital can contribute to the generation of systemic risk.
All of these steps were vividly illustrated during the recent
financial crisis.
American International Group's (AIG) inability to value its
portfolio accurately and agree on valuations and collateral
exchanges with its counterparties posed a serious problem for AIG
and its counterparties during the financial crisis.\153\ According
to the Financial Crisis Inquiry Commission Report:
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\153\ See Testimony Before the Financial Crisis Inquiry
Commission, including AIG/Goldman Sachs Collateral Call Timeline,
available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0701-AIG-Goldman-supporting-docs.pdf (timeline
documenting valuation disputes and collateral calls); Testimony of
Joseph Cassano, available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-Cassano.pdf; and AIG Statement
Summary, available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-AIG-Statement-Summary.pdf.
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The OTC derivatives market's lack of transparency and of
effective price discovery exacerbated the collateral disputes of AIG
and Goldman Sachs and similar disputes between other derivatives
counterparties.\154\
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\154\ Financial Crisis Inquiry Commission, ``The Financial
Crisis Inquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United
States,'' Jan. 2011, at 353, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf [hereinafter the FCIC Report.
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It is with the financial crisis in mind that I interpret the
Commission's authority generally and more specifically here, under
section 731 of the Dodd-Frank Act which added new section 4s(i) to
the Commodity Exchange Act (CEA).\155\ The portfolio reconciliation
rules in section 23.502 will ensure that SDs/MSPs have portfolio
valuations consistent with those of their counterparties. The
portfolio compression rules in section 23.503 will reduce
operational risks. The swap trading relationship documentation
requirements will 23.504 will ensure that documentation practices in
the swaps market cover a number of key terms. The documentation of
these terms will give counterparties greater certainty as to their
legal rights and responsibilities. These final rules, taken in
conjunction with the Commission's other Dodd-Frank Act-related
regulations, including part 43 regulations on real-time reporting
and subpart H of part 23 on Business Conduct Standards for Swap
Dealers and Major Swap Participants with Counterparties \156\ will
contribute substantially to encouraging early and effective dispute
resolution and will ensure the ``timely and accurate confirmation,
processing, netting, documentation, and valuation of all swaps.''
\157\
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\155\ Pub. L. 111 (2010). CEA section 4s(i) states that each
registered swap dealer and major swap participant shall conform with
such standards as may be prescribed by the Commission by rule or
regulation that relate to timely and accurate confirmation,
processing, netting, documentation, and valuation of all swaps.
\156\ See, specifically 17 CFR 23.431(a)(3)(i) requiring SDs and
MSPs to disclose ``the price of the swap and the mid-market mark of
the swap.''
\157\ CEA section 4s(i).
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While these rules represent considerable progress, I believe it
should not be viewed in a vacuum and that the Commission should
respond nimbly in responses to changes in the market that could
frustrate the underlying purpose of these final rules (and all other
Commission rules for that matter). Notwithstanding the progress the
Commission has made, I remain concerned that are still a number of
areas that this final rule touches upon that remain areas of
potential future concern:
1. Dispute resolution and the requirement to document
alternative methods for determining the value of a swap or a dispute
resolution process under regulation 23.504(b)(4)(iii).
This provision, combined with the provision in regulation
23.503(c) to report
[[Page 55966]]
``any valuation dispute in excess of $20,000,000'' within one
business day if the dispute is with another SD/MSP or five business
days for non-SDs/MSPs, should encourage the resolution of disputes.
These regulations are buttressed by efforts being made by certain
industry organizations. I encourage the Commission to remain
vigilant in this area and to monitor the disputes reported to the
Commission and to engage with the public to determine whether these
regulations have their intended effect.
2. The implied cost of credit and the requirement to document
credit support arrangements under regulation 23.504(b)(3).
I am concerned that these rules do not expressly require SDs and
MSPs to document the cost of credit if such costs are a factor in
the price a SD or MSP charges a counterparty. While this issue has
been discussed since the earliest days of the negotiations and
planning surrounding the drafting of the Dodd-Frank Act--and many
market participants acknowledged that added costs would be attendant
to engaging in non-cleared transactions--the Commission could
provide, in this rulemaking, an additional level of transparency to
transactions involving creditworthiness considerations.\158\ I
believe that requiring the documentation of the embedded cost of
credit as a transaction fee or credit premium would have deter the
practice of charging customers a price on a swap that depends on
creditworthiness. My concern is mitigated somewhat by regulation
23.431(d)(2) (a provision finalized in a previous rulemaking) which
requires that SDs and MSPs provide their non-SD/MSP counterparties
``with a daily mark, which shall be the mid-market mark of the
swap.'' \159\ Such a provision would assist an end-user to infer the
embedded cost of credit they were charged by their SD or MSP
counterparty. Armed with this information, I encourage market
participants to seek documentation of the embedded cost of credit as
a transaction fee or credit premium. As the Commission's regulations
become effective, I invite the public to alert the Commission if the
practice of charging a credit fee in the price (i.e., an embedded
cost of credit) for a swap becomes problematic by, for example,
diminishing the price discovery utility of real-time data published
to the public under part 43 of the Commission's rules.
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\158\ See Better Markets comment letter.
\159\ 77 FR 9733 (Feb. 17, 2012).
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3. Rehypothecation of uncleared swaps collateral and the
requirement to document rehypothecation terms for assets used as
margin for uncleared swaps under regulation 23.504(b)(3)(iii).
This requirement is consistent with section 724(c) of the Dodd-
Frank Act (adding section 4s(l)(1)(A) to the CEA) and is a welcome
inclusion in these rules.\160\ Rehypothecation occurs when a person
uses assets held as collateral for one counterparty in transactions
with another counterparty. This practice contributed to the
financial crisis in a number of ways, including: (1) Rehypothecated
collateral was particularly difficult to recover in bankruptcy \161\
and (2) rehypothecation increases leverage in the financial
system.\162\ While many buy-side firms are learning from the
financial crisis and requesting their collateral to be held in
segregated accounts, the potential for a dealer default that could
affect rehypothecated collateral still exists. In light of recent
events, the Commission and the public should keep a watchful eye on
the risks in this area.
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\160\ ``A swap dealer or major swap participant shall be
required to notify the counterparty of the swap dealer or major swap
participant at the beginning of a swap transaction that the
counterparty has the right to require segregation of the funds or
other property.''
\161\ This is because once the collateral is rehypothecated,
then the posting party could lose their proprietary interest in the
collateral and as a result in bankruptcy, such a party could fall
into the category of unsecured creditors. This can delay or prevent
recovery of collateral from a bankrupt counterparty.
\162\ IMF researchers recently estimated that off-balance sheet
funding for dealers from rehypothecation amounted to $4.5 trillion
during November 2007 and that it contributed substantially to the
size of the shadow banking system. See, The (sizeable) Role of
Rehypothecation in the Shadow Banking System, Manmohan Singh and
James Aitken, IMF Working Paper, July 2010, available at http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf.
[FR Doc. 2012-21414 Filed 9-10-12; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: September 11, 2012
See Also:
