Security-Based Swaps: Capital, Margin and Segregation Requirements

Transcription

1 Security-Based Swaps: Capital, Margin and Segregation Requirements SEC Proposes Rules Regarding Capital, Margin and Collateral Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants SUMMARY On October 18, 2012, the SEC proposed rules on capital, margin and collateral segregation for non-bank Security-Based Swap Dealers and non-bank Major Security-Based Swap Participants, along with amendments to the current minimum net capital requirements for broker-dealers permitted to use internal value-at-risk models. If adopted, the proposals would require, among other things, that: SBSDs maintain certain minimum net capital levels according to prescribed fixed and ratio-based minimums; MSPSPs maintain a positive tangible net worth and post and receive collateral on a daily basis with respect to non-cleared security-based-swaps; Broker-dealers permitted to use internal value-at-risk models hold increased levels of net capital; SBSDs take capital charges in connection with uncollateralized transactions with commercial end users and uncollateralized pre-effective date security-based-swap transactions; SBSDs and MSBSPs implement risk management procedures and liquidity stress tests; SBSDs collect from certain counterparties margin collateral in connection with security-based swap transactions; and SBSDs segregate customers margin collateral on cleared and uncleared security-based swap transactions from collateral held for other types of customer transactions. The SEC requests comments on all aspects of the proposals. Comments are due to the SEC within 60 days after publication of the proposals in the Federal Register. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 BACKGROUND Title VII of the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ) divided regulatory responsibility for setting margin and capital requirements for security-based swap dealers ( SBSDs ) and major security-based swap participants ( MSBSPs ). 1 Section 15F of the Securities Exchange Act of 1934 (the Exchange Act ), added by Section 764 of the Dodd-Frank Act, requires that the SEC prescribe capital and margin requirements for SBSDs and MSBSPs which are not otherwise regulated by a prudential regulator. 2 Section 3E of the Exchange Act, added by Section 763 of the Dodd-Frank Act, provides the SEC with the authority to establish margin collateral segregation requirements for SBSDs and MSBSPs. The authority to prescribe margin and capital requirements for bank-sbsds and MSBSPs was vested with their prudential regulators, who have already proposed applicable margin and capital requirements. 3 The Commodity Futures Trading Commission (the CFTC ) was also given responsibility for setting capital and margin requirements for non-bank swap dealers and non-bank major swap participants. 4 The SEC has now proposed rules (the Proposed Rules ) to implement Sections 763 and 764 of the Dodd Frank Act. 5 PROPOSED RULES ON CAPITAL REQUIREMENTS A. SECURITY-BASED SWAP DEALERS AND BROKER-DEALERS The SEC s proposed rule prescribing capital requirements for non-broker-dealer SBSDs ( Stand-Alone SBSDs ), Rule 18a-1, is modeled after current Rule 15c3-1, which governs capital required to be held for broker-dealers, and is designed to ensure that SBSD customer assets are protected in the event, and also mitigate the effects, of an SBSD failure, while allowing SBSDs enough flexibility to conduct their security-based swaps business. Proposed amendments to Rule 15c3-1 will establish capital requirements for SBSDs registered as brokerdealers. The amendments to Rule 15c3-1 would apply only to broker-dealer SBDSs, whereas proposed Rule 18a-1 would apply only to Stand-Alone SBSDs. In each case, the capital standards are based on a net liquid assets test, which requires that firms hold at all times more than one dollar of liquid assets for each dollar of unsubordinated liabilities, such as money owed to customers, counterparties and creditors. 1. Minimum Net Capital Requirements The SEC s proposed minimum net capital requirements would distinguish between SBSDs registered as broker-dealers and Stand-Alone SBSDs, and also would apply different standards to SBSDs approved by the SEC to use internal models 6 to calculate the minimum amount of required regulatory capital. Stand- Alone SBSDs not approved to use internal models to calculate net capital would be required to compute net capital using standardized haircuts to asset values. Standardized haircuts are prescribed by asset class, including haircuts by type of security-based swap. Broker-dealer SBSDs would be required to use -2-

3 the existing standardized haircuts contained in Rule 15c3-1, in addition to proposed new standardized haircuts for security-based swaps and other swaps. The minimum net capital requirement for Stand-Alone SBSDs would be equal to the greater of: (i) a fixed dollar minimum amount and (ii) a financial ratio requirement equal to 8% (the 8% Margin Factor) of the margin required for cleared and uncleared security-based swaps. 7 The margin required for cleared and uncleared security-based swaps is calculated as the sum of: (i) the greater of the total margin required to be delivered by the SBSD with respect to security-based swap transactions cleared for security-based swap customers at a clearing agency or the amount of the deductions that would apply to the cleared security-based swap positions of the security-based swap customers pursuant to proposed Rule 18a-1 and (ii) the total margin amount calculated by the Stand-Alone SBSD with respect to non-cleared securitybased swaps pursuant to proposed new Rule 18a-3. The 8% Margin Factor is designed to adjust the capital required to the risk associated with the types of security-based swaps entered into by SBSDs. Additionally, a fixed-dollar minimum net capital requirement of $20 million would apply at all times. SBSDs registered as broker-dealers would be subject to a net capital requirement equal to the greater of (i) a fixed-dollar minimum amount and (ii) the sum of the financial ratio amount required under Rule 15c3-1 for broker-dealer activities plus the 8% margin factor. For broker-dealer SBSDs not using internal models, the fixed-dollar amount would be $20 million (the same as for Stand-Alone SBSDs). 8 For broker-dealer SBSDs using internal models, the amount would be $1 billion. In addition to the minimum net capital requirements discussed above, Stand-Alone SBSDs that have applied to, and have been permitted by, the SEC to use internal risk models must also maintain $100 million of tentative net capital (net liquid assets before haircuts ) to account for risks not fully captured by risk models. Broker-dealer SBSDs that seek to use internal models to calculate net capital must also apply to the SEC to become an ANC Broker-Dealer, 9 as is currently required of broker-dealers under Rule 15c3-1. The Proposed Rules would increase the fixed minimum capital required for ANC Broker-Dealers from the present $500 million to $1 billion, as well as increase the tentative net capital requirement for ANC Broker-Dealers to $5 billion. Additionally, ANC Broker-Dealers would be required to provide an early warning notice to the SEC if their tentative net capital falls below $6 billion. In the event that an ANC Broker-Dealer s capital falls below $6 billion, the Proposed Rules allow the SEC to impose certain operational conditions on the firm and restrict its business activities. -3-

4 The following chart summarizes the Proposed Rules net capital requirements: Type of Registrant Rule 18a-1: Stand-Alone SBSD Stand-Alone SBSD (using internal models) Rule 15c3-1: Tentative Net Capital Requirement Minimum Net Capital Requirement Fixed Dollar Financial Ratio N/A $20 million 8% Margin Factor $100 million $20 million Broker-Dealer SBSD N/A $20 million ANC Broker-Dealer SBSD $5 billion $1 billion 8% Margin Factor 8% Margin Factor + current Rule 15c3-1 ratio 8% Margin Factor + current Rule 15c3-1 ratio 2. Net Capital Treatment of Security-Based Swaps The Proposed Rules would allow ANC Broker Dealers and SBSDs approved by the SEC to use internal value-at-risk models for security-based swaps to take net capital deductions determined by the models for their OTC security-based swap positions. SBSDs and broker-dealers not approved to use internal models must take standardized haircuts proposed by the SEC. Rule 15c3-1 currently does not contain standardized haircuts for security-based swaps, and broker-dealers are currently required to apply a standardized deduction for security-based swaps based on the existing catchall provisions of Rule 15c3-1. The SEC proposes to establish two sets of standardized haircuts for security-based swaps; one set for security-based swaps that are credit default swaps ( CDS ) and another for all other types of securitybased swaps. The proposed standardized haircuts for CDS security-based swaps would be based on a maturity-grid approach, with deductions reflecting the length of time to maturity and the amount of the current offered basis point spread of a CDS. Displayed along the vertical axis of the proposed grid are nine maturity categories, which range from the smallest deduction required for CDS maturities of 12 months or less, up to the largest deduction for CDS maturities of 121 months or longer. The horizontal axis of the proposed grid would contain six spread categories, and would range from 100 basis points or less (requiring the smallest deduction) to 700 basis points and above (requiring the largest deduction). The SEC notes that in addition to basing the maturity-grid proposal on Rule 15c3-1 s existing approach for other securities and the approach taken for CDSs in Rule 4240 of the Financial Industry Regulatory Authority ( FINRA ), the CDS standardized haircut proposal draws largely on [SEC] staff experience and reasoned judgments about the appropriate specifications. The proposed standardized haircuts for CDSs would also allow the netting of long and short positions in CDSs where the CDSs reference: -4-

5 the same entity, obligation or basket of obligations; the same credit events that would trigger a payment; the long and short positions are in the same or adjacent maturity and spread categories (i.e., neighboring boxes on the maturity grid); and have a maturity within three months of the other maturity category. Reduced deductions on CDSs could also be taken where the long and short CDS positions are in the same maturity and spread categories, but reference corporate entities in the same industry sector. 10 Finally, reduced deductions would also be permitted for strategies where the SBSD is long (short) a bond or asset-backed security and long (short) the protection through a CDS referencing the underlying bond or asset-backed security. 11 The proposed standardized haircuts for non-cds security-based swaps would reflect the changes in the market value of the security referenced in the contract, and would be calculated by multiplying the non- CDS security-based swap contract s notional amount by the deduction currently prescribed in Rule 15c3-1 for holding the underlying security. -5- While the proposed methodology for standardized haircuts of non-cds security-based swaps prescribes a separate deduction for each position, the proposed amendments to Appendix A to Rule 15c3-1 would allow broker-dealer SBSDs (and non-sbsd broker-dealers) to take a single standardized deduction for a portfolio of equity positions involving the same equity security though a standardized theoretical pricing model. Rule 18a-1 contains an analogous provision for Stand-Alone SBSDs. The proposed amendments to Appendix A would allow firms to group equity security-based swaps, options, security futures, and long and short equity positions involving the same underlying security and stress the current market price for each position at ten equidistant points reflecting a range of positive and negative future market movements. The gains or losses at each stress point would be netted, and the stress point that creates the largest potential net loss for the portfolio would be used to calculate the aggregate deduction for all positions in the portfolio. 3. Net Capital Treatment of Swaps Appendix B to Rule 15c3-1 currently prescribes capital deductions for commodities positions of a brokerdealer by incorporating by reference deductions in CFTC Rule 1.17 to the extent Rule 15c3-1 does not otherwise prescribe a deduction. Appendix B to proposed Rule 18a-3 would prescribe capital deductions for commodities positions of Stand-Alone SBSDs and would be modeled on Appendix B to Rule 15c3-1. With respect to proprietary positions in swaps, Appendix B to Rule 15c3-1 would be amended to establish standardized haircuts for proprietary swap positions held by broker-dealers, and analogous provisions would be included in Appendix B to Rule 18a-3 for proprietary swap positions held by SBSDs. The standardized haircuts would be similar to those for security-based swaps. CDSs on a broad-based securities index would be subject to a maturity grid similar to that for CDS security-based swaps, and other swaps would be subject to a standardized haircut in which the notional amount of the swap would

6 be multiplied by the percentage deduction required for the relevant asset or event. ANC Broker-Dealers and SBSDs approved to use internal models could apply to include different types of swaps in their valueat-risk models and, if approved, would not need to apply the standardized haircuts. 4. Credit Risk Charges The SEC notes that obtaining collateral is one of the ways dealers in OTC derivatives manage their credit risk exposure to counterparties. Proposed Rule 18a-3 would require an SBSD to obtain collateral from a counterparty to cover current and potential future exposure to the counterparty. The current two-business day period for broker-dealers to obtain additional collateral would be reduced to one business day. An exception is made for commercial end users 12 to address concerns that collateral requirements would make hedging by commercial companies prohibitively expensive. An SBSD that does not collect collateral from a commercial end user would be required to take a capital charge equal to the amount by which the SBSD s current and future exposure is uncollateralized. ANC Broker-Dealers, as well as Stand-Alone SBSDs that are permitted to use internal models, would be allowed to take a credit risk charge, based on the methodology currently contained in Appendix E to Rule 15c3-1, in lieu of a full capital charge in the amount of uncollateralized exposure. The credit risk charge would be calculated as the sum of: a counterparty exposure charge; a concentration charge if the current exposure to a single counterparty exceeds certain thresholds; and a portfolio concentration charge if aggregate current exposure to all counterparties exceeds certain thresholds. The SEC indicates that upon the effectiveness of the Dodd-Frank Act s reforms of OTC derivatives, ANC Broker-Dealers could experience greatly increased amounts of receivables relating to OTC derivatives. To the extent such receivables are not collateralized, they could adversely affect an ANC Broker-Dealer s liquidity in the event of a counterparty default. Consequently, the SEC has proposed that ANC Broker- Dealers and SBSDs approved to use internal models subject uncollateralized receivables from counterparties arising from security-based swaps to a 100% deduction from net worth, except when the counterparty is a commercial end user. In the case of commercial end users, ANC Broker-Dealer and Stand-Alone SBSDs approved to use internal models would take a credit charge in lieu of the 100% deduction, and any other non-bank SBSD would be required to take a capital charge equal to the current exposure to the commercial end user less any positive equity in the commercial end user s account. Rule 15c3-1 currently requires a broker-dealer to take a deduction from net worth for under-margined accounts. The SEC proposes to extend that requirement for broker-dealer SBSDs, and would require broker-dealer SBSDs to take a deduction from net worth for the amount of cash required in the account of each security-based swap customer to meet the margin requirements of a clearing agency, selfregulatory organization or the SEC after any required margin deposits by the customer are outstanding by -6-

7 one business day or less. An analogous provision in proposed Rule 18a-1 would also apply the same requirement for under-margined customer accounts for Stand-Alone SBSDs. Furthermore, the Proposed Rules would require SBSDs to take a capital charge where a counterparty posts the required amount of margin collateral, but such collateral may be insufficient to adequately cover the risk associated with the counterparty s position. When a SBSD does not hold margin from a counterparty because the margin has been segregated and is held by a third-party custodian, the SEC notes that the SBSD s lack of physical possession or control over its collateral would result in an inability to liquidate the collateral promptly, requiring a capital charge in the amount of the segregated collateral less any positive equity in the counterparty s account. Finally, when an uncleared security-based swap transaction occurs prior to the effective date of the Proposed Rules (a legacy uncleared security-based swap ), a SBSD would not be required to collect margin collateral on legacy uncleared security-based swaps but would be required to take a capital charge equal to the margin amount required to be collected, less any positive equity in the legacy uncleared security-based swap counterparty s account. 5. Risk Management Procedures and Liquidity Stress Tests Under the Proposed Rules, SBSDs would be required to create a risk management control system in accordance with Rule 15c3-4 under the Exchange Act: 13 A risk control unit that reports directly to senior management and is independent from business trading units; Separation of duties between personnel responsible for entering into a transaction and those responsible for recording the transaction in the books and records; Periodic reviews (which may be performed by internal audit staff) and annual reviews (which must be conducted by independent certified public accountants) of risk management systems; and Written guidelines covering: Quantitative guidelines for managing overall risk exposure; The type, scope and frequency of reporting by management on risk exposures; The procedures for and the timing of the governing body's periodic review of the risk monitoring and risk management written guidelines, systems and processes; The process for monitoring risk independent of the business or trading units whose activities create the risks being monitored; The performance of the risk management function by persons independent from or senior to the business or trading units whose activities create the risks; The authority and resources of the groups or persons performing the risk monitoring and risk management functions; The appropriate response by management when internal risk management guidelines have been exceeded; The procedures to monitor and address the risk that an OTC derivatives transaction contract will be unenforceable; -7-

8 The procedures requiring the documentation of the principal terms of OTC derivatives transactions and other relevant information regarding such transactions; and The procedures authorizing specified employees to commit the OTC derivatives dealer to particular types of transactions. ANC Broker-Dealers and Stand-Alone SBSDs approved to use internal models would also be subject to new liquidity risk management requirements. These firms would be required to perform a liquidity stress test at least monthly, taking into account certain assumed conditions which would be presumed to last for 30 consecutive days. 14 The results of the liquidity stress test would need to be provided within ten business days of the month end to the members of senior management having responsibility to oversee risk management. Any assumptions underlying the liquidity stress test would be required to be reviewed at least quarterly by senior management responsible for risk management, and at least annually by other senior management. The results of the liquidity stress test are designed to be used to ensure the firm has sufficient contingent liquidity. The liquidity reserves based upon the results of the liquidity stress test would be required to be maintained by firms at all times in the form of unencumbered cash or U.S. Government securities. Complementing the liquidity stress tests, ANC Broker-Dealers and Stand-Alone SBSDs would be required to establish a written contingency funding plan that would need to: set out strategies for addressing liquidity shortfalls in emergency situations; and address the policies, rules and responsibilities for meeting the liquidity needs at the time and communicating with the public and market participants during a liquidity stress event. 6. Additional Provisions of Existing Rule 15c3-1 Incorporated into Proposed Rule 18a-1 The Proposed Rules would also include the following provisions of current Rule 15c3-1 into proposed Rule 18a-1, making them applicable to SBSDs: debt-equity ratio requirements that limit the use of subordinated loans; SEC notice requirements relating to the withdrawal of excess net capital; subsidiary consolidation requirements (Appendix C to Rule 15c3-1); and requirements for subordinated loan agreements (Appendix D to Rule 15c3-1). B. MAJOR SECURITY BASED SWAP PARTICIPANTS Under proposed Rule 18a-2, MSBSPs would be required to maintain a positive tangible net worth at all times and comply with SEC Rule 15c3-4, which is discussed above under Section A.5. The Proposed Rules define tangible net worth as an MSBSP s net worth determined in accordance with U.S. generally accepted accounting principles, but excluding goodwill and other intangible assets. MSBSPs would need to include in their tangible net worth calculations all liabilities or obligations of subsidiaries or affiliates that the MSBSP guarantees, endorses or assumes, directly or indirectly. -8-

9 PROPOSED RULES ON MARGIN REQUIREMENTS A. SECURITY-BASED SWAP DEALERS The Dodd-Frank Act added Section 15F(e) of the Exchange Act to allow the SEC to establish initial and variation margin requirements for uncleared security-based swap transactions for SBSDs and MSBSPs. Section 15F(e) requires that the initial and variation margin requirements proposed by the SEC help ensure the safety and soundness of SBSDs and MSBSPs. The SEC modeled the margin requirements for SBSDs, contained in proposed Rule 18a-3, after the margin requirements set for broker-dealers by self-regulatory organizations. In general, under proposed Rule 18a-3, an SBSD would need to collect margin collateral from counterparties to uncleared security-based swap transactions to cover current and future exposure to these counterparties, with certain exemptions. 1. Daily Calculations and Collection Requirements Proposed Rule 18a-3 would require SBSDs to perform daily calculations 15 for each account of its counterparties to uncleared security-based swaps to determine appropriate initial and variation margins to be collected from those counterparties. The calculations would also assist in determining the 8% Margin Factor. On the business day following each calculation, the SBSD would be required to collect eligible collateral from counterparties in an amount at least equal to the negative equity in the account plus a margin amount to address potential future exposure. The required collateral would be determined in two steps: First, a determination of the amount of equity in a counterparty s account by marking-to-market all securities positions in the account, including security-based swap positions 16, adding any credit balances (such as payables from the SBSD to the counterparty) and subtracting any debit balances. 17 Second, a determination of the margin amount required to address potential future exposures to the counterparty, determined either by a standardized approach or a model-based method. The margin amounts required for a security-based swap entered into with an SBSD not using internal models would be calculated by applying the standardized haircuts required under the SBSD capital rules, discussed above. The SEC notes that this approach would maintain consistency between the proposed margin and capital rules. Proposed Rule 18a-3 would divide security-based swaps into two classes: security-based CDSs and all other security-based swaps, and provide a standardized methodology to determine the margin amount for each class. -9- SBSDs approved to use internal models would be permitted to use their internal value-at-risk models to determine appropriate margin amounts for debt security-based swaps. Margin for equity security-based swaps would be required to be determined using the standardized haircut approach, even if a firm has been approved to use internal models. 2. Eligible Collateral The SEC proposes to allow counterparties to meet their margin requirements by delivering cash, securities, and/or money-market instruments to an SBSD. 18 Other categories of assets would not satisfy

10 a counterparty s margin requirements. If securities or money-market instruments are delivered by a counterparty to satisfy margin requirements, their value towards satisfying the counterparty s margin requirement would be determined only after applying the prescribed haircuts contained in Rule 15c3-1, as proposed to be amended, or in proposed Rule 18a-1, to account for the risk that such instruments could not be readily liquidated in the event of the counterparty s default. Securities and money market instruments which have no ready market or cannot be publicly offered or sold because of statutory, regulatory or contractual arrangements would be subject to a 100% deduction and would have no value towards satisfying margin requirements. The SEC has specifically requested comment on whether the Proposed Rules should define the term eligible collateral in a more limited manner as the CFTC and potential regulators have proposed Exceptions to the Application of the Margin Requirements The SEC has proposed exceptions to the margin requirements contained in the proposed Rule 18a-3. Collateral would not be required to be collected by SBSDs: To cover future or current exposure to transactions with commercial end users; To cover future or current exposure to accounts holding only legacy uncleared security-based swaps; or To cover future exposure to the accounts of non-commercial end user counterparties if the counterparty elects to have its margin amount segregated pursuant to Section 3E(f) of the Exchange Act. The SEC has also put forth alternative proposals for the requirements to collect margin when an SBSD s counterparty is another SBSD: SBSDs would be required to collect initial but not variation margin to address negative equity in the account of another SBSD; or SBSDs would be required to collect variation and initial margin in all transactions with other SBSDs, but the initial margin would be held with an independent third-party custodian; When an exception to the requirement to collect margin applies, an SBSD is generally required to recognize a capital charge equal to the amount of the margin that it would have been required to collect in the absence of the exception. Lesser capital charges are required for SBSDs using internal models when transacting with commercial end users, and such SBSDs are permitted to take a model-based credit risk charge. 4. Risk Monitoring and Procedures Under proposed Rule 18a-3, SBSDs would be required to monitor the risk of each account of a counterparty to an uncleared security-based swap, and would also need to establish, maintain and document procedures and guidelines for monitoring such risk. The risk monitoring procedures and -10-

11 guidelines are modeled on the requirements of FINRA Rule 4240, and would need to include, at a minimum, procedures and guidelines for: Obtaining and reviewing the account documentation and financial information necessary for assessing the amount of current and potential future exposure to a given counterparty permitted by the SBSD; Determining, approving and periodically reviewing credit limits for each counterparty, and across all counterparties; Monitoring credit risk exposure to the SBSD from non-cleared security-based swaps, including the type, scope and frequency of reporting to senior management; Using stress tests to monitor potential future exposure to a single counterparty and across all counterparties over a specified range of possible market movements over a specified time period; Managing the impact of credit exposure related to uncleared security-based swaps on the SBSD s overall risk exposure; Determining the need to collect collateral from a particular counterparty, including whether that determination was based upon the creditworthiness of the counterparty and/or the risk of the specific uncleared security-based swap contracts with the counterparty; Monitoring the credit exposure resulting from concentrated positions with a single counterparty and across all counterparties, and during periods of extreme volatility; and Maintaining sufficient equity in the account of each counterparty to protect against the largest individual potential future exposure of a uncleared security-based swap carried in the account of the counterparty as measured by computing the largest maximum possible loss that could result from the exposure. The risk monitoring policies proposed under Rule 18a-3 are specifically designed to account for the risks undertaken by SBSDs when acting as dealers in uncleared security-based swaps, and serve as part of the broader system of risk management controls to be established by an SBSD under Rule 15c3-4, which are described above under Section A.5. B. DAILY CALCULATION AND MARGIN COLLECTION FOR MAJOR SECURITY-BASED SWAP PARTICIPANTS Proposed Rule 18a-3 would require MSBSPs to perform daily calculations of the amount of equity in the account of each of its counterparties to uncleared security-based swaps to determine whether the MSBSP or the counterparty has current exposure to the other. Similar to the calculation required to be made by SBSDs, discussed above, MSBSPs would first be required to calculate the equity in an account through marking-to-market all positions in the account. The MSBSP would then add any credit balance in the account or subtract any debit balance to determine the account s equity, including offsetting payables and receivables from derivative transactions pursuant to a Qualifying Netting Agreement. However, MSBSPs would not be required to: calculate a margin amount because they would not be required to collect margin collateral to cover potential future exposure to counterparties under the Proposed Rules; or reduce the fair market value of securities and money market instruments held in the account of a counterparty for purposes of determine the account s level of equity. -11-

12 On the next business day following the equity calculations, MSBSPs would be required to collect collateral to cover their current exposure to a counterparty in the case of a negative equity account balance, as well as deliver collateral to a counterparty when that counterparty s account has a positive equity balance. The SEC s proposed requirement is designed to neutralize the credit risk between the MSBSPs and their counterparties. MSBSPs would not be required to collect collateral from a counterparty if the counterparty s account has negative equity when: the counterparty is a commercial end user; 20 the counterparty is an SBSD; or the counterparty s account holds only legacy uncleared security-based swaps. The MSBSP would also not be required to deliver collateral when a legacy uncleared security-based swap counterparty s account has positive equity. PROPOSED RULES ON SEGREGATION Dodd-Frank amended the Exchange Act to require that collateral for cleared security-based swaps be segregated from the collateral of other customer transactions. Uncleared security-based swap counterparties to SBSDs can elect to have collateral segregated from the SBSD at an independent thirdparty custodian or waive the right to collateral segregation altogether. The proposed rule on segregation, Rule 18a-4, is modeled on the current rule for broker-dealer collateral segregation, Rule 15c3-3 under the Exchange Act, and would require that in order to safeguard counterparties securities and cash, an SBSD must: (1) maintain physical possession or control over excess securities collateral, and (2) maintain an reserve of funds or qualified securities in an account at a bank that is equal in value to the net cash owed to customers. Proposed Rule 18a-4 would apply to all types of SBSDs, including bank-sbsds, Stand- Alone SBSDs and broker-dealer SBSDs. Proposed Rule 18a-4 prescribes requirements on how cash, securities and money market instruments of customers with cleared security-based swap transactions must be segregated when a SBSD commingles those assets with the assets of other customers ( Omnibus Segregation ). Further, assets of customers of uncleared security-based swap transactions would be required to be treated in the same manner as assets of cleared security-based swap customers unless the counterparty to the uncleared security-based swap elects to have its assets individually segregated or affirmatively waives its right to segregation altogether. Omnibus Segregation requirements would not apply to MSBSPs, and if an MSBSP holds collateral from a counterparty to an uncleared security-based swap, it would be subject to the segregation requirements only of Section 3E of the Exchange Act and would not be required to segregate collateral unless the counterparty requested segregation. -12-

13 A. NOTICE REQUIREMENTS AND SUBORDINATION AGREEMENTS The Proposed Rules would also require SBSDs and MSBSPs to provide notice to counterparties of uncleared security-based swap transactions of their right to require segregation of collateral provided for such transactions, as required by Exchange Act Section 3E(f), prior to the execution of the first uncleared security-based swap occurring after the effective date of the Proposed Rules. The notice must be in writing. SBSDs would also be required to obtain agreements from counterparties that elect individual segregation or waive segregation altogether that subordinate those counterparties claims against the SBSD to the claims of customers from whom (or on whose behalf) the SBSD has received funds or other property with respect to a security-based swap transaction. By agreeing to subordination, these counterparties would not be treated as security-based swap customers, consistent with the exclusion from the definition of customer in Rule 15c3-3 of persons whose interests are subordinated. The subordination agreement of a counterparty that elects to have collateral held by a third-party custodian would be conditional; the subordination agreement would be ineffective if the counterparty s collateral is included in a SBSD s bankruptcy estate. B. POSSESSION AND CONTROL REQUIREMENT Proposed Rule 18a-4 would require an SBSD to maintain possession and control of all Excess Securities Collateral (defined below) that has been provided by customers with respect to cleared or uncleared security-based swaps (the Physical Possession and Control Requirement ). Excess Securities Collateral would be defined as all customer securities held by the SBSD that exceed the current exposure of the SBSD to the customer, but would exclude: securities held by a qualified clearing agency account 21 to the extent those securities are being used to meet a margin requirement of the clearing agency resulting from another security-based swap transaction of the customer; and securities held by another SBSD to the extent those securities are being used to meet a margin requirement of the other SBSD resulting from a transaction to hedge the risk of a uncleared securitybased swap transaction with the customer. The exceptions would allow a clearing agency to hold securities as collateral against obligations of the SBSD s customers arising from their cleared security-based swap transactions, as well as allowing an SBSD to finance customer transactions in uncleared security-based swaps by using customer collateral to secure offsetting transactions with another SBSD, provided the collateral is held in a qualifying account at another SBSD. In no instance would an SBSD be permitted to use Excess Securities Collateral to finance its own business operations. C. RESERVE ACCOUNT REQUIREMENT Proposed Rule 18a-4 would require any non-bank SBSD to maintain at all times a reserve of funds or qualified securities at a bank that is not the SBSD or an affiliate of the SBSD, for the benefit of its -13-

14 customers, in an amount that is equal to the value of the net cash owed to security-based swap customers of the SBSD (the Customer Reserve Account ). The amount of net cash owed to customers would be computed pursuant to the formula contained in Exhibit A of proposed Rule 18a-4, which takes into account various credit and debit items, including credit balances in customer accounts and securities borrowed to effectuate customer short-sales. If total credits exceed total debts, an SBSD would need to maintain that amount on deposit in the Customer Reserve Account in the form of cash or certain qualified securities. Qualified securities would include obligations of the United States, obligations fully guaranteed as to principal and interest by the U.S., and general obligations of any State or subdivision of a State that are not traded flat or in default, were part of an initial offering of $500 million or more, and were issued by an issuer that has published audited financial statements within 120 days of its most recent fiscal year. If qualified securities in a Customer Reserve Account are municipal securities, an SBSD must take standardized deductions to the value of the municipal securities, even if the SBSD is approved to use internal value-at-risk models. D. IMPLICATIONS 1. Commercial End Users While the Proposed Rules do not require an SBSD to obtain collateral from a commercial end user, the SBSD would be required to take a capital charge for the uncollateralized current and potential future expenses to the commercial end user. The SEC seeks comment on whether the cost of these charges would be passed along to the commercial end user or effectively result in SBSDs requiring collateral from commercial end users. 2. Legacy Uncleared Security-Based Swaps The SEC recognizes that it would not be feasible for SBSDs to renegotiate legacy uncleared securitybased swaps and, therefore, the Proposed Rules do not require these positions to be collateralized. However, SBSDs will be subject to a capital charge based on the uncollateralized exposure and will be required to segregate those legacy uncleared security-based swaps in a separate account. In light of these requirements, clients may consider whether they should leave existing legacy uncleared securitybased swaps in unregulated entities and book new business in SBSDs. Such a result would raise netting, documentation and operational issues, as well as client relationship issues. 3. OTC Derivatives Dealers The SEC in the Proposing Release often cites to the rules applicable to OTC derivatives dealers and uses those rules as a guide to the rules governing SBSDs. The SEC expressly requests comments on whether the rules for OTC derivatives dealers should be amended to permit a broader range of activities by OTC derivatives dealers. Clients with, or in the process of establishing, an OTC derivatives dealer may wish to comment on this proposal. -14-

15 4. Segregation The Proposed Rules, consistent with the statutory provisions of Dodd-Frank, permit counterparties to uncleared swaps to waive third-party segregation of collateral. However, the Proposed Rules condition this on the counterparty s entering into a subordination agreement prior to entering into an uncleared security-based swap transaction. The need to negotiate and execute a subordination agreement may make waiver of the segregation requirement more unlikely, especially since the negotiation of the agreement may delay the execution of a transaction. In the case of counterparties electing third-party segregation, the Proposed Rules require the SBSD to take a capital charge with respect to the collateral held in third-party segregation. This requirement could result in SBSDs refusing to engage in business with counterparties that elect third-party segregation. The segregation rules also provide a more limited rehypothecation right to SBSDs than broker-dealers have under Rule 15c3-3. Under Rule 15c3-3 a broker-dealer may rehypothecate up to 140% of a customer s debit balance, but the Proposed Rules permit rehypothecation only to cover clearing agency requirements and back-to-back hedging transactions. These more limited uses of customer securities collateral may impact the liquidity of SBSDs. 5. Portfolio Margining While the SEC seeks comment on portfolio margining, the Proposed Rules do not appear designed to encourage portfolio margining. We expect this to be an area of comment. * * * Copyright Sullivan & Cromwell LLP

16 ENDNOTES The Dodd-Frank Act generally defines an SBSD as any person that (i) holds itself out as a dealer in security-based swaps, (ii) makes a market in security-based swaps, (iii) regularly enters into security-based swaps with counterparties in the ordinary course of its business for its own account, or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market-maker in security-based swaps. An MSBSP is defined in the Dodd-Frank Act as any person, other than an SBSD, that (i) maintains a substantial position in security-based swaps for any of the major security-based swap categories as determined by the SEC (excluding positions held for hedging or mitigating commercial risk and positions maintained by any employee benefit plan (or any contract held by such a plan) as defined in paragraphs (3) and (32) of Section 3 of ERISA for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan), (ii) has substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets, or (iii) is a financial entity that is not subject to capital requirements imposed by any federal banking agency, is highly leveraged relative to the amount of capital it holds and maintains a substantial position in outstanding security-based swaps in any major security-based swap category. In a joint release with the CFTC in April 2012, the SEC adopted final rules and provided further guidance with respect to these and other definitions. See our memorandum to clients, dated June 8, 2012, entitled CFTC and SEC Issue Final Swap-Related Rules Under Title VII of Dodd-Frank: CFTC and SEC Issue Final Rules and Guidance to Further Define the Terms Swap Dealer, Security-Based Swap Dealer, Major Swap Participant, Major Security-Based Swap Participant and Eligible Contract Participant. The prudential regulators are: the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Company, the Farm Credit Administration and the Federal Housing Finance Agency. See Margin and Capital Requirements for Covered Swap Entities, 76 F.R (May 11, 2011). The CFTC has proposed capital and margin requirements for swap dealers and major swap participants, see Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 F.R (April 28, 2011). Proposed Rule: Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker- Dealers, SEC Release No , available at (the Proposing Release ) (Oct. 18, 2012). Firms approved to use internal models use internal value-at-risk models to determine market risk charges for proprietary securities and derivatives positions and to take a credit risk charge in lieu of a 100% charge for unsecured receivables related to over-the-counter ( OTC ) derivatives transactions. The SEC note that the 8% Margin Factor is consistent with an 8% risk margin proposed by the CFTC for customer and non-customer exchange-traded futures and swap positions cleared by a derivative clearing organization. The SEC notes that the $20 million fixed dollar minimum capital requirement is consistent with the CFTC s proposed capital requirements for non-bank swap dealers, but is not required of OTC derivative dealers. An ANC Broker-Dealer is a broker-dealer approved by the SEC to use internal value-at-risk models. When applying to become an ANC Broker-Dealer, firms must provide the SEC with certain information, including descriptions and types of the models used, risk management controls, and categories of positions the ANC broker-dealer holds in proprietary accounts. -16-

17 ENDNOTES (CONTINUED) The Proposed Rules do not identify a specific source for determining industry sector; rather, the SBSD would need to use and document a reasonable industry sector classification system and would need to be able to demonstrate the reasonableness of the system it uses. If the SBSD is long a bond, it would be required to take only 50% of the otherwise required deduction on the bond or asset-backed security, and no deduction would be required for the CDS. However, the SBSD must be able to deliver the debt security to satisfy the SBSD s obligations under the related CDS. If the SBSD is short the bond or asset-backed security, no deduction would be required on the CDS, but the full deduction would still be required on the bond or asset-backed security. Proposed Rule 18a-3(b)(2) defines commercial end user to mean any person, other than a natural person, that engages primarily in commercial activities that are not financial in nature and is not a financial entity (as defined in Section 3C(g)(3) of the Exchange Act, which includes swap dealers, SBSDs, major swap participants, MSBSPs, commodity pools and private funds); and is using uncleared security-based swaps to hedge or mitigate risk relating to commercial activities. Rule 15c3-4 applies to OTC derivatives dealers. The assumed conditions would be: a stress event that includes a decline in creditworthiness of the firm severe enough to trigger contractual credit-related commitment provisions of counterparty agreements; the loss of all existing unsecured funding at the earlier of its maturity or put date and an inability to acquire a material amount of new unsecured funding, including intercompany advances and unfunded committed lines of credit; the potential for a material net loss of secured funding; the loss of the ability to procure repurchase agreement financing for less liquid assets; the illiquidity of collateral required by and on deposit at clearing agencies or other entities which is not deducted from net worth or which is not funded by customer assets; a material increase in collateral required to be maintained at registered clearing agencies of which the firm is a member; and the potential for a material loss of liquidity caused by market participants exercising contractual rights and/or refusing to enter into transactions with respect to the various businesses, positions and commitments of the firm, including those related to customer businesses of the firm. Intra-day calculations would be required during periods of extreme volatility and for accounts with concentrated positions. The marking-to-market would not include the time value of any OTC options. The SBSD would be permitted to net payables and receivables from derivative transactions by applying a netting agreement meeting the requirements of Appendix E to Rule 15c3-1 (a Qualifying Netting Agreement ), which require: the netting agreement to be legally enforceable in each relevant jurisdiction (including in insolvency proceedings); the gross receivables and gross payables subject to the netting agreement with a counterparty be determinable at any time; and -17-

18 ENDNOTES (CONTINUED) for internal risk management purposes, a SBSD using internal models monitors and controls its exposure to the counterparty on a net basis. The SEC has also proposed additional requirements for eligible collateral, which include: the collateral must be subject to the physical possession or control of the SBSD; the collateral must be liquid and transferable; the collateral must be capable of being liquidated promptly by the SBSD without intervention by any other party; the collateral agreement between the SBSD and the counterparty must be legally enforceable by the SBSD against the counterparty and any other parties to the agreement; the collateral must not consist of securities issued by the counterparty or a party related to the SBSD, or to the counterparty; and if the SEC has approved the SBSD s use of an internal value-at-risk model to compute net capital, the approval allows the SBSD to calculate deductions for market risk for the type of collateral. The CFTC and prudential regulators have limited eligible collateral to cash, foreign currency to the extent the payment obligations under the security-based swap or swap is denominated in the currency, obligations guaranteed by the United States as to principal and interest, and, with respect to initial margin only, a senior debt obligation of the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Federal Home Loan Banks and the Federal Agriculture Mortgage Corporation or any insured obligation of a Farm Credit System bank. Unlike SBSDs, MSBSPs would not be required to take a credit risk or capital charge on the amount of uncollected collateral from a commercial end user. A qualified clearing agency account would be defined to mean the account of an SBSD at a clearing agency established to hold funds and other property in order to purchase, margin, guarantee, secure, adjust or settle cleared security-based swap transactions for customers of the SBSD. The qualified clearing agency account must also meet the following conditions: the account is designated Special Clearing Account for the Exclusive Benefit of the Cleared Security-Based Swap Customers of [name of the SBSD] ; the clearing agency has acknowledged in a written notice provided to and retained by the SBSD that the funds and other property in the account are being held by the clearing agency for the exclusive benefit of the security-based swap customers of the SBSD in accordance with the regulations of the Commission and are being kept separate from any other accounts maintained by the SBSD with the clearing agency; and the account is subject to a written contract between the SBSD and the clearing agency which provides that the funds and other property in the account shall be subject to no right, charge, security interest, lien, or claim of any kind in favor of the clearing agency or any person claiming through the clearing agency, except a right, charge, security interest, lien, or claim resulting from a cleared security-based swap transaction effected in the account. -18-