Security-based swap execution facility registration? The SEC has rules

Adoption of framework designed to increase transparency and integrity, says regulator.

On Thursday, the SEC adopted final rules to create a framework for the registration of security-based swap execution facilities (SBSEFs).

The adoption, the SEC said, was designed to increase the transparency and integrity of the security-based swap market, plus acknowledge the fact that the 2008 financial crisis and breakdowns in the US mortgage markets featured credit default swaps at the center of those events.

New Regulation SE creates a regime for the registration and oversight of SBSEFs and was required under Title VII of the Dodd-Frank Act relating to the over-the-counter derivatives market. The new rules address the Exchange Act’s trade execution requirement for security-based swaps and the cross-border application of that requirement. They also add a requirement to mitigate conflicts of interest at SBSEFs and national securities exchanges that trade security-based swaps. And they promote consistency between Regulation SE and existing rules under the Exchange Act, the SEC said.

Components of Reg SE

The components of Regulation SE are directives and frameworks that:

  • establish a process for SBSEF registration;
  • create procedures for rule and product filings by SBSEFs;
  • offer permissible execution methods for SBS that are subject to the SEA’s trade execution requirement;
  • set out a procedure for SBSEFs to make an SBS available to trade and establish certain exemptions from the trade execution requirement;
  • implement the 14 core principles for SBSEFs, such as trade monitoring; recordkeeping; designation of a chief compliance officer and establishment of reporting obligations for that CCO; and conflict of interest requirements;
  • address cross-border matters; and
  • impose requirements addressing conflicts of interest involving SBSEFs and SBS exchanges.

SEC oversight of swaps

Security-based swaps overseen by the SEC still are quite significant, with a notional value of approximately $8.5 trillion.

SEC Chair Gary Gensler observes in a statement he issued on Regulation SE yesterday that his agency heard from many market participants suggesting that it look to the Commodity Futures Trading Commission (CFTC’s) rules as a rulemaking template.

“I believe aligning the SEC’s regime closely with the CFTC’s garners many of the same benefits – bringing together buyers and sellers with transparent, pre-trade pricing. That lowers risk in the marketplace and protects investors,” Gensler said.

“Based upon the current market for security-based swaps, we expect that the entities that will register as SBSEFs also are registered as SEFs with the CFTC. Further, many participants in the security-based swap market also participate in the swaps markets that the CFTC oversees. Thus, by aligning our security-based SEFs rules with the CFTC’s rules for other SEFs, this adoption facilitates efficiencies for and minimizes the new burdens on market participants through a framework with which they already comply.”

The rules were first proposed in April of last year, and the public comments the SEC received caused the agency to eliminate a size-based exception for block trades from the final rule, Gensler said, pushing off to a later date any appropriate block-size threshold considerations.

The effective date for the final rule is 60 days after publication in the Federal Register.

Designation of Chief Compliance Officer

One of Regulation SE’s core principles requires each registered SBSEF to designate a chief compliance officer and requires the CCO to review the SBSEF’s compliance with the core principles, resolve conflicts of interest, be responsible for establishing and administering policies and procedures required under the principles, establish procedures for the remediation of noncompliance, prepare and sign an annual report that describes the SBSEF’s compliance, certify that the report is accurate and complete, and submit the report to the SEC.

(This CCO-focused core principle is substantively identical to the CFTC’s one in the swaps arena.)

The final rule contains an interesting reference from a commenter who addressed the CCO role specifically. The commenter felt strongly that the CCO should have a single compliance role and no other competing role or responsibility that could create conflicts of interest or threaten its independence. Therefore, the commenter suggests that the rules restrict the CCO position from being held by an attorney who represents the SBSEF or its board of directors, such as an in-house or general counsel.

The commenter also stated that the remuneration of the CCO must be specifically designed in such a way that avoids potential conflicts of interest with its compliance role, and have a direct reporting line to the independent directors, reporting to the audit committee at least yearly, with the independent directors only being allowed to designate or remove the CCO.

“I believe aligning the SEC’s regime closely with the CFTC’s garners many of the same benefits – bringing together buyers and sellers with transparent, pre-trade pricing. That lowers risk in the marketplace and protects investors.”

Gary Gensler, Chair, SEC

The SEC rule drafters responded to the commenter’s suggestions by noting that key provisions of the rule would sufficiently protect the independence and authority of an SBSEF’s CCO in performing the required functions, since (among other things) it requires that the position of CCO carry with it sufficient authority and resources to fulfill the position’s duties, and says that the CCO shall have supervisory authority over all staff acting at the CCO’s direction. The SBSEF remains responsible for establishing and administering required policies and procedures, the SEC says.

As far as the comment about dual-hatted CCOs goes, the SEC said there are strong economic incentives for a dually registered entity to appoint the same individual to serve as the CCO for both the swap and security-based swap businesses; so, any added requirements imposed by the SEC could increase costs for those businesses while generating marginal benefits.