Swap Dealers and Major Swap Participants Regulation

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FINAL RULES: Registration of Swap Dealers and Major Swap Participants Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants Duties for Swap Dealers and Major Swap Participants Conflicts of Interest for Swap Dealers, Major Swap Participants, Futures Commission Merchants, and Introducing Brokers Designation of Chief Compliance Officer and Preparation of Annual Compliance Report CFTC/SEC Joint Final Rule on Swap Entity Definitions

The CFTC has issued rule proposals under Dodd-Frank regarding swap dealers (SDs) and major swap participants (MSPs) at six different meetings in 2010 and 2011. The issues discussed were: duties; registration; conflicts of interest; required compliance policies; reporting and recordkeeping; further defining “swap dealer,” “major swap participant” and “eligible contract participant”; business conduct standards, confirmation; confirmation, reconciliation and compression; swap trading relationship documentation; orderly liquidation termination; and margin requirements for uncleared swaps.

In late 2011, the commission began issuing final rules pertaining to SD/MSPs. Topics for which a final rulemaking has been issued can be found in the alert box at the top of the page. Summaries and links can also be found below.

Descriptions of the open meetings and their corresponding proposals can be found below.

Contents 1 CFTC Open Meetings 2 SD-MSP Proposals from the November 10, 2010 CFTC Meeting 3 SD-MSP Proposals from the November 19, 2010 CFTC Meeting 4 SD-MSP Proposals from the December 1, 2010 CFTC Meeting 5 SD-MSP Proposal from the December 9, 2010 CFTC Meeting 6 SD-MSP Proposal from the December 16, 2010 CFTC Meeting 7 SD-MSP Proposal from the January 13, 2011 CFTC Meeting 8 SD-MSP Proposal from the January 20, 2011 CFTC Meeting 9 SD-MSP Proposal from the April 12, 2011 CFTC Meeting 10 SD-MSP Proposal from the April 27, 2011 CFTC Meeting 10.1 SEC Meetings 11 SD-MSP Proposal from the June 29, 2011 SEC Meeting 12 SD-MSP Proposal from the October 12, 2011 SEC Meeting 13 References

CFTC Open Meetings

SD-MSP Proposals from the November 10, 2010 CFTC Meeting

Duties for Swap Dealers and Major Swap Participants

The Duties proposal requires swap dealers and major swap participants to:

• Establish risk management programs that must take into account all relevant risks;
• Monitor trading through staff training, trade supervision, and establish early warning, testing, compliance, and annual audit systems;
• Establish business continuity and disaster recovery systems;
• Disclose information and make it available for inspection by the commission; and
• Adopt appropriate policies concerning anti-competitive trading or clearing practices.^[1]

Note: the SD/MSP Duties Final Rule approved at the CFTC Open Meeting, February 23, 2012

Registration of Swap Dealers and Major Swap Participants

The SD-MSP registration proposal would require:

• The establishment of a process for the registration of swap dealers and major swap participants;
• Swap dealers and major swap participants to become and remain members of a registered futures association;
• Subject affiliates of swap dealers and major swap participants to these requirements; and
• The prohibition of a swap dealer or major swap participant from association with a person who is subject to a statutory disqualification.^[2]

Note: the final rule on SD/MSP registration approved at the CFTC Open Meeting, January 11, 2012

Conflicts of Interest for Swap Dealers, Major Swap Participants, Futures Commission Merchants, and Introducing Brokers

The Conflicts of Interest proposal is intended to create partitions within such entities between individuals involved with research or analysis and those involved with trading and clearing activities, by:

• placing restrictions on non-research personnel influencing the content of research reports;
• prohibiting the supervision of research analysts by trading and clearing personnel;
• prohibiting from a research analyst's compensation his or her contribution to trading or clearing activities;
• prohibiting the exchange, or offer of exchange, of favorable research for business or compensation; and
• requiring full disclosure of potential conflicts of interest.^[3]

Note: the SD/MSP/FCM Conflicts of Interest Final Rule approved at the CFTC Open Meeting, February 23, 2012

Required Compliance Policies, Designation of Chief Compliance Officer

According to the proposal, each swap dealer, major swap participant, and futures commission merchant must appoint a "chief compliance officer" (CCO), who should have an "appropriate background," must register with the commission, and will be responsible for:

• establishment of compliance policies;
• resolution of conflicts of interest;
• ensuring compliance of the registrant with the compliance policies, rules, and regulations;
• identifying noncompliance issues; and
• establishment of procedures for the remediation of such noncompliance issues.
• preparation and submission of an annual report on compliance policies and their effectiveness.

The CCO shall report to the board of directors and senior officers of the entity.

Note: the Compliance Policies and CCO Duties Final Rule approved at the CFTC Open Meeting, February 23, 2012

SD-MSP Proposals from the November 19, 2010 CFTC Meeting

Protection of Collateral of Counterparties to Uncleared Swaps

Requirements of the rule:

• (SDs) and (MSPs) must notify their counterparties that such counterparties have "a right to require that any initial margin which they post to guarantee uncleared swaps be segregated at an independent custodian;"
• The custodian must be and "independent third party;"
• There must be in place a signed custody agreement;
• Such segregated funds may be invested according to existing CFTC rules governing futures customers; and
• Final rule will reflect new rules regarding, among other things, protection of funds before and after commodity broker bankruptcies.

SD-MSP Proposals from the December 1, 2010 CFTC Meeting

Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants

According to the proposal, swap dealers and major swap participants will be required to retain and submit:^[4]

• transaction and position information for all swap activities;
• recordkeeping rules such as basic business records, minutes from the entity's governing body, audit reports, financial records, and records of all data submitted to swap data repositories'
• daily trading execution records, including pre-and post-execution data, as well as any hedges or offsetting positions.

Note: the SD/MSP Reporting, Recordkeeping, and Daily Trading Records Requirements approved at the CFTC Open Meeting, February 23, 2012 Further Defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant”

The SEC and CFTC each approved proposals that would further define a series of terms related to the swaps market, including “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant.”^[5] For more information, see Swaps Definitions Regulation.

Note: the CFTC/SEC Joint Final Rule on Swap Entity Definitions approved at the CFTC Open Meeting, April 18, 2012, 2012

SD-MSP Proposal from the December 9, 2010 CFTC Meeting

Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties

According to the proposal, certain activities will be prohibited and certain duties will be imposed on SDs/MSPs in their dealings with counterparties. The general policies and procedures to ensure compliance and prevent evasion of the Act and proposed rules are:

• Diligent supervision;
• “Know your counterparty” and “true name and owner” of counterparty; and
• Record retention requirements.^[6]

Note: The CFTC Final Rule: Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties was approved at the CFTC Open Meeting, January 11, 2012

SD-MSP Proposal from the December 16, 2010 CFTC Meeting

Confirmation, Portfolio Reconciliation, and Portfolio Compression Requirements for Swap Dealers and Major Participants

According to the proposal, each swap dealer and major swap participant must:

• ensure that, prior to entering into a swap with a counterparty, the parties have agreed in writing to all terms governing their trading relationship;
• include in its swap trading relationship documentation written documentation in which the parties agree on the methods, procedures, rules, and inputs for determining the value of each swap at any time from execution to the termination, maturity, or expiration of the swap;
• create a record containing certain items of information whenever its submits a swap for clearing to a registered derivatives clearing organization (DCO); and
• perform an annual audit of the required swap trading relationship documentation to ensure compliance.^[7]

SD-MSP Proposal from the January 13, 2011 CFTC Meeting

Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants

According to the proposal, each swap dealer or major swap participant also would be required to include in its swap trading relationship documentation written documentation in which the parties agree on the methods, procedures, rules, and inputs for determining the value of each swap at any time from execution to the termination, maturity, or expiration of the swap. The regulations also would require swap dealers and major swap participants to notify the commission of swap valuation disputes that have not been resolved within set time periods.^[8]

SD-MSP Proposal from the January 20, 2011 CFTC Meeting

Orderly Liquidation Termination Provision in Swap Trading Relationship Documentation for Swap Dealers and Major Swap Participants

Summary of the proposal:

• Documentation must include language that both counterparties understand the orderly liquidation procedures,
• The FDIC is given one (1) business day in which to transfer positions to a qualified third party,
• The non-defaulting counterparty may not be allowed to liquidate the swap holding, as the FDIC will have until 5:00 pm on the one business day in which to seek a qualified third party to which the swap can be transferred.^[9]

SD-MSP Proposal from the April 12, 2011 CFTC Meeting

Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants

Under the CFTC Proposal, margin requirements will vary depending upon the counterparty of the SD/MSP:

• The rules would not impose margin requirements on commercial end users, defined under the proposed rules as non-financial entities.
• For trades between two SD/MSPs, each party must collect and pay initial and variation margin.
• For trades between a SD/MSP and a financial entity, the SD/MSP must collect, but not pay, margin.
• For trades with a non-financial entity ("commercial end-user"), no margin is required, but rather a counterparty credit agreement must be arranged and abided by.
• Calculation of margin would entail the use of a margin model from a derivatives clearing organization (DCO), prudential regulator, or other model approved by the commission.
• Margin must be posted in the form of an approved asset class, and would be required to be held at a third-party custodian.^[10]

SD-MSP Proposal from the April 27, 2011 CFTC Meeting

Parts 1, 23, and 140 Capital Requirements of Swap Dealers and Major Swap Participants

Under the CFTC Proposal:

SD/MSPs that are also FCMs must hold the greater of:

• $20 million;
• if the FCM is a retail foreign exchange dealer, the amount required by rules governing retail foreign exchange dealers;
• 8 percent of the risk margin required for customer and non-customer exchange-traded futures positions and over-the-counter (OTC) swap positions that are cleared by a clearing organization;
• the amount of adjusted net capital required by a registered futures association of which the FCM is a member; and
• for an FCM that also is registered as a securities broker or dealer, the amount of net capital required by SEC rules.

SD/MSPs not FCMs, but are nonbank subsidiaries of U.S. bank holding companies:

• the same rules that apply to the bank holding company, generally an 8 percent of total capital to risk-weighted assets ratio, of which:
  • half, or 4 percent, is in the form of Tier 1 capital, and
  • a minimum of $20 million of Tier 1 capital.

SD/MSPs that are neither FCMs nor subsidiaries of a bank holding company

• tangible net equity equal to $20 million, and
• additional amounts for market risk and over-the-counter derivatives credit risk.^[11]

SEC Meetings

SD-MSP Proposal from the June 29, 2011 SEC Meeting

Business Conduct Standards for Security-Based Swap Dealers and Major Security-Swap Participants

Under the SEC proposal, security-based swap dealers and major security-based swap participants would be required to:

• "verify whether a counterparty is an eligible contract participant and whether it is a special entity;
• disclose to the counterparty material information about the security-based swap, including material risks, characteristics, incentives and conflicts of interest;
• provide the counterparty with information concerning the daily mark of the security-based swap;
• provide the counterparty with information regarding the ability to require clearing of the security-based swap;
• communicate with counterparties in a fair and balanced manner based on principles of fair dealing and good faith;
• establish a supervisory and compliance infrastructure; and
• designate a chief compliance officer that is required to fulfill the described duties and provide an annual compliance report.

The proposed rules also would require security-based swap dealers to:

• determine that any recommendations they make regarding security-based swaps are suitable for their counterparties (this proposal is similar to the FINRA rule regarding suitability, including institutional suitability);
• establish, maintain and enforce policies and procedures reasonably designed to obtain and retain a record of the essential facts concerning each known counterparty that are necessary to conduct business with such counterparty; and
• comply with rules designed to prevent 'pay-to-play.'"^[12]

SD-MSP Proposal from the October 12, 2011 SEC Meeting

Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants

• Security-based swap dealers and major swap participants must electronically file Form SBSE to register with the SEC.
  
• Security-based swap entities that are already registered with the CFTC may file the shorter form, Form SBSE-BD, in order to register with the SEC.
  

"In addition, the proposed rule would require the security-based swap entities to:

• Promptly update their forms if the forms become inaccurate.
  
• Have a knowledgeable, senior officer provide a certification as to the firm’s financial, operational and compliance capabilities to the Commission within a specified timeframe.
  
• Obtain and retain certain information from each of its associated persons that are involved in effecting security-based swaps, and have its Chief Compliance Officer certify that no such associated person is 'statutorily disqualified.'
  

The proposed rule also would also require each security-based swap entity that resides outside the U.S. to:

• Identify a U.S. agent who can accept legal documents on behalf of the company.
  
• Certify and submit an opinion of counsel that the non-U.S. entity is able to provide the SEC with access to its books and records and submit to on-site inspections and examination by the SEC."
  

References

1. ↑ Open Meeting on Fourth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on March 7, 2011.
2. ↑ Open Meeting on Fourth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on March 7, 2011.
3. ↑ Open Meeting on Fourth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on March 7, 2011.
4. ↑ Open Meeting on Sixth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on February 16, 2011.
5. ↑ SEC Proposes Joint Rules with CFTC to Define Swap Related Terms. Securities and Exchange Commission. Retrieved on January 25, 2011.
6. ↑ Open Meeting on Seventh Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on March 21, 2011.
7. ↑ Open Meeting on Eighth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on March 21, 2011.
8. ↑ Open Meeting on Ninth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on March 21, 2011.
9. ↑ Open Meeting on Tenth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on March 21, 2011.
10. ↑ Open Meeting on Thirteenth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on April 15, 2011.
11. ↑ Open Meeting on Fourteenth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on July 13, 2011.
12. ↑ SEC Proposes Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants. SEC. Retrieved on June 29, 2011.