SEC finalizes step in Title VII regulatory framework

Key points

The SEC has adopted rule amendments and new rules under Title VII of the Dodd-Frank Act (Wall Street Transparency and Accountability), which established a new regulatory framework for the U.S. over-the-counter (OTC) derivatives markets. These final rules:

• Establish capital and margin requirements for nonbank security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs) for which there is not a prudential regulator (hereinafter, all SBSD and MSBSP references are to nonbank entities), including:
  • Broker-dealers registered as SBSDs (broker-dealer SBSDs)
  • Broker-dealers registered as major security-based swap participants (broker-dealer MSBSPs)
  • Nonbank SBSDs not registered as broker-dealers (stand-alone SBSDs)
  • Nonbank MSBSPs not registered as broker-dealers (stand-alone MSBSPS).
• Increase net capital requirements for broker-dealers authorized to use internal models to compute net capital (ANC broker-dealers)
• Establish segregation requirements for SBSDs and related notification requirements
• Amend existing cross-border rules to provide a mechanism for foreign nonbank SBSDs and MSBSPs to seek substituted compliance with respect to capital and margin requirements.

The SEC first proposed these rules in October 2012 and reopened the comment period in 2018. The final rules will become effective 60 days after publication in the Federal Register. Compliance is required 18 months after the later of i) the effective date of final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs (these rules have not yet been finalized), or ii) the effective date of the final rules addressing the cross-border application of certain security-based swap requirements.

Similarly, the final rules also set the Registration Compliance Date for SBSDs and MSBSPs as 18 months after the later of i) the effective date of final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs, or ii) the effective date of the final rules addressing the cross-border application of certain security-based swap requirements. (see page 298, final rule)

Capital

Capital requirements – SBSDs

SEC Rule 15c3-1 (as amended) and new Rule 18a-1 prescribe minimum net capital requirements for SBSDs that are the greater of a fixed dollar amount and an amount derived by applying a financial ratio. The SEC summarizes the minimum net capital requirements in the following table.

• Broker-dealer SBSDs will be subject to the requirements of the broker-dealer net capital rule, Rule 15c3-1.
• Stand-alone SBSDs (including firms also registered as OTC derivatives dealers) will be subject to the capital requirements in new Rule 18a-1, which is structured similarly to Rule 15c3-1.
• The “financial ratio requirement” is calculated as 2 percent of the firm’s exposures to its security-based swap customers (2 percent margin factor). The 2 percent multiplier may be increased by SEC order to as much as 4 percent after three years from the compliance date and 8 percent after five years. 
• “Tentative net capital” equals net capital before deducting standardized haircuts or market and credit risk charges. SBSDs that use models to compute net capital and ANC broker-dealers are subject to tentative net capital requirements.
• When computing net capital, SBSDs must:
  • Deduct most unsecured receivables
  • Deduct 100 percent of an unsecured receivable arising from electing not to collect variation margin from a counterparty to a non-cleared security-based swap or swap; alternatively, SBSDs authorized to use models and ANC broker-dealers will be permitted to deduct a credit risk charge, subject to a cap
  • Deduct 100 percent of the amount of calculated initial margin for a security-based swap or swap transaction if the firm elects not to collect initial margin pursuant to an exception in the margin rule; SBSDs authorized to use models will be permitted to deduct a credit risk charge
  • Apply standardized haircuts to proprietary position if not approved to use model-based haircuts. ANC broker-dealers and OTC derivatives dealers may use model-based haircuts.

Risk Management. SBSDs must also comply with Rule 15c3-4, which requires them to establish, document, and maintain a system of internal risk management controls to include market, credit, leverage, liquidity, legal, and operational risks.

Capital requirements – MSBSPs

SEC Rule 18a-2 prescribes capital requirements for stand-alone MSBSPs, and requires them to have, and maintain at all times, a positive tangible net worth (defined to mean net worth excluding goodwill and other intangible assets).

Risk Management. All MSBSPs must also comply with Rule 15c3-4 with respect to their security-based swap and swap activities.

Margin

Margin requirements – SBSDs

Calculation. SEC Rule 18a-3 prescribes margin requirements for nonbank SBSDs with respect to non-cleared security-based swaps. The Rule requires a SBSD to calculate with respect to each account of a counterparty as of the close of business each day: i) the amount of current exposure in the account (i.e., variation margin) and ii) the initial margin amount for the account. Variation margin is calculated by marking the position to market. Initial margin must be calculated by applying standardized haircuts in Rule 15c3-1 or 18a-1, as applicable.

• A SBSD may apply to the SEC for authorization to use a model (including an industry standard model) to calculate initial margin.
• Broker-dealer SBSDs must use the standardized haircuts to compute initial margin for non-cleared security-based swaps referencing equities securities and indexes even if approved to use a model.
• Stand-alone SBSDs may use a model to calculate initial margin for non-cleared equity security-based swaps provided the account of the counterparty does not hold equity security positions other than equity security-based swaps.

Collecting Collateral. Under SEC Rule 18a-3, nonbank SBSDs must collect collateral from a counterparty to cover variation and/or initial margin requirement as well as to deliver collateral to the counterparty to cover a variation requirement, as appropriate. SBSDs are not required to post initial margin to counterparties. Margin collateral must meet or exceed the margin requirement after applying the standardized haircuts and must meet certain conditions, including i) have a ready market, ii) be readily transferable, and iii) not consist of securities issued by the SBSD or the counterparty.

Exceptions. A nonbank SBSD need not collect variation or initial margin or deliver variation margin to certain counterparties under certain circumstances.  The SEC summarizes these exceptions in the following table.

Margin requirements – MSBSPs

SEC Rule 18a-3 prescribes margin requirements for MSBSPs with respect to non-cleared security-based swaps. It requires them to calculate variation margin for the account of each counterparty daily and to collect collateral from, or deliver collateral to, a counterparty to cover the variation margin requirement. Exceptions, as outlined in the Rule, apply to the collection of variation margin to certain counterparties (similar to those for SBSDs), though there is no exception to delivering variation margin to those same types of counterparties. No requirements to collect or deliver initial margin.

Segregation

Segregation requirements - SBSDs and broker dealers

Segregation requirements for broker-dealer SBSDs (other than firms registered as OTC derivatives dealers) and stand-alone broker-dealers are codified in SEC Rule 15c3-3. The segregation requirements for all other stand-alone SBSDs (including firms that have no other registration, are registered as OTC derivatives dealers, or are bank SBSDs) are codified in SEC Rule 18a-4. Further:

• The segregation rules require money, securities, and property of a security-based swap customer relating to cleared and non-cleared security-based swaps to be segregated but can be commingled with money, securities, or property of other customers (referred to as “omnibus segregation”).
• The omnibus segregation requirements are mandatory with respect to money, securities or other property relating to cleared security-based swaps held by a stand-alone broker dealer or SBSD. For non-cleared security swap transactions, the omnibus segregation requirements are an alternative to the statutory provisions and a counterparty may elect to have initial margin individually segregated or to waive segregation.
• An SBSD or stand-alone broker must maintain i) possession or control over excess securities collateral (securities and money market instruments that are not being used to meet variation margin requirements of the counterparty), and ii) a security-based swap customer reserve account to segregate cash and/or qualified securities in an amount equal to the net cash owed to security-based swap customers.

Exemptions. A stand-alone SBSD or a bank SBSD will be exempt from the requirements of Rule 18a-4 if the firm meets certain conditions, including that it i) does not clear security-based swap transactions for other persons, ii) provides notice to the counterparty regarding the right to segregate initial margin, iii) discloses in writing that any collateral received will not be subject to a segregation requirement, and iv) discloses how a claim for the collateral would be treated in bankruptcy or other formal liquidation proceeding.

Alternative Compliance

SEC Rule 18a-10 provides an alternative compliance mechanism for a stand-alone SBSD registered as a swap dealer and predominantly engaged in a swaps business. These firms may elect to comply with the capital, margin, and segregation requirements of the Commodity Exchange Act and the CFTC’s rules in lieu of SEC Rules 18a-1, 18a-3, and 18a-4. To qualify, the stand alone SBSD may not be registered as a broker-dealer or an OTC derivatives dealer and must meet certain conditions.

Cross-Border

Foreign SBSDs and MSBSPs have the potential to avail themselves of substituted compliance to satisfy the capital and margin requirements. Substituted compliance is not available for segregation requirements, though SEC Rule 18a-4 provides an exception for foreign stand alone or bank SBSDs or MSBSPs from the segregation requirements for certain transactions. There are no exceptions from the segregation requirements for cross-border transactions of a stand-alone broker-dealer or a broker-dealer SBSD or MSBSP.

KPMG perspective

The issuance of these rules brings the SBSDs one step closer to meeting the registration requirements required under the Dodd Frank Act. It establishes nonbank financial responsibility requirements for both stand-alone and broker-dealer SBSDs as well as non SBSD broker-dealers dealing in security-based swaps and swap transactions. The issuance of these rules will enable the CFTC to finalize their regulatory responsibility rules, as the CFTC rules cross reference certain SEC Capital Rules.

The finalization of the SBSD registration requirements and the CFTC financial responsibility rules address the significant issues that caused the financial crisis of 2007 - 2009. The capital markets are both stronger and more transparent today than pre-crisis.

We anticipate firms with multiple swap dealers and potential SBSDs will now determine the most beneficial capital structure for its entities. Once determined, firms will need to take the necessary steps to consolidate the entities, which will possibly require repapering of various customer agreements. 

Firms that wish to use models should take steps as soon as possible to start the approval process with the SEC so that once registration is required, their use of models will have been approved