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SEC Adopts Risk Mitigation Rules for Uncleared Security-Based Swaps
Practical Law Legal Update w-023-4696 (Approx. 7 pages)
SEC Adopts Risk Mitigation Rules for Uncleared Security-Based Swaps
by Practical Law Finance
| Published on 06 Jan 2020 • USA (National/Federal) |
The SEC adopted final rules requiring security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs) to apply specific risk-mitigation techniques, such as portfolio compression, portfolio reconciliation, and trade relationship documentation, to their portfolios of security-based swaps (SBS) not submitted for clearing.
On December 18, 2019, the SEC adopted final rules (final SBS risk-mitigation rules) under the Securities Exchange Act of 1934 (Exchange Act) requiring security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs) (together, SBS entities) to apply specific risk mitigation techniques, such as portfolio compression, portfolio reconciliation, and trade relationship documentation, to their portfolios of security-based swaps (SBS) not submitted for clearing.
The final SBS risk mitigation rules include:
- Rule 15Fi-3, relating to portfolio reconciliation (see SBS Portfolio Reconciliation).
- Rule 15Fi-4, relating to portfolio compression (see SBS Portfolio Compression).
- Rule 15Fi-5, relating to trading relationship documentation (see SBS Trading Relationship Documentation).
- An interpretation addressing the application of the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements to cross-border SBS activities and an amendment to Rule 3a71-6 to provide SBS entities that are not US persons an opportunity to satisfy the new requirements through substituted compliance.
- Corresponding amendments to recordkeeping, reporting, and notification requirements applicable to SBS entities.
The final SBS risk mitigation rules substantially track the CFTC's rules on portfolio reconciliation, compression, and written trading relationship documentation for swap dealers (SDs) and major swap participants (MSPs), which have been in effect since 2012 (see Practice Note, The Dodd-Frank Act: Internal Business Conduct (IBC) Rules for Swap Dealers and MSPs).
The SEC notes that any SBS entity that is also registered with the CFTC as an SD is already subject to similar CFTC requirements. The SEC has therefore attempted to minimize compliance burdens by substantially harmonizing its rules with analogous CFTC regulations.
The SEC issued a press release on the final SBS risk mitigation rules.
The effective date of the final SBS risk mitigation rules is April 6, 2020.
SBS Portfolio Reconciliation
As part of the adoption of Rule 15Fi-3, the SEC also amended existing Rule 15Fi-1 to add the following new definitions:
- Portfolio reconciliation, which is defined as the process by which counterparties to one or more SBS:
- exchange the terms of all SBS in the SBS portfolio between the counterparties;
- exchange each counterparty’s valuation of all outstanding SBS entered into between the counterparties as of the close of business on the immediately preceding business day; and
- resolve any discrepancies in valuations or material terms.
- Security-based swap portfolio, which is defined to include all SBS currently in effect between a particular SBS entity and a particular counterparty.
- Valuation, which is defined as the current market value or net present value of an SBS.
- Material term, which is defined as each term that is required to be reported to a registered swap data repository (SDR) or the SEC under Regulation SBSR (see Practice Note, US Derivatives Regulation: SEC Regulation SBSR Data Reporting for Security-Based Swaps).
Similar to the CFTC rule, Rule 15Fi-3(a) requires each SBSD to engage in portfolio reconciliation with each of its SBS entity counterparties with a frequency based on the size of the SBS portfolio. For two SBS counterparties with an SBS portfolio of:
- 500 or more SBS, portfolio reconciliation must occur once each business day for as long as the portfolio exceeds this threshold.
- Between 50 and 500 SBS on any business day, portfolio reconciliation must occur on a weekly basis.
- Less than 50 SBS at any time during a calendar quarter, portfolio reconciliation must occur on a quarterly basis.
- Rule 15Fi-3 also requires that SBS entity counterparties immediately resolve any discrepancy in material terms and SBS entities must have in place policies and procedures reasonably designed to resolve a valuation discrepancy of 10% or greater as soon as possible but no later than five business days from the date it is discovered.
- Rule 15Fi-3(b) requires reconciliation of SBS portfolios between an SBS entity and a counterparty that is not an SBS entity and requires SBS entities to perform portfolio reconciliation no less frequently than:
- Once quarterly for SBS portfolios that include more than 100 SBS at any time during the calendar quarter.
- Once annually for each SBS portfolio that includes no more than 100 SBS at any time during the calendar year.
SBS entities must establish, maintain, and follow written procedures reasonably designed to resolve in a timely fashion any discrepancies in the valuation or material terms of each SBS identified as part of a portfolio reconciliation with a non-SBS entity.
Under Rule 15Fi-3(c), each SBS must promptly notify the SEC of any SBS valuation dispute exceeding $20,000,000, at either the transaction or portfolio level if it is not resolved within:
- Three business days for disputes involving an SBS entity counterparty.
- Five business days for disputes with a counterparty that is not an SBS entity.
The final SBS risk-mitigation rules also expand the exception in Rule 15Fi-3(d) for cleared SBS from portfolio reconciliation rules to include:
- Original bilateral SBS transactions.
- SBS transactions cleared by a clearing agency that the SEC has exempted from registration.
SBS Portfolio Compression
Under Rule 15Fi-4, for SBS portfolios between two SBS entities, each SBS entity must establish, maintain, and follow written policies and procedures for:
- Evaluation of bilateral and multilateral portfolio compression exercises that are initiated, offered, or sponsored by any third party;
- Periodically engaging in both bilateral portfolio compression exercises and multilateral portfolio compression exercises with its SBS counterparties.
- Terminating each fully offsetting SBS with its SBS counterparties in a timely fashion.
For SBS portfolios between an SBS entity and a non-SBS entity, the SBS entity must establish, maintain, and follow written policies and procedures for:
- Periodically engaging in bilateral or multilateral portfolio compression exercises with the relevant counterparty.
- Periodically terminating fully offsetting SBS.
Rule 15Fi-4 includes definitions of the terms "bilateral portfolio compression exercise" and "multilateral portfolio compression exercise," which are substantively identical to the corresponding CFTC definitions (17 CFR 23.500(b) and (h)).
SBS Trading Relationship Documentation
Rule 15Fi-5 requires an SBS entity to establish, maintain, and follow written policies and procedures designed to ensure the execution of written SBS trading relationship documentation with each counterparty, regardless of whether the counterparty is an SBS counterparty, prior to, or contemporaneously with, executing any SBS transaction.
The policies and procedures must:
- Require that the SBS trading relationship documentation:
- is in writing.
- includes all terms governing the trading relationship between the SBS entity and its counterparty.
- Require that the SBS trading relationship documentation include credit support arrangements covering (among other things):
- initial margin (IM) and variation margin (VM) requirements;
- types of assets that may be used as margin (eligible collateral) and corresponding asset valuations haircuts;
- investment and rehypothecation terms for assets used as margin for uncleared SBS; and
- custodial arrangements for margin assets, including whether margin assets are to be segregated with an independent third party.
- Require that the swap trading relationship documentation between certain types of financial counterparties include written documentation in which the parties agree on the process for determining the value of each SBS for purposes of complying with:
- the margin requirements under Section 15F(e) of the Exchange Act (see Practice Note, US Derivatives Regulation: Margin Collateral Rules); and
- the risk-management requirements under Section 15F(j) of the Exchange Act.
- Require SBS entities to disclose certain information to their counterparties regarding their legal status and the status of the SBS.
Rule 15Fi-5 provides exceptions to the trading relationship documentation requirements for:
- SBS that are executed prior to the rule's compliance date.
- Cleared SBS.
- SBS executed anonymously on a national securities exchange or SBS execution facility (SBSEF), subject to certain conditions.
The final SBS risk mitigation rules amend Rule 15Fi-1 to add a definition of "financial counterparty" for purposes of determining when the required SBS trading relationship documentation would need to include a valuation methodology. This definition is substantively identical to the CFTC's definition of "financial entity" (17 CFR 23.500(e)).
In addition, the final SBS risk mitigation rules require each SBS entity to have an independent auditor conduct periodic audits sufficient to identify any material weakness in its documentation policies and procedures.
Cross-Border Application and Corresponding Amendments
The final SBS risk mitigation rules also:
- Include a final cross-border interpretation which treats the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements as entity-level requirements that apply to an SBS entity's entire SBS business without exception, including in connection with SBS transactions conducted with foreign counterparties (see Practice Note, The Dodd-Frank Act: Cross-Border Application of Swaps Rules: SEC Cross-Border Security-Based Swaps Rules).
- Amends Rule 3a71-6 (17 CFR 240.3a71-6) to address the potential availability of substituted compliance in connection with the application of the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements to cross-border SBS activities.
- Makes corresponding changes to the recordkeeping, reporting, and notification requirements applicable to SBS entities.