SEC Proposes Rules on Registration of Security-Based Swap Execution Facilities SUMMARY On February 2, 2011, the Securities and Exchange Commission (the SEC ) proposed Regulation SB SEF, 1 which sets forth rules to govern the creation, registration and operation of security-based swap execution facilities ( SB SEFs ) under Section 763 of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act ). A SB SEF is a regulated trading system or platform in which multiple participants have the ability to execute or trade security-based swaps ( SB Swaps ) by accepting bids and offers made by multiple participants in the facility. The SEC s proposed rules are similar to, but differ in certain important respects from, the rules proposed by the Commodity Futures Trading Commission (the CFTC ) in its release of January 7, 2011, 2 regarding the regulation of swap execution facilities ( SEFs ) under Section 721(a) of the Dodd-Frank Act. The CFTC s proposed regime for SEFs was the subject of a separate Memorandum to Clients. 3 In particular, under the SEC proposal, a request for quote ( RFQ ) may be sent to as few as one market participant, but a SB SEF is required to publicly disseminate a composite indicative quote reflecting all responses to that request for quote. Comments are due on April 4, 2011. I. BACKGROUND The Dodd-Frank Act amends the Securities Exchange Act of 1934 (the Exchange Act ) to establish a framework for the regulation of trading of SB Swaps through SB SEFs. This framework includes registration requirements as well as 14 core principles ( Core Principles ) with which SB SEFs must comply and which the SEC must implement through its rulemaking, including monitoring of trade processing, timely publication of trading information, and the avoidance of conflicts of interest, as more fully discussed below. The Dodd-Frank Act also sets forth the framework within which the CFTC must New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
regulate the registration and operation of SEFs and the exchange of swaps (other than SB Swaps) through them. The Dodd-Frank Act amended the Exchange Act 4 to require that all transactions in SB swaps must be executed on an exchange or on a SB SEF registered with the Commission (or a SB SEF exempt from registration), unless no exchange or SB SEF makes the SB swap available to trade or the SB swap transaction is subject to the clearing exception in Section 3C(g) of the Exchange Act (the socalled end-user exception ). 5 This requirement is known as the mandatory trade execution requirement. Section 3D(a)(1) of the Exchange Act provides that no person may operate a facility for the trading or processing of SB swaps, unless the facility is registered as a SB SEF or as a national securities exchange. Section 3D(c) of the Exchange Act requires a national securities exchange, to the extent it also operates a SB SEF and uses the same electronic trade execution system for listing and executing trades in SB swaps, to identify whether the electronic trading of SB swaps is taking place through the exchange or the SB SEF. II. EXECUTION AND TRADING A. DETERMINATION OF AVAILABILITY TO TRADE The SEC preliminarily has expressed the view that the decision to make a SB Swap available to trade would mean more than the decision to simply trade or list a SB Swap on a SB SEF or an exchange. The determination would be made using objective criteria established by the SEC, rather than by one or a group of SB SEFs. The SEC solicits comments to craft these objective standards. By way of example, the SEC has proposed two potential criteria, including (1) the percentage of trading in a particular SB Swap taking place on exchanges and SB SEFs compared to the aggregate percentage of trading taking place for that SB Swap on exchanges and SB SEFs and in the OTC market, or (2) the overall volume in the SB Swap, wherever executed. The SEC also indicates that a minimum trading threshold could be used based on the number of transactions or notional amount executed over a specified period. The proposed regulation requires each SB SEF to establish a swap review committee to determine which SB Swaps will trade on the SB SEF and which SB Swaps will be excluded. The swap review committee would be comprised of each class of participants and other market participants, such as customers of the SB SEF. To determine whether a certain SB Swap can trade on that SB SEF, the swap review committee must periodically consider whether the liquidity in the SB Swap is at an appropriate level for the SB Swap s trading platform on which it trades, whether the SB Swap would be more suited for trading on a different type of platform, 6 such as a platform that provides for increased price transparency for participants entering orders, RFQs, or other trading interest, and whether the SB Swap is readily susceptible to manipulation. 7 The first review of SB Swaps by the swap review committee will not be earlier than 120 days after the initiation of trading for a given SB Swap. 8 Decisions made by the swaps -2-
review committee would be promptly reported to the Chief Compliance Officer ( CCO ) or the regulatory oversight committee. B. SCOPE OF DEFINITION OF SB SEF A SB SEF, similar to a SEF, is a trading system or platform in which multiple participants have the ability to execute or trade SB Swaps by accepting bids and offers made by multiple participants in the SB SEF, including any trading facility that facilitates the execution of SB Swaps between persons and is not a national securities exchange. 9 The SEC interprets the multiple participant requirement to mean a system or platform that allows more than one participant to interact with the trading interest of more than one other participant on that system or platform. The SEC interprets the multiple participant requirement to require a SB SEF to provide at least a basic functionality to allow any market participant the ability to make and display executable bids or offers accessible to all other participants on the SB SEF. A SB SEF would be able to offer functionality to a participant enabling that participant to choose to send a single RFQ to any number of specific liquidity-providing participants on that SB SEF platform, including to just a single liquidity provider. A SB SEF may operate multiple trading models for different SB Swaps, provided that each of the trading methods that the SB SEF offers market participants when viewed in isolation must meet the multiple participant to multiple participant requirement as defined by the proposed rules. For example, a SB SEF could operate both a multi-dealer RFQ mechanism for less liquid SB Swaps and a limit order book for more liquid SB Swaps. A SB SEF, however, is not required to operate multiple trading models. Thus, it is conceivable that a SB SEF could only operate a multi-dealer RFQ mechanism as its chosen trading system. A platform where a single dealer interacts with multiple customers, by contrast, would not qualify as a SB SEF. 10 A number of trading systems would fit this definition, including a limit order book (in which bids and offers are published anonymously) and RFQ systems. However, the proposing release specifies that bilateral market-participant-to-market-participant transactions would not be permitted because there would be only one party able to seek a quote and only one party that is able to provide a quote in response. 11 This includes bilateral transactions via telephone or email and transactions in which a broker contacts a market participant on behalf of another market participant to execute the trade. On the other hand, a brokerage model where a broker receives quotes from more than one customer and then distributes the quote to all or less than all the participants in the platform would meet the multiple participant requirement. The proposed regulation differs from the CFTC proposed rule, which requires that a quote-requesting market participant send a RFQ to a minimum of five other market participants. In contrast, the proposed regulation, as interpreted by the SEC, would allow a quote-requesting market participant to send a RFQ to just one market participant. However, the SEC would require that a SB SEF that operates a RFQ -3-
platform create and disseminate to all market participants a composite indicative quote for each SB Swap traded through the system, which would include both composite indicative bids and composite indicative offers. We expect this requirement to be subject to significant comment. C. EXECUTION DELAY FOR CROSSING AND MATCHING TRADERS Unlike the CFTC proposed rule, which provides that traders on a SEF who have the ability to execute against a customer s order or to match two customers must have their trades rest for 15 seconds before the two trades can be matched, the proposed regulation does not provide for a similar timing delay. III. BLOCK TRADES The proposed rules require SB SEFs to establish and enforce rules governing the manner in which block trades would be handled. The proposed rules permit a SB SEF to create different trading rules for block trades from trading rules for non-block trades in response to concerns raised by liquidity providers that requiring an excessive level of pre-trade transparency will result in front-running and could diminish liquidity. However, the SEC believes that block trades should be subject to the same minimum pre-trade transparency requirements as other trades, including the dissemination of composite indicative quotes. The proposing release states that permitting block trades to be executed off of the SB SEF and then reported to the SB SEF without interacting with other trading interest on the SB SEF (i.e., effectively using the SB SEF as a print facility ), could circumvent the mandatory trade execution requirement and undermine the goals of providing for more transparent and competitive trading on a SB SEF. This approach is different from the one taken in the CFTC proposed rule, which exempts block trades from any pre-trade transparency and permits block trades to be executed on SEFs through voice-based execution. The SEC indicates that in a system that permits participants to display firm quotes a block trade would need to interact with the displayed orders like any other trade. Moreover, if a SB SEF operated both a limit order book and a RFQ mechanism, a RFQ would need to interact with the limit order book before execution. This requirement may discourage a SB SEF implementing both a RFQ and limit order book system. Unlike the CFTC, 12 the SEC has not set minimum amounts for block trades. Instead, the size of a block trade is set by reference to Rule 900 of Regulation SBSR relating to trade reporting. The proposed rules provide that swap data repositories ( SDRs ) will be required to establish and maintain written policies and procedures for calculating and publicizing block trade thresholds for all SB Swaps reported to the SDRs. Each SB SEF would use the same threshold. However, until the SEC establishes criteria for block trades, a SB SEF may use its own criteria to establish what constitutes a block trade. -4-
Under proposed Regulation SBSR, non-block transactions are to be reported as soon as technologically practicable, but no later than 15 minutes from the time of execution, whereas block trade details other than size are to be reported immediately upon receipt of information about the block trade from the reporting party. 13 These requirements differ from the proposed CFTC regime, under which non-block transactions are to be reported as soon as technologically practicable following execution, whereas block trades in standardized swaps are to be reported within 15 minutes. 14 A. FORM SB SEF IV. REGISTRATION AND COMPLIANCE SB SEF applicants must electronically file Form SB SEF and the related exhibits with the SEC. Form SB SEF is substantially similar to Form 1 for registration as a national securities exchange. If an applicant files its application with the SEC on or before July 31, 2014, and indicates that it is requesting to be considered for temporary registration, the SEC may grant the applicant temporary registration as a SB SEF pending review of the application. This would give the SEC sufficient time to review an application more thoroughly before granting a registration that is not limited in duration. This is similar to the CFTC proposed rule, which provides that the CFTC, upon the request of a SEF applicant, may grant temporary grandfather relief from the registration requirement to a qualifying entity (e.g., a dealer-to-customer platform), allowing it to continue operating during the pendency of the application process. 15 B. EXEMPTION FROM REGISTRATION AS A NATIONAL SECURITY EXCHANGE AND AS A BROKER The SEC preliminarily has determined to conditionally except registered SB SEFs from registration both as a national securities exchange and as a broker. However, with respect to the broker exemption, this exemption could be lost if the SB SEF engaged in activities in any capacity, other than as a SB SEF (for example, acting as an agent to a counterparty to a SB Swap or acting in a discretionary manner with respect to a SB Swap). The broker exemption would not extend to inspection provisions of the Exchange Act or the statutory disqualification provisions of the Exchange Act, but would exempt SB SEFs from the Securities Investors Protection Act. We note that the SEC does not propose to exclude SB SEFs from registration as dealers. Dealer registration would most likely arise in connection with a multi-dealer RFQ system. C. FINANCIAL RESOURCES The proposed rules require that SB SEFs maintain financial resources: with a value that would permit the SB SEF to meet its financial obligations to participants, notwithstanding a default by the participant creating the largest financial exposure in extreme but plausible market conditions; and -5-
sufficient to exceed the total amount that would enable the SB SEF to cover its operating costs for a one-year period, as calculated on a rolling basis. Unlike the CFTC proposed rule, the SEC would not require SB SEFs to keep at least enough cash or highly liquid securities available to cover six months of operating costs. 16 Neither agency has defined the term operating costs. However, the proposed rule requires that the SB SEF, in determining whether it has adequate financial resources, use reasonable assumptions and estimates and not overstate resources or understate expenses, liabilities or financial exposure. D. COMPLIANCE WITH CORE PRINCIPLES As part of the application process, a SB SEF must demonstrate through exhibits to the application that it has the structures and rules in place to comply with the 14 Core Principles described in Section 3D(d) of the Exchange Act and the related rules and regulations. Among other requirements, the Core Principles require SB SEFs to establish rules for a market participant to become qualified as a participant on the SB SEF. A SB SEF must admit to its platform all persons registered as security-based swap dealers ( SBSDs ), major security-based swap participants ( MSBSPs ) or registered brokers. 17 The SB SEF may, but is not required to, admit to its platform eligible contract participants ( ECPs ) that are not registered with the SEC as SBSDs, MSBSPs or brokers. The SB SEF must set minimum requirements for these ECPs, such as: (1) becoming a member in, or having an arrangement with a member of, a registered clearing agency to clear trades in SB Swaps, (2) meeting minimum financial responsibility and recordkeeping and reporting requirements and (3) agreeing to comply with the SB SEF rules, including consenting to disciplinary procedures for violations of those rules. SB SEFs are required to set specific standards to ensure the financial integrity of all their participants. In the case of transactions not cleared through a registered clearing agency, the SB SEF is permitted by the proposed rules to consider counterparty credit risk in selecting potential counterparties. Other Core Principles added by the Dodd-Frank Act to the Exchange Act include: (1) requirement of compliance with the Core Principles themselves, (2) compliance with rules, (3) ensuring that SB Swaps are not readily susceptible to manipulation, (4) monitoring of trading and trade processing, (5) establishing rules for obtaining information, (6) ensuring financial integrity of transactions, (7) exercising emergency authority, (8) timely publication of trading information, (9) recordkeeping and reporting, (10) antitrust considerations, (11) avoidance of conflicts of interest, (12) maintaining adequate financial resources, (13) establishing system safeguards and (14) designation of a CCO. E. CONFLICTS OF INTEREST The proposed rules also contemplate several requirements for the avoidance of conflicts of interest. First, at least 20% of the total number of the directors of a SB SEF must be selected by market participants. In -6-
particular, the proposed rules require that SB SEF participants be permitted to participate in the nomination process and have the right to petition for alternative candidates. Second, a SB SEF must prevent any participant or group of participants that beneficially own an interest in the SB SEF from dominating or exercising disproportionate influence in the selection of such directors if the participant or group of participants may thereby dominate or exercise disproportionate influence on the selection or appointment of the entire Board of the SB SEF. For example, if a group of five participants together owned a SB SEF and as a result were able to select the directors to the SB SEF Board, the owners would be precluded from also being fair-representation directors. Third, at least one director must be a representative of investors who are not SBSDs or MSBSPs, and such director must not be a person associated with a participant to the SB SEF. 18 F. CHIEF COMPLIANCE OFFICER The Dodd-Frank Act amendments to the CEA and the Exchange Act require that each SEF and SB SEF appoint a CCO and that the respective agencies promulgate rules defining the duties of the CCO. A SB SEF CCO s duties include the review of the compliance of the SB SEF with the Core Principles, the resolution of any conflicts of interest that may arise, the monitoring of a SB SEF s compliance with the Exchange Act, and the establishment of procedures for the remediation of non-compliance issues. Unlike the CFTC proposed rule, the SEC proposed regulation does not require that the CCO and the general counsel of the SB SEF be different individuals. The CCO must report directly to the SB SEF Board or a senior officer, must have a position of sufficient seniority and authority to compel compliance with policies and procedures, must keep the SB SEF Board or senior officer apprised of significant compliance issuers and must be competent and knowledgeable regarding the federal securities laws. The compensation and removal of the CCO would require the approval of a majority of the SB SEF Board. The CCO must prepare and certify an annual report that includes a description of the following: compliance of the SB SEF with the Exchange Act; and the policies and procedures of the SB SEF (including the code of ethics and policies and procedures regarding conflicts of interests). The annual report would require, among other things: information on all investigations, inspections, examinations, and disciplinary cases opened, closed or pending during the reporting period; all grants and denials of access to the SB SEF; all material changes to policies and procedures since the prior report; any recommendations for material changes to policies and procedures as a result of an annual review; and the results of the SB SEF s surveillance program. * * * -7-
ENDNOTES 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Registration and Regulation of, Release No. 34-63825, February 2, 2011, 76 Fed. Reg. 10948, February 18, 2011. CFTC Notice of Proposed Rulemaking on Core Principles and Other Requirements for Swap Execution Facilities, RIN 3038 AD18, 76 Fed. Reg. 1214, January 7, 2011. This Memorandum to Clients can be found at http://www.sullcrom.com/swap-execution-facility- Requirements/. Dodd-Frank Act, Section 763(a), adding Section 3C(h) of the Exchange Act. Dodd-Frank Act, Section 763(a) of the, adding Section 3C(g) to the Exchange Act. This section exempts SB Swaps from the clearing requirement where one of the counterparties to the SB Swap: (A) is not a financial entity; (B) is using SB Swaps to hedge or mitigate commercial risk; and (C) notifies the SEC of how it generally meets its financial obligations associated with entering into non-cleared SB Swaps. See also End-User Exception to Mandatory Clearing of Security-Based Swaps, Release No. 34 63556, 75 Fed. Reg. 79992, December 21, 2011. The SEC does not provide guidance for what would be appropriate liquidity for a SB Swap to trade on a particular SB SEF or what would make one SB SEF more suited for trading a particular SB Swap. The SEC notes that the decision of the swap review committee to determine whether a SB Swap should be traded is not the same as a determination that such SB swap had been made available for trading within the meaning of Section 3C(h) of the Exchange Act. The swap review committee s decision, therefore, would not in and of itself be the sole determinant of when a SB swap could no longer trade in the OTC market. The SEC does not provide any guidance as to readily susceptible to manipulation but cites exchange rules that focus on the trading volume, number of holders and market value of securities underlying derivatively priced products. Proposed Rule 242.811(c)(4). Dodd-Frank Act, Section 761(a), amending Exchange Act Section 3(a)(77). The SEC notes that two independent single dealer platforms may not be construed in the aggregate to meet the multiple dealer requirement. Proposing release at 10954. The CFTC defines block size as the greater of (a) the 95th percentile of transaction size in that category of swap instrument in the past calendar year (distribution test) and (b) the largest of five times the mean, median, and mode of transaction sizes for that category swap instrument over the past calendar year (social size multiple test). Reporting and Dissemination of Security-Based Swap Information, Release No. 34-63346, December 2, 2010, 75 Fed. Reg. 75208, at 75284-85. CFTC Notice of Proposed Rulemaking on Real-Time Public Reporting of Swap Transaction Data, RIN 3038-AD08, December 7, 2010, 75 Fed. Reg. 76140, at 76172, 76176; proposed Rules 43.3(a)(1), 43.5(k)(2). CFTC proposed Rule 37.3(b). CFTC proposed Rule 37.1301(c). Under Title VII of the Dodd-Frank Act, a SBSD is defined as any person that holds itself out as a dealer in SB Swaps; makes a market in SB Swaps; regularly enters into SB Swaps with counterparties in the ordinary course of its business for its own account; or engages in any activity causing the person to be commonly known in the trade as a dealer or market-maker in SB -8-
ENDNOTES (continued) 18 Swaps. A MSBSP is defined as a person, other than a SBSD, that meets any of the following three tests: maintains a substantial position in swaps for any of the major swap categories as determined by the SEC (excluding positions held for hedging or mitigating commercial risk); has substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or 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 swaps in any major swap category. For these definitions, see our Memorandum to Clients on Proposed Definitions Under Title VII of the Dodd-Frank Act, which can be found at http://sullcrom.com/proposed-swap-definitions- Under-Title-VII-of-the-Dodd-Frank-Act/. Proposed Rule 242.820(b). The term person associated with a participant is proposed to mean any partner, officer, director, or branch manager of such participant, any person directly or indirectly controlling, controlled by, or under common control with such participant, or any employee of such participant. Copyright Sullivan & Cromwell LLP 2011-9-
ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 800 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish (+1-212-558-3715; rishj@sullcrom.com) or Alison Alifano (+1-212- 558-4896; alifanoa@sullcrom.com) in our New York office. CONTACTS New York David J. Gilberg +1-212-558-4680 gilbergd@sullcrom.com Kenneth M. Raisler +1-212-558-4675 raislerk@sullcrom.com Robert W. Reeder III +1-212-558-3755 reederr@sullcrom.com SC1:3000789v12-10-