The Securities and Exchange Commission today proposed rules intended to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities, and national securities exchanges that post security-based swaps or make them available for trading.
Prior to passage of the Dodd-Frank Act, the over-the-counter derivatives market was largely unregulated. The new law fills a number of significant regulatory gaps and gives the SEC important new tools to better protect investors.
"The concern about conflicts of interest stems from the fact that the over-the-counter derivatives markets have a relatively high concentration of market activity through a limited number of dealers who earn significant revenues from their transactions," said SEC chairman Mary L. Schapiro. "By creating a structure that would promote more independent voices within clearing organizations and trading venues, this proposed rule is intended to make these entities less susceptible to promoting the interests of a few participants."
The SEC’s proposed rules — known as Proposed Regulation MC — require security-based swap clearing agencies, security-based SEFs and security-based swap exchanges to adopt ownership and voting limitations as well as certain governance requirements.
Public comments on the proposed rules should be received by the Commission no later than 30 days after they are published in the Federal Register.
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FACT SHEET
Overview
The Dodd-Frank Wall Street Reform and Consumer Protection Act authorizes the Commission to regulate security-based swaps and to take steps to encourage centralized clearing, fair competition and transparency in the trading of security-based swaps.
One particular section, Section 765, lays out requirements designed to mitigate conflicts of interests at clearing agencies that clear security-based swaps, at security-based swap execution facilities (SEFs) and at national securities exchanges that post or make available for trading security-based swaps. To accomplish this, the section provides that the Commission may adopt rules that include numerical limits on control of, or voting rights with respect to, such clearing agencies, execution facilities and exchanges.
Today, the Commission will consider a proposal, Proposed Regulation MC, which would impose such voting and ownership limitations and substantive governance standards on these entities.
Recently, the Commodity Futures Trading Commission proposed similar rules with respect to derivatives clearing organizations that clear swaps, and swap execution facilities and boards of trade designated as contract markets that post swaps or make swaps available for trading.
What Is a SEF?
The Dodd-Frank Act defines "security-based swap execution facility" ("security-based SEF") to mean "a trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility that (A) facilitates the execution of security-based swaps between persons; and (B) is not a national securities exchange."
What Are The Conflict of Interest Concerns?
The over-the-counter derivatives market has a relatively high concentration of market activity among a limited number of dealers that earn significant revenues from the currently opaque over-the-counter market. For example, five large commercial banks currently represent 97 percent of the total U.S. banking industry notional amounts of derivatives outstanding (Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2010). This concentrated market structure creates the potential for conflicts of interests if a similarly small number of firms are able to control the trading and clearing venues for the security-based swaps market.
Commission staff has identified three primary areas where it believes a conflict of interest could adversely affect the central clearing of security-based swaps.
First, participants could seek to limit access to the security-based swap clearing agency by other participants in order to maintain a competitive advantage.
Second, participants could seek to limit the scope of products eligible for clearing at the security-based swap clearing agency, particularly if there is an economic incentive to keep the product traded in the over-the-counter market.
Third, participants could seek to lower the risk management controls of a security-based swap clearing agency in order to reduce their collateral requirements.
With respect to security-based SEFs and security-based swap exchanges, SEC staff believes that participants or members of such trading venues may be motivated to restrict the scope of security-based swaps that are eligible for trading if there is a strong economic incentive to keep such swaps in the over-the-counter market.
Similarly, such participants or members may seek to restrict the number of direct participants in the trading venue in order to limit competition and increase their ability to maintain higher profit margins. Finally, security-based SEF and security-based swap exchange participants or members may have an incentive to promote their commercial interests over the regulatory oversight responsibilities of the facilities or exchanges.
What Is Required Under The Proposal?
The proposed rules, known as Proposed Regulation MC, require security-based swap clearing agencies, security-based SEFs and security-based swap exchanges to adopt ownership and voting limitations as well as certain governance requirements.
Key elements of the proposal include requiring, with respect to security-based swap clearing agencies, one of the following two alternatives:
Alternative 1
Restrict an individual clearing agency participant from beneficially owning or voting more than 20 percent of any voting interest in the security-based swap clearing agency.
Restrict clearing agency participants from beneficially owning or voting more than 40 percent of any voting interest in the security-based swap clearing agency in the aggregate with any other clearing agency participants.
The board of directors and any committee that has authority to act on behalf of the board be composed of 35 percent of independent directors.
The nominating committee be composed of a majority of independent directors.
Alternative 2
Restrict an individual clearing agency participant from beneficially owning or voting more than 5 percent of any voting interest in the security-based swap clearing agency.
The board of directors and any committee that has authority to act on behalf of the board be composed of a majority of independent directors.
The nominating committee be composed solely of independent directors.
Other key elements of the proposal:
Security-based SEFs and security-based swap exchanges restrict participants or members, as applicable, from owning or holding more than 20 percent of any voting interest of such entity.
The board of directors of a security-based SEF or security-based swap exchange, any executive committee of the board of a security-based SEF or security-based swap exchange, and any board committee exercising powers of the board of a security-based SEF or security-based swap exchange be composed of a majority of independent directors.
The nominating committee of a security-based SEF or security-based swap exchange consists solely of independent directors.
The board of directors of a security-based SEF or security-based swap exchange establish a regulatory oversight committee consisting solely of independent directors to oversee the security-based SEF’s or security-based swap exchange’s regulatory program, and any recommendation of a regulatory oversight committee that is not adopted by the board of a security-based SEF or security-based swaps exchange be reported promptly to the Commission.
The disciplinary panels of a security-based swap clearing agency, security-based SEF or security-based swap exchange be compositionally balanced and include one person who would qualify as an independent director.
What’s Next?
The proposal seeks public comment and data on a broad range of issues relating to the proposed rules, including the conflicts of interest identified and the costs and benefits associated with the proposal. After careful review of comments, the Commission will consider whether to adopt the proposed rules or to modify them.
