The Securities and Exchange Commission today voted to propose rules requiring the application of risk mitigation techniques to portfolios of uncleared security-based swaps.  Proposed Rules 15Fi-3 through 15Fi-5 would establish requirements for registered security-based swap dealers and major security-based swap participants (SBS Entities) with respect to:

  • Reconciling outstanding security-based swaps with applicable counterparties on a periodic basis.
  • Engaging in certain forms of portfolio compression exercises, as appropriate.
  • Executing written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap transaction.

Relationship documentation, portfolio reconciliation, and portfolio compression are important tools for increasing operational efficiency and reducing risk for SBS Entities.  For example, requiring SBS Entities to document the terms of their trading relationship with each of their counterparties before executing a new security-based swap transaction should foster greater transparency and legal certainty by allowing market participants to have a clear understanding of each other’s rights and obligations from the outset of the transaction.  Portfolio reconciliation further supports these goals by providing counterparties with a mechanism for identifying any discrepancies in the terms of a transaction throughout the life of the trade.  Finally, portfolio compression allows market participants to reduce their total number of open contracts – generally without affecting their net exposure – resulting in fewer trades to manage, maintain, and settle, and fewer opportunities for processing errors.

By proposing these rules, the Commission is taking another step in standing up its regime pursuant to Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and demonstrating its continued commitment to sound and efficient regulation of markets. 

“These are a series of common sense rules that should aid all participants in our swaps markets improve operational efficiency and reduce back-office risks,” said SEC Chairman Jay Clayton.  “I am also pleased that we were able to craft these rules in a manner that further harmonizes the Commission’s requirements applicable to security-based swap dealers and major security-based swap participants with the corresponding requirements applicable to CFTC-regulated entities.”

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FACT SHEET

Risk Mitigation Techniques for Uncleared Security-Based Swaps 


Action

The Securities and Exchange Commission today announced that it has voted to propose Rules 15Fi-3 through 15Fi-5 under the Securities Exchange Act of 1934 (Exchange Act) that, if adopted, would require the application of specific risk mitigation techniques to portfolios of security-based swaps not submitted for clearing to a central counterparty.  Specifically, the proposal would establish requirements for each registered security-based swap dealer or major security-based swap participant (collectively, an “SBS Entity”) with respect to, among other things, (1) reconciling outstanding security-based swaps with applicable counterparties on a periodic basis, (2) engaging in certain forms of portfolio compression exercises, as appropriate, and (3) executing written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap transaction.

Highlights

Proposed Rule 15Fi-3: Portfolio Reconciliation

  • Under the proposal, the term “portfolio reconciliation” would be defined to mean the process by which the two parties to one or more security-based swaps:
    • Exchange the terms of all security-based swaps in the security-based swap portfolio between the counterparties.
    • Exchange each counterparty’s valuation of all outstanding security-based swaps entered into between the counterparties as of the close of business on the immediately preceding business day.
    • Resolve any discrepancy in valuations or material terms.
  • For purposes of the above definition, the term “material terms” would be defined to include:
    • With respect to any security-based swap that has not yet been previously reconciled pursuant to proposed Rule 15Fi-3, each term that is required to be reported to a registered swap data repository (“SDR”) or the Commission pursuant to Regulation SBSR.
    • With respect to all other security-based swaps, each term that is required to be reported to a registered swap data repository or the Commission pursuant to Regulation SBSR; provided, however, that such definition would not include any term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap.
  • Proposed Rule 15Fi-3(a) would apply to security-based swap portfolios between two SBS Entities as follows:
    • The SBS Entity counterparties would be required to engage in portfolio reconciliation no less frequently than:
      • Each business day for each portfolio that includes 500 or more security-based swaps.
      • Weekly for each portfolio that includes more than 50 but fewer than 500 security-based swaps on the business day during any week.
      • Quarterly for each portfolio that includes no more than 50 security-based swaps at any time during the calendar quarter.
    • Any discrepancy in a material term (other than with respect to valuation) must be resolved immediately.
    • Valuation discrepancies of ten percent or greater of the higher valuation must be resolved as soon as possible, but in any event within five business days of identifying the discrepancy.
  • Proposed Rule 15Fi-3(b) would apply to security-based swap portfolios between an SBS Entity and a counterparty who is not an SBS Entity as follows:
    • The SBS Entity would be required to establish, maintain, and enforce written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation no less frequently than:
      • Quarterly for each portfolio that includes more than 100 security-based swaps at any time during the calendar quarter.
      • Annually for each portfolio that includes no more than 100 security-based swaps at any time during the calendar year.
    • The policies and procedures also must provide that any discrepancy in the valuation or in a material term must be resolved in a “timely fashion.”
  • Proposed Rule 15Fi-3(c) would create a reporting obligation in the event of certain unresolved security-based swap valuation disputes.
    • Specifically, an SBS Entity would be required to promptly notify the Commission of any security-based swap valuation dispute in excess of $20,000,000, at either the transaction or portfolio level, if not resolved within:
      • Three (3) business days, if the dispute is with a counterparty that is an SBS Entity.
      • Five (5) business days, if the dispute is with a counterparty that is not an SBS Entity.

Proposed Rule 15Fi-4: Portfolio Compression

  • Proposed Rule 15Fi-4(a) would apply to security-based swap portfolios between two SBS Entities, and would require each SBS Entity to establish, maintain, and follow written policies and procedures for:
    • Evaluating 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, in each case when appropriate, with its SBS Entity counterparties.
    • Terminating each fully offsetting security-based swap with its SBS Entity counterparties in a timely fashion, when appropriate.
  • Proposed Rule 15Fi-4(b) would apply to security-based swap portfolios between an SBS Entity and a counterparty who is not an SBS Entity, and would require the SBS Entity to establish, maintain, and follow written policies and procedures for periodically terminating fully offsetting security-based swaps and for engaging in bilateral or multilateral portfolio compression exercises with the applicable counterparty, when appropriate and to the extent requested by any such counterparty

Proposed Rule 15Fi-5: Trading Relationship Documentation

  • Proposed Rule 15Fi-5(a)(2) would require each SBS Entity to establish, maintain, and enforce written policies and procedures reasonably designed to ensure that it executes written security-based swap trading relationship documentation with each of its counterparties (regardless of whether the counterparty is an SBS Entity) prior to, or contemporaneously with, executing a security-based swap with such counterparty.
  • Pursuant to proposed Rules 15Fi-5(b)(1) and (3), the applicable policies and procedures would need to:
    • Require that the security-based swap trading relationship documentation be in writing, and that it include all terms governing the trading relationship between the SBS Entity and its counterparty, 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, allocation of any applicable regulatory reporting obligations (including pursuant to Regulation SBSR), governing law, valuation, and dispute resolution.
    • Require that the security-based swap trading relationship documentation include credit support arrangements, which would be required to address certain margin-related matters identified in the proposed rule.
  • Proposed Rule 15Fi-5(b)(4) would require that the applicable policies and procedures provide that the relevant swap trading relationship documentation between certain specified types of financial counterparties 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 security-based swap at any time from execution to the termination, maturity, or expiration of such security-based swap.
    • Such valuation methodology would be for the purposes of complying with the margin requirements under Section 15F(e) of the Exchange Act (and applicable regulations), and the risk management requirements under Section 15F(j) of the Exchange Act (and applicable regulations).
    • The rule also specifies that an SBS Entity would not be required to disclose to the counterparty confidential, proprietary information about any model it may use to value a security-based swap.
  • Proposed Rules 15Fi-5(b)(5) and (6) would require that the policies and procedures governing the applicable trading relationship documentation require SBS Entities to disclose certain information to their counterparties regarding both their legal status and the status of the security-based swap.
  • Proposed Rule 15Fi-5(c) would require each SBS Entity to have an independent auditor conduct periodic audits sufficient to identify any material weakness in its documentation policies and procedures required by the rule.

Other Highlights

  • The release also requests comment on whether certain aspects of the proposed rules, if adopted, could provide the factual predicate for allowing an SDR to potentially satisfy its obligations under Section 13(n)(5)(B) of the Exchange Act and Rule 13n-4(b)(3) thereunder to verify the terms of each security-based swap with both counterparties.
  • The Commission also proposes to treat the proposed rules as entity-level requirements that apply to an SBS Entity’s entire security-based swap business without exception, including in connection with any security-based swap business it conducts with foreign counterparties.
  • Finally, the release contains proposed amendments to Rule 3a71-6 to address the potential availability of substituted compliance in connection with proposed Rules 15Fi-3 through 15Fi-5.

Next Steps

The Commission will seek public comment on the proposed rules and rule amendments for 60 days following publication in the Federal Register.

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